Asset Allocation

Highlights Portfolio Strategy Selling in the S&P cable & satellite index is overdone. Recession type valuations fully reflect the acquirer discount heavyweight CMCSA is still commanding. Lift exposure to neutral. Content providers' assets are highly coveted, and these firms remain in play as media is undergoing a tectonic shift. The industry's demand backdrop is also on the rise, signaling that it no longer pays to underweight the S&P movies & entertainment index. Increasing construction expenditures, ballooning balance sheets, soft relative selling prices and a rising U.S. dollar all suggest that restaurant profits will underwhelm. Downgrade to underweight. Recent Changes Raise the S&P cable & satellite index to neutral today. Lift the S&P movies & entertainment index to a benchmark allocation today. Act on the downgrade alert and trim the S&P restaurants index to underweight today. Table 1 Has The Reward/Risk Tradeoff Changed? Has The Reward/Risk Tradeoff Changed? Feature Geopolitical risks held equities hostage last week as President Trump toughened his tariff rhetoric toward China. While the risk of a global trade spat remains acute, the market is becoming desensitized to daily trade-related headlines and remains resilient. Given the plethora of political risks and upcoming midterm elections, I look forward to hearing Greg Valliere's keynote speech in BCA's Toronto Investment Conference on September 24-25. Importantly, last week rising protectionism along with "Three Policy Puts Going Kaput" compelled BCA's Global Investment Strategy service to turn more cautious toward global risk assets over its 6 to 12 month cyclical horizon, prompting them to downgrade global equities from overweight to a neutral stance.1 We have sympathy for this view and acknowledge that the risks to our still sanguine U.S. equity market view, which we have been flagging in recent publications, have increased a notch. We are especially worried about the greenback's appreciation and increasing potential to infiltrate SPX EPS in calendar 2019 (please see Chart 2 and Chart 4 from the June 4th Weekly Report). Given that technology has the highest foreign sales exposure (58% of total sales) among GICS1 sectors, and a 26% market cap weight, we are closely monitoring leading indicators for tech profits. Indeed, for calendar 2019 the S&P tech sector's contribution to S&P 500 profit growth is the highest at 21%, with financials right on its tail at 20% (Chart 1). Energy sector EPS base effects are filtered out in 2019, but industrials, that have a 37% foreign sales exposure and are at the epicenter of President Trump's tariff rhetoric, also explain 13% of SPX EPS growth in calendar 2019 (Chart 1). Chart 1Contribution To S&P 500 2019 EPS Growth Has The Reward/Risk Tradeoff Changed? Has The Reward/Risk Tradeoff Changed? In fact, over a structural (2-3 year) time horizon we are aligned with BCA's more bearish equity outlook. We have been advocating this longer term thesis in our travels visiting BCA clients (please download our latest marketing slide deck here that highlights our bearish secular equity market view). Importantly, the three signposts we are monitoring to help us time the end of the business cycle, and thus equity bull market, are: 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). There are currently no ticks in any of these three boxes, and we conclude that the S&P 500 has yet to peak for the cycle (Chart 2). Crucially, the Fed is inflating a massive bubble by staying too easy for too long. It is rather obvious to us that the U.S. economy is firing on all cylinders with real non-residential investment growing near 10% in Q1, but the real fed funds rate is still near the zero line (Chart 3). In addition, recent Fed minutes signaled that the Fed is willing to take some inflation risk, which will further push equity markets into steeper disequilibrium. It would be unprecedented for the cycle to end with the real fed funds rate glued to zero (Chart 3). Chart 2Recession Indicators Recession Indicators Recession Indicators Chart 3Real Fed Funds Rate Is Still Zero! Real Fed Funds Rate Is Still Zero! Real Fed Funds Rate Is Still Zero! Moreover, the U.S. economy just received a two year fiscal stimulus injection which is rare in both duration and magnitude during the late stages of the expansion and thus inherently inflationary. Worrisomely, the last time this happened was in the mid-to-late 1960s that led to the inflationary 1970s (please see Chart 1 and Table 2 from our October 9th "Can Easy Fiscal Offset Tighter Monetary Policy?" Weekly Report). Tack on the starting point of a World War-like debt-to-GDP ratio and the only regulatory mechanism for government profligacy is the bond market (Chart 4). Chart 4Interest Rates Have Nowhere To Go But Up Interest Rates Have Nowhere To Go But Up Interest Rates Have Nowhere To Go But Up Another way to make the debt arithmetic work is if one believes the White House's real GDP projections of 3%+ as far as the eye can see, which stand in marked contrast to the IMF's, the CBO's and the Fed's own projections (Chart 5). Therefore, the path of least resistance for interest rates is higher as a way to slow down the economy and also rein in debt excesses. Typically, this overheating late in the cycle is synonymous with a blow off phase in equities (Chart 6), before the bottom falls out. Chart 5Don't Believe The White House Don't Believe The White House Don't Believe The White House Chart 6Blow Off Phase Blow Off Phase Blow Off Phase In sum, while BCA downgraded global equities to neutral last week on a cyclical time horizon, we are deviating from the BCA House View and still believe that the S&P 500 will make new all-time highs in absolute terms before the next recession hits. This week we are making a few subsurface changes to the S&P consumer discretionary sector, but we maintain an underweight allocation to this interest rate-sensitive sector. New Media Landscape: (Pipelines Vs. Content Providers) Vs. Netflix At last count Netflix broke into the top 25 largest companies (market cap based) in the S&P 500, and if it keeps up its frenetic pace it is on track to surpass Boeing. While legacy media giants had a chance to scoop up Netflix in the past few years, its current stratospheric valuation makes it uneconomical and nonsensical. Instead, the specter of Netflix, as well as other tech giants circling the space, has accelerated an inter- and intra-industry consolidation (bottom panel, Chart 7). Why? Because Netflix not only went straight to the consumer on a new medium, the internet, and sped up cord cutting, but also blurred industry lines by becoming a content provider producing its own original content in addition to offering third party content. The media landscape is thus still trying to adjust to the Netflix induced "creative destruction" and media executives are scrambling to compete with/protect legacy franchises from Netflix. The recently cleared AT&T/Time Warner merger has intensified the bidding war of remaining crown jewel assets in the legacy content media world. We were well positioned for this shake up in the space as we went underweight the media complex in early March.2 But now, we deem that the easy money has been made and most of the negative narrative is reflected in bombed out relative valuations despite depressed relative profit and sales growth estimates (second & third panels, Chart 7). As a result we recommend lifting exposure back to benchmark in the broad S&P media index. Beyond these industry related intricacies, the macro backdrop is starting to turn in favor of media outfits, warning that it no longer pays to be bearish. Chart 8 shows that relative consumer outlays on media have spiked recently. The implication is that industry revenue growth has more upside. BCA's ad spending indicator also corroborates this firming top line growth message, as does the latest ISM services survey that remains squarely above the 50 boom/bust line on a broad array of measures. Unsurprisingly, this budding demand recovery has translated into a pick up in industry pricing power with our media selling price gauge even surpassing overall inflation. The implication is that media profits could surprise to the upside. Chart 7M&A Frenzy Continues M&A Frenzy Continues M&A Frenzy Continues Chart 8Overlooked Demand Recovery Overlooked Demand Recovery Overlooked Demand Recovery While our sense is that pipelines (S&P cable & satellite index) are the likely losers and content providers (S&P movies & entertainment) are the likely winners from the ongoing broad media deck reshuffling, the way we are executing the S&P media upgrade to neutral is by lifting both the S&P cable & satellite and S&P movies & entertainment sub-indexes to neutral. On the cable front, M&A activity is weighing heavily on relative share prices as index heavyweight Comcast is a possible acquirer of the Murdoch empire assets. However, this bellwether company is not a pure pipeline play and were it to win the FOX-related assets bidding war, it would further diversify its cash flow. Monetizing those assets involves execution risk, especially as the legacy cable business is wrestling with decelerating selling prices and still has to contend with cord cutting (top & middle panels, Chart 9). Encouragingly, the bottom panel of Chart 9 shows that likely all the negative news flow is already baked into compelling relative valuations. With regard to the content providers, not only are some of these assets currently caught up in a bidding war, but every remaining independent content provider is now in play, and deal hungry investment bankers are aggressively pitching M&A to media (and likely other industry) CEOs. Macro headwinds are also morphing into tailwinds for the S&P movies & entertainment group. Consumer confidence is pushing multi decade highs and given the fact that the economy is at full employment any increase in discretionary consumer incomes will likely further boost recreation outlays (Chart 10). Industry pricing power is also expanding at a healthy clip at a time when industry executives are showing labor restraint (Chart 11). If selling prices stay firm on the back of improving demand as we expect, then movies & entertainment profit margins will enter an expansion phase (middle panel, Chart 10). Chart 9Cable's Blues Are ##br##Well Discounted Cable's Blues Are Well Discounted Cable's Blues Are Well Discounted Chart 10Firming ##br##Recreation Outlays... Firming Recreation Outlays... Firming Recreation Outlays... Chart 11And Recovering Operating Metrics##br## Remain Underappreciated And Recovering Operating Metrics Remain Underappreciated And Recovering Operating Metrics Remain Underappreciated None of this rosy outlook is reflected in cyclically low S&P movies & entertainment relative valuations (bottom panel, Chart 10). Bottom Line: Book relative profits of 13.5% in the S&P cable & satellite index since inception and lift to neutral. Boost the S&P movies & entertainment index to a benchmark allocation for a relative loss of 8.3% since the early March inception. As a result the broad S&P media index also commands a neutral weighting. The ticker symbols for the stocks in the S&P cable & satellite and S&P movies & entertainment indexes are: BLBG: S5CBST - CMCSA, CHTR, DISH and BLBG: S5MOVI - DIS, FOXA, FOX, VIAB, respectively. Portion Control In Restaurants Restauranteurs are eternal optimists; at least that is the lesson we take from the National Restaurant Association's Restaurant Performance Index (RPI) which only rarely dips below the expansion line (Chart 12, second panel). However, changes in this overly optimistic sentiment survey are useful as they closely lead the S&P restaurants index's relative performance. This indicator has recently rolled over and we think the timing is right to turn negative on restaurants (Chart 12, bottom panel). The recent evaporation of industry pricing power echoes the RPI's early indications of a downturn (Chart 13, second panel). In view of how tightly it moves with relative industry sales, the growth outlook for restaurants has darkened considerably. The underlying driver of weakening pricing power is the industry's collapsing share of the consumer's wallet over the past two years, which has been at least as destructive to industry growth as the Great Recession (Chart 13, bottom panel). While both relative consumption and sales, which move in lockstep, have been staging a recovery in 2018, they both remain firmly in deflationary territory. Meanwhile, industry wages - the largest input cost - have been expanding above trend for the better part of the past four years (Chart 14, second panel). Though restaurant wage growth has recently slowed considerably it has not been enough to bring our margin proxy out of negative territory, implying sliding relative earnings growth is set to continue (Chart 14, bottom panel). Chart 12Optimism Reigns In Restaurants Optimism Reigns In Restaurants Optimism Reigns In Restaurants Chart 13Falling Pricing Should Weigh On Sales Falling Pricing Should Weigh On Sales Falling Pricing Should Weigh On Sales Chart 14Labor Costs Are A Profit Headwind Labor Costs Are A Profit Headwind Labor Costs Are A Profit Headwind A rising U.S. dollar is an additional profit headwind for this heavily internationally-geared consumer discretionary sub-index. Despite dollar strength offering an input cost tailwind via lower food commodity costs, declining translation of foreign profits will likely swamp those gains. McDonald's and Starbucks, which together represent 80% of the weight of the S&P restaurants index, had 62% and 49%, respectively, of their locations outside the U.S. at the end of last year. To compensate for a tough profit outlook, restaurants have embarked on a construction spending spree that shows no signs of abating (Chart 15, second panel). The predictable result has been a near-doubling of leverage ratios over the past three years (Chart 15, bottom panel). A weak profit backdrop signals that relief from these levels will be hard to find. Chart 15Restaurants Are Binging On Debt Restaurants Are Binging On Debt Restaurants Are Binging On Debt Chart 16Valuations Do Not Reflect Risks Valuations Do Not Reflect Risks Valuations Do Not Reflect Risks Valuations have been treading water at above-normal levels for several years (Chart 16, second and third panels). Perky valuations seem poised for a fall given the cloudy profit outlook and the higher risk premium that recently geared up balance sheets typically command. Bottom Line: Still-high valuations are not supported by falling returns in an increasingly capital intensive industry. Accordingly, we are pulling the trigger on last month's downgrade alert on the S&P restaurants index and moving to an underweight allocation. The ticker symbols for the stocks in this index are: BLBG: S5REST - MCD, SBUX, YUM, DRI, CMG. What Does All This Mean For The S&P Consumer Discretionary Index? Chart 17Stay Underweight Consumer Discretionary Stay Underweight Consumer Discretionary Stay Underweight Consumer Discretionary Despite the S&P media's heavy weighting in the broad consumer discretionary sector, our S&P restaurants downgrade sustains the below benchmark allocation in the S&P consumer discretionary sector. Importantly, the three key factors weighing on this early-cyclical sector we identified in early March remain intact: rising fed funds rate, quantitative tightening and higher prices at the pump (Chart 17). Meanwhile, were we to exclude AMZN from the day the S&P included it in the SPX and the S&P 500 consumer discretionary index (November 21st, 2005), then the vast majority of consumer discretionary stocks are actually following the typical historical relationship with the Fed's tightening cycle (middle panel, Chart 17). Put differently, the equal weighted S&P consumer discretionary relative share price ratio is indeed following the Fed's historical tightening path (bottom panel, Chart 17). Bottom Line: Earnings underperformance will eventually result in relative share price underperformance. Stay underweight the S&P consumer discretionary index. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 19, 2018, available at gis.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Short oil and gas versus financials. Stick with underweights in the classically cyclical sectors. Downgrade the FTSE100 to neutral. Overweight France, Ireland, Switzerland and Denmark. Underweight Italy, Spain, Sweden and Norway. European equities will struggle to make much headway versus the technology-dominated S&P500 and MSCI Emerging Markets. Overall market direction will be range-bound through the summer. Feature Two market oddities stood out in the first half of the year. The first oddity was the abrupt decoupling of bank equity performance from bond yields (Chart I-2). For many years, bank equity performance and bond yields have been joined at the hip (Chart I-3). The faithful relationship exists because higher bond yields tend to signal stronger economic growth, either real or nominal. Stronger growth should be good for banks as it is associated with both accelerating credit growth and lower provisions for non-performing loans. Chart of the WeekWhen Technology Outperforms, European Equities Struggle Versus Emerging Market Equities When Technology Outperforms, European Equities Struggle Versus Emerging Market Equities When Technology Outperforms, European Equities Struggle Versus Emerging Market Equities Chart I-2Oddity 1: Banks Abruptly Decoupled##br## From Bond Yields Oddity 1: Banks Abruptly Decoupled From Bond Yields Oddity 1: Banks Abruptly Decoupled From Bond Yields Chart I-3Banks And Bond Yields Have Been ##br##Joined At The Hip For Years Banks And Bond Yields Have Been Joined At The Hip For Years Banks And Bond Yields Have Been Joined At The Hip For Years The second oddity was the abrupt decoupling of crude oil from industrial metal prices (Chart I-4). It is rare for crude oil to outperform copper by 30% in the space of just six months (Chart I-5). Chart I-4Oddity 2: The Crude Oil Price Abruptly ##br##Decoupled From Metal Prices It Is Rare For Crude Oil To Outperform Copper By 30% In Six Months It Is Rare For Crude Oil To Outperform Copper By 30% In Six Months Chart I-5It Is Rare For Crude Oil To Outperform ##br##Copper By 30% In Six Months It Is Rare For Crude Oil To Outperform Copper By 30% In Six Months It Is Rare For Crude Oil To Outperform Copper By 30% In Six Months Explaining The Oddities In The 1st Half The underperformance of banks is consistent with similar underperformances in the other classically growth-sensitive sectors - industrials, and basic materials (Chart I-6). Furthermore, the underperformances of these cyclicals is closely tracking the downswing in the global 6-month credit impulse (Chart I-7). Chart I-6The Odd Man Out: ##br##Oil And Gas The Odd Man Out: Oil And Gas The Odd Man Out: Oil And Gas Chart I-7The Underperformance Of Cyclicals Is Closely ##br##Tracking The Global 6-Month Credit Impulse The Underperformance Of Cyclicals Is Closely Tracking The Global 6-Month Credit Impulse The Underperformance Of Cyclicals Is Closely Tracking The Global 6-Month Credit Impulse Note also that these underperformances started well before any inkling of a trade spat. Hence, the recent escalation in the trade skirmishes is reinforcing a change of trend that was already in place. Taken together, this evidence would strongly suggest that global growth is not accelerating; it is decelerating. Oil is the odd man out because its supply dynamics, rather than demand dynamics, have been dominating its price action, lifting its year-on-year inflation rate to 60%. However, a large part of this surge in year-on-year inflation is also to do with the 'base effect', the dip in the oil price to $45 a year ago. The base effect is a statistical quirk, and shouldn't really bother markets. After all, most people do not consciously compare today's price with that exactly a year ago. Unfortunately, central banks' inflation targets are based on year-on-year comparisons, and this could explain why bond yields have decoupled from growth. If oil price inflation is running at 60% it will underpin headline CPI inflation, central bank reaction functions, and thereby bond yields. So here's the explanation for the oddities in the first half. Banks, industrials, and the other classically cyclical sectors are taking their cue from global growth and industrial activity, which does appear to be losing momentum. In contrast, bond yields are taking their cue from the oil price, given its major impact on headline inflation and on central bank reaction functions. Spotting An Opportunity In The 2nd Half Chart I-8Crude Oil's 12-Month Inflation Rate Is 60% Crude Oil's 12-Month Inflation Rate Is 60% Crude Oil's 12-Month Inflation Rate Is 60% Ultimately, an oil price spike based on supply dynamics without support from stronger demand is unsustainable - because the higher price eventually leads to demand destruction (Chart I-8). On the other hand, if global demand growth does reaccelerate, it is the beaten-down bank equity prices that have the recovery potential. Either way, this leads us to a compelling intra-cyclical trade: short oil and gas versus financials. In aggregate though, we expect cyclical sectors to continue underperforming defensives through the summer. Based on previous credit impulse mini-cycles, we can confidently say that mini-deceleration phases last at least six to eight months and that the typical release valve is a decline in bond yields. In this regard, the apparent disconnect between decelerating growth and slow-to-budge bond yields risks protracting this mini-deceleration phase. Therefore, through the summer, it is appropriate to stick with underweights in the classically cyclical sectors. The strategy has worked well since we initiated it at the start of the year, and it is too early to take profits. Likewise, the portfolio of high-quality government 30-year bonds which we bought in early May is performing well, and we expect it to continue doing so for the time being. Don't Over-Complicate The Investment Process! To reiterate, stick with an underweight to the classical cyclicals versus defensives; and within the cyclicals, short oil and gas versus financials. These sector stances then have a very strong bearing on regional and country equity allocation. This is because up to a quarter of the market capitalisation of each major stock market is in one dominant sector, and this dominant sector gives each equity index its defining fingerprint (Table I-1): for the FTSE100, it is oil and gas; for the Eurostoxx50 it is financials; for the Nikkei225 it is industrials. So all three of these regional indexes are dominated by classical cyclicals. Table I-1Each Major Stock Market Has A Defining Sector Fingerprint Oddities In The 1st Half, Opportunities In The 2nd Half Oddities In The 1st Half, Opportunities In The 2nd Half For the S&P500 and MSCI Emerging Markets indexes, the dominant sector is technology. Although the technology sector is not strictly speaking defensive, it is much less sensitive to growth accelerations and decelerations than the classical cyclicals. There is another important factor to consider: the currency. The FTSE100 oil and gas stock, BP, receives its revenue and incurs its costs in multiple major currencies, such as euros and dollars. In this sense, BP's global business is currency neutral. But BP's stock price is quoted in London in pounds. This means that if the pound strengthens, the company's multi-currency profits will decline relative to the stock price and weigh it down. Conversely, if the pound weakens, it will lift the BP stock price. So the currency is the channel through which the domestic economy can impact its stock market, albeit it is an inverse relationship: a strong currency hinders the stock market; a weak currency helps it. The upshot is that the defining sector fingerprints for the major indexes turn out to be: FTSE100 = global oil and gas shares expressed in pounds. Eurostoxx50 = global banks expressed in euros. Nikkei225 = global industrials expressed in yen. S&P500 = global technology expressed in dollars. MSCI Emerging Markets = global technology expressed in emerging market currencies. Professional investors might argue that this trivializes an investment process on which they spend a lot of time, resource, research, and ultimately money. But we would flip this argument around. To justify the large amounts of time and resource spent on the investment process, professional investors are often guilty of over-complicating it! We fully admit that many factors influence the financial markets, but these factors follow the Pareto Principle, also known as the 80:20 rule. A small number of causes explain the majority of effects. And the 20% that explains 80% of a stock market's relative performance is its defining sector fingerprint. The Chart of the Week and Chart I-9-Chart I-12 should dispel any lingering doubts that readers might have. Chart I-9FTSE 100 Vs. S&P 500 = Global Oil And Gas##br## In Pounds Vs. Global Tech In Dollars FTSE 100 Vs. S&P 500 = Global Oil And Gas In Pounds Vs. Global Tech In Dollars FTSE 100 Vs. S&P 500 = Global Oil And Gas In Pounds Vs. Global Tech In Dollars Chart I-10FTSE 100 Vs. Nikkei 225 = Global Oil And Gas ##br##In Pounds Vs. Global Industrials In Yen FTSE 100 Vs. Nikkei 225 = Global Oil And Gas In Pounds Vs. Global Industrials In Yen FTSE 100 Vs. Nikkei 225 = Global Oil And Gas In Pounds Vs. Global Industrials In Yen Chart I-11FTSE 100 Vs. Euro Stoxx 50 = Global Oil And Gas ##br##In Pounds Vs. Global Banks In Euros FTSE 100 Vs. Euro Stoxx 50 = Global Oil And Gas In Pounds Vs. Global Banks In Euros FTSE 100 Vs. Euro Stoxx 50 = Global Oil And Gas In Pounds Vs. Global Banks In Euros Chart I-12Euro Stoxx 50 Vs. S&P 500 = Global Banks ##br##In Euros Vs. Global Tech In Dollars Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Tech In Dollars Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Tech In Dollars So what does all of this mean for investors right now? A stance that is short oil and gas versus financials necessarily implies that the FTSE100 will struggle versus the Eurostoxx50, given the FTSE100's oil and gas fingerprint and the Eurostoxx50's banks fingerprint. Hence, today we are taking profits in our overweight to the FTSE100, and downgrading this position to neutral. This leaves us with overweight positions to France, Ireland, Switzerland and Denmark, and underweight positions to Italy, Spain, Sweden and Norway. Meanwhile, a stance that is underweight the classical cyclicals necessarily implies that European equities will struggle to make much headway versus the technology-dominated S&P500 and MSCI Emerging Markets. Finally, in terms of overall market direction, we expect the range-bound pattern established in the first half of the year to hold through the summer. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* There are no new trades this week. However, we reiterate that the outperformance of oil and gas versus financials is technically very stretched, which reinforces the fundamental arguments in the main body of this report to go short oil and gas versus financials. 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-13 Short oil and gas versus financials Short oil and gas versus financials The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Three macro "policy puts" are in jeopardy of disappearing or, at the very least, being repriced. Fed Put: Rising inflation has made the Fed more reluctant to back off from rate hikes at the first hint of slower growth or falling asset prices. China Put: Worries about high debt levels, overcapacity, and pollution all mean that the bar for fresh Chinese stimulus is higher than in the past. Draghi Put: Bailing out Italy was a no-brainer in 2012 when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. These factors, along with additional risks such as mounting protectionism, warrant a more cautious 12-month stance towards global equities and other risk assets. The fact that valuations are stretched across most asset classes only adds to our concern. A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase over the balance of the year, with the next big move for global equities probably being to the downside. Buckle Up One of BCA's key ongoing themes is that policy and markets are on a collision course. We are starting to see this impending crash play out across the world. Higher Inflation Is Tying The Fed's Hands A slowdown in global growth caused the Fed to abort its tightening plans for 12 months starting in December 2015. Global growth is faltering again, but this time around the Fed is less eager to hit the pause button. In contrast to 2015, the U.S. economy has run out of spare capacity. The unemployment rate fell to a 48-year low of 3.75% in May. For the first time in the history of the Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS), there are more job vacancies than unemployed workers (Chart 1). Average hourly earnings surprised on the upside in May, while the Employment Cost Index for private-sector workers - the cleanest and most reliable measure of U.S. wage growth - rose at a robust 4% annualized pace in the first quarter. Labor market surveys, which generally lead wage growth by three-to-six months, are pointing to a further acceleration in wages (Chart 2). Chart 1There Are Now More ##br##Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers Chart 2U.S. Wage Growth Is Set To Accelerate U.S. Wage Growth Is Set To Accelerate U.S. Wage Growth Is Set To Accelerate The Dollar Rally Can Keep Going Rising wages will put more income into workers' pockets, who will then spend it. Stronger demand can be partly satisfied by imports, but it will take a change in relative prices for that to happen. U.S. imports account for only 16% of GDP. Unless the prices of foreign-made goods decline in relation to the prices of domestically-produced goods, the bulk of any additional household income will be spent on goods produced in the U.S. This means that the dollar needs to strengthen. The Fed's broad trade-weighted dollar index is