Gov Sovereigns/Treasurys

Our analysis is often focused on China, commodities prices and Asia's business cycle. The key points of these discussions are applicable to the majority of EM countries and their financial markets. Yet, there are some countries that are not exposed to China, commodities or global trade. India and Turkey are two prominent examples from the EM space that fall into this category. This week we re-visit our analysis on these economies and their financial markets. Feature India: Inflation Holds The Key Indian government bonds sold off sharply over the past eight months, with the yield gap widening significantly relative to EM local currency bonds (Chart I-1, top panel). During this time, the country's stock market has been underperforming the EM benchmark notably (Chart I-1, bottom panel). Rising Indian inflation was a main culprit behind the selloff. However, the most recent print for headline CPI was down (Chart I-2). Diminished inflation worries have recently led to a modest drop in bond yields. Chart I-1India Relative To EM: Bonds And Stocks India Relative To EM: Bonds And Stocks India Relative To EM: Bonds And Stocks Chart I-2Indian Inflation Has Accelerated Indian Inflation Has Accelerated Indian Inflation Has Accelerated The key question for investors is if inflation will rise or stay tame. This, by extension, will determine whether Indian stocks will outperform their EM counterparts. Risks: Inflation, Fiscal Balance And Bond Yields Odds point to upside inflation surprises ahead, and a potential rise in bond yields: The supply side of the economy has been stagnant. Chart I-3 illustrates that Indian consumption has been outpacing investments since 2012, creating a significant accumulated gap. Capex is now picking up (Chart I-4, top panel) but the fact that past investment was low means that the output gap could become positive sooner than later. Chart I-3Consumption Is Outpacing Investments Consumption Is Outpacing Investments Consumption Is Outpacing Investments Chart I-4Timid Pick Up In Capex Insufficient Pickup In India's Supply Side Insufficient Pickup In India's Supply Side Crucially, in order for the capex rebound to be robust and sufficient to expand the economy's productive capacity, Indian commercial banks need to finance corporate investments aggressively. The bottom panel of Chart I-4 shows that this is not yet the case. On the fiscal front, the Indian central government released a mildly expansionary 2018-2019 budget, and is pushing for fiscal consolidation beyond 2019. Importantly, this was the last budget announcement of the ruling National Democratic Alliance (NDA) coalition before the 2019 general elections. It therefore entails a 10% increase in government expenditures. Growing government expenditures are often inflationary in India; hence a 10% rise in government spending could boost inflation modestly (Chart I-5). Additionally, there are also non-trivial risks that the Bharatiya Janata Party (BJP) government might end up spending beyond the official budget announcement in order to appease voters in the run-up to the 2019 general elections. The risks of overspending extend to state governments as well. The latter plan to raise their employees' housing rental allowances (HRA). Depending on the magnitude and timing of these increases, inflation could accelerate significantly and have spillover effects. Turning to bond yields, excess demand for credit by borrowers against a restricted supply of financing by banks is also creating a ripe environment for higher bond yields: The combined Indian central and state fiscal deficit is very wide, signaling strong demand for credit by the government (Chart I-6, top panel). Yet broad money creation by banks has generally been weak (Chart I-6, bottom panel). Chart I-5Indian Government ##br##Expenditure Is Inflationary Indian Government Expenditure Is Inflationary Indian Government Expenditure Is Inflationary Chart I-6Large General Fiscal Deficit ##br##Amid Slow Money Creation Large General Fiscal Deficit Amid Slow Money Creation Large General Fiscal Deficit Amid Slow Money Creation Chart I-7 illustrates that the combined central and state government fiscal deficit plus the annual change in the total broad stock of money is negative. This signals that new money creation might be insufficient. Commercial banks' holdings of government bonds is also falling (Chart I-8, top panel). Indian banks are at the margin beginning to turn their focus to private sector lending (Chart I-8, bottom panel). Chart I-7Insufficient New Funding ##br##For The Economy India: Insufficient Funding For The Economy India: Insufficient Funding For The Economy Chart I-8Indian Commercial Banks Are Shifting ##br##Focus To The Private Sector Indian Commercial Banks Are Shifting Focus To The Private Sector Indian Commercial Banks Are Shifting Focus To The Private Sector This is expected as commercial banks' holdings of government bonds have reached 29% of total deposits, which is significantly above the minimum required Statutory Liquidity Ratio (SLR) of 19.5%. Given the ongoing improvement in private sector growth and hence demand for credit, Indian banks are now more inclined to augment their loan portfolios. Non-bank financial corporations such as insurance companies could offset banks' lower demand for government securities, but the former are not as large players as banks to make a meaningful impact. They own only 24% of government bonds compared to the banks' 42% ownership. Mutual funds and other non-bank finance corporations' ownership of government bonds is even smaller than that of insurance companies. Chart I-9India's Cyclical Profile India's Cyclical Profile India's Cyclical Profile Bottom Line: Upside risks to government spending, the budget balance and inflation will likely keep upward pressure on domestic bond yields. That amid high equity valuations might lead to lower share prices in absolute terms. India Can Still Outperform The EM Benchmark While Indian government bonds could sell off and stocks could fall in absolute terms, India is in a better position relative to its EM counterparts. Our view remains that we will see a material slowdown in Chinese growth this year - which is negative for commodities prices and EM economies. This scenario will be beneficial for India at the margin relative to other EM bourses. Importantly, Indian economic activity is gaining upward momentum: Overall loan growth has picked up meaningfully, and consumer loan growth in particular is accelerating at a double-digit pace (Chart I-9, top panel). Motorcycle sales have resumed their upward trend (Chart I-9, panel 2). Commercial vehicle sales are now accelerating robustly (Chart I-9, panel 2) and manufacturing production has picked up noticeably (Chart I-9, panel 3). Bottom Line: We recommend investors keep an overweight position in Indian equities versus the EM benchmark. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Turkish Markets Are In Freefall The lira has been in freefall and local bond yields have spiked (Chart II-1) following the Turkish government's announcement that it wants to stimulate growth even further by implementing a new investment incentive package worth $34 billion, or 5% of GDP. Our view is that the recent lira depreciation as well as the selloff in stocks and bonds have further room to go. Stay short/underweight Turkish risk assets. The Turkish economy is clearly overheating and inflation has broken out into double digit territory (Chart II-2). This comes as no surprise, given high and accelerating wage growth together with stagnant productivity gains (Chart II-3, top panel). Unit labor costs are surging in both manufacturing and services sectors (Chart II-3, bottom panel). Demand is booming, as such firms will likely succeed in hiking selling prices further, reinforcing the wage-inflation spiral. Chart II-1Turkey: Currency Is Falling And ##br##Bond Yields Are Rising Turkey: Currency Is Falling And Bond Yields Are Rising Turkey: Currency Is Falling And Bond Yields Are Rising Chart II-2Turkey: Genuine Inflation Breakout Turkey: Genuine Inflation Breakout Turkey: Genuine Inflation Breakout Chart II-3Turkey: Wage Growth Is Too High Turkey: Wage Growth Is Too High Turkey: Wage Growth Is Too High Most alarmingly, Turkish policymakers are doing the opposite of what is currently needed - instead of tightening, they have been easing policy: On the fiscal side, government expenditures excluding interest payments have accelerated significantly (Chart II-4). On the monetary policy side, Turkey's banking system has been relying on enormous amounts of liquidity provisions by the central bank (Chart II-5, top panel) to sustain its ongoing credit boom and hence economic growth. Chart II-4Turkey: Fiscal Policy Is Easing Turkey: Fiscal Policy Is Easing Turkey: Fiscal Policy Is Easing Chart II-5Turkey: Monetary Policy Is Too Accommodative Turkey: Monetary Policy Is Too Accommodative Turkey: Monetary Policy Is Too Accommodative On the whole, the central bank's net liquidity injections into the banking system continue to increase rapidly. The nature of the central bank's reserves provisions to commercial banks has shifted away from open market operations and more towards direct lending to banks (Chart II-5, bottom panel). Yet, the essence remains the same: to provide liquidity to banks so that the latter can continue expanding their balance sheets. Adding all the liquidity facilities - the intraday, overnight and late window facilities - the Central Bank of Turkey's (CBT) outstanding funding to banks is TRY 90 billion, or 3% of GDP, abnormally elevated on a historical basis. All this entails that monetary policy is too loose. Consistently, even though local currency bank loan growth has moderated, it still stands at 18% (Chart II-6). With the newly announced government stimulus plan, bank loan growth will likely accelerate from an already high level. As debt levels rise, so are debt servicing costs (Chart II-7). Notably, debt (both domestic/local currency and external debt) servicing costs will continue to escalate as the currency plunges. The reason is that Turkish private sector external debt stands at 40% of GDP, with 13% of GDP being short-term, the highest among EM countries. Currency depreciation will make external debt more expensive to service. Chart II-6Turkey: Rampant Credit Growth Turkey: Rampant Credit Growth... Turkey: Rampant Credit Growth... Chart II-7Higher Debt Servicing Costs ...Means Higher Debt Servicing Costs ...Means Higher Debt Servicing Costs Lastly, the Turkish authorities are expanding the Credit Guarantee Fund, what we would call the "free money" program. The aim of this fund is to incentivize banks to lend more, making the government essentially assume credit risk on loans extended to small and medium enterprises. Under this scheme, the government is effectively giving a green light to flood the economy with more money/credit. This will only heighten inflationary pressures and lead to much more currency devaluation. So far, the scheme has been responsible for the creation of TRY 250 billion, or 8% of GDP worth of new credit. The new tranche of this program announced in January of this year entails another TRY 55 billion. While smaller than the previous tranche, it is still significant at 1.8% of GDP. Fiscal and monetary policies are overly simulative and the country's twin deficits - both fiscal and current account - are widening (Chart II-8). The current account deficit now exceeds 6% of GDP. With foreign holdings of equities and government bonds already at historic highs (Chart II-9), it is questionable whether Turkey has the capacity to attract more capital inflows to finance a widening current account deficit on a sustainable basis. Chart II-8Turkey: Large Twin Deficits Turkey: Large Twin Deficits Turkey: Large Twin Deficits Chart II-9Turkey: Foreign Holdings Of ##br##Stocks And Bonds Are Large Turkey: Foreign Holdings Of Stocks And Bonds Are Large Turkey: Foreign Holdings Of Stocks And Bonds Are Large Remarkably, despite extremely strong exports due to robust growth in the euro area, the current account deficit in Turkey has been unable to narrow at all. This confirms the excessive domestic demand boom. Chart II-10The Turkish Lira Is Not Cheap The Turkish Lira Is Not Cheap The Turkish Lira Is Not Cheap Even after undergoing large nominal depreciation, Chart II-10 demonstrates that the Turkish lira is still not cheap, according to unit labor cost-based real effective exchange rate, which in our opinion is the best valuation measure for currencies. With wage and general inflation in the double digits and escalating, it will take much more nominal deprecation for the lira to become cheap. At this point, the Turkish authorities are clearly over-stimulating growth while disregarding inflation. The current policy stance will all but ensure that the lira depreciates much further. Excessive money creation is extremely bearish for the local currency. To put the amount of outstanding money into perspective and gauge exchange rate risk, one can compute the ratio of foreign exchange reserves to broad money (local currency money supply). Chart II-11 illustrates that the current net level of foreign exchange reserves (excluding banks' foreign currency deposits at the central bank) including gold currently stands at US$30 billion, which is equivalent to a mere 11% of broad local currency money M3. The ratio for other EM countries is considerably higher (Chart II-12). Chart II-11Turkey: Central Bank FX ##br##Reserves Level Is Inadequate Turkey: Central Bank FX Reserves Level Is Inadequate Turkey: Central Bank FX Reserves Level Is Inadequate Chart II-12Foreign Exchange Reserves Adequacy In EM Country Perspectives: India And Turkey Country Perspectives: India And Turkey Given the inflationary backdrop and the risk of further currency depreciation, interest rates will have to rise. With time this will inevitably trigger another upward non-performing loan (NPL) cycle. Banks are very under-provisioned for non-performing loans (NPLs). Even worse, banks have been reducing the ratio of NPL provisions to total loans in order to book strong profits. NPLs and NPL provisions are set to rise substantially, and banks' equity will be considerably eroded as a result. Lastly, as Chart II-13 demonstrates, rising interest rates are bearish for bank share prices. Investment Implications The government is doubling down on pro-growth policies and is disregarding inflation. Hence, inflation will spiral out of control and the central bank will fall even more behind the curve. This is extremely bearish for the lira. We are reiterating our short position on the lira. We remain short the lira versus the U.S. dollar, but the lira will likely also continue to plummet versus the euro as well. As such, we are also reiterating our underweight/short stance on Turkish stocks in general, and banks in particular (Chart II-14). Chart II-13Turkey: Higher Interest Rates ##br##Will Hurt Bank Stocks Turkey: Higher Interest Rates Will Hurt Bank Stocks Turkey: Higher Interest Rates Will Hurt Bank Stocks Chart II-14Stay Short/Underweight Turkish Stocks Stay Short/Underweight Turkish Stocks Stay Short/Underweight Turkish Stocks A weaker lira will undermine returns for foreign investors on Turkish domestic bonds and assures widening sovereign and corporate credit spreads. Dedicated EM fixed income and credit portfolios should continue to underweight Turkey within their respective EM universes. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights U.S. Treasury Curve: The U.S. Treasury curve has flattened to new cyclical lows as the market has moved to fully price in the Fed's interest rate forecasts. Inflation expectations must rise further for those forecasts to be fully realized, however. Expect renewed U.S. curve steepening through higher inflation expectations and longer-term Treasury yields in the next 3-6 months. UST-Bund Spread Update: Stay in our recommended 10yr UST-Bund spread widening trade. as Treasury yield increases will not be matched in Bunds given slowing euro area economic momentum and a more balanced tone from the ECB. Global IG Corporate Sector Allocation: Our investment grade (IG) sector allocations, taken from our relative value models, have added positive performance since our last update in August. Feature The unpredictable, and at times unruly, behavior of financial markets over the first few months of 2018 has been exhausting for investors. A calm January was followed by the early February volatility spike and, more recently, huge intraday swings based on the ebb and flow of news on U.S. trade and foreign policy. Yet when looking at the year-to-date returns for various asset classes, the numbers do not seem unusually alarming given the amount of surrounding noise. Chart of the WeekA Long Road Back From The VIX Spike A Long Road Back From The VIX Spike A Long Road Back From The VIX Spike The S&P 500 index is only down -0.7%, while both equities in both the euro area and emerging markets (EM) equities are up +1.8% and +1.1%, respectively (using MSCI data in U.S. dollar terms). Credit markets are also delivering rather boring performance so far in 2018, from U.S. high-yield (+1.2% excess return over government debt) to euro area investment grade and EM hard currency corporates (both with an -0.1% excess return in U.S. dollar terms). Admittedly, these numbers look far less flattering considering the robust rally in risk assets in January. Yet the year-to-date returns simply do not line up with our impression of how investors' feel about how this year has gone so far. The perception is much gloomier than the actual outcome. Right now, markets are looking for guidance and direction and finding little of both. A big problem is that global bond yields, most notably in the U.S., have not fallen much from the highs for the year - even with global growth clearly losing some steam in the first quarter of 2018. The reason? Global inflation is in a mild cyclical upswing, a product of persistently tight labor markets and rising oil prices (Chart of the Week). The "leadership" in government bond markets has shifted away from accelerating global growth and an upward repricing of future central bank tightening, to rising inflation and unchanged monetary policy expectations. The notion of central bankers not being friendly to the markets remains our key theme for this year. We continue to expect that policymakers will not respond to the latest softer patch of economic data and will focus more on the reacceleration of inflation. This is especially true with risk assets stabilizing and volatility measures like the U.S. VIX index continuing to drift lower and, more importantly, the "volatility of volatility" (as measured by the VVIX index) now back to the levels that prevailed before the early February volatility spike (bottom panel). Although as BCA's strategists discussed at our View Meeting yesterday, volatility can quickly return with a vengeance given softer global growth momentum, and with the geopolitical calendar heating up next month (the U.S. government must make its final decision on the China trade tariffs and investment restrictions).1 This led the group to downgrade our recommended global equity exposure and upgrade our global bond exposure on a tactical (0-3 months) basis, although our more medium-term cyclical allocations (6-12 months) were unchanged (overweight stocks versus bonds). From the point of view of global bond markets, we may now be in period of mild "stagflation" with softening growth and rising inflation. We remain of the view that the former is temporary and the latter is not. This backdrop will keep global bond yields under upward pressure for at least the next few months, with better expected performance of corporate debt over governments - albeit with the potential for higher volatility given more elevated geopolitical risks. What Next For The U.S. Treasury Curve? The Treasury curve flattened to a new cyclical low last week, with the spread between 2-year and 10-year bonds now sitting at 45bps. On the surface, this flattening seems consistent with a Fed that is maintaining a "cautiously hawkish" message and that its rate hike plans for 2018 are unchanged despite more volatile financial markets. Chart 2This UST Curve Flattening Is Different This UST Curve Flattening Is Different This UST Curve Flattening Is Different What makes this current episode different from other bouts of Treasury curve flattening over the past five years, however, is the starting point for the absolute of bond yields. According to our two-factor valuation model for the 10-year Treasury yield, yields are now just a touch above fair value, which is currently 2.78%. That yield valuation was at least +25bps before the previous flattening episodes between 2014 and 2017 (Chart 2). That distinction is critical in differentiating a bull flattener from a bear flattener. Simply put, longer-dated Treasuries are not yet cheap enough to suggest that investors should extend duration risk to benefit from any additional curve flattening from here. In fact, we see a greater risk that Treasury curve re-steepens a bit from here, as there is more room for longer-term inflation expectations to move higher than there is for the front-end of the curve to reprice an even more hawkish Fed. The recent softening of cyclical global economic data has been occurring while realized inflation rates have been slowly rising from depressed levels (Chart 3). Yet in the U.S., the slowing of growth seen in the first quarter of the year remains very modest compared to that seen in Europe or Japan, while core inflation rates (for both the CPI index and the PCE deflator) have accelerated back to 2%. The Atlanta Fed's GDPNow forecasting model is calling for Q1/2018 growth of 1.9%, while the New York Fed's Nowcast model is predicting Q1 growth of 2.8%. While both forecasts are a deceleration from the 3% rates seen in the previous three quarters in 2017, neither is below U.S. potential GDP growth, which the U.S. Congressional Budget Office now estimates to be 1.9%. Even in China, where the economy had been slowing as policymakers have aimed to tighten monetary policy and slow credit growth, cyclical indicators such as the Li Keqiang index (the preferred indicator of our China strategists) have shown a bit of a rebound of late. Right now, underlying U.S. growth and inflation momentum are still pointing towards the Fed delivering on its current projection of an additional 50bps of rate hikes in 2018, taking the funds rate to 2.25%, with even a chance of an additional hike if inflation continues to accelerate. This is essentially fully priced with a 2-year Treasury yield just under 2.4%, however, and the real funds rate is now at neutral according to measures like the Fed's r-star. Therefore, additional flattening pressures from the front end of the curve are unlikely unless the Fed is willing to signal a faster pace of rate hikes than currently laid out in its economic projections (the "dots"). At the same time, the 10-year TIPS inflation breakeven remains 25-35bps below the 2.4-2.5% range that would be consistent with the market expecting U.S. inflation to sustainably return to the Fed's 2% inflation target on the headline PCE deflator. Hence, a steeper Treasury curve is far more likely than a flatter Treasury curve from current levels. Where could this view go wrong? Perhaps the Trump administration's trade skirmishes with China could broaden into a full-on trade war that could cause deeper damage to U.S. equities, dampen growth expectations and drive longer-term yields lower. Coming at a time when there is a significant short position in the U.S. Treasury market, this could look similar to the prolonged bull-flattening seen in 2015-16. During that episode, duration exposure flipped from a big net short to very net long according to measures like the J.P. Morgan Duration Survey (Chart 4, top panel), while the market priced out all expected Fed rate hikes (2nd panel). However, that also occurred alongside a 50bp decline in inflation expectations (3rd panel) and a big deceleration of U.S. growth (bottom panel), both related to a weakening global economy and collapsing oil prices. It is uncertain if the current U.S.