Financial Markets

Highlights Asset allocation: overweight industrial commodities versus equities... ...and neutral equities versus bonds. The euro: neutral for a broad basket but stay long JPY/EUR. The pound: long-term upside, but a better entry point awaits for those who can fine tune. Italian assets: buy when the 10-year BTP yield moves closer to 3 percent. Feature Some people ascribe this year's market action to economics, others ascribe it to geopolitics, but we put it down to mathematics (Chart of the Week). Chart of the WeekEquities Are In 'No Man's Land' As my colleague Peter Berezin recently pointed out, economies and markets can undergo disruptive 'phase transitions' analogous to when water transitions to ice. For water, a 4 degree drop in temperature from 6 degrees to 2 degrees produces no discernible effect, but the same 4 degree drop from 2 degrees to minus 2 degrees produces major disruption, as roads freeze over, pipes burst, and so forth.1 Similarly, as economic or financial stresses build, nothing discernible happens until a phase transition is reached, at which point everything goes haywire. Our thesis is that markets may be near such a phase transition. To explain why, we first need to correct the great misunderstanding of finance, the misunderstanding of risk. The Evolutionary Basis Of Investment Risk One of the major breakthroughs in behavioural finance was the discovery that we care deeply about the asymmetry of an investment's potential returns. Rationally, this asymmetry shouldn't matter if the expected value of the gains equals or exceeds the expected value of the losses. But it does matter, and the reason is that we significantly overestimate the probabilities of extreme tail-events (Chart I-2). Chart I-2We Overestimate The Probability Of Tail-Events Evolutionary biologists argue that this bias originated tens of thousands of years ago, when our distant ancestors had to survive daily 'fight or flight' threats. Faced with constant mortal danger, there was no time for measured analysis. Survival depended on a quick processing of choices into simple chunks: no risk, low risk, high risk. Thereby, our brains evolved to process a one in thousand and, say, a one in hundred chance of danger simply into the 'low risk' chunk, meaning that the 0.1 percent risk is overestimated to 1 percent - or whatever we define as low risk. Fast forward to today's financial markets, and our brains still overestimate extreme tail-events. It follows that for investments whose return distributions are asymmetric, the more extreme tail dominates the perception of its risk. Put simply, investors assess the risk of an investment in terms of its most extreme potential loss versus its most extreme potential gain in a short space of time (Chart I-3). Chart I-3Investors Assess Risk As The Most Extreme Potential Loss Versus Gain Why in a short space of time? The answer is that while most professional investors have long-term objectives, they must report mark-to-market performances every quarter or half-year. Unfortunately, a fund manager who delivers a deep short-term loss is in grave danger of being fired - the modern day equivalent of our distant ancestors' daily fight for survival. And it is nominal losses that matter because even in a period of deflation, any decline in the price level is unlikely to boost real returns over a period of a few months. Correcting The Great Misunderstanding Of Finance So the great misunderstanding of finance is to equate risk with volatility. Risky assets, such as equities, are risky not because they are volatile in the conventional (root mean squared) sense. After all, nobody worries if the price goes up sharply! Also, it is a great misunderstanding to think that equities do not provide diversification benefits. They clearly do - witness the protection that equities provided to bondholders in the bond bloodbath that followed President Trump's surprise victory in 2016 (Chart I-4). Chart I-4Equities Protected Bondholders In The Post Trump Victory Bond Bloodbath The real reason that risky assets are risky is because they have the propensity to experience much larger short-term losses than short-term gains - captured in the saying: equities climb up the stairs on the way up, but they jump out of the window on the way down. But here's the key point. At very low bond yields, bond returns develop the same (or worse) asymmetry as equity returns. Given the lower bound to yields, bond prices have no more stairs to climb... only a window to jump out of! (Chart I-5) The upshot is that equities lose their excess riskiness versus bonds, meaning that their valuations experience a phase transition sharply upwards. The corollary is that when bond yields normalise, equities regain their excess riskiness versus bonds - and their valuations must suffer a phase transition sharply downwards. Chart I-5At A 2% Bond Yield, Bond Returns Have the Same Negative Asymmetry As Equity Returns According to our empirical and theoretical analysis, this phase transition sharply downwards is most pronounced when the global (10-year) bond yield rises through 2 percent. In rule of thumb terms, this is when the sum of the yields on the T-bond, German bund and JGB breaches and remains above 4 percent (Chart I-6). At such a phase transition, it would be prudent to de-risk portfolios and sit aside, at least for a while. Chart I-6When The Sum Of 10-Year Yields On The T-Bond, Bund, And JGB = 4%, The Global 10-Year Yield = 2% Just below this level, a sum in the 3-4 percent range defines a kind of 'no man's land' in which equities drift sideways, perfectly explaining the behaviour of the market through the past year. With the sum now at 3.75 percent, the current message is to remain at neutral allocation to equities versus bonds. Instead, our main asset allocation recommendation is a relative value position: long industrial commodities versus equities - and the position has already gained 4 percent in the past two weeks. The Main Risk For European Institutions Is Existential Sticking with this week's theme of risk, the main risk confronting Europe's major institutions such as the ECB, the EU Council, and the EU Commission is an existential risk. This is because the very existence of the pan-European project relies on the ongoing (largely) unanimous support of a collection of sovereign European nations. As these sponsoring nations often have conflicting claims and interests, Europe's major institutions have intentionally designed themselves as rules-based organisations. Adherence to the rules is essential to avoid the bias, exceptionalism, and moral hazard that could tear apart the pan-European project. And this simple unifying principle explains the current stance of the ECB towards monetary policy, the stance of the EU Council towards Brexit, and the stance of the EU Commission towards the Italian budget. For the ECB, its main policy tools - interest rates, forward guidance on interest rates, and asset purchases - are calibrated to deliver its single objective: aggregate euro area CPI inflation 'below but close to 2 percent'. After a recent wobble in euro area growth, the 6-month credit impulse has ticked up (Chart I-7). Hence, it would be hard for the ECB to conclude that the convergence of inflation to its medium-term target has been blown off course (Chart I-8) - so we expect no major changes to the ECB's forward guidance. Leaving our overall stance to the EUR as neutral, with a preferred long exposure to JPY/EUR. Chart I-7The Euro Area 6-Month Credit Impulse Has Ticked Up Chart I-8Euro Area Inflation Has Been Drifting Up To Target Turning to the EU Council's strategy for Brexit, it will be unyielding on the indivisibility of the EU's four freedoms: goods, services, capital, and people. To do otherwise would be to undermine the strength and integrity of one of the EU's greatest achievements: the largest single market in the world. To give the U.K. special favours would risk giving it an unfair competitive advantage, as well as setting a dangerous precedent for other EU countries that wanted out. Hence, to avoid a hard North/South or East/West border for Ireland, the U.K.'s only option will be to remain indefinitely in a customs union with the EU. Once this is recognised and accepted by the U.K. parliament, the pound will rally.2 Finally, relating to the Italian budget, the EU Commission will adhere to the broad principle of its fiscal rules - again, because it cannot set a dangerous precedent for others. However, there may be some 'give' on the 2019 deficit in return for some 'take' on the 2020 and 2021 deficits. Ultimately, we expect de-escalation and compromise in this battle - but we recommend remaining neutral towards Italian assets until the 10-year BTP yield moves closer to 3 percent (Chart I-9). Chart i-9Remain Neutral Italian Assets Until The 10-Year BTP Yield Moves Closer To 3% Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the Global Investment Strategy Weekly Report 'Phase Transitions In Financial Markets: Lessons For Today' October 19, 2018 available at gis.bcaresearch.com 2 Please see the European Investment Strategy Weekly Report 'Understanding Brexit, Scandinavian Markets, And Semiconductors' October 18, 2018 available at eis.bcaresearch.com Fractal Trading Model* This week we note that the sharp sell-off in the Portuguese stock market is technically exhausted and ripe for a countertrend move. We prefer to express this as a market neutral pair-trade: long Portugal/short Hungary. Set the profit target at 6% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 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 Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Highlights Duration Strategy: The recent market turmoil was a long overdue risk asset correction that does not change any fundamental underpinnings for rising global bond yields. Stay below-benchmark on overall global duration exposure, concentrated in an underweight stance on U.S. Treasuries. Country Allocations: Continue allocating duration risk for global government bond portfolios in favor of countries where central banks will have difficulty raising interest rates (Australia, U.K., Japan core Europe) relative to countries where rate hikes are more necessary and likely to happen (U.S., Canada). Feature Repricing "Central Banker Puts" Can Be Painful By a quirk of our scheduling, we have not published a regular Weekly Report since September, during what became a period of more turbulent global financial markets. While we trust that our clients have enjoyed the Special Reports that we have published instead, we are certain that many are asking an obvious question: have the more jittery markets triggered any change in BCA's views on global fixed income? The answer is "no". Just like the sharp "Vol-mageddon" risk asset selloff back in early February, the origin of the recent volatility spike was soaring U.S. Treasury yields driven by a rapid upward revision of Fed rate hike expectations (Chart of the Week). We had been expecting such an adjustment based on our positive assessment of the underlying momentum of both economic growth and inflation in the U.S. This remains a critical underpinning for our below-benchmark call on U.S. duration exposure, and our increased caution on U.S. spread product. Chart of the WeekRisk Assets Struggling As Bond Yields Rise There is more to the story than just the Fed, however. Throughout the course of 2018, we have been warning that global central banks moving away from accommodative monetary policies would be the greatest threat to market stability. This is not only a story of Fed rate hikes. A reduction in the pace of asset purchases by the European Central Bank (ECB) and the Bank of Japan (BoJ), combined with outright contraction of the Fed's swollen balance sheet, has created a backdrop more conducive to volatile spikes - especially if the global economy is losing upward momentum at the same time. The OECD leading economic indicator has been steadily declining throughout 2018, a reflection of the more challenging backdrop for non-U.S. growth. It is no coincidence that, without the support from accelerating liquidity or positive economic momentum, many of last year's best performing investments (Italian government bonds, the Turkish lira, Emerging Market (EM) hard currency corporate debt) have been some of 2018's worst (Chart 2). Investors were willing to ignore the poor structural fundamentals underlying those markets when times were good, but have been much more cautious in 2018 with a less supportive macro environment. Chart 2The Darlings Of 2017 Are The Duds Of 2018 While there have been numerous political headlines that have caused bouts of market turbulence in the past few months - the escalating U.S.