up 8% since the start of February. While we are not as bullish on the dollar as we were a few months ago, we still believe that the path of least resistance for the greenback is up. Our long DXY trade recommendation has gained 12.1% inclusive of carry since we initiated it. We are raising the target price from 96 to 98. A stronger dollar can help deflect some additional spending towards imports, but this won't be enough to fully cool the economy. Services, which generally cannot be imported, account for nearly two-thirds of GDP. Since it takes time to shift resources from goods-producing sectors to service sectors, any rising aggregate demand will boost service prices. Outside of housing, service-sector inflation is already running at 2.4%, a number that is likely to rise further over the coming year (Chart 3). This will keep the Fed on edge. Hard Times For Emerging Markets The combination of rising U.S. rates and a stronger dollar is bad news for emerging markets. Eighty percent of EM foreign-currency debt is denominated in dollars. Outside of China, EM dollar debt is now back to late-1990s levels both as a share of GDP and exports (Chart 4). Chart 3Faster Wage Growth Will Push ##br##Up Service Inflation Faster Wage Growth Will Push Up Service Inflation Faster Wage Growth Will Push Up Service Inflation Chart 4EM Dollar Debt Back To Late-1990s Levels EM Dollar Debt Back To Late-1990s Levels EM Dollar Debt Back To Late-1990s Levels The wave of EM local-currency debt issued in recent years only complicates matters. If EM central banks raise rates to defend their currencies, this could imperil economic growth and make it difficult for local-currency borrowers to pay back their loans. Rather than hiking rates, some EM central banks may simply choose to inflate away debt. Consider the case of Brazil. Ninety percent of Brazilian sovereign debt is denominated in reais. The Brazilian government won't default on its debt per se. However, if push comes to shove, Brazil's central bank can always step in to buy government bonds, effectively monetizing the fiscal deficit. The specter of trade wars only adds to the risks facing emerging markets. A larger U.S. budget deficit will drain national savings, leading to a bigger trade deficit. Rather than blaming his own macroeconomic policies, President Trump will blame America's trading partners. Global trade has already been flatlining for over a decade (Chart 5). Trump's trade agenda will further undermine the global trading system. Emerging markets will bear the brunt of that development. Chart 5Global Trade Has Crested Global Trade Has Crested Global Trade Has Crested Chinese Stimulus To The Rescue? When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive new stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. Today, Chinese growth is slowing again. May data on industrial production, retail sales, and fixed asset investment all disappointed. Property prices in tier 1 cities are down year-over-year. Our leading indicator for the Li Keqiang index, a widely followed measure of economic activity, is in a clear downtrend (Chart 6). So far, the policy response has been fairly muted. Reserve requirements have been cut and some administrative controls loosened, but the combined credit and fiscal impulse has plunged (Chart 7). Onshore and offshore corporate bond yields have increased to multi-year highs. Bank lending rates are rising, while loan approvals are dropping (Chart 8). Chart 6Chinese Growth Is Slowing Anew Chinese Growth Is Slowing Anew Chinese Growth Is Slowing Anew Chart 7China: Policy Response To Slowdown ##br##Has Been Muted So Far China: Policy Response To Slowdown Has Been Muted So Far China: Policy Response To Slowdown Has Been Muted So Far Chart 8China: Credit Tightening China: Credit Tightening China: Credit Tightening We have no doubt that China will stimulate again if the economy appears to be heading for a deep slowdown. However, the bar for a fresh round of stimulus is higher today than it was in the past. Elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities can respond with the usual barrage of infrastructure spending and increased bank lending. The economy needs to feel more pain before policymakers come to its aid. Draghi's Dilemma The Italian economy was showing signs of weakness even before bond yields exploded higher. Domestic demand slowed to a mere 0.3% qoq in Q1. The PMIs, consumer confidence, and the Bank of Italy's Ita-Coin cyclical indicator all decelerated (Chart 9). Italy would benefit from a more competitive cost structure, but the political will to undertake the sort of reforms Germany implemented in the late 1990s, and that Spain implemented after the Great Recession, has been sorely lacking (Chart 10). Unwilling to take tough actions to improve competitiveness, the Five Star-Lega coalition government has proposed loosening fiscal policy to support demand. Chart 9Italy's Economy Is Weakening... Again Italy's Economy Is Weakening... Again Italy's Economy Is Weakening... Again Chart 10Italy: More Work Needs To Be Done On ##br##The Labor Competitiveness Front Italy: More Work Needs To Be Done On The Labor Competitiveness Front Italy: More Work Needs To Be Done On The Labor Competitiveness Front Italy's shift towards populism is arriving at the same time that the ECB is looking to wind down its asset purchase program. This means that a key buyer of Italian debt is stepping back just when it may be needed the most. Getting the ECB to bail out Italy will not be as straightforward this time around. Recall that Mario Draghi and Jean-Claude Trichet penned a letter to the Italian government in 2011 outlining a series of reforms they wanted to see enacted as a condition of ongoing ECB support. The contents of the letter were so explosive that they precipitated the resignation of then-PM Silvio Berlusconi when they were leaked to the public. One of the reforms that Mario Draghi demanded - and the subsequent government led by Mario Monti ultimately undertook - was the extension of the retirement age. Italy's current government has explicitly promised to reverse that decision much to the consternation of the ECB and the European Commission. It was one thing for Mario Draghi to promise to do "whatever it takes" to protect Italy when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. Investment Conclusions The outlook for global risk assets is likely to be more challenging over the coming months. With that in mind, we are downgrading our 12-month recommendation on global equities and credit from overweight to neutral. A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase again over the balance of the year, with the next big move for global equities probably being to the downside. Although Treasurys could rally in the near term, higher U.S. inflation will push bond yields up over a 12-month horizon. Given that yields are positively correlated across international bond markets, rising U.S. yields will put upward pressure on yields in the rest of the world. As such, we recommend shifting equity allocations towards cash rather than long-duration bonds. We would also reduce credit exposure. Within the commodity complex, the backdrop for crude remains more favorable than for economically-sensitive metals. Investors should underweight EM equities, credit, and currencies relative to their developed market peers. The Fed needs to tighten U.S. financial conditions to prevent the economy from overheating. Chart 11 shows that EM equities almost always fall when that is happening. Chart 11Tighter U.S. Financial Conditions Do Not Bode Well For EM Stocks Tighter U.S. Financial Conditions Do Not Bode Well For EM Stocks Tighter U.S. Financial Conditions Do Not Bode Well For EM Stocks A stronger dollar will hurt the profits of U.S. multinationals. That said, the sector composition of the U.S. stock market is a bit more defensive than it is elsewhere. On balance, we no longer have a strong view that euro area and Japanese equities will outperform the U.S. in local-currency terms, and hence we are closing our trade recommendation to this effect for a loss of 5.4%. If macro developments evolve as we expect, we will shift to an outright bearish stance on risk assets later this year or in early 2019 in anticipation of a global recession in 2020. That said, we would consider moving our 12-month recommendation temporarily back to overweight if global equities were to sell off by more than 15% over the next few months or the policy environment becomes markedly more market friendly. But at current prices, the risk-reward trade-off no longer justifies a high degree of bullishness. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Feature In a Global Investment Strategy service Special Report sent to all BCA clients yesterday,1 we recommended downgrading global equities to neutral (from overweight) over the coming year. For BCA's China Investment Strategy service, the most immediate implication of this change in recommendation is that an overweight stance towards Chinese stocks within a global portfolio is no longer justified. Consequently, we are closing two open positions in our trade book: 1) long MSCI China ex-technology / short MSCI All Country World ex-technology, and 2) long MSCI China value / short MSCI All Country World value. The rationale behind our downgrade of global equities is rooted in the view that there has been an unfavorable shift in the risk/reward balance for risky assets. A potential slowdown in global growth, fueled by protectionist action in the U.S. and dollar-driven weakness in emerging markets, could be met by intransigent policy, particularly in the U.S. In this scenario, financial markets would be set up for a collision course with global policymakers, which could precipitate a material selloff in risky asset prices before a sufficiently large policy response could be deployed. In the case of China, we have argued many times over the past several months that a slowdown in its industrial sector raised the risk of eventual underperformance of ex-tech "old economy" stocks versus their global peers. Chart 1 highlights that our leading indicator for the Li Keqiang index suggests that the index itself is set to decelerate further over the coming months, and we have highlighted that this poor domestic growth momentum means that fiscal or monetary stimulus will likely be required if China suffers a sudden export shock. This week's sharp escalation of protectionist action between the U.S. and China clearly raises the risk of such a shock. In addition, we showed in a January Special Report that China has become a high-beta equity market versus the global benchmark (in common currency terms) over the past few years,2 and Chart 2 shows that this is true even for ex-tech stock prices. In our judgement, the combination of an ongoing slowdown in China's industrial sector, a significant escalation in the imposition of import tariffs between the U.S. and China, and an unfavorable shift in the risk/reward balance of global risky asset prices is a compelling reason to reduce pro-cyclical exposure to China. Chart 1China's Old Economy Will Continue To Slow China's Old Economy Will Continue To Slow China's Old Economy Will Continue To Slow Chart 2Chinese Stocks Are High Beta, Even Excluding Technology Chinese Stocks Are High Beta, Even Excluding Technology Chinese Stocks Are High Beta, Even Excluding Technology Bottom Line: We are closing two pro-cyclical positions in our trade book, and recommend that investors downgrade Chinese stocks to neutral within a global equity portfolio. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see Global Investment Strategy Special Report "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 19, 2018, available at gis.bcaresearch.com. 2 Pease see China Investment Strategy Special Report "China: No Longer A Low-Beta Market", dated January 11, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Three macro "policy puts" are in jeopardy of disappearing or, at the very least, being repriced. Fed Put: Rising inflation has made the Fed more reluctant to back off from rate hikes at the first hint of slower growth or falling asset prices. China Put: Worries about high debt levels, overcapacity, and pollution all mean that the bar for fresh Chinese stimulus is higher than in the past. Draghi Put: Bailing out Italy was a no-brainer in 2012 when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. These factors, along with additional risks such as mounting protectionism, warrant a more cautious 12-month stance towards global equities and other risk assets. The fact that valuations are stretched across most asset classes only adds to our concern. A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase over the balance of the year, with the next big move for global equities probably being to the downside. Buckle Up One of BCA's key ongoing themes is that policy and markets are on a collision course. We are starting to see this impending crash play out across the world. Higher Inflation Is Tying The Fed's Hands A slowdown in global growth caused the Fed to abort its tightening plans for 12 months starting in December 2015. Global growth is faltering again, but this time around the Fed is less eager to hit the pause button. In contrast to 2015, the U.S. economy has run out of spare capacity. The unemployment rate fell to a 48-year low of 3.75% in May. For the first time in the history of the Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS), there are more job vacancies than unemployed workers (Chart 1). Average hourly earnings surprised on the upside in May, while the Employment Cost Index for private-sector workers - the cleanest and most reliable measure of U.S. wage growth - rose at a robust 4% annualized pace in the first quarter. Labor market surveys, which generally lead wage growth by three-to-six months, are pointing to a further acceleration in wages (Chart 2). Chart 1There Are Now More ##br##Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers Chart 2U.S. Wage Growth Is Set To Accelerate U.S. Wage Growth Is Set To Accelerate U.S. Wage Growth Is Set To Accelerate The Dollar Rally Can Keep Going Rising wages will put more income into workers' pockets, who will then spend it. Stronger demand can be partly satisfied by imports, but it will take a change in relative prices for that to happen. U.S. imports account for only 16% of GDP. Unless the prices of foreign-made goods decline in relation to the prices of domestically-produced goods, the bulk of any additional household income will be spent on goods produced in the U.S. This means that the dollar needs to strengthen. The Fed's broad trade-weighted dollar index is up 8% since the start of February. While we are not as bullish on the dollar as we were a few months ago, we still believe that the path of least resistance for the greenback is up. Our long DXY trade recommendation has gained 12.1% inclusive of carry since we initiated it. We are raising the target price from 96 to 98. A stronger dollar can help deflect some additional spending towards imports, but this