-China trade skirmish would have an equivalent impact on both the U.S. economy and the Treasury curve, especially given a starting point of stronger global growth a far more positive demand/supply balance in world oil markets. Chart 3A Whiff Of Stagflation? A Whiff Of Stagflation? A Whiff Of Stagflation? Chart 42018 Is Not 2015/16 2018 Is Not 2015/16 2018 Is Not 2015/16 In sum, we are sticking to our view that the Treasury curve is more likely to bear-steepen through higher longer-term yields than flatten bearishly through more discounted Fed hikes or flatten bullishly through much weaker growth and inflation. We continue to recommend a below-benchmark duration stance in the U.S., within an underweight allocation in a currency-hedged global government bond portfolio. We are also are sticking with our tactical trade of staying short the 10-year U.S. Treasury versus the 10-year German Bund, even with the spread now looking a bit too wide on our fundamentals-based valuation model (Chart 5). The unrelenting string of disappointing economic data in the euro area has already resulted in a far more cautious tone from European Central Bank (ECB) officials regarding the potential for quick rate hikes after the expected end of the asset purchase program at the end of this year. The gap between the U.S. and euro area data surprise indices has proven to be a good directional indicator for the Treasury-Bund spread (Chart 6, bottom panel). Given our views on the potential for renewed bear-steepening in the Treasury curve, which is unlikely to be matched in the German curve in the next 3-6 months, we see no reason to take profits yet on our spread trade. Chart 5UST-Bund Spread Now A Bit Too Wide... UST-Bund Spread Now A Bit Too Wide... UST-Bund Spread Now A Bit Too Wide... Chart 6...But Too Soon For Spread Tightening ...But Too Soon For Spread Tightening ...But Too Soon For Spread Tightening Bottom Line: The U.S. Treasury curve has flattened to new cyclical lows as the market has moved to fully price in the Fed's interest rate forecasts. Inflation expectations must rise further for those forecasts to be fully realized, however. Expect renewed U.S. curve steepening through higher inflation and longer-term Treasury yields in the next 3-6 months. Stay in our recommended 10-year Treasury-Bund spread widening trade, as Treasury yield increases will not be matched in Bunds given slowing euro area economic momentum and a more balanced tone from the ECB. A Brief (And Belated) Performance Update For Our Corporate Bond Sector Allocations It has been some time (August 2017) since we last published a performance update for our investment grade (IG) corporate sector allocations for the U.S., euro area and U.K. As a reminder, those allocations come from our relative value model, which is designed to measure the valuation of each individual sector compared to the overall Barclays Bloomberg corporate bond index for each region. The methodology takes each sector's individual option-adjusted spread (OAS) and regresses it in a panel regression with all the other sectors in each region, as a function of the sector's duration, convexity (duration squared) and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and the fair value OAS is our valuation metric from the model for each region. The latest output from the models can be found in the tables and charts in the Appendix starting on Page 14. We also show the duration-times-spread (DTS) for each sector in those tables, using that as our primary way to measure the volatility of each sector. The scatterplot charts in the Appendix show the tradeoff between the valuation residual from our model and each sector's DTS. Chart 7Performance Of Our IG Sector Allocations Stagflation-ish Stagflation-ish We then apply individual sector weights based on the model output and our desired level of overall spread risk that we wish to take in our recommended credit portfolio. At our last update in August 2017, we made a decision to keep the overall (weighted) DTS of our sector tilts roughly equal to the overall IG corporate DTS for each region. With credit spreads looking tight at the time, credit spread curves flat relative to history, and with the Fed in the midst of a tightening cycle, we did not see a case for taking aggressive spread risk (i.e. having a high aggregate DTS) in the portfolio. The performance of our latest sector recommendations since our last update in August 2017, and in the first quarter of 2018, are shown in Chart 7. We show both the total return and excess return of each sector versus duration-matched government bonds. Since that last review, our U.K. sector allocations have performed the best, delivering an additional 12bps of total return and 10bps of excess return versus the U.K. IG corporate index. Our euro area corporate allocations have added 2bps of total return and 3bps of excess return, while our U.S. allocations have modestly underperformed both on total return (-1bp) and excess return. We also show the performance numbers for just the first quarter of 2018 in Chart 7, and we will present the return numbers on this quarterly basis in the future as part of our regular model bond portfolio performance reviews. The sector allocations offered a modest underperformance in Q1 2018, with -5bps of total return and -8bps of excess return coming mostly from euro area and U.K. allocations. The U.S. allocations actually outperformed by +3bps on a total return basis in Q1. The return numbers for our U.S. sector allocations can be found in Table 1. Since our last update in August, the best performing sectors (in excess return terms) for our U.S. portfolio allocation were the overweights to all Energy sub-sectors (+35bps combined), Cable & Satellite (+4bps) and Banks (+4bps). Of those names, only the Independent Energy sub-sector delivered a positive excess return (+3bps) in Q1 2018. Table 1U.S. Investment Grade Performance Stagflation-ish Stagflation-ish The return numbers for our euro area sector allocations can be found in Table 2. Since our last update in August, the best performing sectors (in excess return terms) for our euro area portfolio allocation were the overweights to Financials (+35bps, coming mainly from Banks, Senior Debt and Insurance) and Integrated Energy (+13bps). Those overweights also delivered small positive excess returns (+3bps and +1bps, respectively) in Q1 2018. The return numbers for our U.K. sector allocations can be found in Table 3. Since our last update, the best performing sector (in excess return terms) was the overweight to Financials (+6bps, coming mostly from Banks). Looking ahead, credit spread curves remain very flat by historical standards (Chart 8), which suggests there is not enough spread compensation for extending credit risk to lower quality tiers. Thus, we are sticking with keeping our target DTS for our combined sector allocations equal to that of the overall IG index for each region. We will update our sector allocations in an upcoming Weekly Report. Table 2Euro Area Investment Grade Performance Stagflation-ish Stagflation-ish Table 3U.K. Investment Grade Performance Stagflation-ish Stagflation-ish Chart 8Credit Quality Curves Remain Very Flat Credit Quality Curves Remain Very Flat Credit Quality Curves Remain Very Flat Bottom Line: Our investment grade (IG) sector allocations, taken from our relative value models, have added positive performance since our last update in August. We continue to recommend a cautious approach to sector allocation, targeting index levels of spread risk (in aggregate) in the U.S. euro area and U.K. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility", dated April 11, 2018, available at gps.bcaresearch.com. Appendix Appendix Chart 1U.S. Corporate Sector Valuation And Recommended Allocation* Stagflation-ish Stagflation-ish Appendix Chart 1U.S. Corporate Sector Risk Vs. Reward* Stagflation-ish Stagflation-ish Appendix Table 2Euro Area Corporate Sector Valuation And Recommended Allocation* Stagflation-ish Stagflation-ish Appendix Chart 2Euro Area Corporate Sector Risk Vs. Reward* Stagflation-ish Stagflation-ish Appendix Table 3U.K. Corporate Sector Valuation And Recommended Allocation* Stagflation-ish Stagflation-ish Appendix Chart 3U.K. Corporate Sector Risk Vs. Reward* Stagflation-ish Stagflation-ish Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Stagflation-ish Stagflation-ish Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The ECB admits that its policy is considerably more accommodative than it would be absent the need to integrate the weaker euro area economies. But a strategy designed to integrate some is alienating others, both within the euro area and outside it. The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. It follows that the 10% undervaluation of the euro will eventually correct. And German consumer services will structurally outperform the consumer goods exporters. Feature Let's begin with some facts, which are difficult to dispute. Fact 1: The euro area is running a €400 billion trade surplus with the rest of the world, equivalent to 4% of euro area GDP. €300 billion of this surplus resides in Germany.1 Fact 2: The trade surplus is a direct result of the undervaluation of the euro (Chart of the Week). This we know, because the surplus has evolved as a perfect mirror image of the euro's undervaluation as calculated by the ECB itself. The central bank admits that the euro is undervalued by around 10%2 (Chart I-2). Chart of the WeekThe Euro Area's Huge Trade Surplus Is Due To The Undervalued Euro The Euro's Huge Trade Surplus Is Due To The Undervalued Euro The Euro's Huge Trade Surplus Is Due To The Undervalued Euro Chart I-2The Euro Is Undervalued By 10% The Euro Is Undervalued By 10% The Euro Is Undervalued By 10% Fact 3: The substantial undervaluation of the euro is the unavoidable result of the of the ECB's extreme experiment with bond buying and zero and negative interest rates. This we know, because the euro's undervaluation is a near perfect function of the yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts (Chart I-3 and Chart I-4). Chart I-3The Euro Is Undervalued Because Of The ##br##ECB's Ultra-Accommodative Policy The Euro Is Undervalued Because Of The ECB's Ultra-Accommodative Policy The Euro Is Undervalued Because Of The ECB's Ultra-Accommodative Policy Chart I-4The Euro Has Tracked Expected##br## Relative Monetary Policy The Euro Has Tracked Expected Relative Monetary Policy The Euro Has Tracked Expected Relative Monetary Policy Nevertheless, a reasonable riposte to facts 1-3 is that the ECB does not target the euro exchange rate. The ECB sets policy to achieve its price stability mandate, which it defines as an inflation rate of "below, but close to, 2%", the same definition as the Federal Reserve uses. Given that the ECB is further from its price stability mandate than the Fed is, the ECB has to set much more accommodative policy. And there the story might end. 2% Inflation In The Euro Area Is Different To 2% Inflation In The U.S. Except that the story has a twist. The price stability mandates of the ECB and Fed appear very similar, but they are not. The ECB mandate is much harder to achieve, because of two further facts. Fact 4: The definitions of consumer prices in the euro area and the U.S. are quite different. The euro area's Harmonized Index of Consumer Prices (HICP) excludes the consumption costs of owner-occupied housing, whereas the U.S. consumer price basket includes it at a very substantial 25% weight. The omission of owner-occupied housing costs - which consistently tend to rise faster than other prices - makes it much more difficult for overall inflation to reach 2%. Indeed, excluding shelter, core inflation in the U.S. today is running at 1.2%, the same rate as in the euro area (Chart I-5 and Chart I-6). Chart I-5Core Inflation Is Higher##br## In The United States... Core Inflation Is Higher In The United States... Core Inflation Is Higher In The United States... Chart I-6...But On A Like-For-Like Basis, Core Inflation##br## Is Not Higher In The United States ...But On A Like-For-Like Basis, Core Inflation Is Higher In The Euro Area! ...But On A Like-For-Like Basis, Core Inflation Is Higher In The Euro Area! Fact 5: The ECB has a single mandate of price stability, whereas the Fed has a dual mandate of price stability and maximizing employment. Some people even argue that the Fed has a triple mandate which includes financial stability. The point is that for Fed policy, price stability is only one of several considerations, creating flexibility; whereas for ECB policy, price stability is the only consideration, creating inflexibility. Nevertheless, a reasonable riposte to facts 4-5 is that we must just accept that the ECB and Fed operate within different frameworks. If the ECB's framework necessitates ultra-accommodative monetary policy today, then so be it. And there the story might end. Why Should Americans Pay For European Integration? Except that the story has another twist. The ECB framework wasn't always what it is today. Fact 6: On May 8 2003, the ECB changed its definition of price stability from "inflation below 2%" to "inflation below, but close to, 2%". Thereby, the addition of three small words transformed the flexibility of a 0-2% inflation range to the inflexibility of a 2% point target. Why did the ECB change its objective and make it so much more difficult? Here is the answer, straight from the horse's mouth: "The founding fathers of the ECB thought about the adjustment within the euro area, the rebalancing of the different members. To rebalance these disequilibria, since the countries do not have the exchange rate, they have to readjust their prices. This readjustment is much harder if you have zero inflation than if you have 2%" - Mario Draghi So there you have it - the ECB admits that it changed its objective to ease the integration burden on weaker euro area economies. The undisputed consequence is structurally easier monetary policy than would be the case without the integration burden. The ECB also admits that an unavoidable result is a structurally undervalued euro, meaning a substantial competitive advantage for the euro area versus its major trading partners, including the United States. To which President Trump might rightly ask: why should American competitiveness shoulder the burden for European integration? Trump's crosshairs may be trained on Germany, which is running the largest export surplus. But he should redirect his focus to the ECB. The majority of German export hyper-competitiveness is no fault of Germany, it is due to the structural undervaluation of the euro (Chart I-7). Moreover, while an undervalued euro benefits exporters, it hurts euro area household real incomes by raising the prices of dollar-denominated energy and food imports, whose demand is inelastic. German households are also deeply unhappy about the negligible interest on their savings. Chart I-7The Majority Of Germany's Hyper-Competitiveness Is Due To The Undervalued Euro The Majority Of Germany's Hyper-Competitiveness Is Due To The Undervalued Euro The Majority Of Germany's Hyper-Competitiveness Is Due To The Undervalued Euro The Way Forward, And Some Investment Considerations Ultra-accommodative policy was not the game changer that is sometimes claimed. The euro area's strong recovery started more than a year before the ECB even mooted its extreme accommodation. The turning point came in 2013 when euro area banks stopped aggressively de-levering their balance sheets ahead of the bank stress test (Chart I-8). Chart I-8The Euro Area Recovery Started In 2013 When Banks Ended Their Aggressive De-Levering The Euro Area Recovery Started In 2013 When Banks Ended Their Aggressive De-Levering The Euro Area Recovery Started In 2013 When Banks Ended Their Aggressive De-Levering Mario Draghi admits that policy today is considerably more accommodative than it would be absent the need to integrate the weaker euro area economies. But a strategy designed to integrate some is alienating others, both within the euro area and outside it. The ECB has a legal obligation to achieve price stability as its sole objective, but the precise definition of price stability is up to the central bank. To reintroduce some flexibility, it has two options: 'cross-sectional' flexibility, by reintroducing an inflation target range; or 'longitudinal' flexibility by a more relaxed interpretation of the 'medium term' timeframe required to achieve its point target. Of these two options, we expect a gradual move to greater longitudinal flexibility, especially as 'medium term' is already open to considerable interpretation. This will create three structural investment opportunities. The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. It follows that the 10% undervaluation of the euro - as calculated by the ECB itself - will eventually correct. As the euro area's structural over-competitiveness gradually corrects, the decade-long outperformance of consumer goods exporters versus consumer services will reverse, especially in Germany (Chart I-9 and Chart I-10). Overweight German consumer services versus consumer goods exporters. Chart I-9Consumer Services Have ##br##Underperformed In Europe... Consumer Services Have Underperformed In Europe... Consumer Services Have Underperformed In Europe... Chart I-10...But Are Starting To Turn ##br##Around In Germany ...But Are Starting To Turn Around In Germany ...But Are Starting To Turn Around In Germany Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Q4 2017 at an annualised rate. 2 Please see https://www.ecb.europa.eu/stats/balance_of_payments_and_external/hci/html/index.en.html The ECB uses three metrics to assess the euro area's competitiveness versus its major trading partners: GDP deflators, CPIs, and unit labour costs. The average of the three metrics suggests that the euro is undervalued by around 10%.The assessment of euro undervaluation assumes that the major euro area economies entered the monetary union at a broadly correct level of competitiveness against each other and against their other major trading partners. This assumption seems valid, given that the net external position of these economies were all in equilibrium at the onset of monetary union. Fractal Trading Model* This week, we note that the rally in the Spanish 10-year government bond is extended and ripe for a countertrend reversal. Implement this as a pair-trade: short the Spanish 10-year bond, long the German 10-year bund. The profit target and symmetrical stop-loss is 1%. Lever up to increase potential return. We are also pleased to report that our short Helsinki OMX / long Eurostoxx600 trade achieved its 3% profit target and is now closed. This leaves five open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Spain 10-Year Gov. Bond Price Spain 10-Year Gov. Bond Price The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##Br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Duration: The balance of risks does not suggest that we should abandon our cyclical below-benchmark duration stance. Positioning is stretched and global growth is no longer accelerating, but U.S. growth is firm and the Fed is less sensitive to tighter financial conditions than in the past. Inflation: The biggest risk for bond markets is that investors wake up to the fact that core inflation is trending quickly back to the Fed's 2% target. The re-anchoring of inflation expectations will pressure the 10-year Treasury yield higher by 23 - 43 basis points. Labor Market: A forecast for stronger wage growth at this stage of the cycle relies on relatively modest assumptions about future gains in employment. Feature Chart 1Bond Bear On Pause Bond Bear On Pause Bond Bear On Pause It's risky out there. Confronted with pain in the equity market, increasingly hawkish trade rhetoric from Washington and some moderation in global economic data, investors have hit pause on the bond bear market. Yields at the front-end of the curve have leveled-off during the past few weeks and the 10-year yield is refusing to take out its 2013 peak (Chart 1). But could any of these risks actually derail the cyclical bear market in bonds? This week we stress test our cyclical below-benchmark duration recommendation by re-considering the three risks we outlined in February, plus one additional risk for good measure.1 Risk 1: Positioning Investors have been overwhelmingly short bonds for the past few months and this consensus has not wavered even as yields declined. Whenever there is widespread consensus around a trade it is often a signal of overbought/oversold conditions. Case in point, since the financial crisis extreme net short bond positions have often coincided with lower Treasury yields during the subsequent three months (Chart 2). This has been particularly true for net speculative positions in 10-year Treasury futures and the All Clients portion of the J.P. Morgan duration survey. The Active Clients portion of the survey has not displayed as consistent a relationship with yield changes, but much like the other two positioning indicators in Chart 2, it currently sits deep in "net short" territory. Chart 2Bond Market Looks Oversold Bond Market Looks Oversold Bond Market Looks Oversold Interestingly, a survey of sentiment shows that investors have mostly been bullish on bonds since 2010, with only a few brief exceptions when more than 50% of respondents indicated that they were bearish. All of the cases when investors turned bearish coincided with a subsequent decline in yields, and sentiment is currently consistent with those prior episodes (Chart 2, bottom panel). In short, widespread consensus around the "short bond" trade was a risk that we flagged in February and it remains a risk today. Risk 2: Unrealistic Expectations Chart 3Data Surprises Still Positive Data Surprises Still Positive Data Surprises Still Positive Related to the widespread consensus around the "short bond" trade is the risk that investors might also be overly optimistic about the pace of U.S. economic growth. U.S. economic data have been consistently surprising to the upside since the middle of last year (Chart 3). The risk is that, in the face of strong data, investors start to revise up their expectations for future economic growth. Eventually those expectations become unrealistically high and the economic data are bound to disappoint. This is why the economic surprise index is