-China "tariff war", the Italian fiscal debate with the European Union - the short-term impact of these moves is magnified when global monetary policy is being tightened and global growth is cooling. The reason why central banks have been forced to turn more hawkish (or at least less dovish) is that diminished economic slack has forced their hands. For policymakers with an inflation-targeting mandate, the Phillips curve framework remains the primary analytical framework. When they see low unemployment, they get nervous. When they see low unemployment AND rising inflation, then become hawkish. Three-quarters of OECD countries now have an unemployment rate below the estimate of the full-employment NAIRU - the highest level in a decade - and realized inflation rates are accelerating in the major developed economies (Chart 3). Our own Central Bank Monitors are signaling the need for tighter monetary policy in most countries, while yields at the front-ends of government bond curves are steadily rising. Chart 3Central Bankers Still Believe In The Phillips Curve Looking ahead, we continue to see more upward pressure on global bond yields in the next 6-12 months. Market pricing for the future policy actions of the major central bank did not move much even with the surge in volatility earlier this month. The markets now understand that the "policymaker put" that central bankers have implicitly sold to investors has a much lower strike price when labor markets are tight and inflation is accelerating. It will take much larger selloffs to cause central banks to become less hawkish. We still see the decisions we made in late June, moving to a more cautious recommended stance on overall risk in fixed income portfolios, as appropriate. Staying below-benchmark on overall global duration risk, while underweighting those countries where the central banks are under the greatest pressure to tighten policy, is the most sensible way to allocate a fully-investment government bond portfolio. That means underweighting the U.S. and Canada and overweighting Japan, Australia and the U.K. (Chart 4). In terms of credit, we are maintaining an overall neutral stance, but favoring the U.S. versus European equivalents and a maximum underweight on EM credit. Chart 4Interest Rates Remain Unfazed By More Jittery Markets Bottom Line: The recent market turmoil was a long-overdue risk asset correction that does not change any fundamental underpinnings for rising global bond yields. Stay below-benchmark on overall global duration exposure, concentrated in an underweight stance on U.S. Treasuries. The Most Important Charts For Our Most Important Country Duration Views When determining our recommended fixed income country allocation, there are a few critical indicators we are watching to assess if those views should be maintained. We now go over each of those indicators for the most important developed economy bond markets: U.S. (Underweight): Watch TIPS Breakevens & The Employment/Population Ratio U.S. Treasuries have been the one major government bond market this year that has seen a rise in both inflation expectations and real yields. The breakeven inflation rate implied by the spread between 10-year nominal Treasuries and TIPS has gone up from 1.97% to 2.10% since the start of 2018, while the real 10-year TIPS yield has climbed from 0.44% to 1.09% over the same period. The rise in inflation expectations has occurred alongside an acceleration of U.S. economic growth and a generalized rise in inflation pressures. Reliable cyclical leading indicators like the ISM Manufacturing index and the New York Fed's Underlying Inflation Gauge are pointing to an acceleration of U.S. core CPI inflation towards the 2.5-3% range over the next year (Chart 5). This would be enough to push 10-year TIPS breakevens comfortably into the 2.3-2.5% range that we deem consistent with the Fed's price stability target (core PCE inflation at 2%). Chart 5U.S.: Both Real Yields & Inflation Expectations Are Rising Any larger move in inflation expectations would only occur if the Fed were to accommodate it by not continuing to hike rates at the current 25bps/quarter pace. That is unlikely with the strength of the U.S. labor market suggesting that the Fed is behind the curve on rate hikes. The U.S. employment/population ratio for prime age (25-54 years old) workers has almost returned back to the peak levels of the mid-2000s near 80% (bottom panel). The Fed had to push the real funds rate to over 3% during that cycle to get policy to a restrictive setting above the Fed's estimate of the r-star neutral real rate. While it is unlikely that the Fed will need to push the real funds rate to as high a level as in the mid-2000s, the current real rate has not even caught up to the Fed's r-star estimate, which is starting to slowly increase alongside the stronger U.S. economy. That implies a higher nominal funds rate would be needed to push up the real rate to neutral levels, with even more nominal increases needed if inflation continues to accelerate. With only 62bps of rate hikes over the next year currently discounted in the USD Overnight Index Swap (OIS) curve, there is scope for Treasury yields to rise further over the next 6-12 months. Core Europe (Underweight): Watch Realized Inflation Relative to ECB Forecasts In the euro area, the evolution of unemployment, wage growth and core inflation compared to the ECB's positive forecasts will be the critical driver of the future direction of government bond yields. In its latest set of economic projections published last month, the ECB expects the overall euro area unemployment rate to be 8.3% in 2018, 7.8% in 2019 and 7.4% in 2020.1 With the actual unemployment rate falling to 8.1% in August, the realized outcomes are already exceeding the ECB's forecasts (Chart 6). The same can be said for euro area wages, where the growth in compensation per employee (2.45%) is already running above the 2018 ECB projection of 2.2%. The ECB expects no acceleration of wage growth in 2019 (2.2%), but a further ratcheting up in 2020 (2.7%). Chart 6Euro Area: Expect Higher Yields If ECB Forecasts Materialize In a recent Special Report, we identified a leading relationship between wage growth and core HICP inflation in the euro area of around nine months.2 This would suggest that core HICP inflation should rise towards 1.5% within the next six months based on the current acceleration of wage growth (second panel). This would be above the ECB's current projection for 2018 (1.1%), but in line with the 2019 forecast (1.5%). Core inflation is projected to rise to 1.8% in 2020. If unemployment and inflation even just match the ECB's forecasts, there is likely to be a material repricing of core European bond yields through higher inflation expectations. At 1.7%, 10-year EUR CPI swaps are well below the +2% levels that occurred during the past two ECB rate hike cycles in the mid-2000s and 2010-11 (third panel). Both wage and core price inflation in the euro area were around the ECB's current 2019-2020 projections during both of those prior tightening episodes, suggesting that the past may indeed be prologue when it comes to inflation expectations. Given growing U.S.-China trade tensions, and uncertainties over the future path for Chinese economic growth, there is a risk that the ECB's growth and unemployment forecasts are too optimistic. The euro area economy remains highly levered to exports, and to Chinese demand in particular. Furthermore, the ECB continues to provide very dovish forward guidance, with no rate hikes expected until at least September 2019. Yet with a mere 12bps of rate hikes over the next year currently discounted in the EUR OIS curve, there is scope for core European bond yields to rise further over the next 6-12 months if euro area inflation surprises to the upside. Italy (Underweight): Watch Non-Italian Bond Spreads & The Euro The Italian budget battle with the European Union has been a gripping drama for investors in recent months. Italian bond yields have been under steady upward pressure, with the benchmark 10-year yield getting as high as 3.78%. Yet the story remains as much about sluggish Italian growth as it is about Italian fiscal policy. The populist Italian government has pushed for larger deficits, but has toned down the anti-euro language that dominated the election campaign earlier this year. This is why there has been very minimal contagion from higher Italian bond yields into other Peripheral European bond yields or euro area corporate bond spreads, or into the euro itself which remains very firm on a trade-weighted basis (Chart 7). Chart 7Italy: A Story Of Weak Growth, Not Euro Break-Up We continue to view Italian government bonds as a growth-sensitive credit instrument, like corporate bonds. In other words, faster Italian economic growth implies greater tax revenues, smaller budget deficits and a less worrisome trajectory for Italy's debt/GDP ratio. The opposite holds true when Italian economic growth is slowing. This is why there is a reliable directional relationship between Italy-Germany bond yield spreads and the OECD's leading economic indicator (LEI) for Italy (top panel). With the Italy LEI still in a downtrend, we do not yet see a cyclical case for shifting away from an underweight stance on Italian government bonds. Yet if the 10-year Italian yield were to reach 4%, the implied mark-to-market loss would wipe out the capital of Italy's banks, who own large quantities of government bonds. In that scenario, the ECB would likely get involved to stem the crisis, possibly by further delaying rate hikes of ramping up asset purchases. This would especially be likely if there was significant widening of non-Italian credit spreads and a sharply weaker euro. Hence, watch those markets for signs that the Italy fiscal crisis could trigger a monetary policy response. U.K. (Overweight): Watch Real Wage Growth & Business Confidence In the U.K., our non-consensus call to stay overweight Gilts has not been based on any long-run value considerations. Real yields remain depressed and the Bank of England (BoE) has kept monetary policy settings at extremely accommodative levels. The BoE continues to expect that a rise in real wage growth is likely due to the very tight U.K. labor market. This would support consumer spending and eventually require higher interest rates. The only problem is that this is happening very slowly. The annual growth in U.K. wage growth is now up to 3.1%, the fastest rate since 2008. This is above the pace of headline CPI inflation of 2.5%, thus real wages are finally starting to perk up (Chart 8). A continuation of this trend would feed into faster consumer spending and, eventually, trigger BoE rate hikes. Chart 8U.K.: Brexit Uncertainty + Middling Inflation = BoE Doing Little One other big impediment to the BoE turning more hawkish is the uncertainty over the U.K. government's Brexit negotiations with the EU. The extended Brexit drama has weighed on both U.K. business and consumer confidence, both of which have struggled since the 2016 Brexit vote (third panel). With the March 2019 deadline for the U.K. "officially" leaving the EU fast approaching, the odds of no deal being reached in time are increasing. U.K. Prime Minister Theresa May is desperately trying to avoid a no-deal Brexit, but such an outcome would create further instability in U.K. financial markets and close any near-term window of opportunity for the BoE to try and hike rates. For now, we see the depressed confidence from Brexit uncertainty offsetting the bump up in real wage growth, leaving Gilts on a path to continue modestly outperforming as they have throughout 2018 (bottom panel). An announcement of a Brexit deal would be a likely trigger for us to downgrade Gilts to neutral, and perhaps even to underweight given the developing uptrend in real wage growth. Bottom Line: Continue allocating duration risk for global government bond portfolios in favor of countries where central banks will have difficulty raising interest rates (Australia, U.K., Japan core Europe) relative to countries where rate hikes are more necessary and likely to happen (U.S., Canada). Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1https://www.ecb.europa.eu/pub/pdf/other/ecb.ecbstaffprojections201809.en.pdf 2 Please see BCA Foreign Exchange Strategy/Global Fixed Income Strategy Special Report, "Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan?", dated October 5th 2018, available at fes.bcaresearch.com and gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy Debt saddled small caps have to wrestle with rising interest rates at a time when they lack a valuation cushion. Tack on their high beta status and investors should continue to avoid small caps and instead prefer large caps. Upbeat global demand for U.S. defense goods, firming defense industry operating metrics and a flurry of M&A will more than offset the defense contractors' valuation overshoot. Stay structurally overweight. Recent Changes There are no changes to the portfolio this week. Table 1 Feature In Greek mythology, Daedalus warned his son Icarus not to fly too close to the sun when the pair of them were escaping from Crete, as his wax-made wings would melt. Icarus ignored his father's warning and soared toward the sun that eventually led to his drowning in the Aegean Sea when his wings melted. Is the equity market experiencing an Icarus moment? The S&P 500 is undergoing a healthy reset during crash-prone October, but post-midterms it should make an attempt to vault to fresh all-time highs into year-end. The selloff in the bond market (largely driven by the real component) most likely caused the consternation in stocks, but our sense is that the backup in yields is reflective and not yet restrictive both for stocks and, most importantly, the economy. In the coming weeks we expect a retest, and hold, of the recent lows before waving the all clear sign. Nevertheless, the latest bout of volatility is a cause for concern especially given that the SPX pullback is not sentiment/technical driven as it was earlier in the year when on January 221 and again on January 292 we cautioned clients that the equity market advance was too good to be true and complacency reigned supreme. As a reminder in late-January, equities looked extremely stretched on a number of sentiment and technical indicators. This was not the case, however, heading into October (Charts 1 & 2), and it raises the question: what are stocks discounting with regard