won't be enough to fully cool the economy. Services, which generally cannot be imported, account for nearly two-thirds of GDP. Since it takes time to shift resources from goods-producing sectors to service sectors, any rising aggregate demand will boost service prices. Outside of housing, service-sector inflation is already running at 2.4%, a number that is likely to rise further over the coming year (Chart 3). This will keep the Fed on edge. Hard Times For Emerging Markets The combination of rising U.S. rates and a stronger dollar is bad news for emerging markets. Eighty percent of EM foreign-currency debt is denominated in dollars. Outside of China, EM dollar debt is now back to late-1990s levels both as a share of GDP and exports (Chart 4). Chart 3Faster Wage Growth Will ##br##Push Up Service Inflation Faster Wage Growth Will Push Up Service Inflation Faster Wage Growth Will Push Up Service Inflation Chart 4EM Dollar Debt Back To Late-1990s Levels EM Dollar Debt Back To Late-1990s Levels EM Dollar Debt Back To Late-1990s Levels The wave of EM local-currency debt issued in recent years only complicates matters. If EM central banks raise rates to defend their currencies, this could imperil economic growth and make it difficult for local-currency borrowers to pay back their loans. Rather than hiking rates, some EM central banks may simply choose to inflate away debt. Consider the case of Brazil. Ninety percent of Brazilian sovereign debt is denominated in reais. The Brazilian government won't default on its debt per se. However, if push comes to shove, Brazil's central bank can always step in to buy government bonds, effectively monetizing the fiscal deficit. The specter of trade wars only adds to the risks facing emerging markets. A larger U.S. budget deficit will drain national savings, leading to a bigger trade deficit. Rather than blaming his own macroeconomic policies, President Trump will blame America's trading partners. Global trade has already been flatlining for over a decade (Chart 5). Trump's trade agenda will further undermine the global trading system. Emerging markets will bear the brunt of that development. Chart 5Global Trade Has Crested Global Trade Has Crested Global Trade Has Crested Chinese Stimulus To The Rescue? When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive new stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. Today, Chinese growth is slowing again. May data on industrial production, retail sales, and fixed asset investment all disappointed. Property prices in tier 1 cities are down year-over-year. Our leading indicator for the Li Keqiang index, a widely followed measure of economic activity, is in a clear downtrend (Chart 6). So far, the policy response has been fairly muted. Reserve requirements have been cut and some administrative controls loosened, but the combined credit and fiscal impulse has plunged (Chart 7). Onshore and offshore corporate bond yields have increased to multi-year highs. Bank lending rates are rising, while loan approvals are dropping (Chart 8). Chart 6Chinese Growth Is Slowing Anew Chinese Growth Is Slowing Anew Chinese Growth Is Slowing Anew Chart 7China: Policy Response To Slowdown ##br##Has Been Muted So Far China: Policy Response To Slowdown Has Been Muted So Far China: Policy Response To Slowdown Has Been Muted So Far Chart 8China: Credit Tightening China: Credit Tightening China: Credit Tightening We have no doubt that China will stimulate again if the economy appears to be heading for a deep slowdown. However, the bar for a fresh round of stimulus is higher today than it was in the past. Elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities can respond with the usual barrage of infrastructure spending and increased bank lending. The economy needs to feel more pain before policymakers come to its aid. Draghi's Dilemma The Italian economy was showing signs of weakness even before bond yields exploded higher. Domestic demand slowed to a mere 0.3% qoq in Q1. The PMIs, consumer confidence, and the Bank of Italy's Ita-Coin cyclical indicator all decelerated (Chart 9). Italy would benefit from a more competitive cost structure, but the political will to undertake the sort of reforms Germany implemented in the late 1990s, and that Spain implemented after the Great Recession, has been sorely lacking (Chart 10). Unwilling to take tough actions to improve competitiveness, the Five Star-Lega coalition government has proposed loosening fiscal policy to support demand. Chart 9Italy's Economy Is Weakening... Again Italy's Economy Is Weakening... Again Italy's Economy Is Weakening... Again Chart 10Italy: More Work Needs To Be Done On ##br##The Labor Competitiveness Front Italy: More Work Needs To Be Done On The Labor Competitiveness Front Italy: More Work Needs To Be Done On The Labor Competitiveness Front Italy's shift towards populism is arriving at the same time that the ECB is looking to wind down its asset purchase program. This means that a key buyer of Italian debt is stepping back just when it may be needed the most. Getting the ECB to bail out Italy will not be as straightforward this time around. Recall that Mario Draghi and Jean-Claude Trichet penned a letter to the Italian government in 2011 outlining a series of reforms they wanted to see enacted as a condition of ongoing ECB support. The contents of the letter were so explosive that they precipitated the resignation of then-PM Silvio Berlusconi when they were leaked to the public. One of the reforms that Mario Draghi demanded - and the subsequent government led by Mario Monti ultimately undertook - was the extension of the retirement age. Italy's current government has explicitly promised to reverse that decision much to the consternation of the ECB and the European Commission. It was one thing for Mario Draghi to promise to do "whatever it takes" to protect Italy when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. Investment Conclusions The outlook for global risk assets is likely to be more challenging over the coming months. With that in mind, we are downgrading our 12-month recommendation on global equities and credit from overweight to neutral. A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase again over the balance of the year, with the next big move for global equities probably being to the downside. Although Treasurys could rally in the near term, higher U.S. inflation will push bond yields up over a 12-month horizon. Given that yields are positively correlated across international bond markets, rising U.S. yields will put upward pressure on yields in the rest of the world. As such, we recommend shifting equity allocations towards cash rather than long-duration bonds. We would also reduce credit exposure. Within the commodity complex, the backdrop for crude remains more favorable than for economically-sensitive metals. Investors should underweight EM equities, credit, and currencies relative to their developed market peers. The Fed needs to tighten U.S. financial conditions to prevent the economy from overheating. Chart 11 shows that EM equities almost always fall when that is happening. Chart 11Tighter U.S. Financial Conditions Do Not Bode Well For EM Stocks Tighter U.S. Financial Conditions Do Not Bode Well For EM Stocks Tighter U.S. Financial Conditions Do Not Bode Well For EM Stocks A stronger dollar will hurt the profits of U.S. multinationals. That said, the sector composition of the U.S. stock market is a bit more defensive than it is elsewhere. On balance, we no longer have a strong view that euro area and Japanese equities will outperform the U.S. in local-currency terms, and hence we are closing our trade recommendation to this effect for a loss of 5.4%. If macro developments evolve as we expect, we will shift to an outright bearish stance on risk assets later this year or in early 2019 in anticipation of a global recession in 2020. That said, we would consider moving our 12-month recommendation temporarily back to overweight if global equities were to sell off by more than 15% over the next few months or the policy environment becomes markedly more market friendly. But at current prices, the risk-reward trade-off no longer justifies a high degree of bullishness. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com

Highlights Monetary Policy: Position for rate hikes of 25 bps per quarter for the next 6-12 months and watch nominal GDP growth, cyclical spending and the price of gold for signals about the position of the fed funds rate relative to its equilibrium level. Yield Curve: Curve flattening will proceed as the Fed lifts rates, but some flattening pressure will be mitigated by the re-anchoring of long-dated inflation expectations. Against this back-drop, and given currently attractive valuations, a position long the 7-year bullet and short the duration-matched 1/20 barbell makes the most sense. IG Credit: Moving down-in-quality has a greater positive impact on the risk-adjusted performance of a credit portfolio when excess return volatility and index duration-times-spread are low. At present, down-in-quality allocations within investment grade credit are only marginally attractive. Feature "You just let the machines get on with the adding up," warned Majikthise, "and we'll take care of the eternal verities, thank you very much. [...] "That's right," shouted Vroomfondel, "we demand rigidly defined areas of doubt and uncertainty!" - The Hitchhiker's Guide To The Galaxy, By Douglas Adams Jerome Powell put his stamp on Fed communications at last week's FOMC meeting. He trimmed 100 words from the policy statement and began his post-meeting press conference with a concise "plain-English" summary of how the economy is doing. In short: "the economy is doing very well". But while he expressed confidence in the Fed's assessment of the economy, he was also keen to point out areas where the outlook is cloudier. His central theme seemed to be that we must delineate between those questions that can be addressed by the Fed's reading of the economic data and those that are better left to the philosophers in Douglas Adams' novel. The Chairman stressed the uncertainty surrounding two concepts in particular: the non-accelerating inflation rate of unemployment (NAIRU) and the neutral (or equilibrium) interest rate, even advising that "we can't be too attached to these unobservable variables." But what can we say about these traditionally important policy guideposts? And more importantly, how should we think about them when formulating an investment strategy? The Importance Of NAIRU Chart 1The Fed's Projections The Fed's Projections The Fed's Projections One issue that came up repeatedly in the Chairman's press conference was the seeming disconnect between the Fed's labor market projections and its inflation projections. The Fed expects the unemployment rate to fall far below NAIRU during the next two years, and yet it anticipates only a mild overshoot of its inflation target (Chart 1).1 Ultimately this disconnect will be resolved in one of two ways. Either the Fed is underestimating the inflation pressures that will result from running the unemployment rate so far below NAIRU and will be forced to hike rates more quickly than anticipated, or it will eventually revise its estimate of NAIRU downward. From an investment perspective, this disconnect will only matter if inflation starts to rise more quickly than anticipated and the Fed is forced to ramp up the pace of rate hikes. We discussed this possibility in a recent report and concluded that, on a 6-12 month horizon, the odds of the Fed hiking more quickly than its current 25 bps per quarter pace are low.2 This is principally because the Fed will likely tolerate a fairly substantial overshoot of its inflation target before it feels the need to tighten more quickly. The Importance Of The Neutral Rate For bond investors the theoretical concept of the neutral (or equilibrium) interest rate is much more important. This interest rate represents the threshold between accommodative and restrictive monetary policy. When the fed funds rate is above neutral we should expect the pace of economic growth to slow and inflation pressures to dissipate. At present, the majority of FOMC participants estimate that the neutral fed funds rate is between 2.75% and 3%. At the Fed's current 25 bps per quarter pace, the funds rate will reach neutral by the middle of next year (Chart 2). Chart 2The Federal Funds Rate Will Hit Neutral Next Year The Federal Funds Rate Will Hit Neutral Next Year The Federal Funds Rate Will Hit Neutral Next Year The important question for investors is whether the Fed will start to slow its rate hike pace at that time, or whether it will revise its estimate of the neutral rate based on trends in the economy. Chairman Powell's emphasis on uncertainty makes us lean toward the latter. In a recent report we outlined three factors to monitor that will help us determine whether monetary policy is accommodative (fed funds rate below neutral) or restrictive (fed funds rate above neutral).3 The first factor is the year-over-year growth rate in nominal GDP relative to the fed funds rate (Chart 3). Historically, the year-over-year growth rate in nominal GDP falling below the fed funds rate is a reliable (though often lagging) signal that monetary policy has turned restrictive. A more leading signal of restrictive monetary policy is the proportion of nominal GDP that comes from the most cyclical (or interest rate sensitive) sectors of the economy. Those sectors being consumer spending on durable goods, residential investment and investment on equipment & software. When cyclical spending declines as a proportion of overall growth it is often a sign that the fed funds rate is above its neutral level (Chart 3, panel 2). Finally, we also recommend monitoring the price of gold for clues about the neutral rate of interest. Gold tends to appreciate when the stance of monetary policy becomes more accommodative and depreciate when it becomes more restrictive. The steep decline in the gold price between 2013 and 2016 even preceded downward revisions to the Fed's estimate of the neutral rate (Chart 4). Going forward, an upside breakout in the price of gold would be a signal that we should revise our estimate of the neutral fed funds rate higher. Conversely, a large decline would suggest that monetary policy is turning restrictive and we should think about calling the cyclical peak in bond yields. Chart 3Tracking The Neutral Rate I Tracking The Neutral Rate I Tracking The Neutral Rate I Chart 4Tracking The Neutral Rate II Tracking The Neutral Rate II Tracking The Neutral Rate II Bottom Line: Rather than rely on current estimates of unobservable variables like NAIRU and the neutral rate of interest, investors should monitor developments in the economy and consider how those estimates might evolve over time. For now, investors should expect a rate hike pace of 25 bps per quarter and watch nominal GDP growth, cyclical spending and the price of gold for signals about the position of the fed funds rate relative to its equilibrium