mean-reverting. In prior research we showed that if the data surprise index is below zero it is very likely that Treasury yields fell during the prior 30 days, and vice-versa.2 At the moment, the surprise index is still deep in positive territory, and our simple auto-regressive model predicts that it will remain in positive territory for the next 30 days. For now, positioning is consistent with lower yields in the near-term but data surprises are consistent with higher yields. We would likely recommend a tactical above-benchmark duration positioning if we received a consistent bond-bullish message from both our positioning indicators and our data surprise model. Risk 3: Global Growth Slowdown Chart 4Global Growth Has Peaked Global Growth Has Peaked Global Growth Has Peaked While U.S. economic growth is on a firm footing, growth outside of the U.S. appears to be peaking. As evidence, we note that the fair value reading from our 2-factor Treasury model - a model of the 10-year Treasury yield based on the Global Manufacturing PMI and bullish sentiment toward the U.S. dollar - has fallen during the past few months and now sits at 2.78%, roughly consistent with the current 10-year yield (Chart 4).3 While the Global Manufacturing PMI fell back to 53.4 in March, down from its December peak of 54.5, it's important to note that the index is still elevated compared to recent history. Also, the U.S. contribution to the global index continues to rise, with the bulk of the decline concentrated in the Eurozone (Chart 4, panel 4). Even in the Eurozone we note that the PMI remains healthy, though not at the gaudy levels seen earlier in the year. Another important caveat about our 2-factor model is that it does not contain a variable to capture the degree of resource utilization in the economy.4 Logically, as slack dissipates in the economy and inflationary pressures mount, then the same level of global growth should be associated with a higher Treasury yield, all else equal. This means that at some point, as we approach the end of the cycle, we expect the model to break down and consistently produce fair value readings that are too low. It is unclear whether that point has been reached. Nevertheless, it is clear that global growth is no longer accelerating higher. For now the slowdown appears benign and consistent with continued economic recovery, but that could change if the Global PMI continues to fall in the coming months. Risk 4: Tighter Financial Conditions The decline in Treasury yields during the past few weeks is small potatoes compared to the steep drop in equity prices. This raises the possibility that continued weakness in the equity market will drive a flight-to-quality into bonds, leading to lower yields. Indeed, as we have often pointed out, the Fed has a strong track record of responding dovishly to periods of tightening financial conditions. This dynamic, which we have dubbed the Fed Policy Loop, explains why equity prices and bond yields are positively correlated when inflation is low, but also why this correlation reverses when inflation is high.5 When inflation is far below the Fed's target, the Fed needs the economic recovery to continue because it needs inflation to rise. Because the Fed also believes that sufficiently tight financial conditions lead to slower economic growth, it must respond dovishly whenever financial conditions tighten. This leads to a positive correlation between bond yields and equity prices - equity prices being a main driver of financial conditions. However, if we consider an environment where economic growth is strong and inflation is well above target, as was the case in the 1980s, then the Fed would actually encourage tighter financial conditions. In this instance you would expect a negative correlation between equity prices and bond yields (Chart 5). Chart 5The Fed's Reaction Function Explains The Stock/Bond Correlation The Fed's Reaction Function Explains The Stock/Bond Correlation The Fed's Reaction Function Explains The Stock/Bond Correlation With inflation still below target, the Fed cannot tolerate a severe tightening of financial conditions. But the Fed's tolerance for tighter financial conditions also increases as inflationary pressures mount. As of today our sense is that the correlation between bond yields and equity prices is still positive, though weaker than we have become accustomed to in recent years. Turning to the data, we see that the recent equity sell-off has caused the financial conditions component of our Fed Monitor to fall quite sharply, though it still suggests that financial conditions are "easy" on balance (Chart 6). This squares with Fed Chairman Jerome Powell's interpretation. He described financial conditions as "accommodative" in a speech last Friday.6 Chart 6Fed Monitor Still Suggests Tighter Money Fed Monitor Still Suggests Tighter Money Fed Monitor Still Suggests Tighter Money But most importantly, the top panel of Chart 6 shows that the recent tightening in financial conditions caused only a small tick down in our overall Fed Monitor. This is because tighter financial conditions have been offset by the accelerating economic growth and inflation components of our monitor (Chart 6, panels 3 & 4). This means that the Fed will need to see a more severe sell-off in the equity market or a slow-down in U.S. economic growth before it adopts a more dovish tilt. Unless this occurs, the impact of tighter financial conditions on bond yields will be relatively small. Bottom Line: As of yet we do not see the balance of risks as suggesting that we should abandon our cyclical below-benchmark duration stance. Positioning is stretched and global growth is no longer accelerating, but U.S. growth is on a firm footing and the Fed is less sensitive to tighter financial conditions than it has been in recent years. In fact, at the current juncture we think the biggest mispricing in the bond market is that yields do not adequately compensate investors for the risk of inflation. That could change very soon as inflation starts to print higher, as is explained in the next section. Inflation: The Biggest Risk Chart 7Higher Inflation Is Just Around The Corner Higher Inflation Is Just Around The Corner Higher Inflation Is Just Around The Corner As of last Friday, the compensation for inflation protection priced into the 10-year Treasury yield was 2.07%. The same measure for the 5-year/5-year forward yield was 2.13%. During periods when core inflation is well-anchored around the Fed's target, both measures tend to trade in a range between 2.3% and 2.5% (Chart 7). This means that the re-anchoring of inflation expectations will impart another 23 bps to 43 bps of upside to the nominal 10-year Treasury yield. We think this re-anchoring could occur relatively soon. The main reason we think this could play out soon is that investors do not seem to appreciate how strong inflation has been in recent months. The Bloomberg consensus economic forecast currently calls for year-over-year core PCE inflation of 1.84% by the end of this year and of 2% by the end of 2019. Given that year-over-year core PCE inflation is currently 1.6%, it seems like investors are forecasting a significant jump (Chart 7, panel 2). But we think these forecasts under-appreciate the impact that base effects will have on core inflation during the next few months. Core inflation dropped sharply in March 2017 (Chart 7, bottom panel), a decline caused by a one-off re-pricing of cellphone data plans. This large negative print will fall out of the year-over-year calculation when the March PCE inflation data are reported later this month. In fact, we calculate that even if core inflation rises only 0.1% in March - well below recent readings - year-over-year core PCE inflation will rise to 1.85%, already above the Bloomberg consensus forecast for the end of the year. If core PCE inflation rises 0.2% in March - a reading more consistent with recent trends - then year-over-year core PCE inflation will rise to 1.95%, almost back to the Fed's 2% target. Bottom Line: The biggest risk for bond markets is that investors wake up to the fact that core inflation is trending quickly back to the Fed's 2% target. The re-anchoring of inflation expectations will pressure the 10-year Treasury yield higher by between 23 bps and 43 bps. Wage Growth Near An Inflection Point Chart 8Wage Growth And Labor Market Slack Risk Review Risk Review Last week's employment report disappointed expectations with a nonfarm payroll gain of only 103k. The unemployment rate was flat at 4.1% for the sixth consecutive month, and the employment-to-population ratio for prime age (25-54) workers dropped one tick to 79.2%, from 79.3% in February. For bond investors, the main reason to track the monthly employment report these days is to get a read on the amount of slack remaining in the labor market and how that might translate into stronger wage growth and thus higher inflation and bond yields. This makes the prime age employment-to-population ratio particularly important because it has displayed the most consistent relationship with wage growth during the past 25 years (Chart 8). Based on the historical relationship and the current prime age employment-to-population ratio of 79.2%, the employment cost index for wages & salaries should be rising at a year-over-year pace of 2.8%. This is not too far from the current year-over-year wage growth rate of 2.61%, most recently updated for Q4 2017. Further, the historical relationship shown in Chart 8 suggests that we are quite close to an inflection point where smaller gains in the prime age employment-to-population ratio will lead to larger gains in wage growth. This is one reason why we think inflation will continue to surprise to the upside this year. The other advantage of tracking the prime age employment-to-population ratio instead of the headline unemployment rate is that it is easier to forecast because it does not depend on trends in labor force participation. As is shown in Chart 9, the labor force participation rate for the 25-54 age group has risen considerably since early 2016, suggesting that the headline unemployment rate overstated the tightness in the labor market in early 2016. While it is unclear how much further cyclical upside remains in prime age labor force participation, a focus on the prime age employment-to-population ratio allows us to set that question aside. For example, using demographic forecasts from the Census Bureau, we calculate that if nonfarm payrolls increase by 110k per month on average, then the prime age employment-to-population ratio will stay flat at its current level. With payroll gains currently averaging +211k on a trailing 6-month horizon and +188k on a trailing 12-month horizon (Chart 10), we think it is safe to assume that the prime age employment-to-population ratio will continue to rise in the coming months. Chart 9Prime Age Workers Are Re-Entering The Labor Force Prime Age Workers Are Re-Entering The Labor Force Prime Age Workers Are Re-Entering The Labor Force Chart 10Monthly Employment Growth Monthly Employment Growth Monthly Employment Growth Table 1 shows how different assumptions about monthly employment growth translate into the prime age employment-to-population ratio, and also how the prime age employment-to-population ratio translates into wage growth. For example, we see that if payroll gains average +160k or higher for the next 12 months, then we should see the employment cost index for wages & salaries grow by 2.94% during the next year. Table 1Mapping Employment Growth To Wage Growth Risk Review Risk Review Bottom Line: A forecast for stronger wage growth at this stage of the cycle relies on relatively modest assumptions about future gains in employment. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 3 At the time of publication the 10-year Treasury yield was 2.77%. 4 The model was originally conceived to capture the impact of both the magnitude and the breadth of global growth on U.S. bond yields. For further details please see U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 1, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Caught In A Loop", dated September 29, 2015, available at usbs.bcaresearch.com 6 https://www.federalreserve.gov/newsevents/speech/powell20180406a.htm Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Q1 Performance Breakdown: The GFIS recommended model bond portfolio returned -0.55% (hedged into U.S. dollars) in the first quarter of 2018, underperforming the custom benchmark index by -11bps. The overweight to U.S. corporate bonds was the main drag on performance. Stress Test & Scenario Analysis: We introduce a simple framework to conduct scenario analysis and stress testing of the model bond portfolio. Our conclusion is that some shifting in our corporate bond allocations - reducing exposure to U.S. investment grade, increasing exposure to euro area and emerging market corporates - can actually help eliminate expected losses in scenarios that run counter to our base case. Feature This week, we present our regular quarterly report on the performance of the BCA Global Fixed Income Strategy (GFIS) model bond portfolio. As a reminder to existing readers (and for new clients), the portfolio is a part of our service that is a departure from the usual BCA macro analysis of global fixed income markets. The model portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors, by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. This framework also gives us a vehicle to discuss many of the typical bond portfolio management issues that our clients face on a daily basis. In that vein, we are introducing a new element to our framework in this report - estimating future portfolio performance using scenario analysis, and conducting stress testing of outcomes that are contrary to our base case expectations for global bond markets. Q1/2018 Model Portfolio Performance Breakdown: An Unexpected Hit From U.S. Corporates Chart of the WeekShifting Correlations Hurt##BR##The Model Portfolio In Q1 Shifting Correlations Hurt The Model Portfolio in Q1 Shifting Correlations Hurt The Model Portfolio in Q1 The surge in global market volatility in the first quarter of the year weighed on the returns for the GFIS model bond portfolio. The portfolio had a total return of -0.55% (hedged into U.S. dollars), which lagged that of our custom benchmark index by -11bps.1 The quarter started out on a good note, with the portfolio outperforming by +12bps in January, as gains from our below-benchmark duration stance offset some underperformance from our overweight on global spread product. The story changed in early February, however, as the U.S. wage inflation "scare" and the associated VIX spike resulted in wider U.S. corporate bond spreads. This counteracted the gains on the government bond side of the portfolio as bond yields continued to climb. After yields peaked in mid-February, the portfolio gave back much of the outperformance from duration, with no recovery of the early February losses from spread product (Chart of the Week). In terms of the breakdown between the government bond and spread product allocations in our model portfolio, the former generated +9bps of outperformance versus our custom benchmark index while the latter underperformed by -19bps (Table 1). The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. The main individual sectors of the portfolio that drove the excess returns were the following: Biggest outperformers Underweight U.S. Treasuries (+16bps) Underweight emerging market (EM) U.S. dollar (USD) denominated corporate debt (+5bps) Overweight Japanese government bonds (JGBs) with maturities of ten years or less (+4bps) Underweight EM USD-denominated sovereign debt (+2bps) Biggest underperformers Overweight U.S. investment grade (IG) Financials (-14bps) Overweight U.S. IG Industrials (-8bps) Underweight JGBs with maturities beyond ten years (-8bps) Overweight U.S. Ba-rated high-yield (HY) corporates (-4bps) Table 1GFIS Model Bond Portfolio Q1-2018 Overall Return Attribution GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start Chart 2GFIS Model Bond Portfolio Q1-2018 Government Bond Performance Attribution By Country GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start Chart 3GFIS Model Bond Portfolio Q1-2018 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start The hits from the overweight positions in U.S. corporate debt were the most surprising, given that the U.S. economy and corporate profits are still expanding at a solid pace. That would typically keep corporate credit spreads well-behaved, especially when U.S. Treasury yields are rising or stable as was the case in the first quarter. Yet volatility has spiked and stayed elevated in response to heightened uncertainty over slowing global growth momentum, rising U.S. inflation and worries about future U.S. trade policy. Investors have demanded moderately higher credit risk premiums in the U.S. as a result, to the detriment of U.S. corporate bond performance. This can be seen in Chart 4, which presents the returns of the individual countries and spread product sectors in the GFIS model bond portfolio. The returns are hedged into U.S. dollars (we do not take active currency risk in this portfolio) and also adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market.2 On this "apples-for-apples" basis, U.S. IG corporates were the worst performing fixed income market in the first quarter of 2018. Chart 4Ranking The Winners & Losers From The Model Portfolio In Q1 GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start Looking ahead, we see no need yet to get out of our recommended overweight in global spread product or underweight in global government bond exposure (Chart 5). While there are some signs of slowing growth momentum in major economies (euro area, China), a deeper slowdown is not being heralded by leading economic indicators, which continue to rise. Much of the global economy continues to operate at or beyond full employment, which will continue to put moderate upward pressure on inflation rates. This will force central banks to maintain a relatively hawkish bias, despite more elevated financial market volatility. The most likely outcomes are still more bearish for government bonds than for corporate credit. Chart 5We're Sticking With Our##BR##Spread Product Overweight GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start Having said that - the higher volatility environment does argue for some reduction in the size of the spread product overweight in the model portfolio. Especially after we consider some scenario analysis on returns, as we discuss in the next section. Bottom Line: The GFIS recommended model bond portfolio returned -0.55% (hedged into U.S. dollars) in the first quarter of 2018, underperforming the custom benchmark index by -11bps. The overweight to U.S. corporate bonds was the main drag on performance, thanks to the more elevated level of market volatility and spread widening during the quarter. Stress Tests & Scenario Analysis A common analytical tool used by professional fund managers is to perform "stress tests" on their portfolios. This is done to estimate the size of potential losses that could occur after major market moves, typically those that went against current positioning in a portfolio. Those estimates are critical to the effective risk management of a portfolio. As part of the ongoing development of the infrastructure for our model bond portfolio framework, we are introducing scenario analysis and stress testing of our current recommended allocations. The goal is to determine the magnitude of potential returns that could be expected under our base case and alternative scenarios. This is meant to complement the main risk management tool that we added last year, a "risk budget" based on the tracking error (i.e. volatility difference) of the portfolio versus our custom benchmark.3 We have deliberately been targeting a modest tracking error for our model portfolio, given the historical richness (low yields, tight spreads) of so many parts of the global bond universe. Yet our estimate of the GFIS model bond portfolio's tracking error has fallen even below the low end of the 40-60bp range that we have been targeting (Chart 6).4 Chart 6Lower Tracking Error Through Higher##BR##Corporate Bond Volatility Lower Tracking Error Through Higher Corporate Bond Volatility Lower Tracking Error Through Higher Corporate Bond Volatility This appears to be due to an odd development. The model bond portfolio's volatility was running below that of its benchmark index over the past year, but with the increase in the return volatility of U.S. IG corporate debt - the biggest overweight within spread product - the portfolio's volatility has been converging to that of the benchmark from below, hence lowering the tracking error. In other words, being overweight U.S. IG was a portfolio diversifier last year, but that is no longer the case. This obviously highlights some of the limitations of using tracking error as the sole risk management tool for a bond portfolio. Shifting cross-asset correlations and volatilities can wreak havoc on any "guesstimate" of a portfolio's underlying risk. A more simple solution is to conduct scenario analysis of expected returns, then shock the analysis for changes in the underlying assumptions. The key is having a reasonable framework for estimating returns for various asset classes. For our purposes in the model portfolio, we are using a simple approach to forecast the expected returns. We use a factor-based framework that models changes in global bond yields as a function of changes in the following four variables: the U.S. dollar, the price of oil, the fed funds rate and the VIX index. We show the regression results of our factor-based modeling of yield changes for each spread sector in our model bond portfolio in Table 2A. We ran the regressions for different time horizons, but we decided on using the post-crisis period since 2009 in all cases. We also attempted to model the yield changes of government bonds using those same four factors, but the R-squareds for all those regressions were far too low to make them useful. We instead used a simple approach of calculating the beta since 2009 of changes in individual bond yields to changes in U.S. Treasury yields for each corresponding maturity bucket. We present those yield betas in Table 2B. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start Table 2BEstimated Government Bond Yield Betas To U.S. Treasuries GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start With these tools, we can forecast returns for each bond sector under different scenarios. We can then use those forecasts to predict the expected return for our model bond portfolio under those same scenarios. In Tables 3A & 3B. We show three differing scenarios, with all the following changes occurring over a one-year horizon: Table 3AScenario Analysis For The GFIS Model Portfolio GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start Table 3BU.S. Treasury Yield Assumptions For The Scenario Analysis GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start Our Base Case: the Fed delivers another 75bps of rate hikes, the U.S. dollar rises by 5%, oil prices rise by 20% (the non-consensus view of BCA's commodity strategists), the VIX index stays unchanged at current elevated levels and there is a modest bear steepening of the U.S. Treasury curve. A Very Hawkish Fed: the Fed delivers 150bps of rate hikes, the U.S. dollar rises by 10%, oil prices fall by 10%, the VIX index increases by ten points from current levels and there is a sharp bear flattening of the U.S. Treasury curve. Chart 7U.S. IG Corporates Have A##BR##High Yield Beta (a.k.a. Duration) U.S. IG Corporates Have A High Yield Beta (a.k.a. Duration) U.S. IG Corporates Have A High Yield Beta (a.k.a. Duration) A Very Dovish Fed: the Fed only hikes rates by 25bps, the U.S. dollar falls by 5%, oil prices fall by 5%, the VIX index increases by five points from current levels and there is a modest bull steepening of the U.S. Treasury curve. In Table 3A, we also show the expected yield changes generated by our regressions for each spread product sector and the yield betas to U.S. Treasuries for each government bond market. This produces expected returns for the GFIS model bond portfolio, which are shown in the top part of the table. In our base case, the portfolio is expected to outperform the benchmark by +42bps, but underperform by nearly equivalent amounts in both alternative scenarios. In the bottom part of the table, we show expected returns where we reduce our large overweight to U.S. IG corporates. The latter has a high sensitivity to rising global government bond yields compared to some of our other significant overweights like Japanese government debt and U.S. high-yield (Chart 7). We then take that reduced U.S. IG weighting and increase the exposure to euro area and EM corporate bonds. This adjusted portfolio results in higher excess returns not only in our base case (now +78bps) but even in the "very hawkish Fed" scenario (now +8bps). The "very dovish Fed" scenario produces a similar loss in this scenario (now -37bps), but that is to be expected since this includes a fall in global bond yields that would hurt our current underweight duration stance (Chart 8). Importantly, this adjusted portfolio would not alter the positive carry of the model portfolio (i.e. the portfolio yield remains at 16bps above that of the custom benchmark index, Chart 9) Chart 8Flattening Yield Curves##BR##Have Also Hurt Returns Flattening Yield Curves Have Also Hurt Returns Flattening Yield Curves Have Also Hurt Returns Chart 9Some Help From##BR##Positive Carry Some Help From Positive Carry Some Help From Positive Carry Based on this scenario analysis, we are going to implement the changes in the bottom half of Table 3A. We are cutting our overweight to U.S. IG corporates in half (which still leaves us overweight), raising euro area IG and HY corporate exposure to neutral and reducing the size of our EM corporate underweight. The changes to the model portfolio can be found on Page 14. These changes will reduce our exposure to a sector that not only has become riskier, but which also looks relatively expensive to U.S. high-yield (Chart 10) and which has been underperforming euro area (Chart 11) and EM equivalents (Chart 12). Chart 10U.S. IG Looks More##BR##Expensive Than U.S. HY U.S. IG Looks More Expensive Than U.S. HY U.S. IG Looks More Expensive Than U.S. HY Chart 11An Unexpected Underperformance##BR##Of U.S. IG vs. European Corporates An Unexpected Underperformance Of U.S. IG vs. European Corporates An Unexpected Underperformance Of U.S. IG vs. European Corporates Chart 12An Unexpected Underperformance##BR##Of U.S. IG Vs. Versus EM Corporates An Unexpected Underperformance Of U.S. IG Vs. Versus EM Corporates An Unexpected Underperformance Of U.S. IG Vs. Versus EM Corporates Bottom Line: We introduce a simple framework to conduct scenario analysis and stress testing of the model bond portfolio. Our conclusion is that some shifting in our corporate bond allocations - reducing exposure to U.S. investment grade, increasing exposure to euro area and emerging market corporates - can actually help eliminate expected losses in scenarios that run counter to our base case. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 For Italy & Spain, the bars have two colors since the portfolio weights were changed in mid-February, when we upgraded Italian debt to neutral at the expense of a reduction in Spanish government bond exposure. 3 Please see BCA Global Fixed Income Strategy Special Report, "Adding A Risk Management Framework To Our Model Bond Portfolio", dated June 20th 2017, available at gfis.bcaresearch.com. 4 In general, we aim to target a tracking error no greater than 100bps. We think this is reasonable for a portfolio where currency exposure is fully hedged and less than 5% of the portfolio benchmark is in bonds with ratings below investment grade. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Inflation Pressures Mount Inflation Pressures Mount Inflation Pressures Mount Spread product underperformed equivalent-duration Treasuries for the second consecutive month in March. But last month's underperformance was different than February's in one important way. In February it was the fear of inflation and tighter Fed policy that prompted the sell-off in spread product. Investment grade corporate bonds underperformed Treasuries by 62 basis points, while the Treasury index provided a total return of -75 bps and TIPS outperformed nominals. In March, the sell-off in spread product coincided with Treasury returns of +94 bps and TIPS underperformed nominals. The negative correlation between yields and spreads re-asserted itself signaling that the sell-off was not driven by inflation, but by concerns about a potential slow-down in global growth. A severe slow-down in global growth is not imminent. But higher inflation and tighter Fed policy remain our chief concerns. With that in mind, core inflation printed higher again last month (Chart 1), and we think it is only a matter of time before our TIPS breakeven target range of 2.3% to 2.5% is met. That will trigger a reduction in our recommended allocation to corporate bonds. Stay tuned. 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 91 basis points in March, dragging year-to-date excess returns down to -81 bps. The sell-off of the past two months has returned some value to the investment grade corporate space, but spreads are still quite tight relative to history. The 12-month breakeven spread for a Baa-rated corporate bond has only been tighter 19% of the time since 1989.1 Our opinion of investment grade corporate bonds is unchanged. We continue to view value as relatively unattractive, and will reduce our overweight allocation once both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are above 2.3%. Corporate profit data for the fourth quarter of 2017 were released last week, and our measure of EBITD for the non-financial corporate sector grew at an annualized rate of 2.4%, slightly below the 3% annualized increase in corporate debt. Gross leverage for the non-financial corporate sector ticked higher as a result (Chart 2). In a recent report we showed that sustained periods of corporate spread widening almost always coincide with rising gross leverage.2 We also showed that while most leading profit indicators are still in good shape, a profit margin proxy based on the difference between corporate selling prices and unit labor costs is sending a warning sign. We expect profit growth to fall sustainably below debt growth later this year, driven by rising unit labor costs. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Old Habits Die Hard Old Habits Die Hard Chart 3BCorporate Sector Risk Vs. Reward* Old Habits Die Hard Old Habits Die Hard 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 114 basis points in March, dragging year-to-date excess returns down to -19 bps. The average index option-adjusted spread widened 18 bps on the month and currently sits at 354 bps. The 12-month trailing speculative grade default rate ticked up to 3.56% in February, its highest reading since last July, but Moody's still expects it to decline to 1.96% during the next year. Based on the Moody's default rate projection and our own estimate of the recovery rate, we forecast High-Yield default losses of 0.97% for the next 12 months. This translates to a 12-month excess return of 257 bps for the High-Yield index versus Treasuries, assuming an un-changed junk spread (Chart 3). One hundred basis points of spread widening would lead to an excess return of -149 bps during this time horizon, and 100 bps of spread tightening would lead to an excess returns of +664 bps. However, such a large amount of spread tightening is probably over-optimistic. As inflation continues to rise and the Fed applies the brakes, a floor will likely remain under the VIX index of implied equity volatility and this will prevent junk spreads from recovering their cycle lows (top panel). We continue to await a firmer signal from our inflation indicators before reducing our allocation to high-yield. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in March, dragging year-to-date excess returns down to -39 bps. The conventional 30-year zero-volatility MBS spread widened 7 bps on the month, split between a 4 bps widening in the option-adjusted spread (OAS) and a 3 bps widening in the compensation for prepayment risk (option cost). The widening in MBS OAS has not been as severe as the widening in investment grade corporate OAS. As a result, mortgages no longer appear cheap relative to investment grade corporates (Chart 4). But while the value proposition in mortgages is less alluring, we still see limited potential for spreads to widen during the next 6-12 months. Refinancing risk will remain muted as interest rates rise (bottom panel), and in past reports we showed that extension risk will likely be immaterial.3 In the structured product space, Agency MBS offer 11 bps less spread than Aaa-rated consumer ABS, but are supported by falling residential mortgage delinquencies and easing bank lending standards. In contrast, consumer credit (auto loan and credit card) delinquency rates have bottomed and banks have begun to tighten lending standards (see page 12 for further details). 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 20 basis points in March, dragging year-to-date excess returns down to +2 bps. Sovereign debt underperformed the Treasury benchmark by 58 bps on the month, while Foreign Agencies underperformed by 38 bps and Local Authorities underperformed by 33 bps. Domestic Agencies outperformed duration-equivalent Treasuries by 6 bps, and Supranationals underperformed by a single basis point. USD-denominated sovereign bonds have performed worse than Baa-rated U.S. corporate bonds during the past six months, despite persistent weakness in the U.S. dollar (Chart 5). However, we do not think recent dollar weakness will provide much support for sovereign bond returns going forward. Rather, it is more likely that the U.S. dollar will appreciate during the next 6-12 months as the distribution of global growth shifts toward the United States. This month's issue of the Bank Credit Analyst discusses the cyclical and structural outlook for the U.S. dollar in detail.4 Elsewhere, Foreign Agencies and Local Authorities continue to offer attractive spreads after adjusting for duration and credit rating. We remain overweight those segments of the Government-Related universe despite an overall underweight allocation. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 56 basis points in March, dragging year-to-date excess returns down to +29 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio widened 4% on the month, with short maturities performing somewhat worse than long maturities. The tax-adjusted yield for a 10-year municipal bond remains about 17 bps below the yield offered by an equivalent-duration corporate bond (Chart 6). As we have shown in prior research, investors typically get an opportunity to shift out of corporates and into munis at a positive spread differential before the end of the cycle.5 We will await this more attractive entry point before aggressively shifting our allocation in favor of munis. In a recent report we noted that state and local governments are still working to repair their budgets.6 More states enacted tax increases than decreases in fiscal year 2018 and the projected nominal budget increase across all states is a paltry 2.3%. Fortunately, our Municipal Health Monitor indicates that the hard work is paying off, and suggests that ratings upgrades should continue to outpace downgrades for the time being (bottom panel). Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve flattened in March, as long maturity yields fell quite sharply despite a small increase in yields out to the 2-year maturity point. The 2/10 slope flattened 15 basis points on the month and currently sits at 47 bps. The 5/30 slope flattened 7 bps on the month and currently sits at 41 bps. The trade-off between the pace of Fed rate hikes on the one hand, and the re-anchoring of long-dated TIPS breakeven inflation rates on the other will dictate the path for the yield curve during the next six months. Last month the Fed lifted rates for the sixth time this cycle, and signaled its desire to hike another 2-3 times before the end of the year. But just as further rate hikes will apply flattening pressure to the curve, the recent rebound in inflation will exert some offsetting steepening pressure. The 10-year TIPS breakeven inflation rate is still 25-45 bps below a range that is consistent with inflation being anchored around the Fed's target. We recommend a curve steepening trade for now, specifically a position long the 5-year bullet and short a duration-matched 2/10 barbell, because upward pressure on inflation will make it difficult for the curve to flatten much further during the next few months. We will shift aggressively into flatteners once TIPS breakevens reach our target range. Further, the 2/5/10 butterfly spread is priced for 19 bps of 2/10 flattening during the next six months (Chart 7). In other words, the 2/10 slope needs to flatten by more than 19 bps for a long 5-year bullet position to underperform. We view this as unlikely. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 17 basis points in March, dragging year-to-date excess returns down to +67 bps. The 10-year TIPS breakeven inflation rate fell 7 bps on the month and currently sits at 2.05%. The 5-year/5-year forward TIPS breakeven inflation rate fell 2 bps on the month and currently sits at 2.18%. 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.7 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. If the recent trend in realized inflation continues, then this re-anchoring could occur relatively soon. February data show that the annualized 6-month rate of change in trimmed mean PCE rose to 2.03% (Chart 8), and while the 12-month rate of change held steady at 1.7%, it will start to move higher in March when the strong inflation prints from January and February 2017 are removed from the sample. Pipeline measures of inflation pressure also suggest that inflation will head higher, as evidenced by our Pipeline Inflation Indicator, and in particular, the Prices Paid component of the ISM Manufacturing index which just hit its highest level since 2011 (panel 4). ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 3 basis points in March, dragging year-to-date excess returns down to -19 bps. The index option-adjusted spread for Aaa-rated ABS widened 2 bps on the month and currently sits at 44 bps, 11 bps above its pre-crisis low. While in prior research we highlighted that consumer ABS offer attractive spreads relative to many other sectors, we also pointed out that collateral credit quality is starting to weaken.8 With respect to value, Aaa-rated Consumer ABS offer a 12-month breakeven spread of 21 bps, while Agency MBS offer a spread of 6 bps and Agency CMBS offer a spread of 9 bps.9 However, household debt service ratios and delinquency rates appear to have bottomed for the cycle (Chart 9). While the pace of consumer credit accumulation remains robust, it has also moderated in recent months alongside rising delinquencies and tightening lending standards. We maintain a neutral allocation to ABS for the time being due to attractive valuation, but expect to downgrade in the future as household credit quality deteriorates. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 36 basis points in March, dragging year-to-date excess returns down to +11 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 9 bps on the month and currently sits at 72 bps, close to one standard deviation below its pre-crisis mean. While a spread of 72 bps is still attractive compared to similarly-rated alternatives, we remain concerned about the gap that has emerged between CMBS spreads and the rate of appreciation in commercial real estate (CRE) prices (Chart 10). While bank lending standards on CRE loans are still tightening, they are tightening less aggressively than in recent years (bottom panel). This could eventually remove a headwind from CRE prices, but for now we view a position in non-agency CMBS as overly risky. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 22 basis points in March, dragging year-to-date excess returns down to -14 bps. The index option-adjusted spread widened 6 bps on the month and currently sits at 47 bps. The Agency CMBS sector continues to offer an attractive spread pick-up relative to similar investment alternatives, and has historically exhibited low excess return volatility.10 Remain overweight. 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 2.96% (Chart 11). While the fair value reading from our 2-factor model remains elevated for now, we expect it to fall once March Global PMI data are released this week. Based on a combination of final PMI data and Flash estimates for countries that have yet to report final March figures, we estimate that the Global PMI will decline to 53.8 in March from 54.2 in February. When combined with the most recent reading for dollar bullish sentiment, this gives a fair value of 2.85% for the 10-year Treasury yield. We will provide an official update to the model in next week's report, after the data are finalized. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 1, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.74%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Jeremie Peloso, Research Assistant jeremiep@bcaresearch.com 1 The 12-month breakeven spread is the spread widening required during the next 12 months for the bond to break even with a position in an equivalent-duration Treasury security. 2 Please see U.S. Bond Strategy Weekly Report, "Brainard Gives The Green Light", dated March 13, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 4 Please see Bank Credit Analyst, "U.S. Twin Deficits: Is The Dollar Doomed?", dated March 29, 2018, available at bca.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Profiting From A Higher LIBOR", dated March 20, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 9 The 12-month breakeven spread is the spread widening required during the next 12 months for the bond to break even with a position in an equivalent-duration Treasury security. 10 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 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 Recommended Allocation Quarterly - April 2018 Quarterly - April 2018 Due to the boost from U.S. fiscal stimulus, we do not expect recession until 2020. Despite some signs that growth is peaking, global economic fundamentals remain robust. Markets have wobbled because of the risk of trade war and rising inflation. We think neither likely to derail growth. Not one of our recession indicators is yet sending a warning signal. We are late cycle and volatility is likely to remain high (particularly if the trade war intensifies). But, given strong earnings growth and three further Fed rate hikes this year, we expect global equities to beat bonds over the next 12 months. Except for particularly risk-averse investors, who care mostly about capital preservation, we continue to recommend overweights in risk assets. We are overweight equities (especially euro area and Japan), cyclical equity sectors such as financials and industrials, credit (especially cross-overs and high-yield), and return-enhancing alternative assets such as private equity. Feature Overview Stimulus Trumps Tariffs Risk assets have been choppy so far this year, with global equities flat in the first quarter and the stock-to-bond ratio turning down (Chart 1). Markets were battered by worries about a trade war, signs of growth peaking, a rise in inflation, and bad news from the tech sector. This late in the cycle, with stock market valuations stretched and investors skittish about what might go wrong, we expect volatility to stay high. But the global economy remains robust - and will be boosted by U.S. fiscal stimulus - earnings are growing strongly, and the usual signs of recession and equity bear markets are absent. Though the going will be bumpy over coming quarters, we continue to expect risk assets to outperform at least through the end of this year. U.S. tariffs on steel and aluminum and the threat of $50 billion of tariffs on Chinese imports so far represent a trade skirmish, not a trade war. The amounts pale by comparison with the positive impact coming though from U.S. tax cuts, increased fiscal spending, and repatriation (Chart 2). In history, fights over trade have rarely had a serious impact on growth. They flared up frequently in the 1980s, which was a period of strong economic growth. Even the infamous Smoot-Hawley tariff increase of 1930 is now viewed by most economic historians as having played only a minor role in the collapse of trade during the Great Depression.1 Of course, trade war could escalate. China, as the biggest part of the U.S. trade deficit, is the White House's clear target (Chart 3). Japan in the 1980s, an ally of the U.S., agreed to voluntary exports restraints and to relocate production to the U.S. But China is a global rival.2 Chart 1A Tricky Quarter A Tricky Quarter A Tricky Quarter Chart 2Stimulus Tops Tariffs Quarterly - April 2018 Quarterly - April 2018 Chart 3China Is The Target China Is The Target China Is The Target For now, we expect the impact to be limited since some degree of compromise is the most likely outcome. President Trump sees the stock market as his Key Performance Indicator and would be likely to back off if stocks fell sharply. China knows that it has the most to lose in a prolonged fight. It might suit Xi Jinping's reformist agenda to boost consumption, cut excess capacity, and allow the RMB to appreciate modestly. While the U.S. has some justification for arguing that China's investment rules are unfair, China can also argue that it has made significant progress in recent years in reducing its dependence on exports, its current account surplus, and the undervaluation of its currency (Chart 4). But jitters will continue for a while. May could be a particularly tricky month, with the Iran sanctions waiver expiring on May 12, and the 60-day consultation period for China tariffs ending on May 21. Investors should expect that volatility, which in early January was remarkably low in all asset classes, should stay significantly higher until the end of this cycle (Chart 5). Chart 4...But Has Reduced Dependence On Exports ...But Has Reduced Dependence On