to the economic backdrop? Chart 1Leading Into The Recent Pullback Sentiment And Technicals... Chart 2...Were Not As Extended As In Late-January Our biggest worry is that the 2018 goosing of the economy will soon fall flat as President Trump runs out of firepower to further buoy the economy. In other words, we have likely brought demand/consumption forward which should get reflected in softer 2019 output data, especially if there is gridlock in Congress post the midterms. Keep in mind, that most of the fiscal easing that pertains to stocks is front loaded to this year. The drop in corporate taxes is a one-off EPS boost for 2018, as is the surge in buybacks that was driven by cash repatriation. Buybacks are on pace to reach $1tn in 2018, but are likely to fall back to the more typical $400bn/annum rate next year. The U.S. economy and stock market will have to grapple with both of these fading tailwinds in 2019. One simple way to depict this is our newly conceived BCA Economic Impulse Indicator (EII). Chart 3 shows six economic indicators gauging the state of the U.S. economy. The EII comprises housing, capex, manufacturing, confidence, employment and credit; it is equally weighted shown as a Z-score. At present it is wobbling and diverging negatively from euphoric SPX EPS growth rates. Chart 3 Mind The Gap Not only is the economy humming at an unsustainable pace, but the Fed is also tightening monetary policy and letting maturing securities run off its balance sheet at approximately $50bn/month. If the Fed hikes rates three more times by June 2019, as both the bond market and our fixed income strategists expect, the fed funds rate will reach a range of 2.75%-3%. It then becomes plausible that any letdown in economic data could cause the yield curve to invert. The elimination of the unemployment gap increases the probability of curve inversion (see Chart 1 from the October 23, 2017 Weekly Report), as does another indicator of labor market tightness that recently dropped below zero (Chart 4). Chart 4Full Employment And Yield Curve Joined At The Hip But, we are not there yet and want to be systematic in calling the end of the business cycle, and thus equity bull market, using the three signposts we deemed most important earlier in the year: a yield curve inversion (leading indicator), doubling in year-over-year oil prices based on monthly dataset (coincident indicator) and a mega-merger announcement either in tech or biotech space (confirming anecdotal indicator). With regard to the latter, the rumored Uber IPO fetching a valuation of $120bn may also qualify as an end of cycle anecdotal indicator. Still, none of these three boxes have yet been ticked. Moreover, two other catalysts may assist in prolonging the cycle and breathe a sigh of relief not only in U.S. equities, but also in global bourses: a trade deal with China, and/or a reversal in U.S. dollar strength that would boost global ex-U.S. growth. Netting it all out, while the recent equity market swoon is worrisome it is still too early to call the end of the cycle and we do not think we are in an "Icarus moment". Our broad equity market strategy is to "buy the dip" as we expect EPS to do all the heavy lifting next year with the multiple drifting lower, and we continue to recommend a cyclical over defensive portfolio bent. This week we highlight a deep cyclical capital goods subsector and revisit our size bias. The Bigger The Better The days in the sun are over for small cap stocks. Similar to the double top formation in the early 1980s, small cap stocks have hit a wall and are giving in to their larger brethren. There are high odds that the small over large multi-year ascendancy is over and a reversion, at least, to the historical time trend mean is in order (Chart 5). Chart 5Double Top Since changing our size bias to a large cap bias on May 10, 2018, the S&P 500 has bested the S&P 600 index by over 300bps. Small caps however remain fully valued using different metrics and are extremely overvalued versus the SPX according to the Shiller P/E (or cyclically adjusted P/E, CAPE) methodology of smoothing the earnings cycle over a decade (Chart 6). In fact, this 40% CAPE premium leaves no space for any small cap profit mishaps. Chart 6Small Caps Valuations Are Stretched... Unfortunately, on a number of fronts small cap EPS will underwhelm and significantly trail SPX EPS, the opposite of what optimistic sell-side analysts expect. First, small caps are severely debt saddled as we have highlighted in our recent research. Sustained small cap balance sheet degradation is worrying, with S&P 600 net debt-to-EBITDA close to 4 (compared with 1.5 for the SPX, middle panel, Chart 7). Such gearing is fraught with danger as the default rate has nowhere to go but higher. Chart 7...Amidst Balance Sheet Degradation... Second, small and medium businesses have a higher dependency on bank credit as opposed to the bond market access that mega caps enjoy. Most bank credit is floating rate debt and so are lines of credit, and as the Fed remains firm on tightening monetary policy, interest expense costs are skyrocketing for SMEs. In a relative sense this will weigh on net profits. More generally, given the high indebtedness, small caps are a lot more sensitive to interest rates, and the selloff in the 10-year Treasury note heralds more pain in 2019 (10-year Treasury yield shown inverted, Chart 8). Chart 8 ...And With Rates Rising... Third, relative wage costs are flashing red for small caps. Small cap margins are thin - roughly mid-single digits or 800bps below large caps, and rising labor costs (according to the latest NFIB survey) are warning that this delta will widen, further suppressing relative margins and profitability as large cap wage costs are still well contained (Chart 9). Chart 9...And Labor Costs Perking Up, A Margin Squeeze Looms Fourth, small caps are high(er) beta stocks and when volatility spikes they underperform large caps. When the Fed ballooned its balance sheet and dropped the fed funds rate to zero it suppressed volatility. Now that the Fed has been decreasing the size of its balance sheet and raising interest rates, this is working in reverse and volatility is making a comeback as we have been highlighting in our research, and will continue to weigh on small caps (VIX shown inverted, top panel, Chart 10). Chart 10Large Caps Have The Upper Hand Another way to showcase small caps' riskier status is the close correlation they have with the relative EM equity share price ratio. When EMs outperform the SPX, small caps follow suit and vice versa. Importantly a wide gap has opened recently and we suspect that it will narrow via small caps following the EM higher beta stocks lower (SPX vs. EM ratio shown inverted, bottom panel, Chart 10). Adding it up, a high small cap debt burden, rising interest rates, lack of a valuation cushion, and their high beta status all signal that investors should continue to avoid small caps and instead prefer large caps. Bottom Line: Stick with a large cap bias. Stay With Defense Stocks For The Long-Term We have been overweight the pure-play BCA defense index since late-2015 and there are high odds that this juggernaut that really commenced with the George Walker Bush presidency remains in a secular growth trajectory (top panel, Chart 11). Our strategy is to add exposure on any meaningful pullbacks and keep this index as a structural overweight within the GICS1 S&P industrials index. Chart 11Defense Stocks Are A Secular Growth Play The rise of global "multipolarity" - or competition between the world's great nations - and the decline of globalization, along with a global arms race and increased risk of cyber-attacks, have been documented in our "Brothers In Arms" Special Report. These trends all signal that global defense related spending will remain upbeat in the coming decade.3 In the U.S. in particular, where military spending in absolute terms is greater that the rest of the world put together, defense spending and investment have bottomed and will continue to accelerate. In fact, the CBO continues to project that defense outlays will jump further next year (middle panel, Chart 12). While such a breakneck pace is clearly unsustainable, President Trump is serious about upgrading and updating the U.S. military in order to keep China's geopolitical and military ascendancy in check (as well as to deal with Russia and Iran).4 The upshot is that defense outlays will continue to expand into the 2020s. Chart 12Upbeat Defense Outlays... Such a buoyant demand backdrop is music to the ears of defense contractor CEOs, and represents a boost to defense equity revenue growth prospects. This capital goods sub-industry has extremely high fixed costs and thus any increase in top line growth flows straight to the bottom line. Put differently, defense contractors enjoy high operating leverage. No wonder M&A activity is robust: at least four large deals have been announced in the past year that are underpinning both takeout premia and relative share prices (bottom panel, Chart 13). Chart 13 ...And A Flurry Of M&A Is A Boon For Defense Stocks A closer look at operating metrics corroborates that defense goods manufacturers are firing on all cylinders. New orders recently jumped to fresh all-time highs and the industry's shipments-to-inventories ratio is rising, on track to surpass the 2008 peak. Unfilled orders are also running at a high rate, signaling that factories will keep on humming at least for the next few quarters (Chart 14). Chart 14Firming Operating Metrics Importantly, the industry is not standing still and is making significant investments. U.S. defense capex as reported in the financial statements of constituent firms is growing at roughly 20%/annum or twice as fast as overall capex (Chart 15). Chart 15Industry Is Not Standing Still True, industry indebtedness is also on the rise as some of the expansion has been debt financed, but net debt-to-EBITDA trails the overall market (ex-financials). Similarly, interest coverage has been modestly deteriorating, but is twice as high as the overall market. Impressively, defense ROE is running near 30%, again roughly double the rate of the broad market (Chart 16). Chart 16Healthy B/S With High ROE... Nevertheless, undoubtedly valuations are on the expensive side. Not only is recent M&A fever the culprit, but global investors' insatiable appetite for pure-play defense stocks has also driven valuations into overshoot territory (Chart 17). This is a clear risk to our secular overweight view, however, if our thesis pans out, then these stocks will grow into their pricey valuations as happened in the back half of the 1960s.5 Chart 17 ...But Valuations Are Expensive In sum, upbeat global demand for U.S. defense goods, firming industry operating metrics and a flurry of M&A will more than offset the defense contractors' valuation overshoot. Bottom Line: The secular advance in pure-play defense stocks remains in place. We continue to recommend an above benchmark allocation. The ticker symbols for the stocks in the BCA defense index are: LMT, LLL, NOC, GD and RTN. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Corporate Pricing Power Update," dated January 29, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "A Global Show Of Force?" dated October 10, 2018, available at gps.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights The Fed remains on a tightening course as the U.S. economy has no spare capacity, yet growth in the rest of the world is suffering as EM financial conditions are tightening. It will take more pain for the Fed to capitulate and pause its 25-basis-points-per-quarter hiking campaign. This clash will heighten currency volatility and, as a result, carry trades will suffer. This means the current rebound in EM currencies is to be sold, and the dollar has more upside. China has not been deemed a currency manipulator, hence the RMB could fall more, creating a deflationary shock for the world. Keep an eye on what might become rocky U.S.