level. Gradualism And The Slope Of The Curve The Fed's fairly explicit guidance that rates will rise by 25 bps per quarter is quite helpful when formulating expectations about the slope of the yield curve. For example, we know that the current 1-year par coupon Treasury yield of 2.35% is priced for exactly 100 bps of rate hikes during the next 12 months with no term premium. In other words, investors today should be indifferent between an investment in cash and an investment in a 1-year Treasury note if they are 100% certain that the Fed will stick to its 25 bps per quarter hike pace for the next 12 months. We can also forecast where the 1-year Treasury yield will be six months from now under a few different scenarios (Table 1). The forward curve is consistent with a 1-year Treasury yield of 2.69% six months from now, and we calculate that it will be 2.83% if the market moves to fully discount a rate hike pace of 25 bps per quarter until the end of 2019. If the market only prices in the Fed's median funds rate projection, which calls for three hikes in 2019, then the 1-year Treasury yield will be between 2.62% and 2.81% six months from now, depending on which meetings in 2019 those three rate hikes are delivered. Table 1Forecasting The 1-Year Treasury Yield Rigidly Defined Areas Of Doubt And Uncertainty Rigidly Defined Areas Of Doubt And Uncertainty The main takeaway from these observations is that even in the most hawkish scenario the 1-year Treasury yield will only rise to 2.83%. This is 48 bps above its current level and a mere 14 bps more than what is already priced into the forward curve. Now let's consider the long-end of the curve. The 10-year and 20-year TIPS breakeven inflation rates currently sit at 2.12% and 2.10%, respectively. If inflation expectations become re-anchored around the Fed's 2% target during the next six months, which we expect they will, then both of these rates will reach a range between 2.3% and 2.5% (Chart 5). This alone will apply between 20 bps and 40 bps of upward pressure to the 20-year Treasury yield. The nominal 20-year Treasury yield is currently 2.98% and the forward curve is priced for it to rise to 3.01% in six months. In the most hawkish scenario where the Fed lifts rates 25 bps per quarter and long-maturity yields remain constant, the 1/20 Treasury slope will flatten by 48 bps during the next six months. In the more likely scenario where Fed rate hikes coincide with the re-anchoring of long-dated inflation expectations, the 1/20 slope will flatten by 28 bps or less. Meanwhile, our model of the 1/7/20 butterfly spread shows that it is priced for 55 bps of 1/20 flattening during the next six months (Chart 6). Or put differently, there is so much extra yield pick-up in the 7-year bullet relative to the duration-matched 1/20 barbell that being long the bullet and short the barbell will be profitable unless the 1/20 slope flattens by more than 55 bps. Chart 5Inflation Expectations Are Still Too Low Inflation Expectations Are Still Too Low Inflation Expectations Are Still Too Low Chart 6Butterfly Spread Fair Value Model Butterfly Spread Fair Value Model Butterfly Spread Fair Value Model Bottom Line: Curve flattening will proceed as the Fed lifts rates, but some flattening pressure will be offset by the re-anchoring of long-dated inflation expectations. Against this back-drop, and given currently attractive valuations, a position long the 7-year bullet and short the duration-matched 1/20 barbell makes the most sense. Risk Update On May 22 we initiated a tactical long duration position premised on extended net short positioning in the bond market and the high likelihood of negative near-term data surprises.4 We have seen considerable movement in our indicators during the past two weeks - positioning is now much closer to neutral (Chart 7) and our model no longer expects data surprises to turn negative (Chart 8). Therefore, this week we remove our tactical long duration recommendation. The biggest current risk to our below-benchmark duration stance is the large divergence that has opened up between U.S. growth and the rest of the world (Chart 9). This divergence is putting upward pressure on the U.S. dollar and, much like in 2015, is starting to hurt growth in emerging markets, as we discussed last week. Chart 7Bond Market Positioning Bond Market Positioning Bond Market Positioning Chart 8Data Surprises Should Remain Positive Data Surprises Should Remain Positive Data Surprises Should Remain Positive Chart 9Foreign Growth Is The Greatest Risk Foreign Growth Is The Greatest Risk Foreign Growth Is The Greatest Risk But dollar strength and emerging market weakness is not an imminent threat to higher U.S. yields. Using the 2015 experience as a template, we see in Chart 9 that U.S. yields did not fall until after emerging market financial conditions and global growth had already troughed. In fact, it was not until dollar strength and weak global growth culminated in a dramatic tightening of U.S. financial conditions that the Fed finally signaled a slower pace of rate hikes and Treasury yields declined (Chart 9, bottom panel). Similarly, we don't think the Fed will react to a strong dollar and weak foreign growth until the impact is felt by U.S. risk assets. With U.S. growth still elevated and the dollar having appreciated only modestly so far, we think Treasury yields will avoid this risk during the next few months. Nonetheless, the divergence between U.S. and foreign growth is a risk that bears close monitoring. We will not hesitate to alter our duration stance if the dollar continues to appreciate and the divergence appears close to a breaking point. The Best Time To Move Down In Quality In last week's report we reviewed our assessment of where we stand in the credit cycle. That assessment determines whether we should be overweight or underweight investment grade corporate bonds relative to a duration-equivalent position in Treasuries. This week we zero-in on our allocation to investment grade corporate bonds and consider how we should allocate between the different credit tiers (Aaa, Aa, A and Baa). In next week's report we will look at positioning across the different maturity buckets and industries. We begin our analysis with the four Bond Maps presented in Charts 10-13. These Bond Maps show risk-adjusted return potential on the y-axis. Specifically, the number of months of average spread tightening necessary to achieve the excess return threshold listed in each map's title. The risk-adjusted potential for losses is shown on the x-axis. In this case, it shows the number of months of average spread widening required to underperform Treasuries by the amount listed in the title. Chart 10Investment Grade Corporate Excess Return Bond Map:##br## +/- 50 BPs Threshold Rigidly Defined Areas Of Doubt And Uncertainty Rigidly Defined Areas Of Doubt And Uncertainty Chart 11Investment Grade Corporate Excess Return Bond Map: ##br##+/- 100 BPs Threshold Rigidly Defined Areas Of Doubt And Uncertainty Rigidly Defined Areas Of Doubt And Uncertainty Chart 12Investment Grade Corporate Excess Return Bond Map: ##br##+/- 200 BPs Threshold Rigidly Defined Areas Of Doubt And Uncertainty Rigidly Defined Areas Of Doubt And Uncertainty Chart 13Investment Grade Corporate Excess Return Bond Map:##br## +/- 300 BPs Threshold Rigidly Defined Areas Of Doubt And Uncertainty Rigidly Defined Areas Of Doubt And Uncertainty Credit tiers plotting closer to the bottom-left of the Bond Maps have less potential for return and less risk. Credit tiers plotting closer to the upper-right have greater potential for return and more risk. What we find particularly interesting is that when we set a low return threshold, such as +/- 50 bps, the credit tiers plot almost right on top of each other. In other words, an allocation to Baa-rated corporate bonds gives you a much greater chance of earning 50 bps with about the same risk of losing 50 bps as the other credit tiers. But as we increase the excess return threshold the risk/reward trade-off between the different credit tiers becomes more linear. In Chart 13 we see that Baa-rated bonds have a greater chance of earning 300 bps than the other credit tiers, but also carry a significantly greater risk of losing 300 bps. Chart 14Down-In-Quality Works ##br##Best When Vol Is Low Down-In-Quality Works Best When Vol Is Low Down-In-Quality Works Best When Vol Is Low This leads to an interesting conclusion. A macro environment where we would expect low excess return volatility is also one where moving down in quality within investment grade corporate bonds is most beneficial from a risk/reward perspective. Conversely, moving down in quality will improve the risk-adjusted performance of your portfolio by less (and might even hurt the risk-adjusted performance of your portfolio) in a highly volatile return environment. To test this theory, we first recognize that the excess return volatility of the investment grade corporate bond index is tightly linked with its duration-times-spread (DTS). Low DTS environments have lower excess return volatility, and also less of a spread differential between the lower and higher credit tiers (Chart 14). With this in mind we split the historical time series of monthly corporate bond excess returns into four quartiles based on the index DTS (Table 2). We also exclude recessions from our sample, meaning this analysis is only valid during periods of economic recovery. Not surprisingly, the results show that the standard deviation of monthly excess returns increases alongside index DTS. But we also see that the average return advantage in the Baa-rated credit tier is lower when the index DTS is higher. Table 2Investment Grade Corporate Bond Excess Returns By Credit Tier (1989-Present)* Rigidly Defined Areas Of Doubt And Uncertainty Rigidly Defined Areas Of Doubt And Uncertainty When the index DTS is between 3 and 4.5, the reward/risk ratio in the Baa-rated credit tier exceeds the average of the other three credit tiers by 0.13. This advantage falls to 0.07 when the DTS is between 4.5 and 6.7; and falls further to 0.04 when the DTS is between 6.7 and 9.7. In the highest DTS quartile, the Baa-rated credit tier provides a lower reward/risk ratio than the average of the other three credit tiers. At present the index DTS is 8.4. This puts us in the second highest quartile relative to history, and is consistent with a 12-month standard deviation of monthly excess returns of roughly 77 bps for the corporate bond index. In this environment we should expect down-in-quality allocations to positively impact the risk-adjusted performance of a credit portfolio, but not by as much as in lower DTS environments. Bottom Line: Moving down-in-quality has a greater positive impact on the risk-adjusted performance of a credit portfolio when excess return volatility and index duration-times-spread are low. At present, down-in-quality allocations within investment grade credit are only marginally attractive. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 In order to display a longer history, Chart 1 shows the Congressional Budget Office's estimate of NAIRU rather than the Fed's. At present both estimates are very close. The CBO estimates NAIRU to be 4.65% and the Fed's median projection calls for a NAIRU of 4.5%. 2 Please see U.S. Bond Strategy Weekly Report, "Breaking Points", dated May 29, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy A rare buying opportunity has emerged in the S&P consumer staples index, especially for long-term oriented capital. The bearish story is already baked into current valuations, and industry green-shoots are flying under the radar. Similarly, the bearish packaged foods narrative is well ingrained in depressed relative valuations, whereas the budding recovery in industry final demand is severely underappreciated. This offers investors a compelling entry point to this unloved and under-owned consumer products subgroup. Recent Changes There are no changes to our portfolio this week Table 1 Girding For A Breakout? Girding For A Breakout? Feature The S&P 500 digested receding geopolitical risks last week, and continued to consolidate recent gains. Stocks are poking at the upper end of the 10% trading range in place since early-February, and internal equity dynamics suggest that a breakout in a bullish fashion is in store for later in the summer, as we first posited in late April.1 Chart 1 shows our Equity Market Internal Dynamics Indicator (EMIDI) that does an excellent job capturing the shifting internal forces that drive market returns. This coincident-to-leading market Indicator comprising economically sensitive sectors and portfolio biases is signaling that the path of least resistance is higher for the SPX. Similar to the EMIDI, the Value Line Arithmetic Index (an equal weighted broad-based stock market index) broke out to fresh all-time highs and the Value Line Geometric Index (a gauge of median stock prices) is following closely behind (third & fourth panels, Chart 2). Market darling AAPL is making a run at a $1tn valuation, spearheading the tech-laden NASDAQ Composite that remains on a pattern of hitting higher highs (top panel, Chart 2). Equity buying power is also evident in the breakout of Thomson/Reuters' "Most Shorted Stocks Index" (second panel, Chart 2). All of this suggests that before long the SPX will follow the uptrend and vault to all-time highs, a message corroborated by the record highs in the broad market's advance/decline (A/D) line (bottom panel, Chart 2). Chart 1Breakout... Breakout... Breakout... Chart 2...Looming ...Looming ...Looming An enticing macro backdrop continues to underpin equities. The latest ISM manufacturing report confirmed the IHS Markit U.S. manufacturing PMI release that we highlighted in our Report two weeks ago2: the U.S. is firing on all cylinders and has the potential to pull global growth out of its recent lull. In particular, the reacceleration in the ISM new orders-to-inventories ratio suggests that equities will gain steam in the coming months (second panel, Chart 3). Another source of upbeat news was the backlog subcomponent of the May ISM manufacturing survey. Unfilled orders hit a 14-year high, just shy of the all-time record. Historically, backlogs have been an excellent leading indicator of SPX revenue growth and the current message is that S&P 500 top line growth is on a solid footing (bottom panel, Chart 3). The Fed acknowledged this mini economic overheating last week, and the FOMC slightly bumped its median expectation to a total of four hikes in calendar 2018. Moreover, fiscal easing will continue to gain thrust as the year progresses and the cash repatriation will also provide an assist to the stock market. We are modeling between $650bn-to-$800bn in equity retirement for calendar 2018. Chart 4 depicts our estimates and if the historical correlation between share buybacks and equity prices holds, then there is more upside to stocks in the back half of the year. Nevertheless, retail investors are replenishing cash coffers according to the American Association of Individual Investors (AAII), rather