Exports ...But Has Reduced Dependence On Exports Chart 5Volatility Likely To Stay High? Volatility Likely To Stay High? Volatility Likely To Stay High? Meanwhile, economic fundamentals generally remain strong. The Global Manufacturing PMI has dipped slightly from its cycle-high level in December, with recent currency strength causing some softness in the euro area and Japan (Chart 6). But the diffusion index shows that only three out of the 48 countries currently have PMIs below 50 (Egypt, Indonesia and South Africa). Consensus forecasts expect 2018 global GDP growth to come in at around 3.3%, similar to last year, and as yet show no signs of faltering (Chart 7). On the back of this, BCA's models suggest that global earnings growth will continue to grow at a double-digit pace for at least the rest of this year (Chart 8). Despite the strong growth, we see U.S. inflation picking up only steadily towards the Fed's 2% target.3 Jerome Powell in his first congressional testimony and press conference as Fed Chair showed no rush to accelerate the pace of rate hikes. We think the Fed is likely to hike four times, not three, but the market should not find this unduly hard to digest, as long as it is against a background of robust growth. Chart 6Dip In Growth Momentum? Dip In Growth Momentum? Dip In Growth Momentum? Chart 7Economists' Forecasts Not Faltering Economists' Forecasts Not Faltering Economists' Forecasts Not Faltering Chart 8Earnings Still Growing Strongly Earnings Still Growing Strongly Earnings Still Growing Strongly For the past year, we have highlighted a number of simple indicators we are watching carefully that have previously been reliable indicators of recessions and equity bear markets. Several have started to move in the wrong direction, but none is yet flashing a warning signal (Table 1, Chart 9). Table 1What To Watch For Quarterly - April 2018 Quarterly - April 2018 Chart 9No Warnings Flashing Here No Warnings Flashing Here No Warnings Flashing Here In February, BCA pushed out its forecast of the next recession to 2020, on the back of the U.S. fiscal stimulus. That would suggest turning more cautious on risk assets towards the end of this year - at which time some of these indicators may be flashing. But, until then we continue to recommend - except for the most risk-averse investors who care mainly about capital preservation and not about maximizing quarterly performance - an overweight allocation to risk assets. Garry Evans, Senior Vice President garry@bcaresearch.com Chart 10Not A Full Blown Trade War... For Now! Not A Full Blown Trade War.... For Now! Not A Full Blown Trade War.... For Now! What Our Clients Are Asking What Are The Implications Of U.S. Tariffs? Following recent announcements of tariffs on steel and aluminum and possible broad-based tariffs on Chinese imports, investors have started to worry about the future of global trade. But these moves should be no surprise since President Trump is merely delivering on electoral promises. From a macro-perspective, here are the key implications of rising trade barriers: An all-out trade war would certainly hurt U.S. growth, but a minor skirmish would have little impact. The U.S. is the advanced economy least exposed to global trade, which makes it harder for nations to retaliate. Running a large trade deficit, with imports from China representing 2.7% of GDP whereas exports to China are just 1.0% of U.S. GDP, gives the U.S. considerable leverage in negotiations. Additionally, the majority of Chinese imports from the U.S. are agricultural products, making it harder for China to retaliate with tariffs since these would raise prices for Chinese consumers (Chart 10). On the other hand, U.S. trade partners also have a case. With trade growth trailing output growth, other nations will be less willing to give in to U.S. threats. Additionally, unlike the Cold War era, when the U.S. had a greater influence on Europe and Japan, the world is moving toward a more multipolar structure. However, we do not believe nations will retaliate by dumping U.S. Treasuries, as that would deliver the U.S.'s desired end result of a weaker dollar. Chart 11Rising Wages Are The Missing Factor Rising Wages Are The Missing Factor Rising Wages Are The Missing Factor Finally, if tariffs lead to a smaller trade deficit and firms start to move production back to the U.S., aggregate demand will increase. And, given a positive output gap in the U.S., the Fed would be forced to turn more hawkish, ultimately forcing the dollar up. Equity markets do not like tariffs, and bonds will follow the path that real growth and inflation take. How the situation will develop depends on whether Trump embraces America's traditional transatlantic alliance with Europe and harnesses it for the trade war against China. If he does so, the combined forces of the U.S. and Europe will likely force China to concede. But if Trump goes it alone, a prolonged U.S.-China trade war could turn into a significant risk to global growth. How Quickly Will U.S. Inflation Rise? The equity sell-off in early February was triggered by a slightly higher-than-expected average hourly earnings number. In recent meetings, we find that clients, who last year argued that the structural pressures would keep inflation depressed ("the Philips Curve is dead"), now worry that it will quickly exceed 2%. And it is true that the three-month rate of change of core CPI has jumped recently (Chart 11, panel 1). Investors are clearly skittish about the risk of higher inflation, which would push the Fed to accelerate the pace of rate hikes. We continue to argue that core PCE inflation (the Fed's main measure) will rise slowly to 2% over the next 12 months, but we do not see it accelerating dramatically. Inflation tends to lag GDP growth by around 18 months and the pickup in growth from Q2 last year should start to feed through. This will be magnified by the 8% weakness in the US dollar over the past 12 months, which has already pushed up import prices by 2% YoY. What is missing, however, is wage pressure. Average hourly earnings are growing only at 2.6% YoY. We find that wage growth tends to lag profits by around 24 months (panel 2) and, since profits moved sideways for close to two years until Q2 last year, it may be a few quarters yet before companies feel confident enough to raise wages. Note, too, that wages have been weak compared to profits in this cycle. This is likely partly because of automation, but also because the participation rate for the core working population continues to recover towards its 2007 level, indicating there is more slack in the labor market than the headline unemployment data suggest (panel 3). Should Investors Still Own Junk Bonds? Chart 12Credit Cycle Still On Credit Cycle Still On Credit Cycle Still On The current late stage of the economic cycle has investors worried about the credit cycle and the outlook for corporate credit, in particular high-yield bonds. The number-one concern is stretched valuations. Spreads are close to all-time lows, which means investors should not expect significant capital gain. However, spreads can stay low for extended periods, especially in the late stages of the credit cycle. Junk bonds are a carry trade at this point, and investors can continue to pick up carry before a sustained period of spread widening sets in (Chart 12). A flattening yield curve is bad for junk returns, as it signals monetary policy is too restrictive. But, as inflation continues to trend higher, the curve is likely to steepen while allowing the Fed to deliver rate hikes close to its median projection. The key risk is a scenario in which inflation falters, but the Fed continues to hike. In this case a risk-off episode in credit markets would be likely, but this would be a buying opportunity and not the end of the cycle. Corporate balance-sheets have weakened, and logically investors should demand greater compensation to hold high-yield bonds. But spreads have diverged from this measure since early 2016. However, we expect improvements in corporate health since the outlook for profit growth is strong. However, a great deal of bond issuance has been used for share buybacks. If capital structures have less of an equity cushion, then recovery rates are likely to be lower when defaults do start to rise. Cross-asset volatility has returned. But credit spreads have remained calm thanks to accommodative monetary policy and easing bank lending standards. Also, stricter post-crisis bank capital regulations have mitigated the risk. Finally, the growing presence of open-ended junk bond funds and ETFs increases the risk that, once spreads start to widen, they will widen much more quickly than they would have otherwise. Who Should Invest In Hedged Foreign Government Bonds? In a recently published Special Report,4 we found that hedged foreign government bonds are a good source of diversification for bond portfolios. Hedging not only reduces the volatility of the foreign bonds, it reduces it so much that the risk-adjusted return ratio has significantly improved for investors with home currency in USD, GBP, AUD, NZD, CAD and EUR (Table 2). This is true across different time periods for most fixed income investors other than those in Japan, as shown in Chart 13. Table 2Domestic And Foreign Government Risk Return Profile (December 1999 - January 2018) Quarterly - April 2018 Quarterly - April 2018 Chart 13Domestic Vs. Foreign Treasury Bonds: Consistent Performance Across Time Quarterly - April 2018 Quarterly - April 2018 So the answer depends on investors' objectives and constraints: If investors are comfortable with the volatility in their local aggregate bond indexes, which are already a lot lower than equities, then investors in the U.S., the U.K., Canada and the euro area are better off staying home for higher returns without dealing with hedging operations. For Aussie, kiwi and Japanese investors, however, going abroad enhances returns. If investors focus on lower volatility, then all investors should invest a large portion of their portfolios overseas, with the exception of Japanese investors. If investors focus on risk-adjusted returns, then investors in Australia, New Zealand, the U.S., the U.K. and Canada are better off investing a large portion overseas. Global Economy Overview: Global growth remains robust, though momentum has slowed slightly in recent weeks. No recession is likely before 2020 at the earliest due to strong U.S. fiscal stimulus. Inflation will slowly rise towards central bank targets but there is little reason to expect it to accelerate dramatically, and so we see no need for aggressive monetary tightening. U.S.: Short-term, growth looks to have softened, with the Citigroup Economic Surprise Index turning down (Chart 14, top panel), and the regional Fed NowCasts for Q1 GDP growth pointing to 2.4%-2.7%. However, growth over the next two years should be boosted by the recent tax cuts and government spending increases, which we estimate will push up GDP growth by 0.8% in 2018 and 1.3% in 2019. Wages should start to rise from their current sluggish levels (average hourly earnings only up 2.6% YoY) given the tight labor market, which should boost consumption. Capex (panel 5) is likely to continue to recover due to tax cuts and a high level of businesses confidence. Euro Area: Growth has been steady in recent quarters, with Q4 GDP rising 2.5% QoQ annualized. However, lead indicators such as the PMI (Chart 15, top panel) have rolled over, probably because of the strong euro (up 6.2% in trade-weighted terms over the past 12 months). The effect has yet to be seen in exports, which continue to grow strongly, 6.2% YoY in February, but earnings results for Q4 surprised much less on the upside in the euro area than in the U.S. Chart 14Growth Robust, But Momentum Slowing Growth Robust, But Momentum Slowing Growth Robust, But Momentum Slowing Chart 15Strong Currencies Denting EU And Japanese Growth Strong Currencies Denting EU And Japanese Growth Strong Currencies Denting EU And Japanese Growth Japan: As an export-oriented, cyclical economy, Japan has also benefitted from better global conditions, with GDP rising by 1.6% QoQ annualized in Q4. However, like Europe, the stronger currency has begun to dent the external sector, with industrial production and the leading index slowing (Chart 15, panel 2). However, more encouraging signs are appearing domestically: retail sales rose by 2.5% YoY in January and part-time wages are up 2.0% YoY. As a result, inflation is finally emerging, with CPI (excluding food and energy) up 0.3% YoY. Emerging Markets: China's growth remains steady, with the Caixin PMI at 51 (panel 3). However, credit and money supply growth continue to point to a slowdown in coming months. This may be evident when March data (unaffected by the shifting timing of Chinese New Year) becomes available. Elsewhere in EM, growth has picked up moderately: Q4 GDP growth came in at an annualized rate of 7.2% in India, 3.0% in Korea, and even 2.1% in Brazil and 1.8% in Russia. Interest rates: A modest rise in inflation expectations (panel 4) has led to a rise in long-term rates, with the U.S. 10-year yield rising from 2.5% to almost 3% during Q1 before slipping back a little. We expect the Fed to hike four times this year, and think this will push up the 10-year Treasury yield to 3.3-3.5% by year-end. The ECB continues to emphasize that it will move only slowly to raise rates after halting asset purchases later this year, and we think the market has correctly priced the timing of the first hike for Q4 2019. We see no reason why the BoJ will end its Yield Curve Control policy, with inflation still well below the 2% target. Chart 16Cautiously Optimistic Cautiously Optimistic Cautiously Optimistic Global Equities Tip-Toeing Through The Late Cycle. Global equities experienced widespread corrections in the first quarter after a very strong start in January gave way to fear of rising inflation in the U.S., fear of slowing growth in China, and fear of rising geopolitical tensions globally. The return of macro volatility was so violent that it pushed the VIX to high readings not seen since 2015. Granted, a background of stretched valuations, complacency, and the "fear of missing out" also contributed to the market correction. The healthy correction of global equities from the high in late January has seen valuations contracting as earnings continued to grow at strong pace (Chart 16). BCA's house view is that global growth may be peaking, but should remain strong and above trend, underpinning decent earnings growth for the next 9-12 months. As such, we retain our pro-cyclical tilts in global equity allocations, overweight cyclical sectors and underweight defensive sectors; overweight high-beta DM markets (Japan and euro area); neutral on the U.S. and Canada; and underweight EM and Australia, the markets that would suffer most from a deceleration in Chinese growth. However, we are late in the cycle and valuations remain stretched by historical standards despite the recent correction. With macro volatility returning, investors should be very conscious of potential risks that could derail the uptrend in equities. For investors with higher aversion to risk, we suggest raising cash by selling into strength or dialing down the overweight of cyclicals vs defensives. Anatomy Of EM/DM Outperformance Since their low in early 2016, EM equities have outperformed DM in total return terms by more than 20%, of which 262 bps came in the first quarter of 2018, despite the rising volatility in all asset classes recently. As show in Chart 17, the outperformance of EM over DM has been dominated by three sectors: Technology, Financials and Energy. In the two-year period ending December 2017, over half of the EM outperformance came from the Tech sector, followed by Financials and Energy, accounting for 32% and 14% respectively. In Q1 2018, however, Tech's contribution dropped sharply to 0.3%, while Financials and Energy shot up to 51% and 33% respectively. Even though Energy is a relatively small sector, accounting for 6-7% of benchmark weights in both EM and DM, the diverging performance between EM and DM Energy sectors has played an important role in the EM outperformance. In the two years ending December 2017, EM Energy outperformed its DM counterpart by 32%, the same magnitude as the Tech sector (Table 3). In Q1 2018, EM Energy gained 7.6% while DM Energy suffered a 5.2% decline, resulting in a staggering 13% outperformance (Table 4). Chart 17Sector Contributions To EM/DM Outperformance Quarterly - April 2018 Quarterly - April 2018 Table 3Two-Year Performance Attribution* (December 2015 - December 2017) Quarterly - April 2018 Quarterly - April 2018 Table 4Q1/2018 Attribution* (December 2015 - December 2017) Quarterly - April 2018 Quarterly - April 2018 Country-wise, Brazil and China led the outperformance, helped by the Brazilian real's 30% appreciation against the U.S. dollar. BCA's EM Strategy believes that Brazilian equities and the real will both weaken given the country's weak governance and poor fiscal profile. Chart 18Style Performance Style Performance Style Performance We are neutral on Tech globally, and the general reliance of EM equities on Chinese growth, and the high leverage in EM do not bode well for EM equities. Remain underweight EM vs. DM. A Sector Approach To Style Year to date, the equal-weighted multi-factor portfolio has outperformed the global benchmark slightly, largely driven by the strong outperformance of Momentum and Quality, while Value and Minimum Volatility (MinVol) have underperformed (Chart 18, top three panels). This is in line with our previous regime analysis that indicated rising growth and inflation is a good environment for Momentum and Quality, but a bad one for Min Vol.5 As we have argued before, we prefer sector positioning to style positioning because 1) the major style tilts such as Value/Growth, Min Vol and Small Cap/Large Cap have seen significant sector shifts over time, and 2) sector selection offers more flexibility. As shown in Chart 18 (bottom three panels), the relative performance of Min Vol is a mirror image of Cyclicals vs Defensives, while Value/Growth is highly correlated with Cyclicals/Defensives. In a Special Report,6 we elaborated in-depth that sector selection is a better alternative to size selection, especially in the U.S. We maintain our neutral view on styles, and continue to favor Cyclicals versus Defensives. Given that we are at the late stage of the business cycle, investors with lower risk tolerance may consider gradually dialing down exposure to cyclical tilts. For stock pickers, this would mean favoring stocks with low volatility, high quality and strong momentum. Government Bonds Maintain Slight Underweight On Duration. Despite rising volatility due to changes in inflation expectations and uncertain developments in geopolitics, the investment backdrop has been evolving in line with our 2018 Strategy Outlook. Global growth continues at a strong pace (Chart 19) and our U.S. Bond Strategy has increased its yield forecast to the range of 3.3-3.6%, from 2.80-3.25% previously, reflecting both a higher real yield and higher inflation expectations. The U.S. 10-year Treasury yield increased by 34 bps in Q1 to 2.74%, still lower than our fair value estimate, implying that there is still upside risk for global bond yields. As such, investors should continue to underweight duration in global government bonds. Favor Linkers Vs. Nominal Bonds. The base case forecast from our U.S. Bond Strategy is that the U.S. TIPS breakeven will rise to 2.3-2.5% around the time that U.S. core PCE reaches the Fed's 2% target rate, likely sometime in 2H 2018. Compared to the current level of 2.05, this means the 10-year TIPS has upside of 25-45 bps, an important source of relative return in the low-return fixed income space (Chart 20). Maintain overweight TIPS vs. nominal bonds. In terms of relative value, however, TIPS are no longer cheap. For those who have not moved to overweight TIPS, we suggest "buying TIPS on dips". In addition, inflation-linked bonds (ILBs) in Australia and Japan are still very attractive vs. their respective nominal bonds (Chart 20, bottom panel). Overweight ILBs in those two markets also fits well with our macro themes. Chart 19Further Upside In Bond Yields Further Upside In Bond Yields Further Upside In Bond Yields Chart 20Favor Inflation linkers Favor Inflation linkers Favor Inflation linkers Corporate Bonds We continue to favor both investment grade and high-yield corporate bonds within the fixed-income category. High-yield spreads barely reacted to the sell-offs in equities in February and March (Chart 21). We see credit spreads as a useful indicator of recessions and equity bear markets and so the fact that they did not rise suggests no broad-based risk aversion. Moreover, this resilience comes despite significant outflows from high-yield ETFs, $4.4 billion year-to-date, almost completely reversing the inflows over the previous three quarters. We still find spreads in this space attractive. BCA estimates the default-adjusted spread is still around 250 basis points (assuming default losses of 1.3% over the coming 12 months) which, while not cheap, is less overvalued than other fixed-income categories (Chart 22). Investment grade spreads, however, have widened in recent weeks (Chart 21), with the rise concentrated in the highest-quality credits. This is most likely because investors see little value in these securities. We keep our overweight but we focus on cross-over credits and sectors where valuations are still reasonable, for example energy, airlines and insurance companies. Excessive leverage remains a concern for corporate bond losses in the next recession. BCA's Corporate Health Monitor (Chart 23) has improved in recent quarters, mostly due to stronger profitability. But the deterioration in interest coverage ratios in recent years makes companies vulnerable to higher rates. We estimate that a 100 basis point increase in interest rates across the corporate curve would lead to a drop in the ratio of EBITDA to interest expenses from 4.0 to 2.5.7 Sectors such as Materials, Technology, Consumer Discretionary and Energy appear especially at risk.8 Chart 21IG Spreads Have Widened, But Not HY IG Spreads Have Widened, But Not HY IG Spreads Have Widened, But Not HY Chart 22Junk Bonds Still Offer Some Value Junk Bonds Still Offer Some Value Junk Bonds Still Offer Some Value Chart 23Leverage Is A Worry For The Next Recession Leverage Is A Worry For The Next Recession Leverage Is A Worry For The Next Recession Commodities Chart 24OPEC Agreements Hold The Key OPEC Agreements Hold The Key OPEC Agreements Hold The Key Energy (Overweight): Demand/supply fundamentals have been driving prices in crude oil markets (Chart 24). Fundamentals remain favorable as strong global demand is keeping the market in physical deficit. However, the outlook for demand has turned cloudy as the market may start to price in the possibility of a trade war which would dent growth. Also, threats of renewed sanctions against Iran and deeper ones against Venezuela could potentially disrupt supply sufficiently to push up the crude price. Given rising uncertainties with the demand and supply outlook, we expect increased volatility in the crude price. We maintain our forecasts