-EU trade negotiations. Short CAD/NOK. Short GBP/NZD. Feature A significant increase in volatility across markets has been the defining characteristic of the past two weeks. This tumultuous environment is likely to persist as the Federal Reserve is set to tighten policy, and EM financial conditions deteriorate further. While it is true that enough market turbulence could cause the Fed to blink and temporarily pause its tightening cycle, the U.S. central bank has yet to hit this pain threshold. As a result, we expect carry trades and EM currencies to suffer further, even as we established a few hedges last week. The Battle Between The Fed And Global Growth Has Just Begun The Fed is set to increase interest rates further. For now there is little reason for the institution that sets the global risk-free rate to deviate from its current trajectory of increasing interest rates by 25 basis points per quarter. First, capacity utilization in the U.S. keeps increasing, and in fact, the amount of spare capacity in the U.S. economy is at its lowest level since 1989. This kind of capacity pressure has historically been enough to prompt the Fed to keep increasing rates, as it points toward growing inflationary risks (Chart I-1). Chart I-1No Spare Capacity In The U.S. Second, the labor market is currently at full capacity. This week's release of the JOLTS data not only highlighted that U.S. job openings continue to rise and are now well above the number of unemployed workers, but it also showed that the voluntary quit rate is at a 17-year high. U.S. workers are no longer petrified by fear of not finding a job if they were to jettison their current one. This is symptomatic of an economy running beyond full employment. Additionally, as Chart I-2 illustrates, the number of states where the unemployment rate stands below levels consistent with full employment is near a record high. Historically, this indicator has explained the Fed's policy well. Chart I-2The Labor Market And The Fed Third, and obviously a consequence of the previous two points, various components of the ISM survey are pointing toward an acceleration in U.S. core inflation (Chart I-3). This highlights that with the U.S. at full employment, the rise in inflation is giving free reign to the Fed to further lift interest rates. This development explains why Federal Open Market Committee members are much more willing than previously to display hawkish colors. Chart I-3U.S. Inflation Is In An Uptrend The problem for the currency market is that this hawkish Fed is not emerging in a vacuum. Global growth has begun to slow, and in fact is set to slow more. Korean export growth has been decelerating sharply, which historically has been a harbinger for global profit growth and global industrial production (Chart I-4). Chart I-4U.S. Strength Does Not Equate To Global Strength What lies behind this growth slowdown? In our view, two key shocks explain this vulnerability. First, China is deleveraging. Chart I-5 shows that efforts to curtail corporate debt have been bearing fruit. In response to the regulatory and administrative tightening imposed by Beijing, smaller financial institutions are not building up their working capital required to expand their loan book. As a result, the Chinese credit impulse remains weak. The chart does highlight that deleveraging could take a breather in the coming months, in keeping with the change in official rhetoric. However, this pause is likely to be temporary. Do not expect China to push enough stimulus in its economy to cause a sharp rebound in indebtedness and capex. Xi Jinping has not yet abandoned his shadow bank crackdown, which weighs on overall credit expansion. Chart I-5Chinese Policy Tightening In Action Chinese Deleveraging Is Still Worth Monitoring Second, EM liquidity is deteriorating. Chart I-6 illustrates that global reserves growth has moved into negative territory. Historically, this indicates that our EM Financial Conditions Index (FCI) will continue to tighten. Many factors lie behind this deterioration in the EM FCI, among them: the collapse in performance of carry trades;1 the increase in the dollar and in U.S. interest rates that is causing the cost of servicing foreign currency debt to rise; and EM central banks fighting against currency outflows. Chart I-6Global Liquidity Is Tightening, So Are EM FCI This tightening in the EM FCI has important implications for global growth. As Chart I-7 shows, a tightening EM FCI is associated with a slowdown in BCA's Global Nowcast of industrial activity. As such, the tightening in EM financial conditions suggests that global industrial production can slow further. Since intermediate goods constitute 44% of global trade, this also implies that global exports growth could suffer more in the coming quarters. As a result, Europe, Japan and commodity producers remain at risk. The same can be said of EM Asia, which is the corner of the global economy most levered to global trade and global manufacturing. In fact, our Emerging Markets Strategy colleagues are currently reducing their allocation to Asia within EM portfolios.2 Chart I-7Tighter EM Financial Conditions Equal Lower Growth This deterioration in global growth and global trade is deflationary for the global economy. It is also deflationary for the U.S. economy. As we have highlighted in the past, since the U.S. economy is less levered to global trade and global IP than the rest of the world, weakening global growth tends to lift the greenback. Thus, if global goods prices are declining, such a shock can be compounded in the U.S. by a rising dollar. Does this mean the Fed will be forced to stop hiking rates in response to the growing turmoil engulfing the global economy and global financial markets? The Fed feedback loop suggests that if the dollar rises enough, if U.S. spreads widen enough, and if deflationary pressures build enough in response to these shocks, it will back off, as it did in 2016 (Chart I-8). Chart I-8The Fed Policy Loop However, the key question is that of the Fed's current pain threshold. We posit that 2018 is not 2016. As Ryan Swift argues in the most recent installment of BCA's U.S. Bond Strategy, the stronger the domestic economy is and the deeper domestic U.S. inflationary pressures are, the more the Fed will tolerate weaker global growth and tighter U.S. financial conditions.3 Currently, the U.S. domestic economy is so strong and so inflationary that despite less supportive U.S. financial conditions, our Fed Monitor still points toward more rate hikes in the coming quarters (Chart I-9). This is in sharp contrast to 2016, when the Fed Monitor highlighted the need for easier policy as U.S deflationary pressures were greater than inflationary ones. Chart I-9The BCA Fed Monitor 2018 Is Not 2016 As a result, we think that before the Fed blinks, the situation around the world will have to get worse. This means investors can expect further strength in the dollar and a further increase in borrowing costs around the world. Moreover, since the increase in U.S. bond yields is dominated by real rates, this means that the global cost of capital will continue its ascent - exactly as global growth is easing. This means financial markets could experience additional pain. In fact, Chart I-10 shows that the global shadow rate is a leading indicator of the currency market's volatility. Since the Fed is raising rates and the European Central Bank is tapering its asset purchases, the global shadow rate has scope to rise further. This points toward a continued increase in FX volatility. Higher FX volatility means that carry trades are likely to deteriorate again.4 If carry trades are to suffer more, this also implies that the current rebound in EM currencies is likely to prove temporary. Moreover, since an unwind in carry trades means that liquidity is leaving high interest rate countries, this also means that the EM FCI is set to tighten further, and global IP could suffer more. Chart I-10Higher Vol Ahead Hence, we recommend investors maintain a defensive stance in their FX exposure, favoring the dollar and the yen over the euro and commodity currencies. To be clear, we bought the NZD last week, but this position is a hedge. China is trying to manage the growth slowdown and is attempting to implement targeted stimulus measures. The risk is real that Beijing over-stimulates, which would cause the USD to weaken. The NZD is the best place to protect investors against this risk. Bottom Line: The Fed will continue to tighten policy as the U.S. economy is running well above capacity, creating domestic inflationary pressures. Meanwhile, EM economies are being hit by the combined assault of Chinese deleveraging and tightening financial conditions. This means the Fed is hiking in an environment of sagging global growth. Since it will take more pain for the Fed to back off, the dollar will rise further and carry trades will bear the brunt of the pain as FX volatility will pick up more. Use any rebound in EM currencies to sell them. Do the same with commodity currencies; AUD/JPY has further downside ahead. Breathe A Sigh Of Relief: China Is Not A Currency Manipulator On Wednesday, the U.S. Treasury published its bi-annual Macroeconomic and Foreign Exchange Policies of Major Trading Partners of the United States report, better known in the market as the "Currency Manipulator Report." Despite the White House's vociferous pronouncements, the Treasury declined to name China a currency manipulator. This does not mean that it will not in the future, but it does mean that China may be willing to let the RMB weaken a bit further in the coming months to alleviate the pain of the trade war with the U.S. After all, a simple way to nullify the impact of tariffs is to let your currency fall. If Washington is not willing to take up this year's depreciation as a pretext for additional tariffs, then Beijing could just let the markets do its bidding and let the RMB weaken. This is dangerous for the global economy and for commodity prices. A weaker RMB means that the purchasing power of Chinese buyers in international markets will decline. This also means that the volume of Chinese purchases of industrial commodities could suffer. As a result, we continue to recommend investors minimize their exposure to the AUD. Moreover, a weaker RMB could cause fears of competitive devaluation across Asia, which means the Asian currency complex remains at risk. The most interesting piece of news from the report was that China only meets one of the three criteria that must be met to be deemed a currency manipulator: a bilateral trade surplus with the U.S. greater than US$20 billion. The Chinese aggregate current account surplus is well below the 3% of GDP threshold used by the U.S. Treasury, and the Chinese monetary authorities are not intervening in a single direction to depress their currency. But as Table I-1 shows, Japan, Germany and Korea already meet two of the Treasury's three criteria, and are thus ostensibly at an even greater risk of being named currency manipulators than China. However, the U.S. has already concluded a new trade deal with Korea that contains a currency component, and is seeking to do the same with Japan. Table I-1Where Does China Stand On The Treasury's Grid? It is true that naming China a currency manipulator will ultimately be a political decision, and on this front, the outlook is not good for China due to the structural decline in U.S.-China relations. But a chat with Matt Gertken of our Geopolitical Strategy Service reminded us that the EU and the U.S. are beginning to negotiate a trade deal, and Germany's large trade surplus could easily become a target. The U.S. and EU did not conclude the TTIP trade deal, so there is no foundation for the upcoming negotiations as there was with Korea, Canada, and Mexico. This raises the risk that the negotiations could be difficult and that the White House could threaten to implement tariffs against Germany under section 232 of the Trade Expansion Act of 1962 as a lever during the negotiations to get a more favorable deal for the U.S. This also means that heated trade negotiations between Europe and the U.S. could become a source of headline risk in the coming months, especially in the New Year - something the market does not need. Ultimately the U.S.'s main beef is with China and the Trump administration will want Europe's assistance in that quarrel. But Trump may still believe he can use tough tactics with the EU along the way. Bottom Line: China is not a currency manipulator. China could use this lack of designation as an opportunity to let the RMB weaken a bit further in the coming months. Moreover, Germany's large trade surpluses and the impending U.S.-EU trade negotiations suggest that the White House could use the lever of tariffs under section 232. This means that the risk of U.S.-EU trade-war headlines hitting the wire in the winter will be meaningful, though not as consequential as the U.S.-China conflict. This will contribute to higher volatility in the FX market. Sell CAD/NOK A potentially profitable opportunity to sell CAD/NOK has emerged. To begin with, CAD/NOK is an expensive cross, trading 10% above its purchasing-power-parity equilibrium (Chart I-11). While valuations are rarely a good timing tool in the FX markets, the technical picture is also interesting as the Loonie is losing its upward momentum against the Nokkie (Chart I-12). Chart I-11CAD/NOK Is Expensive Chart I-12From A Technical Perspective, CAD/NOK Is Vulnerable Economics point to a favorable picture as well. Now that the Norges Bank has joined the Bank of Canada in increasing rates, peak policy divergence is over. When policy divergences were at their apex, CAD/NOK was not able to break out. With Norway's current account standing at 6.6% of GDP versus -3% for Canada, without the help of policy, the CAD is likely to lose an important support versus the NOK. Moreover, there is scope for upgrading interest rate expectations in Norway relative to Canada. As Chart I-13 illustrates, the Canadian credit impulse has fallen relative to that of Norway, and Canada's employment growth is contracting when compared to the Nordic oil producer. This helps explain why Canadian PMIs are near record lows vis-Ã -vis Norway's, and why Canadian relative LEIs are also plunging to levels only recorded twice over the past 20 years. Chart I-13Canada's Economy Is Underperforming Norway's Additionally, CAD/NOK has historically tracked the performance of both exports and retail sales growth in Canada relative to Norway. Both these indicators have sharply diverged from CAD/NOK, and they suggest this cross could experience significant downside over the coming quarters (Chart I-14). This also further reinforces the idea that the Norwegian output gap may now be closing fast, especially relative to Canada. Chart I-14Economic Indicators Point To CAD/NOK Weaknesses In fact, Norwegian core inflation has also gathered steam, rising at a 2.2% rate, in line with Canada's. Meanwhile, Norwegian house prices are proving sturdier than Canadian real estate prices. This combination of similar inflation, improving growth, and outperforming dwelling prices suggests there is scope for investors to upgrade their assessment