than actively participating in the latest market run up. At the margin, this beefing up of retail investor dry powder represents a headwind to additional equity market gains. We heed the message from this traditionally leading Indicator and in order for our cyclical (9-12 month horizon) sanguine equity market view to pan out, individual investors will have to drawdown their cash balances (AAII cash shown inverted, Chart 5). Chart 3Macro Tailwinds Macro Tailwinds Macro Tailwinds Chart 4Corporate Underpinnings... Corporate Underpinnings... Corporate Underpinnings... Chart 5...But Retail Investor Has To Participate ...But Retail Investor Has To Participate ...But Retail Investor Has To Participate This week we are revisiting a broad defensive sector and one of its key subcomponents. What To Do With Staples Investors have deserted consumer staples stocks at a dizzying speed, and valuations have cratered to a multi-decade low, according to our composite Valuation Indicator (Chart 6). Technicals are also as washed out as can be, as staples equities have been sold off indiscriminately. Other sentiment and breadth measures confirm that this safe haven sector has lost its allure: the A/D line is probing multi-year lows, EPS breadth is waning and groups with a positive 52-week rate of change and trading above the 40-week moving average have all but disappeared (Chart 7). Chart 6Buy Into Weakness Buy Into Weakness Buy Into Weakness Chart 7Bombed Out Sentiment Bombed Out Sentiment Bombed Out Sentiment Our sense is that this consumer staples wholesale liquidation provides a great buying opportunity, especially for longer-term oriented capital with a time horizon of at least 2-3 years. Even on a shorter-term outlook, a bounce seems likely from extremely depressed levels, as relative share prices may find support close to the pre-Great Recession trough (top panel, Chart 7). From a cyclical perspective we continue to view this defensive sector as a hedge to our overall portfolio position that sustains a pro-cyclical bent. Importantly, the bearish consumer staples case is well discounted in bombed out valuations. The stock-to-bond ratio is weighing on this fixed income proxy sector that sports a dividend yield on a par with the 10-year Treasury (top & second panels, Chart 8). Moreover, subsiding volatility bodes ill for relative share prices; the opposite is also true (bottom panel, Chart 8). On the demand front, once again the uninspiring non-cyclical spending backdrop is well entrenched in sinking relative share prices. Relative staples retail sales - both compared to discretionary and to total sales - are deflating as is typical in the late stages of the business cycle (top & second panels, Chart 9). Chart 8Bearish Narrative Baked In Bearish Narrative Baked In Bearish Narrative Baked In Chart 9Lack Of Demand... Lack Of Demand... Lack Of Demand... Such waning demand has weighed on industry selling prices at a time when executives are making labor additions, blowing out our wage bill proxy. As a result, profits margins are suffering a squeeze (Chart 10). However, there are some pockets of strength hidden beneath the surface. While non-discretionary demand is losing share versus overall outlays, spending on essentials as a percentage of disposable income is gaining steam. True, this could be a pre-cursor to recession, but our interpretation is that latent staples-related buying power may make a comeback from a still very depressed level and kick-start industry sales growth (bottom panel, Chart 9). Other industry green-shoots are also surfacing. Consumer staples exports are on a slingshot recovery path, expanding by a low double digit growth rate, defying the year-to-date trade-weighted U.S. dollar appreciation (second panel, Chart 11). In fact, given the defensive stature of this index, any additional greenback gains will boost relative profits especially in the first half of 2019 (third panel, Chart 11). Chart 10...Weighing On Margins... ...Weighing On Margins... ...Weighing On Margins... Chart 11...But Green-Shoots Surfacing ...But Green-Shoots Surfacing ...But Green-Shoots Surfacing Finally, CEO confidence of non-durable industries is far outpacing the broad animal spirit recovery according to The Conference Board, and this relative Chief Executive euphoria has historically been positively correlated with share price momentum, underscoring that better times lie ahead for consumer staples stocks (bottom panel, Chart 11). Adding it up, a rare buying opportunity has emerged in the S&P consumer staples index, especially for long-term oriented capital. The bearish story is already baked into current valuations, and industry green-shoots are flying under the radar. Tack on impressive industry return on equity and this index appears extremely undervalued (bottom panel, Chart 6). Bottom Line: Were we not already overweight the S&P consumer staples index, we would not hesitate to lift exposure to above benchmark. Appetizing Packaged Foods Not only have investors shunned consumer staples stocks in general, but the S&P packaged foods sub-index has also suffered, even trailing the broad staples sector. As a reminder, within consumer products we are overweight packaged foods and household products but maintain a below-benchmark allocation to soft drinks. Packaged foods relative share prices have returned to the mid-2000s level offering a compelling entry point for fresh capital, especially longer-term oriented money (top panel, Chart 12). Part of the reason that these stocks are under-owned boils down to their defensive characteristics. These safe-haven equities pay handsome, steadily growing and secure dividends. Thus, when the bond market's selloff gains steam, investors flock to deep cyclical stocks and trim fixed income proxied equities, and vice versa. Moreover, the Warren Buffett induced M&A premia have now fully reversed from this group, with the base effect weighing on relative performance (bottom panel, Chart 12). Nevertheless, we are not willing to throw in the towel in this staples sub-index that offers hidden value. A number of leading industry demand indicators are firming and suggest that a top line growth period is in the cards. Food and beverage exports are rising at a healthy clip, despite the U.S. dollar's year-to-date appreciation, and so are domestic consumer outlays (second panel, Chart 12). The industry's shipments-to-inventories ratio is sending a similar message, jumping to a level last seen four years ago (third panel, Chart 12. Importantly, relative to overall spending, real (volume) food and beverage spending is expanding smartly. Add on tame raw food commodity costs, especially compared with broad commodity price inflation and relative EPS will overwhelm extremely depressed analysts' expectations (relative grain prices shown inverted, bottom panel, Chart 13). Chart 12Budding Demand Recovery... Budding Demand Recovery... Budding Demand Recovery... Chart 13...Should Aid Top Line Growth ...Should Aid Top Line Growth ...Should Aid Top Line Growth This encouraging demand backdrop is showing up in industry pricing power. Rising food manufacturing shipments are underpinning food producers' selling prices (second panel, Chart 14), and coupled with the contained crude food input costs suggest that packaged foods margins will continue to expand (middle panel, Chart 14). Even down the supply chain, food manufacturers' appear to be making significant headway, a harbinger at least of a profit margin relief phase. While channel captains food retailers have been dictating pricing terms to food suppliers for the better part of the past five years, industry producer prices are now on an even keel with CPI foods, a good proxy of what super markets are charging the consumer (fourth panel, Chart 14). Any additional pricing power gains will represent a boost to industry margins and, thus, profitability. Finally, firming demand is also showing up on industry operating metrics: factory activity is running red hot with resource utilization rates vaulting to multi-decade highs and industry hours worked picking up momentum (third panel, Chart 15). While CEOs have expanded the labor footprint and wage inflation is a cause for concern (bottom panel, Chart 15), a simple industry productivity proxy (industrial production divided by employment) shows that profits should enjoy a lift in the coming quarters. Chart 14Margins Can Expand Further Margins Can Expand Further Margins Can Expand Further Chart 15Brisk Factory Activity Brisk Factory Activity Brisk Factory Activity Netting it out, the bearish packaged foods narrative is well ingrained in depressed relative valuations (bottom panel, Chart 14), whereas the budding recovery in industry final demand is severely underappreciated, offering investors a compelling entry point to this unloved and under-owned consumer products subgroup. Bottom Line: Stay overweight the S&P packaged foods index. The ticker symbols for the stocks in this index are: BLBG: S5PACK - MDLZ, KHC, GIS, TSN, K, CAG, HSY, MKC, SJM, HRL, CPB. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Lifting SPX Target," dated April 30, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Unwavering," dated June 4, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Global Inflation has upside on a cyclical basis, but this narrative is well known and investors have already placed their bets accordingly, buying inflation protection in a wide swath of markets. However, global growth has not yet found its footing, suggesting a mini-deflation scare, at least relative to expectations, is likely this summer. The U.S. dollar will benefit in such a scenario, and NOK/SEK will depreciate. While GBP/USD has downside, the pound should rally versus the euro. Weakness in EUR/CAD has not yet fully played out; the recent bout of strength was only a countertrend move. Feature Inflation is coming back, and this will obviously have major consequences for both asset and currency markets. However, macro investing is not just about forecasting fundamentals correctly; often, just as importantly, it is about understanding how other investors have priced in these expected economic developments. Therein lies the problem. While we understand why inflation could pick up, so too have most investors, and they have positioned themselves accordingly. With global growth currently looking shaky, we believe a better entry point for long-inflation plays will emerge in the coming months. In the meanwhile, a defensive, pro-U.S. dollar posture still makes sense. Investors Are Long Inflation Bets We have long argued that inflation was likely to make a cyclical comeback, a return that would begin in the U.S. before spreading to the rest of the globe. This story is currently playing out. However, in response these developments, investors have placed their bets accordingly, and the story currently seems well baked in. Prices of assets traditionally levered to inflation have already moved to discount a significant pick-up in inflation. The most evident dynamics can be observed in the U.S. inflation breakevens. Both the 10-year breakevens as well as the 5-year/5-year forward breakevens just experienced some of their sharpest two-year changes of the past 20 years, notwithstanding the pricing out of a post-Lehman, depression-like outcome (Chart I-1). Breakevens are not alone. Other assets have displayed similar behavior. In the U.S., investors have aggressively sold their holdings of utilities stocks, which have been greatly outperformed by industrial stocks. Traditionally, investors lift the price of XLI relative to that of XLU when they anticipate global inflation to pick up (Chart I-2). Chart I-1Markets Are Positioning Themselves##br## For Higher Inflation Markets Are Positioning Themselves For Higher Inflation Markets Are Positioning Themselves For Higher Inflation Chart I-2U.S. Sectoral Performance Suggests Investors ##br##Have Already Bet On Higher Inflation... U.S. Sectoral Performance Suggests Investors Have Already Bet On Higher Inflation... U.S. Sectoral Performance Suggests Investors Have Already Bet On Higher Inflation... It is not just intra-equity market dynamics that support this assertion. The behavior of the U.S. stock market relative to Treasurys further buttresses the idea that investors have already aggressively discounted an upturn in global consumer prices (Chart I-3). Potentially, the best illustration of investors' preference for inflation protection is currently visible in EM assets. A seemingly paradoxical phenomenon has been puzzling us: How have EM equities managed to avoid the gravitational pull that has caused EM bonds to nearly flirt with the nadir of early 2016? After all, EM equities, EM currencies and EM bonds are normally closely correlated, driven by investors' wagers on the direction of global growth. A simple variable can explain this strange dichotomy: anticipated inflation. As Chart I-4 illustrates, the performance of a volatility adjusted long EM stocks / short EM bonds portfolio tends to anticipate fluctuations in global inflation. The current price action in this basket indicates that investors have made their bets, and they think inflation is going up. Chart I-3...So Does The Stock-To-Bond Ratio ...So Does The Stock-To-Bond Ratio ...So Does The Stock-To-Bond Ratio Chart I-4Inflation Bets Explain Why EM Stocks And EM Bond Prices Have Diverged Inflation Bets Explain Why EM Stocks And EM Bond Prices Have Diverged Inflation Bets Explain Why EM Stocks And EM Bond Prices Have Diverged Anecdotal evidence suggests that in recent quarters, pension plans have been aggressive buyers of commodities - a move that normally coincides with these long-term investors putting in place some inflation hedges. Moreover, positioning in the futures markets corroborates these stories: speculators are still very long commodities like copper and oil - commodities traditionally perceived as efficient protectors against inflation spikes (Chart I-5). Finally, despite the potentially deflationary risks created by Italy three weeks ago, speculators remain short U.S. Treasury futures, bond investors are underweight duration, and sentiment toward the bond market remains near its lowest levels of the past eight years (Chart I-6). Again, this behavior is consistent with investors being positioned for an inflationary environment. Chart I-5Money Has Flown Into Resources Money Has Flown Into Resources Money Has Flown Into Resources Chart I-6Bond Market Positioning Is Still Very Short Bond Market Positioning Is Still Very Short Bond Market Positioning Is Still Very Short Bottom Line: There is a well-defined case to be made that a global economy that was not so long ago defined by the presence of deflationary risks is now morphing into a world where inflation is on the upswing. However, based on inflation breakevens, sectoral relative performance, equities relative to bonds in both DM and EM as well as on the positioning of investors in commodity and bond markets, this changing state has been quickly discounted by investors. The Decks Are Stacked, But Where Does The Economic Risk Lie? The problem facing investors already long inflation protection every which way they can be is that the global economy is slowing, which normally elicits deflationary fears, not inflationary ones. This seems a recipe for disappointment, albeit one that is likely to help the dollar. Our global economic and financial A/D line, which tallies the proportion of key variables around the world moving in a growth-friendly fashion, has fallen precipitously. This normally heralds a slowdown in global economic activity (Chart I-7). Chart I-7Global Growth Is Losing Traction Global Growth Is Losing Traction Global Growth Is Losing Traction In similar vein, global leading economic indicators have also begun to roll over - a trend that could gain further vigor if the diffusion index of OECD economies experiencing rising versus contracting LEIs is to be believed (Chart I-8). The global liquidity picture has also deteriorated enough to warrant caution. Currency carry strategies - as approximated by the performance of EM carry trades funded in yen - have sagged violently. This tells us that funds are flowing out of EM economies and moving back to countries already replete with excess savings like Japan or Switzerland (Chart I-9). Historically, these kinds of negative developments for global liquidity have preceded industrial slowdowns, as EM now accounts for the lion's share of global IP growth. Finally, China doesn't yet look set to bail out the world's industrial sector. This month's money and credit numbers were weaker than anticipated, and our leading indicator for the Li-Keqiang index - our preferred gauge of industrial activity in the Middle Kingdom - points to further weakness (Chart I-10). This makes it unlikely that China's imports will rise, lifting global growth. Additionally, China has re-stocked in various commodities, suggesting it is front-running its own domestic demand, highlighting the risk that its commodities intake could become even weaker than what domestic growth implies. Chart I-8More Weakness In LEIs More Weakness In LEIs More Weakness In LEIs Chart I-9Global Liquidity Tightening Global Liquidity Tightening Global Liquidity Tightening Chart I-10China Not Yet Set To Bail Out The World China Not Yet Set To Bail Out The World China Not Yet Set To Bail Out The World With this kind of backdrop, we expect the current slowdown in global growth to run further before ebbing, probably in response to what will be a policy move out some kind from China to put a floor under growth. As a result, the current infatuation with inflation hedges among investors may wane for a bit as slower growth could shock inflation expectations downward, especially in a global context that has been defined by excess capacity since the late 1990s. An environment where global inflation expectations could be downgraded in response to slower growth is likely to be an environment where the dollar performs well, particularly as U.S. growth continues to outperform global growth (Chart I-11). This also confirms our analysis from two weeks ago that showed that when bonds rally the dollar tends to outperform most currencies, with the exception of the yen.1 Moreover, with the Federal Open Market Committee upgrading its path for interest rates by one additional hike in 2018, this reinforces the message from our previous work noting that once the fed funds rate moves in the vicinity of r-star, the dollar performs well, nearly eradicating the losses it incurred when the fed funds rate rises but is well below the neutral rate (Table I-1). This is especially true if vulnerability to higher rates rests outside - not inside - the U.S., as is currently the case.2 Chart I-11The Dollar Likes Lower Global Inflation The Dollar Likes Lower Global Inflation The Dollar Likes Lower Global Inflation Table I-1Fed And The Dollar: Where We Stand Matters As Much As The Direction Inflation Is In The Price Inflation Is In The Price Beyond the dollar, one particular currency cross has historically been a good correlate to investors betting on higher inflation: NOK/SEK. As Chart I-12 illustrates, when investors buy inflation hedges such as going long EM equities relative to EM bonds, this generates a rally in NOK/SEK. These dynamics played in our favor when we were long this cross earlier this year. However, not only are EM equities extended relative to EM bonds, the current economic environment portends a growing risk of investors curtailing these kinds of bets. The implication is bearish for NOK/SEK, and we recommend investors sell this cross at current levels. Chart I-12NOK/SEK Suffers If Inflation Bets Are Unwound NOK/SEK Suffers If Inflation Bets Are Unwound NOK/SEK Suffers If Inflation Bets Are Unwound Bottom Line: Investors have quickly and aggressively positioned themselves to protect their portfolios against upside inflation risks. However, the global economy is still slowing - a development that has further to run. As a result, this current anticipation of inflation could easily morph into a temporary fear of deflation, at least relative to lofty expectations. This would undo the dynamics previously seen in the market. This is historically an environment in which the dollar performs well, suggesting the greenback rally is not over. Moreover, NOK/SEK could suffer in this environment. The Bad News Is Baked Into The Pound There is no denying that the data flow out of the U.K. has been poor of late. In fact, despite what was already a low bar for expectations, the U.K. economy has managed to generate large negative surprises (Chart I-13). One of the direct drivers of this poor performance has been the complete meltdown in the British credit impulse (Chart I-14). Additionally, the slowdown in British manufacturing can be easily understood in the context of slowing global growth (Chart I-15). Chart I-13Anarchy In The U.K. Anarchy In The U.K. Anarchy In The U.K. Chart I-14The Credit Impulse Has Bitten The Credit Impulse Has Bitten The Credit Impulse Has Bitten Chart I-15U.K. Exports Are Slowing Because Of Global Growth U.K. Exports Are Slowing Because Of Global Growth U.K. Exports Are Slowing Because Of Global Growth But, the bad new seems well priced into the pound, especially when compared to the euro. Not only is the GBP trading at a discount to the EUR on our fundamental and Intermediate-term timing models, speculators have accumulated near-record short bets on the pound versus the euro (Chart I-16). This begs the question: Could any positive factor come in and surprise investors, resulting in a fall in EUR/GBP? We think the answer to this question is yes. First, despite the negatives already priced in, incremental bad news have had little traction in dragging the pound lower versus the euro in recent weeks, suggesting that EUR/GBP buying has become exhausted. Second, a falling EUR/USD tends to weigh on EUR/GBP, as the pound tends to act as a low-beta version of the euro (Chart I-17). Chart I-16Investors Are Well Aware Of Britain's Problems Investors Are Well Aware Of Britain's Problems Investors Are Well Aware Of Britain's Problems Chart I-17EUR/GBP Sags When EUR/USD Weakens EUR/GBP Sags When EUR/USD Weakens EUR/GBP Sags When EUR/USD Weakens Third, the economic outlook for the U.K. is improving. It is true that in the context of slowing global growth, the manufacturing and export sectors are unlikely to be a source of positive surprises for Great Britain. However, the domestic economy could well be. As Chart I-14 highlights, the credit impulse has collapsed, but the good news is that outside of the Great Financial Crisis it has never fallen much below current levels, suggesting that a reversion to the mean may be in offing. Additionally, U.K. inflation is peaking, which is lifting British real wages (Chart I-18). In response, depressed consumer confidence is picking up. This is crucial as consumer spending, which represents roughly 70% of the U.K.'s GDP, has been the key drag on growth since 2016. Any improvement on this front will lift the whole British economy, even if the manufacturing sector remains soft. Fourth, Brexit is progressing. This week's vote in the House of Commons was confusing, but it is important to note than an amendment that gives Westminster the right to force a renegotiation between the U.K. and the EU if no deal is reached in 2019 has been passed. This also decreases the risk of a completely economically catastrophic Brexit down the road, but increases the risk that PM Theresa May could be ousted over the next 12 months. Our positive view on the pound versus the euro (or negative EUR/GBP bias) is not mimicked in cable itself. Ultimately, despite the GBP/USD's beta to EUR/GBP being below one, it is nonetheless greater than zero. As such, it is unlikely that GBP/USD will be able to rally if the DXY rallies and the EUR/USD weakens (Chart I-19). Therefore, while we recommend selling EUR/GBP, we are not willing buyers of GBP/USD. Chart I-18A Crucial Support To Growth A Crucial Support To Growth A Crucial Support To Growth Chart I-19Cable Will Not Avoid The Downward Pull Of A Strong Dollar Cable Will Not Avoid The Downward Pull Of A Strong Dollar Cable Will Not Avoid The Downward Pull Of A Strong Dollar Bottom Line: The British economy has undergone a period of weakness, which is already reflected in the very negative positioning of investors in the GBP versus the EUR. However, the bad data points are losing their capacity to push EUR/GBP higher, and the British economy may begin to heal as consumer confidence is rebounding thanks to improving real wages. The low beta of GBP/USD to the euro also implies that a falling EUR/USD will weigh on EUR/GBP. However, while the pound has upside against the euro, it will continue to suffer against the dollar if EUR/USD experiences further downside. What To Do With EUR/CAD? One weeks ago, we were stopped out of our short EUR/CAD trade. Has EUR/CAD finished its fall, or was the recent rally a pause within a downward channel? We are inclined to think the latter. Heated rhetoric on trade has hit the CAD harder than the EUR, as exports to the U.S. represent a much larger share of Canada's GDP than of the euro area, forcing the pricing of a risk premium in the loonie. However, even after a rather explosive G7 meeting, we do believe that a compromise is still feasible and that NAFTA is not dead on arrival. A deal is still likely because, as Chart I-20 demonstrates, Canadian tariffs on U.S. imports are not only marginally in excess of U.S. tariffs on Canadian imports, they are also in line with international comparisons. This suggests only a small push is needed to arrive to a deal that salvages NAFTA, which ultimately is much more important to Canada than the dairy industry. Chart I-20Canada And The U.S. Can Find A Compromise Inflation Is In The Price Inflation Is In The Price Despite this reality, we cannot be too complacent, U.S. President Donald Trump is likely to be playing internal politics ahead of the upcoming mid-term elections. U.S. citizens are distrustful of free trade (Chart I-21), a trend especially pronounced among his base. However, a good result for the GOP in November is contingent on the Republican base showing up at the polls. Firing this base up with inflammatory trade rhetoric is a sure way to do so. This means that risks around NAFTA are still not nil. Chart I-21America Belongs To The Anti-Globalization Bloc Inflation Is In The Price Inflation Is In The Price However, EUR/CAD continues to trade at a substantial premium to fair-value on an intermediate-term horizon (Chart I-22). Moreover, as the last panel of the chart illustrates, speculators remain massively short the CAD against the EUR. This creates a cushion for the CAD versus the EUR if global growth slows. Moreover, technicals are still favorable of shorting EUR/CAD. Not only is EUR/CAD still overbought on a 52-week rate-of-change basis, it seems to be in the process of forming a five-wave downward pattern, with the fourth one - a countertrend wave - potentially ending (Chart I-23). Chart I-22EUR/CAD Is Still Vulnerable EUR/CAD Is Still Vulnerable EUR/CAD Is Still Vulnerable Chart I-23Wave Pattern Not Completed Wave Pattern Not Completed Wave Pattern Not Completed Finally, EUR/CAD tends to perform poorly when the USD strengthens, which fits with our current thematic for the remainder of 2018. Bottom Line: The headline risk surrounding NAFTA has weighed on the loonie against the euro, stopping us out of our short EUR/CAD trade with a small profit. However, the valuation, positioning and technical dynamics suggest the timing is ripe to short this cross once again. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Rome Is Burning: Is It The End?", dated June 1, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "This Time Is NOT Different", dated May 25, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was stellar: NFIB Business Optimism Index climbed to 107.8, outperforming expectations; the price changes and good times to expand components are also very strong; Headline and core PPI both outperformed expectations, auguring well for future consumer inflation; Headline and core retail sales grew by 0.8% and 0.9% in monthly terms, beating expectations; Both initial and continuing jobless claims also came out below expectations, highlighting that the labor market is still tightening, and wage growth could pick up further. The Fed raised interest rates this week to 2%, and added one additional rate hike to its guidance for 2018. FOMC members once again highlighted the "symmetric" target, suggesting that the Fed expects the economy to overheat slightly. An outperforming U.S. economy relative to the rest of the world is likely to propel the greenback this year. Report Links: This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Economic data was largely disappointing: Italian industrial output contracted by 1.2% on a monthly basis, and grew only by 1.9% on a yearly basis; The German ZEW Survey declined substantially across all metrics; European industrial production increased by 1.7% annually, less than the expected 2.8% increase; However, Spanish headline inflation spiked up from 1.1% to 2.1%. Yesterday, ECB President Mario Draghi announced the ECB's plan to taper asset purchases to EUR 15 bn a month in September, and phase them out completely by year-end. Moreover, Draghi highlighted that the ECB was not anticipating to implement its first hike until after the summer of 2019. Furthermore, the ECB President highlighted the current slowdown in global growth, as well as the rising protectionist risk from the U.S. potentially negatively impacting the European economy and the ECB's decisions going forward, suggesting that the plans are not set in stone. 2018 is likely to remain a volatile year for the euro. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Japanese data has been strong this week: Machine orders increased on a 9.6% annual basis, and a 10.1% monthly basis, in April, outperforming expectations by a large margin; The Domestic Corporate Goods Price Index also increased by 2.7% annually, higher than the expected 2.2% increase. As political and economic risks in Europe and South America having subsided for now, the yen has lost some of its glitter. However, with ongoing uncertainty on trade and populism across the globe, we maintain our tactically bullish stance on the yen, especially against commodity currencies and the euro. However, beyond the short-term horizon, the BoJ will remain determined to cap any excess appreciation in the yen, as a strong JPY tightens Japanese financial conditions, weighing on the BoJ's ability to hit its inflation target. This will ultimately limit the yen's upside on a cyclical basis. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Data from the U.K. was somewhat disappointing: Manufacturing and industrial production both increased less than expected, at 1.4% and 1.8%, respectively; The goods trade deficit widened to GBP 14.03bn from GBP 12bn, and the overall trade deficit widened to GBP 5.28bn from GBP 3.22bn; Average earnings grew by 2.8%, less than the expected 2.9%; However, headline inflation came in at 2.4%, less than the expected 2.5%, while retail price inflation also underperformed expectations. This means that the uptrend in real wages continues. Given the limited movement in the pound, it seems that a lot of the bad news was already priced in by last month's depreciation. However, Theresa May's ongoing blunders in parliament represent a continued source of risk for the pound. While the GBP has downside against the EUR, it is unlikely to see much upside against the greenback. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Do Not Get Flat-Footed By Politics - March 30, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was weak: NAB Business Confidence and Conditions surveys both declined, also underperforming expectations; Australian employment grew by 12,000, less than expected. Moreover, full-time employment contracted. While the unemployment rate dropped as a result, this was largely due to a fall in the participation rate. RBA's Governor Lowe, in a speech on Wednesday, announced that any increase in interest rates "still looks some time away" as the slack in the labor market does not seem to be diminishing. Annual wage growth has been constant at 2.1% for the past three quarters, and did not pick up despite an improvement in full-time employment earlier this year. We remain bearish on the AUD. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The NZD is likely to face significant downside against the greenback along with the other commodity currencies as global growth slows down. However, due to its weaker linkages to Chinese industrial demand, the kiwi is likely to see less downside than the AUD. Nevertheless, it is likely to weaken against the CAD and the NOK as the NZD is expensive against these oil currencies, and oil's is likely to continue to outperform other commodities will support this view. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 USD/CAD has been on an uptrend given the greenback generally strong performance since February year, a force magnified by the volatile rhetoric surrounding NAFTA negotiations. However, the Canadian economy has been accelerating this year, thanks to robust growth in the U.S., to a strong Quebecer economy, and to a pickup in Alberta. In addition, the Canadian labor market is tightening further and wage growth is above 3%. Furthermore, risks surrounding NAFTA seem already reflected in the CAD's behavior and valuation. There is more clarity on the CAD versus its crosses than on the CAD versus the USD. Outperforming U.S. and Canadian growth relative to the rest of the world mean that the CAD should outperform most other G10 currencies. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data out of Switzerland was decent: Industrial production increased by 9% in annual terms, albeit less than the previous 19.6% growth; Producer and import prices increased by 3.2% year on year, in line with expectations, however the monthly increase underperformed markets anticipations. With global trade tensions rising, and Germany having entered President Trump's line of sight, the CHF could experience additional upside against the euro in the coming months. However, the SNB is unlikely to deviate from its ultra-accommodative stance, which means that any downside in EUR/CHF will proved to be short lived. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Both headline and core inflation underperformed, coming in at 2.3% and 1.2%, respectively. However, the Regional Network Survey hinted at a pickup in capacity utilization as expectations for industrial output remained robust, as well as at an additional strength in employment. This led to a forecast of a resurgence in inflationary pressures. We expect the NOK to outperform the EUR. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish inflation rose from 1.7% to 1.9%, coming in line with expectations. Additionally, Prospera 1-year inflation expectations survey rose to 1.9% from 1.8% in the March survey. This is likely to provide the Riksbank with reasons to turn gradually more hawkish, which should support the very cheap krona. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights After having written about the role of the U.S. yield curve in forecasting recessions, we are devoting this Special Report to addressing the widely asked question on the effectiveness of the yield curve in determining asset allocation. A naïve, rules-based approach is applied to the yield curve in each of seven countries/regions to produce a dynamic allocation signal between equities and bonds in each country/region. Despite its simplicity, we find that the dynamic portfolio systematically outperforms the 60/40 equity/bond benchmark portfolio in the U.S., Canada, euro area, Switzerland, U.K. and Australia from a long-term perspective (four years), with Japan being the outlier. Despite the dominance of the U.S. in the global economy and also in global asset markets, the equity/bond performance cycle outside the U.S. does not necessarily follow the U.S. Instead, the yield curve in each country provides a consistently better signal than just following U.S. decisions alone. Currently, signals from yield curves still favor equities over bonds. Feature U.S. yield curve inversion has been a good leading indicator for recessions in the U.S. Since the mid-1950s, every U.S. recession has been preceded with curve inversion, as shown in Chart 1. The lead time, however, varies from one month to 18 months. In addition, even though it is true that stocks underperform bonds in a recession, stocks can begin to underperform bonds long before a recession starts and can also continue to underperform long after a recession ends. For example, U.S. stocks/bonds performance ratio peaked in December 1999 and then troughed in September 2002 with a more than 50% drawdown, yet only about 6% occurred between March 2001 and November 2001 - the NBER official dates for the 2001 recession. So could information from the U.S. yield curve itself systematically add value to a stock-bond allocation decision in the U.S.? Even if it could in the U.S., could the same apply elsewhere, given that yield curves in different countries do not move in a synchronized fashion? (Chart 2) Chart 1U.S. Yield Curve Vs. Recession U.S. Yield Curve Vs. Recession U.S. Yield Curve Vs. Recession Chart 2Global Yield Curve Cycle Global Yield Curve Cycle Global Yield Curve Cycle In this Special Report, we use a simplified naïve, rules-based approach to attempt to demonstrate if information from yield curves in seven countries - the U.S., Japan, the U.K, Euro Area, Canada, Australia and Switzerland - can systematically add value in asset allocation decisions. Yield Curves Are An Effective Indicator For Long-Term Asset Allocation The test results are quite encouraging, despite the simplicity and need for further refinement. Except in Japan, yield curves in all six other countries provide value-add information for stock-bond allocation decisions. The solid lines in Chart 3 are the relative total return performance of the active stock/bond portfolio versus the benchmark for each country. The active portfolio is simply constructed based on a naïve rule such that a 10% underweight is given to equities and a 10% overweight is given to bonds when the yield curve reaches the lower band from above. Once the yield curve reaches the upper band from below, the allocation is reversed. The upper and lower bands are explained in our methodology section on page 5, we omit Japan from these charts because, as explained on page 9, its stock/bond ratio has not had a consistent relationship with the yield curve. The dash lines in Chart 3 are the monthly four-year rolling return differentials between the active portfolios and the benchmarks. It is encouraging to see that the four-year rolling performance in each country has suffered only very limited downside. Chart 4 is the same as Chart 3 except that the active bet is maxed out to 40% over- or underweight relative to the 60/40 equity/bond benchmark - i.e. when the signal is bullish for stocks, 100% is in stocks, and when it is bullish for bonds, the weights are 80% bonds and 20% stocks. This is a more extreme version of risk-taking, though the upside/downside trade-off is still quite impressive. This simple approach illustrates that in the long run, the yield curve is a useful indicator for equity/bond allocations. However, it does not do very well on a shorter-term time horizon. As shown in Chart 5, the one-year performance differentials are less appealing. Chart 3Backtest Base Case Backtest Base Case Backtest Base Case Chart 4Backtest Aggressive Case Backtest Aggressive Case Backtest Aggressive Case Chart 5Short-Term Risk Reward Less Appealing Short-Term Risk Reward Less Appealing Short-Term Risk Reward Less Appealing So how are the back tests conducted? The Methodology The Passive Benchmark: A 60/40 fixed-weight equity/bond benchmark is constructed for each country using the MSCI equity total return index and Bloomberg/Barclays Treasury Total Return Index, all in local currencies. The Active Allocation Rule: For each country, a range is set for its yield curve with an upper band and a lower band. The bands are set based on yield curve cycles and also their correlation with stock/bond performance cycles. When the curve reaches the upper band from below, an overweight is assigned to equities until the yield curve reaches the lower band from above, at which point the overweight then shifts to bonds. To determine how the size of the over- and underweight positions impacts the efficacy of the signal, we tested four different bet sizes - from 10% to 40% - in 10% increments, since no short selling is allowed. Objective: The active portfolio in each country is aimed to outperform its passive benchmark with a minimal four-year rolling drawdown. The same approach is applied to all seven countries. In terms of yield curve, the 3M/10 curve works better than the 2/10 curve for the U.S. because the former has better cyclicality. For all other countries, 2/10 yield curves are used. Despite the simplicity of our approach, some interesting observations are worth highlighting: U.S. And Canada: Reduce Risk When Yield Curve Inverts As shown in Chart 6, yield curve inversion in these two countries has historically been a good indication to reduce risk in equities. Bonds in general start to outperform equities after the curve is inverted and continue to do so as the yield curve steepens. However, when the curves steepens near to its cyclical high, then it's time to add risk in equities. Historically, the upper threshold for the U.S. 3M/10 is 3.4%, while for the Canadian 2/10 it is 1.8%. Currently, this indicator alone still favors equities in these two countries. Chart 6AU.S. & Canada: Curve Inversion ##br##Triggers Risk Reduction (I) U.S. & Canada: Curve Inversion Triggers Risk Reduction (I) U.S. & Canada: Curve Inversion Triggers Risk Reduction (I) Chart 6BU.S. & Canada: Curve Inversion ##br##Triggers Risk Reduction (II) U.S. & Canada: Curve Inversion Triggers Risk Reduction (II) U.S. & Canada: Curve Inversion Triggers Risk Reduction (II) Euro Area And Switzerland: Reduce Risk Before Yield Curve Approaches Inversion As shown in Chart 7, the yield curve of the euro area does not invert often, while the Swiss curve has never gone into inversion during the short period for which we have historical data. However, both curves have good cyclicality, which makes the 0.2%-1.8% range works very well for both. Chart 7AEuro Area & Swiss: Reduce Risk##br## Before Curve Inverts (I) Euro Area & Swiss: Reduce Risk Before Curve Inverts (I) Euro Area & Swiss: Reduce Risk Before Curve Inverts (I) Chart 7BEuro Area & Swiss: Reduce Risk ##br##Before Curve Inverts (II) Euro Area & Swiss: Reduce Risk Before Curve Inverts (II) Euro Area & Swiss: Reduce Risk Before Curve Inverts (II) U.K And Australia: Reduce Risk After Yield Curve Has Inverted 2/10 yield curves in both the U.K. and Australia invert more often than in other countries. However, unlike other countries, equities can continue to outperform bonds even after the curve is inverted. The turning point is about minus 50 basis points, as shown in Chart 8. The upper band for Australia is 1.25% and 0.9% for the U.K. Chart 8AU.K. & Australia: Reduce Risk ##br##After Yield Curve Has Inverted (I) U.K. & Australia: Reduce Risk After Yield Curve Has Inverted (I) U.K. & Australia: Reduce Risk After Yield Curve Has Inverted (I) Chart 8BU.K. & Australia: Reduce Risk ##br##After Yield Curve Has Inverted (II) U.K. & Australia: Reduce Risk After Yield Curve Has Inverted (II) U.K. & Australia: Reduce Risk After Yield Curve Has Inverted (II) Japan: Yield Curve Does Not Provide Consistent Information The Japanese stock/bond ratio does not have a consistent relationship with the 2/10 yield curve, as shown in Chart 9. This makes it very difficult to apply the simple approach employed here. Country Divergence U.S. economic cycles have been widely studied. But as shown in Chart 1, correctly identifying recessions in the U.S. does not systematically capture equity/bond relative performance cycles because even U.S. equities can underperform bonds before a recession starts and after a recession ends. Using the yield curve, on the other hand, does a much better job in capturing the equity/bond performance cycle in each country. Chart 10 shows that investors in different countries should pay more attention to local yield curve cycles other than just following a U.S.-centric analysis, even though the U.S. does play a dominant role in the global economy and in global equity and bond indices. Chart 9Japan Is The Outlier Japan Is The Outlier Japan Is The Outlier Chart 10Country Divergences Country Divergences Country Divergences Bottom Line: The yield curve is an effective indicator for equity/bond allocation in most developed countries from a long-run perspective. Currently, yield curve-based signals from the U.S., Canada, Euro Area, Switzerland, the U.K. and Australia all still favor equities over bonds. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com