for the average 2018 prices for Brent and WTI at $74 and $70 respectively. Industrial Metals (Neutral): As President Trump moves ahead with protectionist policies, markets are being spooked by the possibility of a trade war. Looking past the noise, since China remains the largest source of demand, price action will follow domestic Chinese market fundamentals which are a function of how authorities handle a possible growth slowdown. The possibility of global trade disruptions, coupled with a recovery in the U.S. dollar, suggests increased price volatility. We are particularly negative on zinc. Spanish zinc has been flooding into China, depressing physical premiums and causing inventory accumulation (Chart 24, panel 3). Precious Metals (Neutral): Rising trade protectionism, geopolitical tensions, and diverging monetary policy will be sources of increased market volatility for the rest of the year. When equity markets went through a minor correction earlier this year, gold outperformed global equities by 6%. However, rising interest rates and a potentially stronger U.S. dollar are two headwinds for the gold price. We continue to recommend gold as a safe haven asset against unexpected market volatility and inflation surprises (Chart 24, panel 4). Currencies Chart 25Dollar Will Stage A Recovery Rally Dollar Will Stage A Recovery Rally Dollar Will Stage A Recovery Rally U.S. Dollar: Following its 7% depreciation last year, the greenback is flat year to date. A positive output gap and strong inflation readings are giving the Fed enough reasons not to fall behind the curve. Secondly, the proposed fiscal stimulus is likely to increase the U.S.'s twin deficits which has historically been bullish for the currency, as long as it is accompanied by rising real rates. Finally, speculative positions in the dollar are net short, which means any positive surprises will be bullish for the currency. We expect the U.S. dollar to stage a recovery rally in the coming months (Chart 25, panel 1). Carry Trades: Cross-asset class volatility is making a strong comeback. Carry trades fare poorly in volatile FX markets. High-yielding EM currencies like the BRL, TRY, and ZAR will underperform, whereas low yielding safe-haven funding currencies like the Swiss franc and Japanese yen, in countries with outsized net international investment positions, will be the winners. Finally, the return of volatility could hurt global economic sentiment and possibly weigh on growth-sensitive currencies like the KRW, AUD and NZD (Chart 25, panel 2). Euro: Analyzing the euro's strength, we see a 9% divergence in performance between the EUR/USD pair and the trade-weighted euro. Global synchronized growth was driven predominantly by a recovery in manufacturing which benefited the euro area more than the U.S. Also looking at history, the euro tends to appreciate relative to USD in the last two years of economic upswings driven by strong growth. Finally, the recent divergence in relative interest rates is a clear sign that other fundamental factors, such as the current account balance, have been exerting pressure. Sentiment and positioning remain extremely euro bullish, hence any disappointment with economic data will force a correction (Chart 25, panel 3). GBP: Since 2017, the pound has strengthened by over 16% vs. USD. An appreciating currency has dented inflation readings, thereby limiting the pass-through effects via the Bank of England hiking rates. A hurdle to further appreciation is negative growth in real disposable income and declining household confidence. Finally, weak FDI inflows will hurt the U.K.'s basic balance. Since the BoE will find it difficult to tighten policy much, we expect a correction in the next few months (Chart 25, panel 4). Alternatives Investors have been increasing their allocation to alternatives, pushing AUM to a record $7.7 trillion. We continue to recommend allocations through three different buckets: 1) among return enhancers, we favor private equity vs hedge funds; 2) favor direct real estate vs. commodity futures in inflation hedges; 3) favor farmland & timberland vs. structured products as volatility dampeners. But alternatives have a few challenges that require special consideration. Private Equity: Key drivers of returns have changed. In the past, managers were able to succeed by "buying low/selling high". But today, investors need to pick general partners (GPs) who can identify attractive targets and effect strategic and operational improvements. $1.7 trillion of dry powder. Global buyout value grew by 19% in 2017, but deal count grew by only 2%. High valuations multiples, stiff competition, and an uncertain macro outlook will force funds to be selective. Competition from corporate buyers. GPs are fighting with large corporations looking for growth through acquisition. Private equity's share of overall M&A activity globally declined in 2017 for the fourth year running. Competition for targets is boosting entry multiples in the middle-market segment. Hedge Funds: Net exposure for long/short managers has remained static over market cycles, which means investors pay too much for market exposure. But if we see market rotation or increased dispersion of single stock returns, this hedge fund group will benefit. Discretionary macro will benefit from differing growth outlooks, idiosyncratic events, and local rate cycles. Also, potential for more dispersion in the large-cap space and at the index level will benefit systematic macro. Event-driven funds have been hurt by deal-spread volatility as shareholder opposition, anti-trust concerns and political issues led to deal delays. But we continue to favor short-term special situations in less-followed markets such as Asia. Real Estate: After strong growth in capital values, driven by low rates and cap rate compression, investors need to focus on income-driven total returns. Additionally, income returns do not vary across markets nearly as much as capital value growth. Increase focus on core strategies. Look for properties in prime locations with long and stable lease contracts. Investors can also consider loans made to high-quality borrowers which are secured against properties with stable cash flows. Private Debt: With ultra-low yields, private debt offers attractive risk-adjusted return, diversification, and a potential cash flow profile ideal for institutional investors. However, it is critical to source a differentiated pipeline of opportunities. Infrastructure debt, with a long expected useful life, can provide effective duration for liability matching. Risk-adjusted returns can be enhanced by directly sourcing and structuring. Risks To Our View We see the risks to our main scenario (strong growth continuing through 2019, moderate inflation, late cycle volatility, and rising geopolitical risks) as balanced. There are a number of obvious downside risks, including an escalating trade war, a sharp upside surprise to inflation, and the Fed turning more hawkish (perhaps in an attempt to demonstrate its independence if President Trump pressures it not to raise rates). Among the risks less appreciated by investors is a slowdown in China. Leading indicators of the Chinese economy, particularly money supply and credit growth, continue to slow (Chart 26). Xi Jinping's recent senior appointments suggests he is serious about structural reform, which would mean accepting slower growth in the short-term to put China on a sounder long-term growth path. Linked to this, we also think investors are insufficiently concerned about the impact of rising rates on emerging market borrowers. If, as we expect, U.S. long rates rise to close to 3.5% over the next year and the dollar strengthens, the $3.5 trillion of foreign-currency borrowing by EM borrowers could become a burden (Chart 27). Chart 26What If China Slows? bca.gaa_qpo_2018_04_03_c26 bca.gaa_qpo_2018_04_03_c26 Chart 27Highed Indebted EM Borrowers Are A Risk Highed Indebted EM Borrowers Are A Risk Highed Indebted EM Borrowers Are A Risk Chart 28Presidents Like Markets To Rise Quarterly - April 2018 Quarterly - April 2018 Upside risk centers on a continuation of strong growth and dovish central banks. We may be underestimating the impact of U.S. fiscal policy. Our assumption that it will peter out in 2020 may be wrong, if President Trump goes for further stimulus ahead of the presidential election - the third and fourth years of presidential cycles are usually the best for stocks (Chart 28). Wages may stay low because of automation. In the face of this the Fed may stay dovish: it already shows some signs of allowing an overshoot of its 2% inflation target, to balance the six years that it missed it to the downside. All this could produce a stock market meltup, similar to 1999. 1 See, for example, Clashing Over Commerce: A History of U.S. Trade Policy, Douglas J, Irwin, Chicago 2017, chapter 8. 2 For an analysis of the geopolitical implications, please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 27, 2018. 3 Please see the What Our Clients Are Asking: How Quickly Will U.S. Inflation Rise? on page 8 of this Quarterly Portfolio Outlook for the reasons why this is our view. 4 Please see Global Asset Allocation Special Report, "Why Invest In Foreign Government Bonds?" dated March 12, 2018 available at gaa.bcaresearch.com 5 Please see Global Asset Allocation Special Report, "Is Smart Beta A Useful Tool In Global Asset Allocation?" dated July 8, 2016, available at gaa.bcaresearch.com 6 Please see Global Asset Allocation Special Report, "Small Cap Outperformance: Fact Or Myth?" dated April 7, 2017, available at gaa.bcaresearch.com 7 Please see The Bank Credit Analyst, "Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector," dated February 22, 2018. 8 Please see also What Our Clients Are Asking: Should Investors Still Own Junk Bonds, on page 9 of this Quarterly Update, for more analysis of this asset class. GAA Asset Allocation

Highlights Global growth has peaked, but will remain firmly above trend for the remainder of the year. The composition of global growth is shifting back towards the U.S. As often happens in the late stages of business-cycle expansions, asset markets have entered a more volatile phase. A global recession is likely in 2020. Equities: The correction is nearing an end, which will set the stage for a blow-off rally into year-end. For the time being, favor DM over EM stocks, Europe over the U.S., and value over growth. The "real" bear market will start next year. Government bonds: Global bond yields will trend higher over the next 12 months, but will begin moving lower by the middle of next year as recession risks mount. Over the long haul, yields are going higher - much higher. Credit: Spread product will eke out small gains relative to government bonds over the next 12 months. Spreads will blow out as the recession approaches. Investors will be shocked to learn that a lot of what they thought is investment-grade debt is really junk (or worse). Currencies: The U.S. dollar will bounce before resuming its bear market next year. The yen could weaken slightly against the dollar in 2018, but will hold its own against most other currencies. Energy-sensitive currencies such as the CAD will outperform other commodity currencies. Feature Booyah Writing frantically on October 8, 1998, CNBC commentator and former hedge fund manager Jim Cramer entitled his TheStreet.com piece with the indelible words "Get Out Now". Long-Term Capital Management had just imploded. Emerging Markets were crashing. Coming off the heels of a stratospheric ascent, the S&P 500 was down 22% from its highs. The tech-heavy NASDAQ had swooned 33%. The equity bull market had finally ended. Or so he thought. As fate would have it, the S&P 500 bottomed literally the very same minute that Cramer's piece came out.1 It went on to rise 68% before ultimately peaking in March 2000. Cramer would go on to avenge his 1998 call, wisely counseling his readers on October 6, 2008 to "take your money out of the stock market right now, this week." But on that fateful day in 1998, he was wrong. There are many differences in the economic environment between now and then, but on the crucial question of which way global equities are heading, history is likely to rhyme. As was the case in the late 1990s, the shakeout this year may be a prelude to a blow-off rally that takes stocks to new highs. Historically, equity bear markets and recessions almost always overlap (Chart 1). In fact, the most useful lesson I have learned over the past 25 years studying macro and markets is that unless you think a recession is around the corner, you should overweight stocks. It's as simple as that. Chart 1Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Fortunately, another recession is not around the corner. Interest rates are rising but are not yet in restrictive territory. Fiscal policy is being loosened, particularly in the U.S. Easy fiscal policy and still-accommodative monetary policy rarely produce recessions. As we discuss below, a global recession will eventually arrive - probably in 2020 - but that is still two years away. Stocks normally sniff out recessions before they start. However, the lead time is usually about six months. As Table 1 illustrates, equities typically do well in the second-to-last year of business-cycle expansions. We are probably in that window now. Table 1Too Soon To Get Out Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 A Whiff Of Stagflation So why the newfound angst? Partly, it is because markets were technically overbought and due for a correction. We warned clients as much in a report entitled "Take Out Some Insurance", published on February 2nd, one day before the VIX spike began.2 Fears of stagflation are also escalating. Inflation appears to be rising at the same time as global growth is slowing. Real potential GDP has increased at a snail's pace in the G7 economies over the past decade, the result of disappointing productivity gains and sluggish labor force growth (Chart 2). If the world is running out of spare capacity - and GDP growth is forced to climb down towards what many fear is an anemic trendline - then revenue and earnings growth are apt to decelerate. Chart 2Lackluster Productivity Gains And Anemic Labor##br## Force Growth Have Weighed On Potential GDP Lackluster Productivity Gains And Anemic Labor Force Growth Have Weighed On Potential GDP Lackluster Productivity Gains And Anemic Labor Force Growth Have Weighed On Potential GDP Escalating protectionism has further exacerbated anxieties about stagflation. President Trump has threatened to hike tariffs on steel and aluminum, go after China for allegedly stealing U.S. intellectual property, and pull out of NAFTA if a new deal is not negotiated in America's favor. An all-out global trade war would raise consumer prices and reduce output by impairing the efficient allocation of resources across countries. Investors have taken notice. None of these stagflationary concerns can be summarily dismissed, but they are less worrisome than they might appear. Let's start with trade wars. A Trade Spat, Not A Trade War We have long thought that we are in a secular bull market in populism. This is why we argued that investors were greatly understating the risks of Brexit in the weeks leading up to the referendum. It is also why we ignored the derision of others and predicted that Trumpism would prevail back in 2015 and that Trump himself would win the presidency by securing a larger-than-expected share of disgruntled white blue-collar workers in the Midwest.3 Trade protectionism, of course, is a major part of most populist agendas. However, the attractiveness of protectionism tends to ebb and flow depending on the state of the business cycle. There is a reason why the Smoot-Hawley tariff act was introduced during the Great Depression and not the Roaring Twenties. Both economically and politically, beggar-thy-neighbor policies are more appealing when unemployment is high and one more job abroad means one less job at home. That is not the case today, at least not in the U.S. Moreover, while the U.S. legal system gives the president free rein to impose tariffs and other trade barriers, Donald Trump is still constrained by the reaction of the business community and financial markets. After all, this is a president who likes to measure his self-worth by the value of the S&P 500. Needless to say, investors do not like protectionism. It is not surprising, therefore, that Trump has watered down his tariff rhetoric every time the stock market has sold off. It also not surprising that Trump has increasingly focused his wrath on China, a country with which the U.S. business community has had a love-hate relationship. A blue-ribbon commission recently estimated that intellectual property theft - most of it originating from China - costs the U.S. $225 billion-to-$600 billion per year.4 That is a lot of money that American companies could be making but aren't. China will undoubtedly complain that it is being unfairly singled out. It will also threaten retaliatory measures if the Trump administration imposes trade barriers on Chinese imports. In the end, those threats are likely to ring hollow. A war is only worth fighting if you think you can win. China has a very asymmetric trading relationship with the U.S., and one that gives it very little leverage. U.S. exports to China amount to less than one percent of U.S. GDP. That's peanuts - in some cases literally: Nearly half of U.S. goods exports to China consist of soybeans, wheat, cotton, nuts, and other agricultural products and raw materials. It would be difficult to tax them without hurting Chinese consumers. Of course, China could try to punish the U.S. by dumping Treasurys. But why would it? This would only drive down the value of the dollar, giving U.S. exporters a greater advantage. Trump wants that! Saying that you will retaliate against Trump's tariffs by no longer manipulating your currency is not exactly a credible threat.5 In the end, far from retaliating, China will try to placate Trump by easing restrictions on trade and foreign investment and making some politically-calculated purchases of U.S.-made goods. Boeing's stock sold off in the wake of escalating trade tensions. It probably should have risen. Peak Growth? In contrast to last year, global growth is no longer accelerating. Our Global Leading Economic Indicator is still rising, but the diffusion index, which measures the proportion of countries with rising LEIs, is down from its October 2017 high (Chart 3). Changes in the diffusion index have often foreshadowed changes in the composite LEI. An even more worrisome picture is painted by the OECD's LEI, which has actually dipped slightly over the past two months. The OECD's LEI diffusion index has also fallen below 50%. The Chinese economy appears to be slowing on the back of tighter monetary conditions (Chart 4). The Keqiang index, which combines data on electricity production, freight traffic, and bank lending, has come off its highs and our leading indicator for the index is pointing to further weakness. Property price inflation in tier 1 cities has fallen to zero. A number of clients noted during my visit to China last week that a wave of supply has hit the market over the past month following President Xi's warning that homes are for living and for not investing. A weaker Chinese property market could drag down construction spending, with adverse knock-on effects to commodity prices. Slower Chinese growth is rippling across the global economy (Chart 5). Korean exports - a bellwether for global trade - have decelerated. Japanese machinery orders have rolled over. The Baltic dry index has plunged by 40% from its December highs. The expectations component of the German IFO index has fallen to its lowest level since January 2017. Chart 3Global Growth Will Remain Above Trend,##br## But Has Probably Peaked For This Cycle Global Growth Will Remain Above-Trend But Ease From Blistering Pace Global Growth Will Remain Above Trend, But Has Probably Peaked For This Cycle Global Growth Will Remain Above-Trend But Ease From Blistering Pace Global Growth Will Remain Above Trend, But Has Probably Peaked For This Cycle Chart 4China's Industrial Sector Is Set ##br##To Slow Further China Is Slowing China's Industrial Sector Is Set To Slow Further China Is Slowing China's Industrial Sector Is Set To Slow Further China Is Slowing Chart 5Signs Of Slowing##br## Global Growth Signs Of Slowing Global Growth Signs Of Slowing Global Growth So far, the slowdown in global growth has been fairly modest. Goldman's global Current Activity Indicator (CAI), which combines both soft and hard data to gauge underlying economic momentum, was still up 4.9% in March, only slightly below recent cycle highs (Chart 6). The deterioration in a number of leading economic indicators suggests that the slowdown may have further to run. However, we would be surprised if it proves to be especially deep or long-lasting. Global financial conditions are still quite accommodative (Chart 7). Bank balance sheets are in good shape and rising capex intentions should support credit demand over the coming months, even in the face of somewhat higher borrowing costs. Improving labor markets should also bolster consumer confidence. Chart 6But Global Slowdown Has Been Fairly Modest But Global Slowdown Has Been Fairly Modest But Global Slowdown Has Been Fairly Modest Chart 7Global Financial Conditions Are Still Fairly Easy Global Financial Conditions Are Still Fairly Easy Global Financial Conditions Are Still Fairly Easy Back To The USA If global growth were decelerating because capacity constraints were starting to bite, this would be more worrying because it would mean any effort to stimulate demand would simply lead to more inflation rather than stronger economic growth. Reassuringly, that does not appear to be the case. The U.S. has slowed less than other large economies, even though it is closer to full employment. Notably, the manufacturing PMI has continued to rise in the U.S., but has dipped most everywhere else. Both Citigroup's and Goldman's economic surprise indices are still positive for the U.S., but have fallen into negative territory in Europe and Japan (Chart 8). Granted, Bloomberg consensus estimates suggest that U.S. growth will edge down to 2.5% in the first quarter. However, this may reflect ongoing seasonal adjustment problems. First quarter growth has averaged 1.7 percentage points less over the past decade than in the rest of the year. We are particularly skeptical of recent data showing that consumer spending has slowed, which is completely at odds with strong employment growth, rising home prices, and near record-high levels of consumer confidence. Looking out, U.S. demand growth should benefit from all the fiscal stimulus coming down the pike. We expect the fiscal impulse to rise from 0.3% of GDP in 2017 to 0.8% of GDP in 2018, and 1.3% of GDP in 2019 (Chart 9). The actual numbers could be even higher as our estimates do not include any additional expenditures on infrastructure, the possible restoration of earmarks (which could inflate pork-barrel spending), or the high likelihood that recent changes to the tax code will spawn all sorts of unforeseen loopholes, leading to lower-than-expected tax receipts. Chart 8U.S. Is The Standout U.S. Is The Standout U.S. Is The Standout Chart 9Fiscal Stimulus Bode Well For Growth Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Unfortunately, all this fiscal stimulus is coming at a time when the economy does not need it (Chart 10). The U.S. unemployment rate currently stands at 4.1%, 0.4 percentage points below the Fed's estimate of NAIRU. Given the prospect of continued above-trend growth, the unemployment rate is likely to be close to 3.5% by early next year, which would be below the 2000 low of 3.8%. Chart 10Now Is Not The Time For Fiscal Profligacy Now Is Not The Time For Fiscal Profligacy Now Is Not The Time For Fiscal Profligacy Rebalancing Global Demand: The Role Of The Dollar What happens when fiscal stimulus pushes aggregate demand beyond an economy's productive capacity? One possibility is that imports go up, thereby allowing the additional demand to be satiated with increased production from the rest of the world. For this to happen, however, the prices of foreign-made goods sold in the U.S. need to decline relative to the prices of domestically-produced goods. U.S. imports account for only 15% of GDP. Thus, if the prices of U.S.