of the Norges Bank's policy versus that of the BoC. Finally, CAD/NOK is often affected by the spread between the Canadian Oil Benchmark and Brent (Chart I-15). Currently, the WCS/Brent spread is at a record low and may well rebound a bit. However, BCA's Commodity & Energy Strategy service expects Brent prices to rise to US$95/bbl in 2019, with a significant right-tail risk due to supply-curtailment.5 As the bottom panel of Chart I-15 illustrates, the WCS/Brent spread is inversely correlated to aggregate oil prices. Thus, higher Brent prices, especially if caused by supply disruptions, could lead to a continued large discount in the Canadian oil benchmark, and therefore downside risk to CAD/NOK. Chart I-15CAD/NOK Likes Weak Oil Prices This trade is not without risks. CAD/NOK is often positively correlated to the DXY dollar index. This means that this trade is at odds with our USD view. However, in the past five years, CAD/NOK and the DXY have diverged for more than two months more than 10 times. The current domestic fundamentals in Canada relative to Norway suggest that a low-correlation period is likely to emerge. Bottom Line: CAD/NOK is an attractive short. It is expensive and losing momentum exactly as the Canadian economy is falling behind Norway's. As such, investors are likely to upgrade their expectations for the Norges Bank relative to the BoC. This should weigh on CAD/NOK. No Brexit Risk Compensation In GBP; Sell GBP/NZD Six weeks ago, we published a Special Report arguing that while the pound was cheap on a long-term basis, its affordability mostly reflected the expensiveness of the greenback and that actually there was no risk premium embedded in the GBP to compensate investors for Brexit-related uncertainty.6 We argued that because there was a large stock of short bets on the GBP, the pound could rebound on a tactical basis but that such a rebound was likely to prove short-lived as there remained many political hurdles to pass before Brexit uncertainty abated. We thus expected GBP volatility to pick up. Now that the pound has rebounded, where do we stand? The Brexit risk premium remains as absent as it was in early September (Chart I-16). It is also true that the probability of a no-deal Brexit has decreased, which means that long-term investors could benefit from beginning to overweight the pound in their portfolios. However, a political labyrinth remains in front of us, which suggests that GBP volatility is likely to remain elevated, and that the pound could even suffer some tactical downside. Chart I-16No Brexit Risk Premium In GBP We have decided to express this near-term bearish Sterling view by selling GBP/NZD as a way to avoid taking on more dollar risk. First, since November 2016, GBP/NZD has rallied by 20%. Today, long positioning in the pound relative to the Kiwi is toward the top end of the range that has prevailed since 2004 (Chart I-17). This suggests that long bets in the GBP versus the NZD have already been placed. Chart I-17Speculators Are Already Long GBP/NZD Second, the U.K. and New Zealand are two countries where the housing market heavily influences domestic activity. In fact, as Chart I-18 shows, GBP/NZD tends to broadly track U.K. relative to New Zealand house prices. Currently, British residential prices are sharply weakening relative to New Zealand. Previous instances where GBP/NZD strengthened while relative dwelling prices fell were followed by vicious falls in this cross. Chart I-18Relative House Prices Point To A Weaker GBP/NZD... Meanwhile, the U.K. LEI has fallen to its lowest level since 2008 relative to New Zealand's. Moreover, U.K. inflation seems to be rolling over while New Zealand's may be bottoming. This combination suggests that investors expecting more rate hikes from the Bank of England over the coming 12 months but nothing out of the Reserve Bank of New Zealand could be forced to adjust their expectations in a pound-bearish fashion. Finally, over the past four years, GBP/NZD has followed the performance of British relative to Kiwi equities with a roughly one-quarter lag. As Chart I-19 shows, this relationship suggests that GBP/NZD has downside over the remainder of the year. Chart I-19...And So Do Relative Stock Prices Bottom Line: The British pound may be an attractive long-term buy, but the number of political landmines in the Brexit process remains high over the coming four months. As a result, we anticipate volatility in the GBP to remain elevated. Moreover, GBP has had a very nice bull run over the past two months and is now vulnerable to a short-term pullback. In order to avoid taking on more dollar risk, we recommend investors capitalize on the pound's tactical downside by selling GBP/NZD, as economic dynamics point toward a higher kiwi versus the pound. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Canaries In The Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017, and the Weekly Report, titled "Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth", dated December 15, 2017, both available at fes.bcaresearch.com 2 Please see Emerging Markets Strategy Weekly Report, titled "EMs Are In A Bear Market" dated October 18, 2018, available at ems.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, titled "Rate Shock", dated October 16, 2018, available at usbs.bcaresearch.com 4 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com 5 Please see Commodity & Energy Strategy Weekly Report, titled "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 to $95/bbl" dated September 20, 2018, available at ces.bcaresearch.com 6 Please see Foreign Exchange Strategy Special Report, titled "Assessing the Geopolitical Risk Premium In the Pound", dated September 7, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: The retail sales control group growth outperformed expectations, coming at 0.5%, while retail sales ex autos growth surprised to the downside, coming in at -0.1%. JOLTS job openings outperformed expectations, coming in at 7.136 million. Moreover, both continuing jobless claims and initial jobless claims surprised positively, coming in at 1.640 million and 210 thousand respectively. DXY has risen by roughly 0.6% this week. We continue to believe that the dollar has cyclical upside; as the fed will likely raise rates more than what is currently discounted by the market. Additionally, slowing global growth and positive momentum should also provide a boon for the dollar. Tactically, however, positioning remains stretched, which means that a short correction is likely. Report Links: In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 The Dollar And Risk Assets Are Beholden To China's Stimulus - August 3, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the Euro area has been mixed: Industrial production yearly growth outperformed expectations, coming in at 0.9%. Moreover, construction output yearly growth also surprised to the upside, coming in at 2.5%. However, core inflation surprised negatively, coming in at 0.9%, while headline inflation was in line with expectations at 2.1%. EUR/USD has fallen by roughly 1% since last week. We expect the euro to have cyclical downside, given that it will be hard for the ECB to raise rates significantly in an environment where emerging markets are suffering. After all, Europe's economy is highly dependent on exports, which means that any hiccup in EM growth reverberates strongly on European inflation dynamics. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 Time To Pause And Breathe - July 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been positive: Capacity Utilization outperformed expectations, coming in at s positive 2.2%. It also increased relative to last month's reading. Moreover, industrial production yearly growth also surprised positively, coming in at 0.2%. Finally, the Tertiary Industry Index month-on-month growth also surprised to the upside, coming in at 0.5%. USD/JPY has been flat this week. We are neutral on USD/JPY on a cyclical basis, given that the tailwinds of rising rate differentials between U.S. and Japan will likely be counteracted by increased volatility, a positive factor for the yen. Investors who wish to hedge their short exposure to Treasurys can do so by shorting EUR/JPY, given that this cross is positively correlated to U.S. bond yields. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: The yearly growth of average earnings including and excluding bonus outperformed expectations, coming in at 2.7% and 3.1% respectively. However, the claimant count change surprised negatively, coming in at 18.5 thousand. Finally, while the core inflation number of 1.9% outperformed expectations slightly, headline inflation underperformed substantially, coming in at 2.4%. GBP/USD has decreased by roughly 1.5% this week. Overall, we are bearish on the pound in the short-term, given that there is very little geopolitical risk price into this currency at the moment. This means that GBP will be very sensitive to any flare up in Brexit negotiations. We look to bet on renewed Brexit tensions by shorting GBP/NZD. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been mixed: The change in employment underperformed expectations, coming in at 5.6 thousand. Moreover, the participation rate also surprised to the downside, coming in at 65.4%. This measure also decreased from last month's number. However, the unemployment rate surprised positively, coming in at 5% and decreasing from the august reading of 5.3%; the labor underutilization measure tracked by the RBA also fell. AUD/USD has been flat this week. Overall, we continue to be bearish on the aussie, as the deleveraging campaign in China will be felt most strongly on China's industrial sector; a sector to which the Australian economy is highly levered, given that its main export is iron ore. Moreover, raising rates in the U.S. will continue to create an environment of volatility, hurting high beta plays like the AUD. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has risen by 0.4% this week. Last week, we bought the kiwi, as a hedge against dollar weakness. While the dollar has gained strength against most other currencies, the NZD has actually appreciated. We are also shorting GBP/NZD this week. This cross has broadly followed relative house price dynamics between U.K. and New Zealand, and the continued relative outperformance of kiwi housing points towards further weakening in GBP/NZD. Moreover, long positioning on this cross remains very high by historical standards, which means that there can significant downside for this cross on a 3 month basis. Report Links: In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 USD/CAD has risen by roughly 0.5% this week. This week we are shorting CAD/NOK. This cross is expensive according to our PPP valuations. Moreover, the economic picture is also favorable for the NOK as the policy divergence between Norway and Canada has likely reached its peak. The credit impulse and the growth in employment are both stronger in Norway, while Norway's core inflation is now in line with Canada's. This means that rates in Norway have further upside, given that Canada's hiking cycle is much more advanced than Norway's. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been negative: Producer price inflation underperformed expectations, coming in at 2.6%. Moreover, the trade balance also surprised to the downside, coming in at CHF 2.434 million. EUR/CHF has fallen by 0.7% this week, as the EU leaders have expressed their displeasure towards Italy's new fiscal plan. On a structural basis, we continue to be bearish on the franc, as inflationary pressures continue to be too weak in Switzerland for the SNB to move away from its ultra-dovish monetary policy. That being said, political risks in emanating from Europe could prove to be bearish for this cross on a tactical basis. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has risen by roughly 0.7% this week. The Norwegian krone is our favorite currency within the G10 commodity currencies. Norway is the only commodity currency with a substantial current account surplus. Furthermore, our commodity strategists expect oil to continue to strengthen, even though base metals might suffer in the face of Chinese monetary tightening. This relative outperformance by oil will help oil currencies outperform the NZD and the AUD. We are also shorting CAD/NOK this week, as Norway's economic strength is now matching Canada's. Thus, given that the Norges Bank has kept rates lower the BoC, there is room for rate differentials to move against CAD/NOK now that the Norwegian central bank has begun to lift its policy rate. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 USD/SEK has risen by roughly 0.7% this week. We are bullish on the Swedish krona on a cyclical basis, as rates in Sweden are too low for the current inflationary backdrop. In our view, the Risksbank will have to make sure sooner rather than later that its monetary policy matches the country's economic reality. We are also bearish on EUR/SEK, as current real rate differentials points to weakness for this cross. Furthermore, easing by Chinese monetary authorities could provide further downside to EUR/SEK. After all the SEK is more sensitive to liquidity conditions than the EUR, which means that when liquidity is plentiful, EUR/SEK suffers. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The combination of slower global growth, trade protectionism, Italy's budget crisis, and rising Treasury yields have made U.S. equities increasingly vulnerable to a phase transition from euphoric optimism to a more sober appreciation of the risks facing the global economy. The good news is that the U.S. economy is still quite healthy and none of our recession indicators are flashing red. This suggests that the correction which began last week will be just that, a correction. The bad news is that corrections usually end when investors stop believing that they are witnessing a correction and start thinking that a bear market is afoot. Stock market sentiment is still fairly ebullient, which suggests that it will take more pain to put in a bottom. Investors should anticipate renewed weakness in risk assets over the coming days, but be prepared to increase exposure to global equities if they retreat 9% from current levels. Feature Global Equities: How Low Will They Go? I have been on the road meeting clients this week. Not surprisingly, much of the discussion has focused on what caused last week's stock market sell-off and whether the rebound earlier this week marked the end of the correction. At times like these, I am reminded of Robert Shiller's study of the 1987 stock market crash. Soon after the crash, Shiller sent questionnaires to investors soliciting their views on what caused stocks to swoon. Shiller's assessment downplayed the role of program trading, instead ascribing the crash to investor panic.1 Simply put, Shiller contended that investors were selling because other investors were selling. While I broadly agree with Shiller's conclusion, I think his argument can be enhanced by drawing on a ubiquitous concept in physics: the idea of "phase transitions." Phase Transitions In Financial Markets A phase transition occurs when a substance changes from a solid, liquid, or gas into a different state. For example, water remains a liquid until its temperature either falls below zero degrees Celsius, at which point it becomes a solid (ice), or rises above 100°C, where it turns into gas (steam). The relationship between water and temperature is highly nonlinear. To someone who can only visually observe the contents of a kettle, it is difficult to say if the temperature of the water is 20°C or 80°C. The same principle applies to markets. Sometimes, as economic and financial stresses build, nothing discernible happens until a phase transition is reached, at which point everything goes haywire. Importantly for investors, these phase transitions are surprisingly common and, at least with the benefit of hindsight, are often predictable. The Twilight Zone From Boom To Bust Consider the lead-up to five market crashes in the U.S. over the past 100 years: 1929: The conventional wisdom is that the stock market crash of October 1929 was the first hint that the economy was about to go into a tailspin. But, in fact, automobile, machinery, and steel production were already falling by the summer of 1929 (Chart 1). Automobile output had declined by a third by the time stocks reached their zenith. Investors simply ignored the fact that the economic thermostat was plunging towards zero in those late summer months, setting the stage for a phase transition from boom to bust. Chart 1The Economy Had Started To Deteriorate Before The 1929 Stock Market Crash 1987: It was not so much one single thing that caused the stock market crash on October 19, 1987, but a culmination of things that the market either ignored or downplayed in the months leading up to Black Monday. A rising U.S. trade deficit and a falling dollar raised concerns that the Fed would be forced to expedite the pace of rate hikes. The 10-year Treasury yield increased from 7.1% at the start of 1987 to almost 10% on the eve of the crash (Chart 2). The House of Representatives filed legislation that sought to eliminate the tax benefits of financial mergers. Against a backdrop of increasingly stretched valuations, these developments were enough to bring the temperature of the stock market below zero. Chart 2Treasury Yields Spiked In The Run-Up To The 1987 Crash 1998: Popular lore attributes the 22% plunge in the S&P 500 from July 20 to October 8 to the implosion of Long-Term Capital Management (LTCM), but in fact almost all of the decline in the index occurred before the problems at LTCM surfaced. It was more the steady drip of bad news over the course of 1998 - the spread of the EM crisis from Thailand to Indonesia, Malaysia, and South Korea; the collapse of Hong Kong-based Peregrine Investments Holdings, Asia's largest private investment bank at the time; growing fears that China would devalue its currency; and finally, the Russian sovereign debt default - which caused market sentiment among U.S. investors to turn from euphoric ambivalence to bearish panic (Chart 3). Chart 3Key Events During The Asian Crisis 2000: After cutting interest rates three times in the autumn of 1998, the Fed resumed hiking rates, ultimately bringing the fed funds rate to a cycle high of 6.5% in May 2000. The Fed's actions pushed monetary policy into restrictive territory, weakening the foundation on which the stock market boom had been built. A massive wave of equity issuance from initial and secondary public offerings only made matters worse. Net corporate equity issuance went from -$111 billion in 1998, to $6 billion in 1999, to $153 billion in Q1 of 2000 alone (Chart 4). With the market unable to absorb the increase in the supply of shares, prices began to tumble. Chart 4A Tidal Wave Of Equity Issuance Preceded The 2000 Crash 2008: The stock market crash in the autumn of 2008 did not come out of the blue. U.S. home prices peaked in April 2006 - twenty months before the recession officially began. Delinquency rates on both conventional and nonconventional mortgages had already more than doubled by late-2007 (Chart 5). By then, residential investment had already fallen by 2.5% of GDP from its high in December 2005. Investors may be forgiven for not appreciating the full extent of the mortgage problem. However, it should have been clear, even at the time, that nothing was going to fill the void in aggregate demand that the decline in housing-related spending had opened up. This made a recession highly likely. Chart 5The U.S. Housing Sector Weakened Sharply Prior To The 2008 Crash Corrections Vs. Bear Markets The five sell-offs discussed above share many similarities, along with a number of key differences. As far as the similarities are concerned, all five began when stocks were richly priced and macro fundamentals were starting to look increasingly shaky (Chart 6). Chart 6Bear Markets Tend To Occur When Earnings Disappoint The differences lie mainly in what happened to stocks after the dam burst. In 1987 and 1998, equities quickly bottomed; whereas the initial drop in stocks in 1929, 2000, and 2008 was followed by further declines, morphing into major bear markets. The evolution of the economy distinguishes the two sets of episodes. The 1929, 2000, and 2008 sell-offs foreshadowed significant declines in economic activity and corporate earnings. In contrast, neither the stock market crash in 1987 nor the one in 1998 presaged any imminent economic doom. The latter two episodes were among those "false positives" that had led Paul Samuelson to quip decades earlier that "the stock market had predicted nine out of the last five recessions."2 History suggests that recessions are more likely to occur when the economy is suffering from significant macroeconomic imbalances. Both the 1929 and 2008 crashes were preceded by large increases in leverage (Chart 7). This made the financial system highly vulnerable to economic shocks. History also suggests that recessions are more likely to occur when policymakers lack either the will or the tools to stimulate the economy. The Fed did little to arrest the myriad bank failures in the early 1930s. This negligence allowed the money supply to decline by one-third, which caused deflation to set in. Chart 7Large Increases In Leverage Occurred During The Lead-Up To The 1929 & 2008 Crashes Policymakers were more adept in combating the Great Recession, but were nevertheless constrained by a lack of regulatory authority to handle distressed nonbank financial institutions. The zero lower bound on short-term interest rates also limited the Fed's ability to cut rates by enough to revive growth, a pernicious constraint given Congress' unwillingness to enact a sufficiently large fiscal stimulus program. Both the 1987 and 1998 crashes had the potential to spawn recessions. Fortunately, policymakers were quick to put out the fire. The Federal Reserve eased short-term liquidity conditions by engaging in large-scale open market operations in the hours following the 1987 crash. The Fed also issued a statement affirming "its readiness to serve as a source of liquidity to support the economic and financial system."3 Likewise, the FOMC's decision to cut rates in the autumn of 1998 helped to temporarily weaken the dollar and give some breathing room to struggling emerging markets. The Fed was slower to cut rates after the stock market fell in March 2000, partly because the economy was more overheated by that point than it was in 1998. In addition, the bubble in stocks was much greater in 2000, as were the economic imbalances created by years of easy financing, chief of which was a massive overhang of capital spending in the tech sector (Chart 8). Chart 8The Dotcom Boom Created A Massive Overhang In Tech Sector Capex Lessons For Today Buying on the dips in the early stages of a bear market is usually a recipe for disaster. Investors who jumped back into the stock market in September 2008 were in for a rude awakening as stocks continued to plummet into October and November. It was only in March 2009, when the first green shoots appeared, that the stock market finally bottomed. In contrast, buying into a correction tends to be a profitable strategy, provided one does so when technical indicators are signaling that a capitulation point has been reached. This brings us to today. The combination of slower global growth, trade protectionism, Italy's budget crisis, and rising Treasury yields have made U.S. equities increasingly vulnerable to a phase transition from euphoric optimism to a more sober appreciation of the risks presently facing the global economy. The good news is that the U.S. economy is still quite healthy and none of our recession indicators are flashing red (Chart 9). As we discussed two weeks ago, aggregate demand continues to benefit from fiscal stimulus, strong credit growth, and a strengthening labor market.4 While bond yields have risen, they are still far from levels that will choke off growth. This suggests that the correction which began last week will be just that, a correction. Chart 9A U.S. Recession Is Not Imminent The bad news is that corrections usually end when investors stop believing that they are witnessing a correction and start thinking that a bear market is afoot. Stock market sentiment is still fairly ebullient, which suggests that it will take more pain to put in a bottom (Chart 10). This message is echoed by our forthcoming MacroQuant model, which is designed to gauge the "internal temperature" of the market. (Chart 11). It is currently pointing to downside risk for the S&P 500 over the next 30 days. Chart 10Stock Market Sentiment Is Still Fairly Elevated Chart 11MacroQuant* Recommends Continued Caution Towards Equities Even EM sentiment has yet to reach bombed-out levels. The latest BofA Merrill Lynch Global Fund Manager Survey showed that managers were slightly net overweight emerging market equities in October. This is a far cry from 2015, when a net 30% of managers were underweight EM stocks. Bottom Line: Investors should anticipate renewed weakness in risk assets over the coming days, but be prepared to increase exposure to global equities if they retreat 9% from current levels. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Robert J. Shiller, "Investor Behavior in the October 1987 Stock Market Crash: Survey Evidence," NBER Working Paper (2446), November 1987. 2 Paul Samuelson, "Science and Stocks," Newsweek, September 19, 1966 (p. 92). 3 Mark Carlson, "A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal Reserve Response," Federal Reserve, 2006. 