-made goods do not change relative to the prices of foreign-made goods, only 15 cents or so of every additional dollar of income will fall on imports. After all, consumers do not care about the intricacies of balance of payments statistics when they are deciding whether to buy a foreign or domestic automobile. They care about relative prices. This means that either the nominal trade-weighted dollar must appreciate or the U.S. price level must rise relative to foreign prices. Both outcomes imply a "real appreciation" in the dollar exchange rate, which can be thought of as the volume of foreign goods and services that can be acquired by selling a basket of U.S. goods and services.6 In theory, one can envision a scenario where the nominal dollar exchange rate depreciates while the real exchange rate appreciates over the long haul because inflation rises significantly in the U.S. relative to its trading partners. Much of the market commentary has implicitly focused on just such an outcome. Massive fiscal stimulus, as the story goes, will lift U.S. inflation by so much that the dollar will fall over time. The problem with this narrative is that it is difficult to square with the facts. Long-term inflation expectations have actually risen more in the euro area and Japan since Trump got elected (Chart 11). The true puzzle is that rising U.S. real yields have not translated into a stronger dollar (Chart 12). Chart 11Long-Term Inflation Expectations Have ##br##Risen More In Japan And The Euro Area##br## Than The U.S. Since Trump Took Over Long-Term Inflation Expectations Have Risen More In Japan And The Euro Area Than The U.S. Since Trump Took Over Long-Term Inflation Expectations Have Risen More In Japan And The Euro Area Than The U.S. Since Trump Took Over Chart 12The Dollar Has ##br##Decoupled From Interest##br## Rate Differentials The Dollar Has Decoupled From Interest Rate Differentials The Dollar Has Decoupled From Interest Rate Differentials A Trump Risk Premium? What happened, as Hillary Clinton might ask? One answer is that Trump happened. Larry Summers has argued that political uncertainty around Trump's antics (protectionism, the Mueller probe, the porn stars, etc.) has made holding U.S. assets more risky.7 This risk has been exacerbated by the prospect of large current account and fiscal deficits - the so-called "twin deficits" - stretching for as far as the eye can see. If this theory is correct, the increase in U.S. real bond yields may be less the result of better growth expectations and more the consequence of a rising risk premium on long-term government debt. It's an intriguing hypothesis, but it cannot explain why business confidence is near all-time highs or why the S&P 500, despite this year's selloff, has risen by 23% since the U.S. presidential election. It also cannot explain why the yield curve has flattened recently, which is not what you would expect if investors were shunning long-term bonds. Perhaps it is best not to overthink things. The dollar is a high-momentum currency (Chart 13). At the start of 2017, the greenback was overbought (Chart 14). Then global growth began to accelerate, which has historically has been bad news for the dollar (Chart 15). The lion's share of that growth also came from outside the U.S. None of this is true today, but the downward trend in the dollar has remained intact, and that is proving hard to break. Chart 13USD Is A Momentum Winner Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Chart 14USD Was Overbought At The Start Of 2017 USD Was Overbought At The Start Of 2017 USD Was Overbought At The Start Of 2017 Hard but not impossible. The dollar could get a bit of a reprieve. USD Libor has broken out recently (See Box 1 for details). As Chart 16 illustrates, there has been an extremely close relationship between the dollar index and the 3-month lagged value of the Libor-OIS spread. The cost of shorting the dollar is about to spike as borrowing rates linked to Libor reset over the next few weeks. The Libor spread will eventually come down, but perhaps not before the negative momentum against the dollar has turned into positive momentum. Chart 15Slowing Global Growth Tends##br## To Be Bullish For The Dollar Slowing Global Growth Tends To Be Bullish For The Dollar Slowing Global Growth Tends To Be Bullish For The Dollar Chart 16Shorting The Dollar Is About##br##To Get A Lot More Expensive Shorting The Dollar Is About To Get A Lot More Expensive Shorting The Dollar Is About To Get A Lot More Expensive Fixed-Income: Hedged Or Unhedged? Chart 17Bond Yields, Currency-Hedged Bond Yields, Currency-Hedged Bond Yields, Currency-Hedged When European investors buy U.S. bonds, they take on exposure to both the value of the bond and what happens to the euro-dollar exchange rate. If they do not want to assume the currency risk, they can sell the dollar forward, effectively locking in the number of euros they will receive for every dollar sold. The purchase of the bond increases the demand for dollars, while the commitment to sell the dollar increases the supply of dollars. For the value of the dollar, it is largely a wash.8 Likewise, if U.S. investors do not want to bear currency risk when purchasing German bunds, they can sell the euro forward. This also entails two offsetting transactions: One that boosts the demand for euros and one that raises the supply of euros. The spike in USD Libor has increased the currency-hedged return of non-U.S. bonds relative to U.S. bonds. Chart 17 shows that the yield on 10-year Treasurys, hedged into euros, has fallen to 0.06%, which is below the 0.5% yield offered by German bunds. In contrast, the 10-year bund yield, hedged into dollars, has risen to 3.16% - which is above the 2.78% yield offered by Treasurys. All things equal, it becomes less attractive for foreign investors who wish to buy U.S. bonds to hedge currency risk as USD Libor rises. In contrast, it becomes more attractive for U.S. investors to currency-hedge their overseas bond purchases when USD Libor goes up. Unhedged bond purchases bid up the currency of the issuer, but hedged purchases do not. If a smaller share of foreign investors decide to hedge currency risk when buying Treasurys, while a larger share of U.S. investors decide to hedge currency risk when purchasing foreign bonds, the net demand for dollars will rise. This could help the dollar over the coming months. Go Long Treasurys/Short German Bunds, Currency-Unhedged The correlation between the German-U.S. 30-year bond spread and EUR/USD was extremely tight in 2017 but has completely broken down this year (Chart 18). At this juncture, betting on a normalization of this correlation - effectively, a bet that U.S. Treasurys will outperform bunds in currency-unhedged terms - has become too good to resist. In fact, it is almost a "can't lose" wager. Consider the fact that 30-year Treasurys are yielding 182 basis points above comparable-maturity bunds. The euro would have to rise to 1.23*(1.0182)^30=2.11 against the dollar over the next 30 years for investors to lose money on this investment. Chart 18Unsustainable Divergence? Unsustainable Divergence? Unsustainable Divergence? Granted, inflation is likely to be lower in the euro area. CPI swaps are forecasting that euro area inflation will be roughly 40 bps lower compared to the U.S. over the next three decades. However, this would only lift the Purchasing Power Parity (PPP) value of EUR/USD from its current level of 1.32 to 1.49. In other words, long-term investors betting on the euro are effectively betting on a major euro overshoot. The discussion above raises a more fundamental point. Investors often equate their view about the direction in which a currency is heading with whether to be bullish or bearish on it. We completely agree that the trade-weighted dollar will weaken over the long haul because most valuation metrics suggest that the greenback is still expensive. However, given the carry advantage the U.S. enjoys, long-term investors would still be better off overweighting U.S. fixed-income assets. Regional Equity Allocation U.S. equities have outperformed their global peers since the start of 2017 in local-currency terms but have underperformed in common-currency terms (Chart 19). If the dollar rebounds over the next few months, as we expect, this should boost the local-currency value of European stocks since many large multinational European companies generate sales in dollars. Sector skews should also work in Europe's favor. Financials are the largest overweight in euro area bourses, while technology is the biggest overweight in the U.S. (Table 2). Chart 19U.S. Equities Have Outperformed In Local-Currency Terms, But Not In Common-Currency U.S. Equities Have Outperformed In Local-Currency Terms, But Not In Common-Currency U.S. Equities Have Outperformed In Local-Currency Terms, But Not In Common-Currency Table 2Global Sector Skews: Tech Resides In The U.S. And Growth Indexes,##br## Financials Live In The Eurozone And Value Indexes Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 While global growth has peaked, it will remain firmly above trend. This will ensure that spare capacity continues to shrink, taking global bond yields higher. Since the ECB will not raise rates for at least another year, the yield curve in the euro area will steepen, boosting the profitability of European banks (Chart 20). Tech companies are particularly sensitive to changes in discount rates since they often trade on the assumption that most of their earnings will be realized far into the future. As such, higher long-term real bond yields will adversely affect U.S. tech names, especially in an environment where the dollar is strengthening (more than 50% of U.S. tech sales are derived from abroad). Recent concerns over the way Facebook and other tech companies have handled privacy issues could further sour sentiment towards the sector. The outlook for Japanese stocks is a tough call. Japan, like Europe, is trading at a discount relative to the U.S. based on our in-house valuation metrics (Chart 21). However, we do not see much downside for the yen, even after its recent appreciation. The currency remains very cheap by historic standards, Japan's current account surplus has widened to 4% of GDP, and unlike the euro, speculative positioning is short. While Japanese corporate earnings have been able to expand rapidly over the past 16 months without the support of a weaker currency, now that profit margins are near record highs (Chart 22), further gains in profits and equity prices are likely to be limited. Chart 20Euro Area Yield Curve ##br##Steepening Will Boost Banks Euro Area Yield Curve Steepening Will Boost Banks Euro Area Yield Curve Steepening Will Boost Banks Chart 21Japanese And Euro Area##br##Stocks Are Relatively Cheap Japanese And Euro Area Stocks Are Relatively Cheap Japanese And Euro Area Stocks Are Relatively Cheap The combination of higher U.S. rates, a stronger dollar, and weaker Chinese growth will weigh on EM equities over the coming months. There is $17 trillion in U.S. dollar-denominated debt held outside the U.S., most of it in emerging markets. Ironically, weaker Chinese growth will hurt other EMs more than it hurts China. China accounts for more than 50% of base metal demand compared to only 13.5% for oil (Chart 23). This means that the outlook for metal producers such as Brazil, South Africa, Chile, and Australia is more challenging than for energy producers such as Canada and Norway. Chart 22Global Profit ##br##Margin Picture Global Profit Margin Picture Global Profit Margin Picture Chart 23Base Metals Are More Sensitive##br## To Slower Chinese Growth Base Metals Are More Sensitive To Slower Chinese Growth Base Metals Are More Sensitive To Slower Chinese Growth Favor Value Over Growth We expect global value stocks to start outperforming growth stocks after more than a decade of deep underperformance (Chart 24). The valuation measures constructed by Anastasios Avgeriou and his global equity sector strategy team suggest that value stocks are trading more than two standard deviations cheap relative to growth stocks. Earnings revisions are also starting to move in favor of value names9. Similar to the U.S./euro area equity split, financials are overrepresented in value indices, while technology is overrepresented in growth indices. The weights of the energy and consumer discretionary sectors in the U.S. index are roughly the same as the weights of those two sectors in the euro area index. However, energy is overrepresented in global value indices while consumer discretionary is overrepresented in growth indices. Despite our outlook for a somewhat stronger dollar, our commodity strategists see upside for oil prices this year thanks to continued discipline by OPEC 2.0. This should help energy stocks. On the flipside, consumer discretionary stocks often struggle in a rising rate environment, so this should tilt the playing field in favor of value (Chart 25). Chart 24Value Versus Growth: ##br##Compelling Entry Point Value Versus Growth: Compelling Entry Point Value Versus Growth: Compelling Entry Point Chart 25Consumer Discretionary Stocks Do##br## Poorly In A Rising Rate Environment Consumer Discretionary Stocks Do Poorly In A Rising Rate Environment Consumer Discretionary Stocks Do Poorly In A Rising Rate Environment With all this in mind, we are initiating a trade recommendation to go long the All-Country World Value Index relative to the corresponding Growth Index starting today. Investment Conclusions Volatility typically rises in the late stages of business-cycle expansions, as inflation picks up and monetary policy becomes progressively less accommodative (Chart 26). We have entered such a phase. This does not mean that equities cannot go higher. Chart 27 shows that the VIX rose in the late 1990s, even as stocks zoomed to new highs. We are probably at the tail end of an equity correction now. A blow-off rally into year-end is likely. Chart 26A More Hawkish Fed Usually Means A Higher VIX A More Hawkish Fed Usually Means A Higher VIX A More Hawkish Fed Usually Means A Higher VIX Chart 27Volatility Can Increase As Stock Prices Rise Volatility Can Increase As Stock Prices Rise Volatility Can Increase As Stock Prices Rise We expect the fed funds rate to move into restrictive territory in the second half of 2019. Given the usual lags between changes in monetary policy and the real economy, this would place the next recession in 2020. By then, the U.S. fiscal impulse will have dropped back to zero. It is the change in the fiscal impulse that matters for growth. If growth has already slowed to a trend-like pace by late 2019 due to increasingly binding supply-side constraints, the economy could easily stall out in 2020. The extent to which investors may wish to participate in any blow-off rally this year is a matter of personal preference. As was the case in the late 1990s, long-term expected returns have fallen to fairly low levels. A comparison between the Shiller PE ratio and subsequent 10-year returns over the past century suggests that the S&P 500 will deliver a total nominal annualized return of only 3% over the next decade (Chart 28). A composite valuation measure incorporating both the trailing and forward PE ratio, price-to-book, price-to-cash flow, price-to-sales, market cap-to-GDP, dividend yield, and Tobin's Q shows only modestly higher expected returns for stock markets outside the U.S. (Appendix A). As such, while we recommend overweighting global equities over a 12-month horizon, we would not fault investors for taking some money off the table now. A somewhat more defensive posture would certainly be warranted. Recall that the NASDAQ bubble burst in March 2000, but the S&P 500, excluding the technology sector, did not peak until May 2001. During the intervening period, S&P tech stocks underperformed the rest of the market by 70% (Chart 29). As was the case back then, a shift away from tech leadership may be afoot. This would support our value over growth, and euro area over the U.S., recommendations. Chart 28Demanding U.S. Valuations Point##br## To Low Long-Term Returns Demanding U.S. Valuations Point To Low Long-Term Returns Demanding U.S. Valuations Point To Low Long-Term Returns Chart 29The Force Of Tech At ##br##The Turn Of The Century The Force Of Tech At The Turn Of The Century The Force Of Tech At The Turn Of The Century Spread product should be able to eke out small gains relative to government bonds over the next 12 months. Ratings migration has improved markedly following the energy related downgrades in 2014 and 2015. An improving rating migration ratio is usually associated with corporate bond outperformance relative to Treasurys (Chart 30). Spreads will blow out as the recession approaches. In this month's issue of The Bank Credit Analyst, my colleague Mark McClellan simulated the effect on investment grade credit from: 1) A 100 basis-point increase in interest rates across the curve; and (2) A more severe scenario where interest rates rise by 100 basis points and corporate profits fall by 25% peak- to-trough. Mark's calculations suggest that the next recession will see the interest coverage ratio drop more than in previous downturns (Chart 31).10 Investors may be shocked to discover that a lot of what they thought is investment-grade debt is really junk (or worse). Chart 30Ratings Migration Is Supportive For Credit But... Ratings Migration Is Supportive For Credit But... Ratings Migration Is Supportive For Credit But... Chart 31...Corporate Leverage Will Take Its Toll ...Corporate Leverage Will Take Its Toll ...Corporate Leverage Will Take Its Toll We suggested going long the dollar in August 2014. This view worked well for a while but struggled mightily last year. However, the broad trade-weighted dollar index has been fairly stable since September, and is actually up 2.3% since its January lows (Chart 32). The greenback is due for another rally, one that no doubt would catch many traders by surprise. After a heated internal debate, BCA shifted its house view on bonds towards a more bearish stance in July 2016. As fate would have it, our note entitled "The End Of The 35-Year Bond Bull Market" came out on the same day that the U.S. 10-year yield reached an all-time closing low of 1.37%.11 We observed in February that bond positioning had become extremely short and, thus, tactically, yields could come down a bit. This has indeed happened. Over a 12-month horizon, however, we continue to see yields rising more than what is currently priced in. Both the TIPS 10-year and 5-year/5-year forward breakeven rates are 20-40 basis point below the 2.3%-to-2.5% range that prevailed in the pre-recession period (Chart 33). Somewhat higher oil prices should also boost inflation expectations. Chart 32Up Then##br## Down Up Then Down Up Then Down Chart 33Breakevens Still Below Levels Consistent##br## With 2% Inflation Mandate Breakevens Still Below Levels Consistent With 2% Inflation Mandate Breakevens Still Below Levels Consistent With 2% Inflation Mandate In addition, the real yield component could rise as the market revises up its expectation of the terminal rate. Revealingly, the mean and median terminal dots in the Fed's Summary of Economic Projections increased by 8.3 and 12.5 bps, respectively, in March, but are still more than 100 bps below where they were five years ago. Bond yields will increase in the euro area, as the ECB continues to taper asset purchases. We see less scope for yields to rise in the U.K., as the Brexit hangover continues to weigh on growth. Yields in Japan will remain repressed due to the continuation of the Bank of Japan's Yield Curve Control regime. As the next recession approaches, global bond yields will fall, but are unlikely to take out their 2016 lows. As we discussed in a series of recent reports, both yields and inflation will make a series of "higher highs" and "higher lows" in the U.S. and most other countries over the next decade and beyond.12 Appendix B shows stylistic diagrams of how we expect returns across the major asset classes to evolve over the next decade. The spike in the U.S. Libor-OIS spread appears to be driven by the confluence of a couple of factors. First, Congress raised the debt ceiling on February 9th. This has allowed the U.S. Treasury to rebuild its cash reserves by issuing more T-bills. The sale of these T-bills has drained cash from the overnight market. Second, U.S. corporations have started to repatriate dollars held overseas following the passage of the tax bill. This has further exacerbated the dollar shortage abroad. Libor represents unsecured lending, and hence embeds a credit risk premium. Banks and other financial institutions have been reluctant to put up capital to arbitrage the difference between the rate on Libor and OIS (the latter being a good risk-free proxy for the market's expectation of where short-term policy rates will be). This reluctance reflects regulatory changes, rather than systemic financial risk of the sort experienced during the Global Financial Crisis and the European Sovereign Debt Crisis. The 3-month TED spread - the difference between Libor and Treasury yields - has moved up only modestly due to the fact that short-term Treasury yields have also risen relative to short-term interest rate expectations. Bank CDS spreads have barely increased at all. The Libor-OIS spread will probably fall over the remainder of this year. However, the cost of shorting the dollar will still rise as the Fed continues to raise policy rates. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Box 1 What's Up With Libor? The spike in the U.S. Libor-OIS spread appears to be driven by the confluence of a couple of factors. First, Congress raised the debt ceiling on February 9th. This has allowed the U.S. Treasury to rebuild its cash reserves by issuing more T-bills. The sale of these T-bills has drained cash from the overnight market. Second, U.S. corporations have started to repatriate dollars held overseas following the passage of the tax bill. This has further exacerbated the dollar shortage abroad. Libor represents unsecured lending, and hence embeds a credit risk premium. Banks and other financial institutions have been reluctant to put up capital to arbitrage the difference between the rate on Libor and OIS (the latter being a good risk-free proxy for the market's expectation of where short-term policy rates will be). This reluctance reflects regulatory changes, rather than systemic financial risk of the sort experienced during the Global Financial Crisis and the European Sovereign Debt Crisis. The 3-month TED spread - the difference between Libor and Treasury yields - has moved up only modestly due to the fact that short-term Treasury yields have also risen relative to short-term interest rate expectations. Bank CDS spreads have barely increased at all. The Libor-OIS spread will probably fall over the remainder of this year. However, the cost of shorting the dollar will still rise as the Fed continues to raise policy rates. 1 In his book, Confessions Of A Street Addict, which I highly recommend, Cramer wrote: On October 8, a dreary, chilly rainy Thursday in New York ... the stock market bottomed. At eighteen minutes after 12:00 P.M. I ought to know. I caused it. At 12:18 P.M. I capitulated. I couldn't take it anymore. I gave up both literally, at my fund, and virtually, on my website, TheStreet.com, where I penned a piece entitled "Get Out Now". And the prop wash from that article marked the low point in the most vicious bear market of the last century. 2 Please see BCA Global Investment Strategy Weekly Report, "Take Out Some Insurance," dated February 2, 2018, available at gis.bcaresearch.com. 3 Please see BCA Global Investment Strategy reports, "Trumponomics: What Investors Need To Know," dated September 4, 2015; "Worry About Brexit, Not Payrolls", dated June 10, 2016; "Three (New) Controversial Calls", dated September 30, 2016, available at gis.bcaresearch.com. Also see BCA New York Investment Conference presentations: "Five Controversial Calls - Call #5: The Trumpists Will Win" (September 2015), and "Three Controversial Calls - Call #1: Trump Wins And The Dollar Rallies" (September 2016). 4 Please see "Update To The IP Commission Report - The Theft Of American intellectual Property: Reassessments Of The Challenge And United States Policy," The Commission on the Theft of American Intellectual Property (The National Bureau of Asian Research), (2017). 5 The fact that China's foreign exchange reserves have been trending sideways since early last year does not mean that past interventions should be disregarded. Just as both theory and evidence suggest that quantitative easing affects bond yields primarily through the "stock channel" (how many bonds central banks own) rather than the "flow channel" (the purchase or sales of bonds in any given period), the yuan's value is also more affected by the stock of foreign assets the PBOC controls rather than its recent interventions. This makes intuitive sense. If a central bank drives down its currency by buying a lot of foreign assets, and then suspends further purchases, one might expect the currency to stop falling, but one would not expect it strengthen to where it was before the intervention began. 6 Expressed mathematically, the real exchange rate between two currencies is the product of the nominal exchange rate and the ratio of prices between the countries. A real appreciation tends to make a country less competitive, either through a nominal increase in its currency or through an increase in prices in that country relative to those of its trading partners. 7 Larry Summers, "Currency Markets Send A Warning On The US Economy," March 5, 2018. 8 We say "largely" a wash because while selling the dollar forward is not exactly the same as short-selling it in the spot market due to the presence of the so-called currency basis swap spread, it is economically similar. When European investors short-sell the dollar, they are effectively borrowing dollars at Libor, selling them for euros, and parking the proceeds in a short-term account that pays Euribor. Three-month U.S. Libor is 230 bps these days, while three-month Euribor is -33 bps. Thus, European investors lose 263 bps by currency-hedging their U.S. bond purchases. Conversely, when U.S. investors go short the euro, they are effectively borrowing euros, selling them for dollars, and then parking the proceeds in a short-term account paying Libor. Thus, they gain the equivalent amount from the decision to currency-hedge purchases of euro area bonds. 9 Please see BCA Global Alpha Sector Strategy Weekly Report, "Global Size And Style Update," dated March 9, 2018, available at gss.bcaresearch.com. 10 Please see BCA The Bank Credit Analyst, "U.S. Twin Deficits: Is The Dollar Doomed?" dated March 29, 2018, available at bca.bcaresearch.com. 11 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016; and Strategy Outlook, "Third Quarter 2016: End Of The 35-Year Bond Bull Market," dated July 9, 2016. 12 Please see BCA Global Investment Strategy Weekly Report, "What Central Bankers Don't Know: A Rumsfeldian Taxonomy," dated March 16, 2018; Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018. Appendix A APPENDIX A CHART 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 APPENDIX A CHART 2Long-Term Return Prospects Are Slightly Better Outside The U.S. Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 APPENDIX A CHART 3Long-Term Return Prospects Are Slightly Better Outside The U.S. Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 APPENDIX A CHART 4Long-Term Return Prospects Are Slightly Better Outside The U.S. Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Appendix B APPENDIX B CHART 1Market Outlook: Bonds Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 APPENDIX B CHART 2Market Outlook: Equities Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 APPENDIX B CHART 3Market Outlook: Currencies Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 APPENDIX B CHART 4Market Outlook: Commodities Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights There is growing evidence that China's industrial sector is slowing, as are Asian trade flows. EM stocks have seen their tops. Even though current trade tensions between the U.S. and China could well dissipate, we are at the beginning of a long-term geopolitical standoff between these two superpowers. We are reinstating our long MXN / short BRL and ZAR trade. We are also upgrading Mexican sovereign credit and local bonds to overweight within their respective EM benchmarks. This week we review our recommended country allocation for the EM sovereign credit space. Feature The combination of budding signs of deceleration in both China and global trade, the trade confrontation between the U.S. and China as well as elevated equity valuations, leaves EM stocks extremely vulnerable. Odds are that EM share prices have made a major top. A few financial indicators point to a top in EM risk assets and commodities, while several leading economic indicators herald a global trade slowdown. Taken together we are reiterating our bearish stance on EM risk assets. Market- And Liquidity- Based Indicators Financial market indicators are signalling a major top in EM risk assets and commodities prices: The relative total return (carry included) of four equally weighted EM (ZAR, RUB, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc - has rolled over at its previous highs, and is about to break below its 200-day moving average (Chart I-1). This technical profile points to rising odds of a major down-leg in this carry adjusted ratio of seven 'risk-on' versus two 'safe-haven' currencies, herein referred to as the risk-on / safe-haven currency ratio. Importantly, Chart I-2 demonstrates that this risk-on / safe-haven currency ratio has historically been coincident with EM share prices. A breakdown in this ratio would herald a major downtrend in EM equities. This is consistent with our qualitative assessment that EM equities have seen the peak in this rally. Chart I-1A Major Top In Risk-On Versus ##br##Safe-Haven Currency Ratio bca.ems_wr_2018_03_29_s1_c1 bca.ems_wr_2018_03_29_s1_c1 Chart I-2Risk-On Versus Safe-Haven Currency Ratio##br## And EM Share Prices: Twins? bca.ems_wr_2018_03_29_s1_c2 bca.ems_wr_2018_03_29_s1_c2 The annual rate of change in the risk-on / safe-haven currencies ratio leads global export volumes by several months. It currently indicates that global trade has already peaked, and a meaningful slowdown is in the cards (Chart I-3). As we documented in March 15 report,1 global cyclical sectors - mining, machinery and chemicals - have been underperforming since January. Industrial metals prices, including copper, are gapping down, as are steel and iron ore prices in China (Chart I-4). Chart I-3Global Trade Is Set To Slow bca.ems_wr_2018_03_29_s1_c3 bca.ems_wr_2018_03_29_s1_c3 Chart I-4A Breakdown In Metals Prices Is In The Making A Breakdown In Metals Prices Is In The Making A Breakdown In Metals Prices Is In The Making Our aggregate credit and fiscal spending impulse for China projects considerable downside risks for industrial metals prices (Chart I-5). In this context, a question arises: Why is oil doing well so far? Chart I-6 illustrates that industrial metals prices typically lead oil at peaks. Oil prices have historically been a lagging variable of global business cycles. Chart I-5China's Slowdown Is Far From Over China's Slowdown Is Far From Over China's Slowdown Is Far From Over Chart I-6Industrial Metals Lead Oil Prices At Tops Industrial Metals Lead Oil Prices At Tops Industrial Metals Lead Oil Prices At Tops Furthermore, our two measures of U.S. dollar liquidity have rolled over. These two measures have a high correlation with EM share prices and are inversely correlated with the trade-weighted U.S. dollar (Chart I-7A and Chart I-7B). The dollar is shown inverted on Chart I-7B. The rollover in these measures of U.S. dollar liquidity is due to shrinking U.S. banks' excess reserves at the Federal Reserve. The Fed's ongoing balance sheet reduction and the Treasury's replenishment of its account at the Fed will continue to shrink banks' excess reserves, and thereby weigh on these measures of U.S. dollar liquidity. In short, downside risks to EM stocks and upside risks to the U.S. dollar have increased. Last but not least, China's yield curve has recently ticked down again and is about to invert, signaling weaker growth ahead (Chart I-8). Chart I-7AU.S. Dollar Liquidity And EM Stocks... U.S. Dollar Liquidity And EM Stocks... U.S. Dollar Liquidity And EM Stocks... Chart I-7B...And Trade-Weighted Dollar (Inverted) ...And Trade-Weighted Dollar (Inverted) ...And Trade-Weighted Dollar (Inverted) Chart I-8China's Yield Curve Is About To Invert China's Yield Curve Is About To Invert China's Yield Curve Is About To Invert Hard Data In addition, certain economic data have also decisively rolled over, in particular: Taiwanese shipments to China lead global trade volumes by several months, and they now portend a meaningful slowdown in global export volumes (Chart I-9). The basis for this relationship is that Taiwan sends a lot of intermediate products to mainland China. These inputs are in turn assembled by China and then shipped worldwide. Therefore, diminishing trade flow from Taiwan to China is a sign of a slowdown in world trade. The three-month moving average of Korea's 20-day exports growth rate, which includes the March data point, reveals that considerable softness in global trade is underway (Chart I-10). Chart I-9Another Sign Of Peak In Global Trade Another Sign Of Peak In Global Trade Another Sign Of Peak In Global Trade Chart I-10Korean Export Growth Is Already Weak Korean Export Growth Is Already Weak Korean Export Growth Is Already Weak China's shipping freight index - the freight rates for containers out of China - is softening, and its annual rate of change points to weaker Asian exports (Chart I-11). The annual growth rate of vehicle sales in China has dropped to zero, with both passenger cars and commercial vehicles registering no growth in the past three months from a year ago (Chart I-12). Chart I-11Container Freight Rates In Asia Are Softening Container Freight Rates In Asia Are Softening Container Freight Rates In Asia Are Softening Chart I-12China's Auto Sales: Post-Stimulus Hangover China's Auto Sales: Post-Stimulus Hangover China's Auto Sales: Post-Stimulus Hangover Finally, measures of industrial activity in China such as total freight volumes and electricity output growth continue to downshift (Chart I-13). Next week we are planning to publish a Special Report on China's property market. Our initial research shows that structural imbalances remain acute in the nation's real estate market, and a downturn commensurable if not worse than those that occurred in 2011 and 2014-'15 is very likely. Will the Fed and the People's Bank of China (PBoC) reverse their stance quickly to stabilize growth or preclude a downdraft in global risk assets? In the U.S., the primary trend in core inflation is up. Chart I-14 demonstrates that measures of core inflation have recently risen. This, along with the tight labor market, potential upside surprises in U.S. wages and a still-large fiscal stimulus entails that the bar for the Fed to turn dovish will be somewhat higher this year. It may take a large drawdown in the S&P 500 and a meaningful appreciation in the dollar for the Fed to come to the rescue of risk assets. Chart I-13Chinese Industrial Sector Is Decelerating Chinese Industrial Sector Is Decelerating Chinese Industrial Sector Is Decelerating Chart I-14U.S. Core Inflation Has Bottomed U.S. Core Inflation Has Bottomed U.S. Core Inflation Has Bottomed The Chinese authorities on the other hand, had already been facing enormous challenges in balancing the needs for structural reforms and achieving robust growth before the eruption of the trade confrontation with the U.S. As such, the balancing task is becoming overwhelming. Even if the Chinese authorities stop tightening liquidity now, the cumulated impact of earlier liquidity and regulatory tightening will continue to work its way into the economy, thereby slowing growth. Bottom Line: There is growing evidence that China's industrial sector is slowing, as are Asian trade flows. This is bearish for commodities and EM risk assets. Geopolitics: Icing On The Cake The recent U.S. trade spat with China has arrived at a time when global trade and China's industrial cycle have already begun to downshift, as discussed above. At the same time, investor sentiment on global risk assets remains very complacent, and equity and credit markets are pricey. As such, the U.S.-China trade confrontation has become the icing on the cake. U.S. equity valuations are elevated - the median stock's P/E ratio is at an all-time high (Chart I-15). While EM share prices are not at record expensive levels, valuations are on the pricey side. The top panel of Chart I-16 shows the equal-weighted average of trailing and forward P/E, price-to-book, price-to-cash earnings and price-to-dividend ratios for the median EM sub-sector. This valuation indicator is about one standard deviation above its historical mean. Chart I-15U.S. Equities: Median P/E ##br##Is At Record High U.S. Equities: Median P/E Is At Record High U.S. Equities: Median P/E Is At Record High Chart I-16EM Stocks Are Expensive##br## In Absolute Term bca.ems_wr_2018_03_29_s1_c16 bca.ems_wr_2018_03_29_s1_c16 The bottom panel of Chart I-16 illustrates the same valuation ratio relative to DM. Contrary to prevailing consensus, EM equities are not cheap relative their DM peers. Using median multiples of sub-sectors helps remove outliers. We discussed EM stock valuations in greater detail in our January 24 and March 1 special reports; the links to these reports are available on page 17. As to the duration and depth of the U.S.-China trade confrontation, we have the following remarks: If the U.S.'s plan to impose import tariffs on Chinese goods is primarily about domestic politics ahead of the mid-term elections later this year, as well as to obtain some trade concessions from China, then the current standoff will be resolved in a matter of months. If the true intention of the U.S. is to contain China's geopolitical rise to preserve its global hegemony, this episode of import tariffs will likely mark the beginning of a much longer and drawn-out geopolitical confrontation. In such a case, the U.S.-China relationship will likely witness a roller-coaster pattern with periods of ameliorations followed by periods of escalation and confrontation. Critically, mutual distrust will set in - if not already the case - which will hamper cooperation on various issues. As trade tensions ebb and flow in the months ahead, the reality is that America is worried about losing its geopolitical hegemony to the Middle Kingdom. Our colleagues at BCA's Geopolitical Strategy service have been noting for several years that a U.S.-China confrontation is unavoidable.2 Bottom Line: Even though the current trade tensions between the U.S. and China could well dissipate, we are at the beginning of a long-term geopolitical standoff between these two superpowers. Re-Instating Long MXN / Short BRL and ZAR Trade Chart I-17MXN's Carry Is Above Those Of BRL And ZAR MXN's Carry Is Above Those Of BRL And ZAR MXN's Carry Is Above Those Of BRL And ZAR Odds are that the Mexican peso will begin outperforming the Brazilian real and the South African rand. The main reason why we closed these trades in October was due to NAFTA renegotiation risks. Presently, with the U.S.-Sino trade confrontation escalating, the odds of NAFTA abrogation are declining. In fact, the U.S. may attempt to strike a deal with its allies, including its NAFTA partners, to focus more directly on China. Consequently, a menace hanging over the peso from the Sword of Damocles, i.e., NAFTA retraction, will continue to diminish. Consistently, the risk premium priced into Mexican risk assets will wane, helping Mexican markets outperform their EM peers. Interestingly, for the first time in many years, the Mexican peso's carry is above those of the Brazilian real and the South African rand (Chart I-17). Therefore, going long MXN versus ZAR and BRL are carry positive trades. Importantly, the Mexican peso is cheap. Chart I-18A illustrates the peso is cheap in absolute terms, according to the real effective exchange rate (REER) based on unit labor costs. Chart I-18B shows the peso's relative REER against those of the rand and real. These measures are constructed using consumer and producer prices-based REERs. The peso is cheaper than the South African and Brazilian currencies. Not only is Mexico's currency cheap versus other EM currencies, but Mexican domestic bonds and sovereign spreads also offer great value relative to their EM benchmarks (Chart I-19).Finally, the Mexican equity market has massively underperformed the EM benchmark and is beginning to look attractive on a relative basis. Chart I-18AMXN Is Cheap In Trade-Weighted Terms... MXN Is Cheap In Trade-Weighted Terms... MXN Is Cheap In Trade-Weighted Terms... Chart I-18B...And Relative BRL And ZAR ...And Relative BRL And ZAR ...And Relative BRL And ZAR Chart I-19Mexican Local Currency And Dollar Bonds Offer Value Mexican Local Currency And Dollar Bonds Offer Value Mexican Local Currency And Dollar Bonds Offer Value If and as dedicated EM portfolios rotate into Mexican domestic bonds and equities, this will bid up the peso. Brazil and South Africa are leveraged to China and metals, while Mexico is exposed to the U.S. and oil. Our main theme remains that U.S. growth will do much better than that of China. While a potential drop in oil prices is a risk to the peso, Mexican goods shipments to the U.S. will remain strong, benefiting the nation's balance of payments. Macro policy in Mexico has been super-orthodox: the central bank has hiked interest rates significantly, and the government has tightened fiscal policy (Chart I-20, top panel). This has hurt growth but is positive for the trade balance and the currency (Chart I-20). Mexico will elect a new president in July, and odds of victory by leftist candidate Lopez Obrador are considerable. However, we do not expect a massive U-turn in macro policies after the elections. Importantly, the starting point of Mexico's macro settings is very healthy. In Brazil, government debt dynamics remain unsustainable, yet its financial markets have been extremely complacent. Brazil needs much higher nominal GDP growth and much lower interest rates to stabilize its public debt dynamics. As we have repeatedly argued, a major currency depreciation is needed to boost nominal GDP and government revenues. Besides, Brazil is set to hold general elections in October, and there is no visibility yet on the type of government that will enter office. In South Africa, financial markets have cheered the election of President Cyril Ramaphosa, but the outlook for structural reforms is still very uncertain. The recent decision to consider a constitutional change in Parliament that would allow the confiscation of land from white landlords may be an indication that investors have become overly optimistic on the outlook for structural reforms. In short, the median voter in both Brazil and South Africa favors leftist and populist policies. This entails that the odds of supply side reforms without meaningful riots in financial markets are not great. Finally, the relative performance of the MXN against the BRL and ZAR, including carry, seems to be attempting to make a bottom (Chart I-21). Chart I-20Mexico: Improved Macro Fundamentals Mexico: Improved Macro Fundamentals Mexico: Improved Macro Fundamentals Chart I-21A Major Bottom In MXN's Cross? A Major Bottom In MXN's Cross? A Major Bottom In MXN's Cross? Bottom Line: Go long MXN versus an equally weighted basket of BRL and ZAR. Consistently, we also recommend overweighting Mexican local currency bonds and sovereign credit relative to their respective EM benchmarks. We will review the outlook for Mexican stocks in the coming weeks. EM Sovereign Credit Space: Country Allocation Asset allocators should compare EM sovereign and corporate credit with U.S. and European corporate bonds rather than EM local bonds or equities. The basis is that EM sovereign U.S. dollar bonds are a credit market, and vastly differ from local bonds and equities in terms of volatility, risk-reward trade-off and many other parameters. In short, EM credit markets should be compared to DM credit markets and EM equities to DM equities. EM local currency bonds are a separate, unique asset class.3 We continue to recommend underweighting EM sovereign and corporate credit versus U.S. and European corporate bonds. Within the EM sovereign space, our overweights are: Mexico, Argentina, Russia, Hungary, Poland, the Philippines, Chile and Peru. Neutral: Colombia, Indonesia, Egypt and Nigeria. Our underweights are: Brazil, Venezuela, Malaysia, Turkey and South Africa. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EM: Disguised Risks", dated March 15, 2018; the link is available on page 17. 2 Please see Geopolitical Strategy Weekly Report "We Are All Geopolitical Strategies Now", dated March 28, 2018, available at gps.bcaresearch.com. 3 You may request May 7, 2013 Emerging Markets Strategy Weekly Report discussing our perspectives on how asset allocation for EM financial markets should be done. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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