4 Please see Global Investment Strategy Weekly Report, "The Next U.S. Recession: Waiting For Godot?" dated October 5, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The current market action in the EM equity space qualifies as a bear market, not a correction. Yet the magnitude of this drawdown (25%) is still considerably smaller than the median stock price drop (45%) of previous bear markets. Hence, more downside in EM share prices in dollar terms is to be expected. The Federal Reserve is not about to rescue EM - not until U.S. share prices fall considerably and the dollar appreciates sharply. For EM dedicated equity portfolios, we are downgrading Taiwan from overweight to neutral (please see page 11). We reiterate our underweight stance on Peruvian stocks (please see page 14). Feature All happy families are alike; each unhappy family is unhappy in its own way. Leo Tolstoy, Anna Karenina To rephrase Leo Tolstoy's famous quote from Anna Karenina: All bull markets are alike; but, each bear market is distinctive in its own way. The emerging market stock index has dropped by 25% from its January high. We reckon EMs are in a bear market - not a correction. Thus, there is still meaningful downside in EM financial markets, and it is still too early to bottom-fish. Many commentators and investors are comparing the current selloff with other bear markets, most notably those that occurred in 1997-'98 and 2014-'15. Our answer to these comparisons is the above quote from Tolstoy. This EM rout is different from the previous ones, including the most recent one that occurred in 2015. Yet just because this selloff is in certain aspects unlike previous bear markets does not mean it is not a full-fledged bear market. Bear Markets Versus Corrections There is no scientific distinction between a bear market and a correction. The below considerations suggest to us that EMs are in a genuine bear market, not a correction. These deliberations complement rather than substitute our fundamental analysis that foreshadows weakening growth and deteriorating profitability in EM/China - the topics that we regularly discuss at great length in our weekly reports. Chart I-1 portrays EM share prices since the mid-1980s and identifies periods of bear markets. Bear markets differ from corrections not only by the magnitude of drawdowns but also by duration. We define an EM bear market as a drawdown that either lasted longer than six months or in which peak-to-trough price declines exceeded 25%. Chart I-1EM Stock Prices: A Long-Term Perspective Of Bear Markets Table I-1 and Table I-2 illustrate EM equity corrections and bear markets over the past 30+ years, respectively. Median and mean EM equity market corrections have historically lasted one and a half to two months, with price drawdowns of 18% in U.S. dollar terms each (Table I-1). On the other hand, median and mean EM equity bear markets have lasted eight to 10 months, with share prices falling by 45% (Table I-2). The current selloff is already more than eight months old, with share prices down 25% in dollar terms. Its duration has by far surpassed that of previous corrections. Therefore, the current market action in the EM equity space qualifies as a bear market. If this bear market produces a drawdown of 45%, on par with the median bear market, it would require another 30% drop in EM share prices in dollar terms from current levels. The range of price declines of previous EM equity bear markets is between 31% and 67%. For the current selloff to match the lowest point of this range (31%), share prices should fall another 10%. These estimates should help investors conduct their own scenario analyses. Our bias is that there will likely be at least another 15% drop in EM share prices before the risk-reward profile of this asset class improves. The way this EM selloff has been evolving is more consistent with a bear market than a correction. As a rule, EM equity corrections are sharp but short-lived. Table 1 shows that EM equity corrections have typically lasted from one to three months. In corrections, all markets drop together at once. In contrast, bear markets are drawn out, and domino effects leading to rotational selloffs are the norm. The current episode corresponds more to this pattern. Initially, the EM market riot was concentrated among discernably vulnerable markets such as Turkey, Argentina and Brazil. Then, the epicenter of the selloff rotated to emerging Asia, where large equity markets including China, Korea, Taiwan and Hong Kong took a beating1 (Chart I-2). Chart I-2EM: Rotational Selloffs A similar pattern of rotational selloffs prevailed in the 1997-'98 bear market in EM and in 2007-'08 in the U.S. (Chart I-3A and Chart I-3B). Chart I-3ARotational Selloffs During EM Bear Markets Chart I-3BRotational Selloffs During U.S. Credit Crisis In 2007-08 With the exception of bombed-out cases like Turkey and Argentina, there has been no panic-selling or forced liquidation. Although the current EM selloff has already been stretched out, it appears that selling has been rather reluctant. It would be unusual if a selloff of this magnitude and duration, occurring amid worsening EM/China growth and Fed tightening, does not culminate into liquidation/capitulation. We still expect such capitulation to occur. In fact, this would be one of the signposts for us to turn positive on EM. Bottom Line: Taking into account the duration and disposition of the current selloff, EM stocks are in a bear market, not a correction. That said, the magnitude of this drawdown (25%) is still smaller than the median price falloff (45%) and the range of price declines of previous EM bear markets. Hence, there is potentially another 10-30% price drop for EM stocks in dollar terms for this bear market to be on par with the smallest and median EM bear markets, respectively. Technical Signposts Of A Bear Market There are a number of technical signposts that are consistent with further downside in EM risk assets and currencies: Relative share price performance of EM versus DM has failed to break above its long-term moving average that has in the past served as an important technical support or resistance (Chart I-4). This entails that the relative bear market in EM versus DM is intact, and major fresh lows lie ahead. Chart I-4EM Versus DM: Relative Stock Prices In U.S. Dollars In absolute terms, the crest in EM share prices early this year was typical of a major top. The EM equity index has failed to break above its previous tops (Chart I-1 on page 1). This represents bearish price formation. Usually, when a market fails to break above its previous tops, a major downslide ensues. In short, the chart formation of EM stocks is in line with a bear market - not a correction. The breadth of the EM equity selloff has been extensive, entailing a genuine bear market. The stock market selloff has not been limited to large-cap names. Both the EM small-cap and equally-weighted stock indexes have in fact sold off more (Chart I-5). Chart I-5EM Equity Selloff Is Broad-Based The global equity sectors exposed to EM/China growth such as industrials, chemicals, mining and steel have all relapsed after failing to break above their 200-day moving averages (Chart I-6). This entails more downside in their share prices, and corroborates our view that global trade growth will deteriorate further. Chart I-6Global Cyclicals Are Breaking Down Asian semiconductor stocks are breaking down - another bad omen for global trade and Asian growth (Chart I-7). Chart I-7Asian Semiconductor Stocks Are Plunging U.S. Treasury yields as well as U.S. TIPS yields have broken out, and there is more upside to come. Odds are that U.S. interest rate expectations will continue to ratchet higher, which will weigh on EM currencies and risk assets. In terms of risks to our view, the technical profile of the U.S. dollar looks worrisome (Chart I-8). The broad trade-weighted greenback might potentially be forming a head-and-shoulder pattern. If the dollar relapses, EM risk assets will rally, and our negative stance on EM will turn out wrong. Chart I-8Trade-Weighted Broad U.S. Dollar: At A Vulnerable Spot? For now, however, we maintain that current global macro dynamics warrant a stronger dollar. In particular, a stronger dollar is required to redistribute growth away from the U.S. and towards the rest of the world.2 Specifically, the U.S. needs a strong dollar to cap budding inflation. For now, we view the recent dollar's softness as a short-term correction from overbought levels. Is A Replay Of February 2016 In Cards? A number of clients have been questioning whether current global macro dynamics - in certain aspects - is reminiscent of the peak in the dollar and the bottom in EM and global equity and credit markets that occurred in February 2016. Back then, the Fed paused its tightening cycle, and China's fiscal and credit stimulus put a floor under mainland growth. These measures combined marked a major top in the dollar and a bottom in EM risk assets. Presently, conditions are substantially different from those that prevailed during that time. In particular: Presently, there is no basis for the Fed to halt its tightening. The U.S. economy is now much stronger - nominal GDP growth is 5.4% versus 2.4% in the first quarter of 2016 (Chart I-9, top panel). Manufacturing production - excluding oil and mining output - is presently very robust (Chart I-9, middle panel). This stands in stark contrast to early 2016 when it was shrinking. Chart I-9U.S. Growth Is Much Stronger Today Than In Early 2016 Importantly, the U.S. output gap is positive, and core inflation is 2% and rising (Chart I-9, bottom panel). Overall, the Fed is not about to pause. On the contrary, U.S. interest rate expectations are still low relative to what is required to restrain America's growth and cap budding inflation. In short, the Fed is not about to rescue EM - not until the latter's financial and economic conditions deteriorate much more, U.S. asset prices fall considerably and the dollar appreciates sharply. In China, the fiscal and credit stimulus implemented so far has been insufficient to bolster growth. The impact of previous tightening is working its way through the economy, and the recent liquidity and fiscal stimuli have so far been insufficient to kick off a new business cycle upturn. We will re-visit this issue in next week's report. EM equities are not yet as cheap as they were at their 2016 lows, according to their cyclically adjusted P/E (CAPE) ratio (Chart I-10). Another 15% decline in EM share prices will bring the EM CAPE ratio to one standard deviation below its mean - the level where the EM CAPE ratio bottomed in early 2016. Chart I-10EM Cyclically-Adjusted P/E Ratio: Not Very Cheap Crucially, the CAPE ratio is a structural valuation metric. It matters for investment horizons beyond two to three years. It is not a useful gauge for the next 12 months or so. As such, even for long-term investors, the risk-reward trade-off for EM stocks is not yet favorable. Bottom Line: Conditions do not exist for the Fed to halt its tightening campaign. This, along with the currently limited stimulus from China and not-so-cheap EM equity valuations, entail that a major bottom in EM stocks is not in the cards. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Downgrading Taiwanese Stocks 18 October 2018 We have been overweighting Taiwanese stocks within an EM equity portfolio since 2007, and this bourse has outperformed the EM index by 30% since that time (Chart II-1). Presently, odds of a pullback in relative performance have risen considerably, and we recommend reducing allocation to this bourse from overweight to neutral. Chart II-1Take Profits On Overweight Taiwanese Stocks Position With the exception of DRAM prices, semiconductor prices are collapsing (Chart II-2). This is a nail in the coffin for this semi- and technology hardware-heavy bourse. Chart II-2Deflation In Semiconductor Prices In the past, Taiwan has depreciated its currency to offset the impact of falling export prices in dollar terms on corporate profitability. This option is no longer available to the authorities. It seems the Trump administration has made it clear to the island that its political and military support partially hinges on Taiwan not intervening in the currency market. In short, the authorities will not be able to resort to material currency depreciation to fight deflation in manufacturing goods as they have in the past. This is bad news for Taiwan's manufacturing-heavy economy, and especially corporate profitability. Exports and manufacturing are decelerating (Chart II-3). Chart II-3Taiwan's Business Cycle Exports of electronic products parts lead non-financial EBITDA, and currently foreshadow a deteriorating profit outlook (Chart II-4). Chart II-4Taiwan: Corporate Profits Are At Risk The recent underperformance of Taiwanese small-cap stocks versus their EM peers is a red flag for the relative performance of large caps. Last but not least, Taiwan is extremely exposed to U.S.-China strategic tensions, as our geopolitical team has argued.3 Escalating geopolitical and strategic tensions between the U.S. and China are taking us closer to a point where these risks are set to materialize, and the risk premium on Taiwanese equities to rise. This will hurt Taiwanese stocks' performance in both absolute and relative terms. Bottom Line: We are downgrading our allocation to Taiwanese stocks from overweight to neutral within an EM equity portfolio. This bourse is also vulnerable in absolute terms. This shift is also consistent with our overall portfolio strategy of reducing equity allocations to Asia in favor of Latin America, as well as with our new equity trade of shorting emerging Asia versus Latin America - a recommendation we made last week. In emerging Asia, having downgraded Taiwan, we now remain overweight only in Korea and Thailand. Peru: An Unsustainable Divergence 18 October 2018 Relative performance of Peruvian equities to EM has been resilient over the past nine months despite falling industrial and precious metals prices and a buoyant dollar (Chart III-1, top panel). Banks, and in particular Peru's financial behemoth, Credicorp, have been the primary contributors to Peruvian market outperformance.4 Excluding banks from the stock index shows that non-financials stocks have not outperformed the EM benchmark since early 2017 (Chart III-1, bottom panel). Chart III-1Peruvian Relative Equity Performance Has Diverged From Metals Prices Is such a divergence between metals prices and Peru's relative equity performance sustainable over the coming year? We think not. Balance of payment (BoP) dynamics has historically driven the macro cycle in Peru. In 2016-17, a favorable external backdrop - high commodity prices and capital inflows into EM - led to a stable exchange rate that in turn allowed the Peruvian central bank to cut interest rates by 150bps. Domestic demand has recovered briskly. However, based on our overall global macro view, we expect Peru's BoP to deteriorate and the virtuous cycle to reverse for the time being. Terms of trade are set to deteriorate with lower industrial and precious metals prices. Mining exports represent 60% of total exports, and the drop in copper and gold prices will dampen the value of exports. Historically, the currency and share prices perform poorly when the trade balance deteriorates (Chart III-2). Chart III-2Current Account Dictates Currency And Equity Trends Importantly, a strong dollar and a global EM riot will lead to diminishing foreign portfolio inflows. Foreigners own 42% of the local fixed-income market and any currency weakness could prompt hedging of currency risk. This will necessitate the central bank (the BCRP) to intervene in the foreign exchange market to defend the sol. By doing so, the central bank will withdraw domestic liquidity - banks' excess reserves at the BCRP will shrink (Chart III-3). Tightening local currency liquidity will lead to higher interbank rates (Chart III-4). Chart III-3Central Bank Selling FX Reserves = Lower Domestic Liquidity Chart III-4Lower Domestic Liquidity = Higher Rates Rising interbank rates will dampen banks' net interest margin as well as constrain loan growth in the process. In short, banks' profitability will be materially affected. Interestingly, interest rates, shown as inverted in the chart, correlate with banks' share prices (Chart III-5, top panel). Chart III-5Higher Rates Will Hurt Bank Stocks Finally, a slowdown in the economy and higher borrowing costs, both local and U.S. dollar, will cause non-performing loans (NPLs) to rise. Banks will be forced to increase provisions for non-performing assets, hurting bank profits in the process (Chart III-5, bottom panel). In terms of financial markets implications, we have the following observations and recommendations to make: Peruvian stock prices have been unable to break above their previous highs in absolute terms, pointing to a major top (Chart III-6). Chart III-6A Major Top? We recommend maintaining an underweight allocation to Peru in an EM dedicated equity portfolio. A negative external backdrop - rising U.S. interest rates, a strong dollar and falling commodities prices - constitute a major headwind for this equity market. Fixed income investors with local market exposure should consider betting on curve flattening given the outlook of higher short-term rates and decelerating growth. Andrija Vesic, Research Analyst andrijav@bcaresearch.com 1 We discussed the domino effect in Emerging Markets Strategy Weekly Report "EM: Sustained Decoupling, Or Domino Effect?" dated June 14, 2018, the link is available on page 19. 2 Please see Emerging Markets Strategy Weekly Report "Desynchronization Compels Currency Adjustments," dated September 20, 2018, the link is available on page 19. 3 Please see Geopolitical Strategy/Emerging Markets Strategy Special Report "Taiwan Is A Potential Black Swan," dated March 30, 2018, the link is available on ems.bcaresearch.com 4 Credicorp constitutes 70% of the Peru MSCI Index. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The long term direction for the pound is higher... ...but as the EU withdrawal bill passes through the U.K. parliament, expect a very hairy ride. The stock markets in Norway, Sweden and Denmark are driven by energy, industrials, and biotech respectively. Upgrade Sweden to neutral and downgrade Denmark to underweight. Think of semiconductors as twenty-first century commodities. Overweight the semiconductor sector versus broader technology indexes. Chart of the WeekBritish Public Opinion On Brexit Is Shifting Feature The Brexit drama is playing out exactly as scripted (Chart I-2). Chart I-2The Pound Is Following The Brexit Drama In July, we wrote: "The U.K. government's much hyped 'Chequers' proposal for Brexit risks getting a cold shower... the EU27 will almost instantaneously reject the proposed division between goods and services as 'cherry-picking' from its indivisible four freedoms - goods, services, capital, and people... the rejection will be based not just on the EU's founding principles, but also on the practical realities of a modern economy - specifically, the distinction between goods and services has become increasingly blurred." 1 Hence, the Chequers proposal to avoid a hard border between Northern Ireland and the Irish Republic is just wishful thinking: "The Irish border trilemma will remain unsolved, leaving a 'backstop' option of Northern Ireland remaining in the EU single market - an outcome that will be politically unpalatable." 2 What happens next? Understanding Brexit In a sense, Brexit is very simple. The EU27 sees only three options for the long-term political and economic relationship between the U.K. and the EU. Remain in the EU (no Brexit). Plug into an off-the-shelf setup, either the European Economic Area (EEA), European Free Trade Association (EFTA), or a permanent customs union, which already establish the EU relationship with Norway, Iceland, Liechtenstein, and Switzerland (soft Brexit). Become a 'third country' to the EU like, for example, Canada (hard Brexit). The first option, to stay in the EU, is politically impossible unless a new U.K. referendum overturned the original referendum's vote to leave. The second option, to join the EEA, EFTA, or permanent customs union is very difficult for Theresa May - because it is strongly opposed by many of the Conservative government's ministers and members of parliament who regard the option as 'Brino' (Brexit in name only). However, in a significant recent development, the opposition leader Jeremy Corbyn has committed the Labour party to a Brexit that keeps the U.K. in a permanent customs union.3 The third option, to become a 'third country', would very likely require some sort of border in Ireland. As already discussed, the only way to avoid a border would be a perfect alignment between the U.K and EU on tariffs and regulations for goods and services. But then, there would be little point in becoming a third country. Here's the crucial issue. The EU27 does not know which option the U.K. will eventually take, yet it must provide an 'all-weather' safeguard for the Good Friday peace agreement, requiring no border between Northern Ireland and the Irish Republic. Therefore, the EU27 will need the withdrawal agreement to commit: either the whole of the U.K. to a potentially permanent customs union with the EU; or Northern Ireland to a potentially permanent customs separation from the rest of the U.K. - in effect, breaking up the U.K by creating a border between Britain and Northern Ireland. Clearly, the hard Brexiters and/or Northern Ireland unionist MPs will vote down a withdrawal bill which contains either of these commitments, thereby wiping out Theresa May's slender majority. The intriguing question is: might Labour MPs - or enough of them - vote for a potentially permanent customs union to get the soft Brexit they want? Labour would be torn between the national interest and the party interest, as it would be missing a golden opportunity to topple the Conservative government. If the withdrawal bill musters a majority, it would remove the prospect of a 'no deal' Brexit and the pound would rally - because it would liberate the Bank of England to hike interest rates more aggressively (Chart I-3 and Chart I-4). If the bill failed, the government and specifically Theresa May would be badly wounded. She might call a general election there and then. Chart I-3Absent Brexit, U.K. Interest Rates Would Be Higher Chart I-4Absent Brexit, U.K. Interest Rates Would Be Higher If May limped on, parliament would nevertheless have the final say on whether to proceed with a no deal Brexit. And the parliamentary arithmetic indicates that a clear majority of MPs would vote against proceeding over the cliff-edge. At this point with the government paralysed, the only way to unlock the paralysis would be to go back to the people. Either in a general election or in a new referendum, the key issue for the public would be a choice between one of the three aforementioned options for the U.K./EU long-term relationship - because by then, it would be clear that those are the only options on offer. Based on a clear recent shift in British public opinion, the preference is more likely to be for a soft (or no) Brexit than to become a third country (Chart of the Week). Bottom Line: The long term direction for the pound is higher but, as the withdrawal bill passes through parliament, expect a very hairy ride. Understanding Scandinavian Stock Markets The Scandinavian countries - Norway, Sweden, and Denmark - have many things in common: their languages, cultures, and lifestyles, to name just a few. However, when it comes to their stock markets, the three countries could not be more different. Looking at the three bourses, each has a defining dominant sector (or sectors) whose market weighting swamps all others. In Norway, oil and gas accounts for over 40 percent of the market; in Sweden, industrials accounts for 30 percent of the market and financials accounts for another 30 percent; and in Denmark, healthcare accounts for 50 percent of the market (Table I-1). Table I-1The Scandinavian Stock Markets Could Not Be More Different! In a sense, the dominant equity market sectors in Norway and Sweden just reflect their economies. Norway has a large energy sector; Sweden specializes in advanced industrial equipment and machinery and it also has very high level of private sector indebtedness, explaining the outsized weighting in banks. However, Denmark's equity market - dominated as it is by Novo Nordisk, which is essentially a biotech company - has little connection with Denmark's economy. The important point is that the four dominant sectors - oil and gas, industrials, financials, and biotech - each outperform or underperform as global (or at least pan-regional) sectors. If oil and gas outperforms, it outperforms everywhere and not just locally. It follows that the relative performance of the four dominant equity sectors drives the relative stock market performances of Norway, Sweden, and Denmark. Norway versus Sweden = Energy versus Industrials (Chart I-5) Chart I-5Norway Vs. Sweden = Energy Vs. Industrials Norway versus Denmark = Energy versus Biotech (Chart I-6) Chart I-6Norway Vs. Denmark = Energy Vs. Biotech Sweden versus Denmark = Industrials and Financials versus Biotech (Chart I-7) Chart I-7Sweden Vs. Denmark = Industrials And Financials Vs. Biotech Last week, we upgraded some of the more classical cyclical sectors to a relative overweight. Our argument was that if an inflationary impulse is dominating, beaten-down cyclicals have more upside than the more richly-valued equity sectors; and if a disinflationary impulse from higher bond yields is dominating, its main casualty will be the more richly-valued equity sectors. On this basis, our ranking of the four sectors is: Industrials, Financials, Energy, Biotech. Which means the ranking of the Scandinavian stock markets is: Sweden, Norway, Denmark. Bottom Line: From a pan-European perspective, upgrade Sweden to neutral and downgrade Denmark to underweight. Understanding Semiconductors The best way to understand semiconductors is to think of them as twenty-first century commodities. In the twentieth century, many everyday goods and products contained a classical commodity such as copper. Today, the ubiquity of electronic gadgets, devices, and screens contains a twenty-first century equivalent: the microchip. Hence, semiconductors are to the tech world what classical commodities are to the non-tech world. They exhibit exactly the same cycle of relative performance. If, as we expect, beaten-down industrial commodities outperform, it follows that the beaten-down semiconductor sector will outperform broader technology indexes (Chart I-8). Chart I-8Semiconductors Follow The Commodity Cycle Bottom Line: Overweight the semiconductor sector versus technology. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 For example, the sale of a car is no longer the sale of just a good. As car companies often structure the financing of the car purchase, a car purchase can be a hybrid of a good - the car itself, and a service - the financing package. Therefore, a single market for cars requires a single market for both goods and services. 2 The Irish border trilemma comprises: 1. the U.K./EU land border between Northern Ireland and the Irish Republic; 2. the Good Friday peace agreement requiring the absence of any physical border within Ireland; 3.the Northern Ireland unionists' refusal to countenance a U.K./EU border at the Irish Sea, which would entail a customs border between Northern Ireland and the rest of the U.K. 3 At the Labour Party's just-held 2018 conference, Jeremy Corbyn made a commitment to joining a permanent U.K./EU customs union. Fractal Trading Model* This week's recommended trade comes from Down Under. The 25% outperformance of Australian telecoms (driven by Telstra) versus insurers (driven by IAG and AMP) over the past 3 months appears technically extended, with a 65-day fractal dimension at a level that has regularly indicated the start of a countertrend move. Therefore, the recommended trade is short Australian telecoms versus insurers, setting a profit target of 7% and a symmetrical stop-loss. In other trades, long CRB Industrial commodities versus MSCI World Index achieved its profit target very quickly, leaving four 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-9 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 I-1Indicators To Watch - Bond Yields Chart I-2Indicators To Watch - Bond Yields Chart I-3Indicators To Watch - Bond Yields Chart I-4Indicators To Watch - Bond Yields Interest Rate Chart I-5Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations