BCA Indicators/Model

Highlights It has not been a lot of fun being a corporate bond investor in 2018. Global credit markets have struggled to deliver positive returns, amid a news flow that has been overwhelming at times. Geopolitical uncertainty, shifting monetary policy biases, greater inflation pressures, intensifying trade tensions, a rising U.S. dollar, slowing Chinese growth - all have combined to form a backdrop where investors should require wider risk premiums to own risky assets like corporate debt. Yet are wider spreads justified relative to the underlying financial health of companies? Feature Chart 1Global Corporates: Fading Support From##BR##Growth & Monetary Policy Global Corporates: Fading Support From Growth & Monetary Policy Global Corporates: Fading Support From Growth & Monetary Policy Against this backdrop of more uncertainty in credit markets, we are presenting our latest update of the BCA Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) that are designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 16. The broad conclusion from the latest readings on our CHMs is that global credit quality has been enjoying a cyclical improvement across countries, regions and credit tiers. The U.S. has delivered the biggest improvement in corporate health, compared to the recent past and to bearish investor perceptions as well. Much of that can be attributed to the impact of the Trump corporate tax cuts, though. At the same time, there have even been significant improvements in profitability metrics in regions that have lagged during the current global economic expansion, like Peripheral Europe. We recently downgraded our overall global spread product allocation to neutral.1 This reflected the increased concerns of the BCA Strategists that valuations on global risk assets looked rich compared to growing geopolitical risks (U.S.-China trade tensions, U.S.-Iran military tensions). Yet it also was related to the ongoing development of our biggest investment theme for 2018 - the eventual likely collision between tightening global monetary policy and rich valuations on global risk assets. Looking ahead, the tailwinds that have been supportive for corporate health and the performance of global corporate debt in the past couple of years - a coordinated cyclical upturn driving solid earnings growth, with low inflation allowing monetary policies to stay accommodative - are becoming headwinds (Chart 1). The overall OECD leading economic indicator, which is well correlated to the annual excess returns of global high-yield debt, has peaked. Central banks are either delivering rate hikes, talking about rate hikes, or cutting back on the pace of balance sheet expansion. All of these factors will weigh on corporate bond returns over the next 6-12 months. U.S. Corporate Health Monitors: Improving Thanks To Resilient Growth & Tax Cuts Chart 2Top-Down U.S. CHM:##BR##Boosted By Cyclically Strong Profits Top-Down U.S. CHM: Boosted By Cyclically Strong Profits Top-Down U.S. CHM: Boosted By Cyclically Strong Profits Our top-down CHM for the U.S. has been in the "deteriorating health" region for fifteen consecutive quarters dating back to the middle of 2014 (Chart 2). That streak appears set to end soon, as the indicator has been falling since peaking in 2016 and now sits just above the zero line. The resilience of the U.S. economy, combined with the positive impact on U.S. profitability from the Trump corporate cuts, has put U.S. companies in a cyclically healthier position, even with relatively high leverage. It is important to note that the top-down CHM uses after-tax earnings measures in several of the ratios the go into the indicator: return on capital, profit margin and debt coverage. All three of those ratios saw significant upticks in the first quarter of 2018, which is the latest available data for the top-down CHM. The Trump tax cuts did take effect at the start of the year, but given the robust results seen in reported second quarter profits reported so far, a bigger impact will likely be visible once we are able to update the CHM for the most recently completed quarter. The ability for U.S. companies to continue expanding margins will be tested in the next 6-12 months. The tight U.S. labor market is pushing up wage growth, which will pressure margins and prompt some firms to try and raise prices to compensate. Firming U.S. inflation is already keeping the Fed on a 25bps-per-quarter pace of rate hikes, and perhaps more if U.S. inflation continues to accelerate without any slowing of U.S. economic growth. If the Fed starts actively targeting a slower pace of U.S. growth to cool off inflation, credit markets will take notice and U.S. corporate debt will underperform. From a fundamental perspective, the top-down U.S. CHM suggests that the U.S. credit cycle is being extended by the stubborn endurance of the U.S. business cycle. There are no imminent domestic pressures on U.S. corporate finances that should require wider credit spreads to compensate for rising default risk. The bottom-up versions of the U.S. CHMs for investment grade (IG) corporates (Chart 3) and high-yield (HY) companies (Chart 4) have also both improved, with the HY indicator now crossing over the zero line into "improving health" territory. This confirms that the signal from our top-down CHM is being reflected in both higher-rated and lower quality companies. Yet the longer-term issues of high leverage and low interest/debt coverage are not going away, suggesting that potential problems are being stored up for the next U.S. economic downturn. What also remains worrying is the fact that IG interest coverage has fallen in recent years, despite high profit margins and historically low corporate borrowing rates. This indicates that the stock of U.S. corporate debt is now so large that the interest expense required to service that debt is eating up a greater share of corporate earnings, even at a time when profit growth is still quite strong. This will raise downgrade risk if corporate borrowing rates were to rise significantly or if U.S. earnings growth slows sharply. We moved our recommended stance on U.S. IG and HY to neutral at the end of June as part of our downgrade of overall global spread product exposure. We may consider a move back to overweight (versus U.S. Treasuries) on any meaningful spread widening given our optimistic view on U.S. economic growth and the positive measure on credit risk signaled by our CHMs. Yet it may be difficult to get such an opportunity. The U.S. is reaching a more challenging point in the monetary policy cycle with the Fed likely to shift to a restrictive stance within the next 6-12 months. At the same time, there are risks to the U.S. economy stemming from the widening U.S.-China trade conflict, a stronger U.S. dollar and, potentially, the growing turmoil in emerging markets. Yet the state of U.S. corporate health has improved substantially, leaving companies less immediately vulnerable to any of those shocks. Given this balance of risks, a neutral stance on U.S. corporates remains appropriate (Chart 5). Chart 3Bottom-Up U.S. Investment Grade CHM:##BR##Stable, But Watch Profit Margins Bottom-Up U.S. Investment Grade CHM: Stable, But Watch Profit Margins Bottom-Up U.S. Investment Grade CHM: Stable, But Watch Profit Margins Chart 4Bottom-Up U.S. High-Yield CHM:##BR##Cyclical Improvement Bottom-Up U.S. High-Yield CHM: Cyclical Improvement Bottom-Up U.S. High-Yield CHM: Cyclical Improvement Chart 5U.S. Corporates:##BR##Stay Neutral IG & HY U.S. Corporates: Stay Neutral IG & HY U.S. Corporates: Stay Neutral IG & HY Euro Corporate Health Monitors: Strong Economy, Big Improvements Our top-down euro area CHM remains in "improving health" territory, as has been the case for the past decade (Chart 6). The indicator had been worsening towards the zero line during 2016-17, but rebounded in the first quarter of 2018 thanks to a pickup in profit margins and debt coverage. Those positive developments are even more impressive since they occurred during a quarter when there was some cooling from the robust pace of economic growth seen in 2017. Chart 6Top-Down Euro Area CHM: Modestly Improving Top-Down Euro Area CHM: Modestly Improving Top-Down Euro Area CHM: Modestly Improving Interest coverage and liquidity remain in structural uptrends, supported by the super-easy monetary policies of the European Central Bank (ECB) that have lowered corporate borrowing costs (negative short-term interest rates, liquidity programs designed to prompt low-cost bank lending, and asset purchase programs that include buying of corporate bonds). Our bottom-up versions of the CHMs for euro area IG (Chart 7) and HY (Chart 8), which are based on individual company earnings data, both confirm the positive message from the top-down CHM. For IG, a noticeable gap has opened up between domestic and foreign issuers in the euro area corporate bond market. Return on capital, operating margins, interest coverage and debt coverage all ticked higher in the first quarter of this year, while leverage slightly declined. Those developments were not repeated among the foreign issuers in our sample. Within the Euro Area, our bottom-up CHMs show that the gap has closed between IG issuers from the core countries versus the periphery, but both remain in the "improving health" zone. (Chart 9). Somewhat surprisingly, the only ratios where there is a material difference are leverage (150% and falling in the periphery, 100% and stable in the core countries) and interest coverage (rising sharply toward 5x in the periphery, stable just above 6x in the core). Despite the improvement in the CHMs, credit spreads for euro area IG and HY have both widened over the course of 2018, while excess returns have been negative year-to-date (Chart 10). Looking ahead, we see the biggest threat for euro area corporate bond performance to come from a shift in ECB policy. We expect the ECB to follow through on its commitment to fully taper net new government bond purchases by the end of 2018, while continuing to reinvest the proceeds of maturing debt in 2019 and beyond. It is less clear what the ECB will do with its corporate bond buying program, and there has been some speculation that the ECB could leave its corporate program untouched while tapering the government purchases. We doubt that the ECB would want to make such a distinction that would artificially suppress corporate borrowing costs relative to government yields. The ECB is more likely to end both programs concurrently at the end of the year, which will remove a major prop under the euro area corporate bond market. This is a main reason why we are currently recommending an underweight stance on euro area corporates versus U.S. corporates. Chart 7Bottom-Up Euro Area Investment Grade CHMs: Domestic Issuers Looking Better Bottom-Up Euro Area Investment Grade CHMs: Domestic Issuers Looking Better Bottom-Up Euro Area Investment Grade CHMs: Domestic Issuers Looking Better Chart 8Bottom-Up Euro Area High-Yield CHMs: Falling Leverage, Mediocre Profitability Bottom-Up Euro Area High-Yield CHMs: Falling Leverage, Mediocre Profitability Bottom-Up Euro Area High-Yield CHMs: Falling Leverage, Mediocre Profitability Chart 9Bottom-Up Euro Area IG CHMs: Periphery Improving vs Core Bottom-Up Euro Area IG CHMs: Periphery Improving vs Core Bottom-Up Euro Area IG CHMs: Periphery Improving vs Core Yet the bigger reason why we prefer corporates from the U.S. over the euro area is that the relative improvement in corporate health has been bigger in the U.S. The gap between our top-down CHMs for the U.S. and Europe has proven to be an excellent directional indicator for the relative performance of U.S. credit vs Europe (Chart 11). That CHM gap continues to favor U.S. credit, which has been outperforming over the past several months (on a common currency basis compared to euro area debt hedged in USD). Chart 10Euro Area Corporates:##BR##Stay Underweight IG & HY Euro Area Corporates: Stay Underweight IG & HY Euro Area Corporates: Stay Underweight IG & HY Chart 11Relative Top-Down CHMs:##BR##Continue To Favor U.S. over Europe Relative Top-Down CHMs: Continue To Favor U.S. over Europe Relative Top-Down CHMs: Continue To Favor U.S. over Europe U.K. Corporate Health Monitor: Deteriorating Amid Rising Domestic Risks The U.K. CHM saw a significant deterioration in the first quarter of 2018, thanks largely to slowing U.K. growth that has impacted all the profit-focused ratios (Chart 12). The CHM is still in the "improving health" zone, but just barely. Seeing the return on capital, profit margin, interest coverage and debt coverage ratios all roll over at historically low levels is a worrying sign for future U.K. credit quality. This is especially true given the extremely stimulative monetary policy run by the Bank of England (BoE) since the 2008 Global Financial Crisis. The only ratio in the U.K. CHM that has seen steady improvement over the past decade is short-term liquidity (bottom panel), which has been boosted by steady increases in working capital. The performance of U.K. credit has benefited from the BoE's additional monetary policy measures taken after the shock Brexit vote in 2016. This involved both interest rate cuts and asset purchases, which included buying of U.K. corporate bonds. The BoE has shifted its policy bias from easing to tightening over the past year, even with sluggish U.K. economic growth and still-unresolved uncertainty about the future U.K. trading relationship with the European Union. This has raised the risks that the BoE could commit a policy error through additional interest rate hikes over the next 6-12 months, especially if policymakers focus more on targeting higher real policy rates as we discussed in a recent Weekly Report.2 U.K. corporates have been a laggard among global credit markets throughout 2018 and especially so in the month of July during a generally positive month for global corporate debt (Chart 13). We see the underperformance continuing in the coming months, as wider spreads will be required given the uncertainties surrounding Brexit, economic growth and BoE monetary policy. Stay underweight U.K. corporate debt within an overall neutral allocation to global spread product. Chart 12U.K. Top-Down CHM: Cyclical Deterioration U.K. Top-Down CHM: Cyclical Deterioration U.K. Top-Down CHM: Cyclical Deterioration Chart 13U.K. Corporates: Stay Underweight U.K. Corporates: Stay Underweight U.K. Corporates: Stay Underweight Japan Corporate Health Monitor: No Problems Here We added Japan to our suite of global CHMs earlier this year.3 Although the Japanese corporate bond market is small (the Bloomberg Barclays Japan Corporates index only has a market capitalization of $116bn), the asset class does provide opportunities for investors to pick up a bit of yield versus zero-yielding Japanese government bonds (JGBs) Japanese corporate health has been excellent for the past decade, with the CHM steadily holding in "improving health" territory (Chart 14). The trends in the Japan CHM ratios since 2008 are quite different than those seen in the CHMs for other countries. Leverage has been steadily falling, return on capital has been steadily rising (and has now converged to the 6% level seen in other countries' CHMs), and the interest coverage multiple of 9.6x is by far the largest in our CHM universe. Default risk is non-existent in Japan. Only pre-tax operating margins for our bottom-up Japan CHM have lagged those in other countries, languishing at 6% for the past three years. Yet Japanese corporate profits are at all-time highs, a logical outcome when companies can borrow at less than 50bps and earn a return on capital of 6%. That wide gap should allow Japanese companies to continue to earn steady, strong profits even with wage inflation finally showing life in Japan alongside a 2.3% unemployment rate. Japanese corporate bond spreads have widened a bit in 2018, but remain far more stable compared to corporates in other developed markets (Chart 15). The lack of spread volatility has allowed Japanese corporates to steadily outperform JGBs since 2011, even as all Japanese bond yields have collapsed. That trend is likely to continue, as the Bank of Japan (BoJ) is still a long way from being able to credibly pull off any upward adjustment of the current 0% BoJ yield target on 10-year JGBs. Chart 14Japan Bottom-Up CHM: Still Healthy,##BR##But Has Cyclical Improvement Peaked? Japan Bottom-Up CHM: Still Healthy, But Has Cyclical Improvement Peaked? Japan Bottom-Up CHM: Still Healthy, But Has Cyclical Improvement Peaked? Chart 15Japan Corporates:##BR##Stay Overweight vs JGBs Japan Corporates: Stay Overweight vs JGBs Japan Corporates: Stay Overweight vs JGBs Importantly, the BoJ recently introduced new forward guidance that states there will be no interest rate hikes until at least 2020. This will positively affect Japanese corporate health by keeping borrowing costs extremely low and preventing any unwanted strength in the yen that could damage Japanese competitiveness. There is a risk that increasing global trade tensions could impact the export-heavy Japanese economy and damage corporate profit growth and corporate bond performance. We do not yet see that as a major risk that could derail the Japanese economy and we continue to recommend an overweight stance on Japanese corporate debt vs JGBs. Canada Corporate Health Monitor: Faster Growth Hiding Structural Warts We introduced both top-down and bottom-up CHMs for Canada in our previous CHM Chartbook in April. As was the case then, both CHMs are in "improving health" territory (Chart 16). These CHMs are typically correlated to the price of oil, as befits Canada's status as a major energy exporter. Yet the strong CHMs also reflect the solid pace of overall Canadian economic growth. Looking at the individual components of the Canada CHMs, the leverage ratios for both measures have been steadily rising and currently sit above 100%. The return on capital has been in a structural downtrend, as is the case for most countries in our CHM universe (excluding Japan), but has ticked up alongside faster economic growth over the past couple of years. There was a noticeable drop in the margin ratio for the bottom-up CHM, coming entirely from the HY firms within our sample group of companies. Interest coverage and debt coverage ratios remain depressed, even with some improvement in corporate profits. This is partially due to rising interest rates as the Bank of Canada (BoC) has been tightening monetary policy - a trend that we expect to continue over the next 6-12 months. Canadian corporate bond spreads have widened slightly since the start of 2018, but remain tight relative to a longer-term history (Chart 17). Excess returns over Canadian government bonds have flattened out after enjoying a very solid period of outperformance in 2016-17. Looking ahead, there are balanced risks to the outlook for Canadian corporate debt. Chart 16Canada CHMs: Cyclically Improving,##BR##But Longer-Term Problems Are Building Canada CHMs: Cyclically Improving, But Longer-Term Problems Are Building Canada CHMs: Cyclically Improving, But Longer-Term Problems Are Building Chart 17Canadian Corporates:##BR##Stay Neutral Vs Canadian Government Debt Canadian Corporates: Stay Neutral Vs Canadian Government Debt Canadian Corporates: Stay Neutral Vs Canadian Government Debt We continue to expect the BoC to hike rates because of solid growth and faster inflation in Canada. Yet we do not see the BoC moving rapidly to a restrictive monetary stance that would damage growth expectations and trigger some credit spread widening. At the same time, we also see risks stemming from Canada-U.S. trade disagreements that could hurt Canadian growth and cause investors to demand cheaper valuations for Canadian corporate bonds. Adding it all up, a neutral stance on Canadian corporates versus government debt remains appropriate, largely as a carry trade. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Top-down CHMs are now available for the U.S., euro area, the U.K. and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.4 The financial data of a broad set of individual U.S. and euro area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. Table 1Definitions Of Ratios That Go Into The CHMs BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Appendix Chart 1We Now Have CHM Coverage For 92% Of The Developed Market Corporate Bond Universe BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News 1 Please see BCA Global Fixed Income Weekly Report, "Time To Take Some Chips Off The Table; Downgrade Global Corporate Bond Exposure To Neutral", dated June 26 2018, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "An R-Star Is Born", dated August 7th 2018, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Sticking With The Plan", dated March 13th 2018, available at gfis.bcaresearch.com. 4 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors APPENDIX 2: ENERGY SECTOR APPENDIX 2: ENERGY SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: TECHNOLOGY SECTOR APPENDIX 2: TECHNOLOGY SECTOR APPENDIX 2: UTILITIES SECTOR APPENDIX 2: UTILITIES SECTOR Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: The market is only priced for a fed funds rate of 2.83% by the end of 2019. This is well below the range of 3.25% to 3.5% that will prevail if the Fed sticks to its current 25 basis points per quarter rate hike pace. Maintain below-benchmark portfolio duration. The Neutral Rate: Our indicators of the neutral (or equilibrium) fed funds rate are sending conflicting signals. The economic data suggest that the neutral rate might be above 3%, but this is contradicted by weakness in the price of gold. TIPS: Long-dated TIPS breakeven inflation rates remain slightly below target levels, but appear to be increasingly taking their cues from the realized inflation data rather than swings in global growth and commodity prices. Remain overweight TIPS versus nominal Treasuries. Feature In February we published a report that outlined how we expect the cyclical bear market in bonds to evolve. Essentially, we view the bear market as consisting of two stages.1 The first stage is characterized by the re-anchoring of inflation expectations and the second stage deals with determining the neutral (or equilibrium) federal funds rate. In this week's report we track how the two-stage Treasury bear market has progressed since February and consider the implications for portfolio strategy. The First Stage Is Nearly Complete Long-maturity TIPS breakeven inflation rates are slightly higher than when we published our February report, but they are still not at levels we would consider "well anchored". We showed in our February report that prior periods when core inflation was close to the Fed's 2% target coincided with both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates in a range between 2.3% and 2.5%. At present, the 10-year TIPS breakeven inflation rate is 2.10% and the 5-year/5-year forward is 2.19%. As long as TIPS breakeven inflation rates remain below the 2.3% - 2.5% target range, nominal Treasury yields have further cyclical upside due to the re-anchoring of inflation expectations. This re-anchoring will play out as the core inflation data are released and investors come to realize that inflation is no longer consistently undershooting the Fed's target. When that re-anchoring occurs and both the 10-year and 5-year/5-year forward breakevens cross above 2.3%, the first stage of the bond bear market will be complete. One recent development is that TIPS breakevens have risen even as commodity prices have declined (Chart 1). In fact, while breakevens are somewhat higher than when we published our February report, commodity prices - as measured by the CRB Raw Industrials index - are lower. While this shift in correlation is so far only tentative, it could signal that TIPS investors are increasingly influenced by the actual core inflation data and not swings in the global growth outlook. We would not be surprised to see this correlation continue to weaken going forward, especially considering that core inflation looks more and more consistent with the Fed's 2% target. Core CPI for July came in at 2.33% on both a trailing 12-month and 3-month basis, annualized (Chart 2). This is more or less consistent with the pre-crisis period when the Fed's preferred PCE inflation measure was close to the 2% target. Alternative measures of CPI send a similar message (Chart 2, panel 2) and our diffusion index shows that more individual items have accelerated in price than have decelerated in each of the past three months (Chart 2, bottom panel). Taken together, the signals point to further near-term price acceleration. Chart 1Inflation Date Sinking In Inflation Date Sinking In Inflation Date Sinking In Chart 2Inflation Picking Up Steam Inflation Picking Up Steam Inflation Picking Up Steam Digging deeper, we see that the outlook for higher inflation pervades each of the main components of core CPI (Chart 3). The reading from our shelter inflation model has stabilized, core goods inflation continues to track non-oil import prices higher, and the rebound in core services inflation is consistent with rising wage growth. Eventually, we would expect the strengthening dollar to exert a drag on import prices (Chart 4), but it will be some time before this is reflected in the CPI data. Another important development is that, after appearing to have turned a corner in 2016, the residential vacancy rate has dipped back down (Chart 4, bottom panel). Such a low vacancy rate will continue to support strong shelter inflation. Chart 3The Components Of Core CPI The Components Of Core CPI The Components Of Core CPI Chart 4A Headwind And A Tailwind For Inflation Headwing & Tailwind For Inflation Headwing & Tailwind For Inflation Bottom Line: Long-dated TIPS breakeven inflation rates remain slightly below target levels, but appear to be increasingly taking their cues from the realized inflation data rather than swings in global growth and commodity prices. Nominal Treasury yields have further upside at least until both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach a range between 2.3% and 2.5%. We also continue to recommend an overweight position in TIPS relative to nominal Treasury securities. We will remove this recommendation when breakeven rates reach our target range and stage one of the bond bear market is complete. Stage 2 Update: Conflicting Evidence On The Neutral Rate Once inflation expectations are well-anchored at levels consistent with the Fed's target, the cyclical bond bear market will transition into its second stage. How much further Treasury yields rise during this stage will depend on how high the Fed is able to lift interest rates before the economy starts to slow. In other words, the cyclical peak in Treasury yields will be determined by the neutral (or equilibrium) fed funds rate - the level of interest rates where monetary policy is neither accommodative nor restrictive, and which is also consistent with stable inflation near the Fed's 2% target. Unfortunately, the neutral rate can only be known with certainty in hindsight. But in a recent report we presented three factors that investors can track in real time that have forewarned of the shift from accommodative to restrictive monetary policy in the past.2 We review the recent trends in each of these signals below. Signal 1: Nominal GDP Growth Vs The Fed Funds Rate Chart 5The Message From Nominal GDP Growth The Message From Nominal GDP Growth The Message From Nominal GDP Growth A fed funds rate that is above the year-over-year growth rate in nominal GDP is typically a signal (though often a lagging one) that monetary policy has turned restrictive (Chart 5). An intuition that is confirmed by the fact that the spread between nominal GDP growth and the fed funds rate correlates positively with the slope of the yield curve. But while the flattening yield curve has caused some to worry that the Fed is tightening too quickly, the message from nominal GDP growth is that monetary policy is actually becoming more accommodative (Chart 5, bottom panel). If the Fed continues to lift rates at its current pace of 25 basis points per quarter, the fed funds rate will be between 3.25% and 3.5% by the end of 2019. Nominal GDP would have to decelerate fairly substantially from its current 5.4% growth rate to signal restrictive monetary policy by then. Signal 2: Cyclical Spending Another indicator that has historically coincided with restrictive monetary policy and the cyclical peak in bond yields is when growth in the most interest-rate sensitive sectors of the economy (aka the cyclical sectors) slows as a proportion of overall growth (Chart 6). This is especially true for consumer spending on durable goods. Not only is it well below pre-crisis levels as a percent of GDP, but recent data revisions revealed that the personal savings rate is much higher than previously thought. The savings rate looks especially elevated relative to household wealth, which leaves room for spending to accelerate as it falls to more normal levels (Chart 7). Extremely high consumer confidence supports the view that the savings rate will decline (Chart 7, panel 2), and despite recent increases in interest rates and the price of gasoline, consumer spending on essentials is not yet excessive relative to income (Chart 7, bottom panel). Chart 6Signal 2: Cyclical Spending Signal 2: Cyclical Spending Signal 2: Cyclical Spending Chart 7The Outlook For Consumer Spending The Outlook For Consumer Spending The Outlook For Consumer Spending Cyclical spending - which includes consumer spending on durable goods, residential investment and nonresidential investment in equipment & software - is currently rising only slowly as a proportion of GDP, but it remains well below average historical levels. This suggests that further catch-up is likely. Much like consumer spending, residential investment also has a lot of room to play catch-up relative to pre-crisis levels (Chart 6, panel 3). However, growth in residential investment has waned in recent months (Chart 8). The slowdown is likely the result of the housing market coming to grips with higher mortgage rates. But while higher rates have definitely impaired affordability, housing remains quite cheap compared to history (Chart 8, panel 2). A further support for housing is that homebuilders are extraordinarily confident in the outlook (Chart 8, panel 3). This is for good reason. The outstanding housing supply is historically low and continues to contract relative to demand as increases in building permits fail to keep pace with household formation (Chart 8, bottom panel). Unlike consumer spending on durables and residential investment, nonresidential investment in equipment & software is roughly consistent with its average historical level as a proportion of GDP (Chart 6, bottom panel). But so far leading indicators are not pointing to a slowdown. On the contrary, surveys of new orders, capital expenditure plans and CEO confidence suggest that investment growth will stay strong for the next few quarters (Chart 9). At some point, given its higher level relative to GDP, investment could be the cyclical sector that first shows some evidence of weakness. But so far this is not the case. Chart 8The Outlook For Residential Investment The Outlook For Residential Investment The Outlook For Residential Investment Chart 9The Outlook For Non-Residential Investment The Outlook For Non-Residential Investment The Outlook For Non-Residential Investment Signal 3: Gold Chart 10Signal 3: Gold Signal 3: Gold Signal 3: Gold The final signal of restrictive monetary policy we consider is the price of gold. The widely accepted perception of gold as a long-run store of value makes it the ideal "anti-central bank" asset. In other words, gold tends to perform well when monetary policy is perceived to be turning more accommodative relative to its neutral level, and it tends to sell off when policy is perceived to be turning restrictive. Gold is also a useful addition to our suite of indicators because it is a price that is set in financial markets. Compared to our other two indicators which are based on economic data, financial market indicators can provide more of a leading signal. The trade-off, however, is that false signals are far more frequent. Most interestingly, we observe that fluctuations in the price of gold have preceded revisions to the Fed's estimate of the neutral fed funds rate in the post-crisis period (Chart 10). This seems entirely logical. The falling gold price in 2014/15 suggested that the market viewed Fed policy as becoming increasingly restrictive, but market expectations for the near-term path of rate hikes were roughly flat during this period (Chart 10, bottom panel). The only explanation is that investors were revising down their estimates of the neutral fed funds rate during this time, resulting in a de-facto policy tightening. Similarly, around the same time that gold put in a bottom in early 2016, neutral rate estimates from both investors and the Fed started to level-off around the 3% level, where they remain today. Going forward, the implication is that if gold were to break out of its trading range to the upside, it would send a strong signal that the Fed is perceived to be falling behind the curve. Such a price movement would make upward revisions to the neutral fed funds rate, and a higher cyclical peak in Treasury yields, more likely. Conversely, if gold continues its recent slide, it could signal that policy is turning restrictive more quickly than many expect. Bottom Line: Trends in our neutral rate indicators since February are sending conflicting signals. The economic data - nominal GDP growth and cyclical spending - have improved and suggest that we should think about a neutral fed funds rate above the current market consensus of 3%. On the other hand, the weakness in the price of gold suggests that investors view monetary policy as becoming increasingly restrictive. Investment Strategy How best to square these conflicting signals when formulating a portfolio strategy? For the time being we strongly advise investors to maintain below-benchmark duration on a cyclical (6-12 month) horizon. For one thing, the bond bear market remains in its first stage and the market is still not fully convinced that inflation will re-anchor itself around the Fed's 2% target. This alone argues for maintaining below-benchmark duration and an overweight allocation to TIPS versus nominal Treasuries, at least until long-dated TIPS breakevens reach our target range. Beyond that, while the true neutral fed funds rate remains uncertain, the market is only priced for a fed funds rate of 2.83% by the end of 2019. This is well below the range of 3.25% to 3.5% that will prevail if the Fed sticks to its current 25 basis points per quarter rate hike pace, and is consistent with a neutral rate that is well below 3% (Chart 11). Chart 11The Market Not Buying Into The Fed's Current Rate Hike Pace The Market Not Buying Into The Fed's Current Rate Hike Pace The Market Not Buying Into The Fed's Current Rate Hike Pace In other words, current market pricing tilts the risk/reward trade-off firmly in favor of below-benchmark duration, but we will keep a close eye on our neutral rate signals in the coming quarters to see if a more consistent message emerges. Stay tuned. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Valuation measures and technical indicators are widely followed market gauges, but neither set of metrics dependably warns of impending bear markets. Recessions might, however, as they almost always overlap with bear markets. A simple indicator using just three inputs - the yield curve, the index of leading economic indicators ("LEI") and the state of monetary policy - has correctly called all seven recessions of the last fifty years. Our recession indicator is timely as well as accurate. It turns red an average of six months ahead of a recession, aligning closely with the S&P 500's average cyclical peak. Our indicator is currently giving the all-clear signal, and we do not expect it will sound the alarm for at least another year. We do not foresee downgrading equities to underweight before then unless trade tensions take a turn for the worse, the S&P 500 rises parabolically, or the Fed moves its hiking timetable forward. Feature Investors who get the biggest macro questions right will generally find themselves on the right side of their performance benchmarks. The biggest question right now is how much longer the equity bull market will last. Trying to call a market top is folly, but "close enough" counts for recognizing the beginning of bear markets, and we are confident that our recession indicator gets close enough to provide a practical asset-allocation guide. While our indicator has moved closer to sounding the alarm over the last year, it is not yet signaling any immediate trouble.1 Can We Call Bear Markets? Neither we nor any other investor can consistently call market tops or bottoms with any degree of accuracy. The core problem is that doing so requires pinpointing the moment when a firmly established trend reverses for good - after all, a bear market begins the day a bull market concludes, and vice versa. As our colleague Martin Barnes has pointed out, there are no foolproof guides to identifying these inflection points in real time.2 The most popular rules of thumb - valuation measures, technical indicators and the calendar - are of no help at all in forecasting equity bear markets. Equities are surely more vulnerable when they trade at high multiples than when they trade at low multiples, but conventional valuation measures have been all over the map ahead of the eight bear markets that have occurred over the last 50 years (Box 1). The late-'80-to-early-'82 and 1990 bear markets occurred despite P/E, Shiller P/E and P/B multiples that were all comfortably below their long-run medians (Chart 1, second, third and fourth panels). The dot-com-bubble bear market occurred when every valuation metric was at an all-time high, to be sure, but our composite valuation indicator had spent three solid years in extremely overvalued territory (Chart 1, bottom panel) before the bear finally arrived. BOX 1 50 Years Of U.S. Equity Bear Markets For the purposes of this Special Report, we adhere to the classic definition of a bear market - a peak-to-trough closing price decline of at least 20% - and we confine our analysis to the last 50 years. The result is eight bear markets, as shown in Table 1 (we round the 1990 bear up to 20% from 19.9% but leave out the 1998 and 2011 corrections of 19.3% and 19.4%, respectively). Chart 3 shows the S&P 500, in log scale, with NBER-defined recessions shaded in gray and bear markets shaded in light red. The shaded chart brings two key observations to the fore: recessions and bear markets nearly always travel together (gray and light red only failed to overlap in the opening leg of the double-dip Volcker recessions and 1987's Black Monday), and bull markets (the white space in the chart) are more or less the S&P 500's default condition. The bear markets can be nasty, however, and a process that could help a manager sidestep even a portion of their declines could lead to significant outperformance over time. Technical indicators don't provide consistently reliable advance signals, either. Nearly all of the most overheated technical environments of the last 50 years (Chart 2, bottom panel) worked themselves off without tipping into full-fledged bear-market declines. Our composite technical indicator looks much more like a coincident indicator than a leading one. The calendar is of no help at all; since 1968, bull markets have lasted anywhere from two to nine years, and the current one, within two weeks and a percentage point of becoming the longest of the postwar era, may make it to ten. Chart 1Valuation Is A Poor Guide To Bear Markets ... Valuation Is A Poor Guide To Bear Markets ... Valuation Is A Poor Guide To Bear Markets ... Chart 2... And Technicals Aren't Much Better ... And Technicals Aren't Much Better ... And Technicals Aren't Much Better Table 1U.S. Equity Bear Markets, 1968 -2018 How Much Longer Can The Bull Market Last? How Much Longer Can The Bull Market Last? Chart 350 Years Of Recessions And Bear Markets 50 Years Of Recessions And Bear Markets 50 Years Of Recessions And Bear Markets Can We Call Recessions? Given the mingling of gray and red in Chart 3, a reliable recession indicator would be nearly as good as an equity bear market indicator. As noted above, only one recession (January to July 1980) passed without an accompanying bear market. Only the fall 1987 bear market occurred outside of a recession, though the two 19% corrections over our sample period also occurred ex-recessions. We submit that these three declines, accompanied by Black Monday's 20% one-day crash, the Russian crisis and the implosion of Long-Term Capital Management, and the U.S. debt-ceiling showdown and the euro crisis, were sparked by exogenous events that nearly defied prediction. Economists have a deservedly poor reputation for foretelling recessions. As the late economist John Kenneth Galbraith put it, "The only function of economic forecasting is to make astrology look respectable." Perhaps the Ph.Ds have overcomplicated matters by trying to pack too many variables into convoluted models. We have found that just three simple measures, in combination, have called all of the recessions in our 50-year sample without a single false positive. Our Recession Indicators Our first recession indicator is the orientation of the yield curve, defined as the sign of the difference between the 10-year Treasury bond yield and the 3-month T-bill rate.3 When the 3-month's rate exceeds the 10-year's yield, the curve is inverted and a recession typically follows. In our 50-year sample period, the yield curve has successfully called all seven recessions with just one false positive (Chart 4). As a standalone indicator, however, it tends to be overly eager, prematurely signaling the onset of a recession by an average of nearly twelve months (Table 2). Chart 4The Yield Curve Has Called 8 Of The Last 7 Recessions... The Yield Curve Has Called 8 Of The Last 7 Recessions... The Yield Curve Has Called 8 Of The Last 7 Recessions... Table 2Inverted Yield Curves, 1968 - 2018 How Much Longer Can The Bull Market Last? How Much Longer Can The Bull Market Last? Our second recession indicator is the sign of the year-over-year change in the index of the leading economic indicators ("LEI"). When the LEI contracts on a year-over-year basis, a recession typically ensues. As with the inverted yield curve, year-over-year contractions in the LEI have successfully called all of the recessions in our sample with just one false positive (Chart 5). The LEI signal tends to flip to red in a more timely fashion than the perpetually early yield curve, leading recessions by an average of six-plus months (Table 3). Chart 5...And So Have Leading Economic Indicators ...And So Have Leading Economic Indicators ...And So Have Leading Economic Indicators Table 3LEI Contractions, 1968 - 2018 How Much Longer Can The Bull Market Last? How Much Longer Can The Bull Market Last? The false positives go away once we combine the yield curve and the LEI into a single signal. To confirm that signal and make it more robust, we also consider the monetary policy backdrop. Over the nearly 60 years for which BCA's model calculates an estimate of the equilibrium fed funds rate, every recession has occurred when the fed funds rate has exceeded our estimate of equilibrium (Chart 6). In other words, recessions only occur when monetary policy settings are restrictive. In this case, the old market wisdom really is wise: expansions don't die of old age, they die because the Fed murders them. Chart 6Tight Policy Is A Necessary, But Not Sufficient, Recession Ingredient Tight Policy Is A Necessary, But Not Sufficient, Recession Ingredient Tight Policy Is A Necessary, But Not Sufficient, Recession Ingredient From Recession Indicator To Portfolio Strategy Tool Relative asset-class performance in previous bear markets, as detailed in the initial version of this study, published last summer by our Global ETF Strategy service,4 clearly argues for portfolio de-risking ahead of a recession. Investors would have benefited handsomely from overweighting bonds and cash at the expense of equities, overweighting countercyclical stocks and underweighting cyclicals, and overweighting Treasuries while underweighting high-yield corporates. Timing those defensive shifts is hardly clear-cut, however. The lead times between yield curve inversion, LEI contraction, the onset of restrictive monetary policy and the beginning of a recession vary from cycle to cycle. Fortunately for investors, waiting until all of the indicator components are in agreement dampens much of the variability in lead times. As Table 4 shows, the LEI signal is much less hasty than either the yield curve or the policy signals. It typically is the last component to flip, guiding the composite indicator to issue its recession signal just one week ahead of the S&P 500's average pre-recession peak. Sample averages mask in-sample variability, and the composite indicator does not march in lockstep with the S&P 500, but it is timely enough to have managed to catch about three-fourths of every bear market that coincided with a recession (Table 5). Table 4Lead Times For Indicator Components And Bear Markets How Much Longer Can The Bull Market Last? How Much Longer Can The Bull Market Last? Table 5Share Of Bear Markets Captured By Recession Indicator How Much Longer Can The Bull Market Last? How Much Longer Can The Bull Market Last? Why Bother? Some of our colleagues, duly noting forecasting's inherent difficulties, argue that there's little to be gained from attempting to narrow down the potential range of bear-market start dates. Fearful of the consequences of flying too close to the sun, they suggest that investors de-risk when enough common-sense-defying signs of a peak accumulate, and not worry about leaving some performance on the table. Such an approach has the benefits of being flexible and intuitive, but is difficult to apply consistently. Even proponents of former Supreme Court Justice Potter Stewart's legendary I-know-it-when-I-see-it obscenity standard have to concede that its parameters are arbitrary. It is also a concern that licking one's finger and holding it aloft is likely to put one squarely in the midst of the herd. The practicality of Justice Stewart's standard hinges on broad agreement: only if the distribution of opinions within the consensus is very narrow will a good deal of the community be satisfied with decisions based on it. Comity is the enemy of alpha, however, and an investor whose common sense is too common will wind up exiting the market too early and getting back into it too late, underperforming on both sides of the inflection point. The empirical record suggests that there's much to be lost from leaving too early. Bull markets tend to end with a bang, not a whimper (Chart 7 and Table 6). It is unlikely that investors who are willing to forego some returns in the name of security on the way up have the temperament to get back in at the beginning stages of the next rally. Factor in our view that public-market returns will be thin gruel over the next five to ten years compared to what investors have enjoyed since 1982, and one can make a case for trying to capture as much of the current bull market's gains as possible. Chart 7Sprinting To The Finish Line Sprinting To The Finish Line Sprinting To The Finish Line Table 6Finishing In Style How Much Longer Can The Bull Market Last? How Much Longer Can The Bull Market Last? Investment Implications Our composite recession indicator has done an excellent job of flagging recessions in advance. As recessions and equity bear markets are such steadfast companions, the composite recession indicator holds considerable promise as a tool to help investors capture a greater share of bull-market gains while helping them skirt some bear-market losses. Given a flattening but still positively-sloped yield curve, booming year-on-year growth in the LEI, and a policy rate that looks to be at least a year from becoming restrictive, we see no recession on the horizon. Unless trade negotiations fall apart, the S&P 500 melts up, or the Fed's rate-hiking guidance gets much more aggressive, we do not expect that investors will have cause to put their recession/bear market game plan into place for at least another year. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 This Special Report is adapted from the August 16, 2017 Global ETF Strategy Special Report, "A Guide To Spotting And Weathering Bear Markets," available at etf.bcaresearch.com. 2 Please see BCA Research Special Reports, "Timing The Next Equity Bear Market," and "Timing Equity Bear Markets," published January 24, 2014 and April 6, 2011, respectively, available at www.bcaresearch.com. 3 We use the 3-month/10-year segment instead of the more common 2-year/10-year because the 3-month bill is a cleaner proxy for short rates than the 2-year note, which incorporates estimates of the Fed's future actions. 2s/10s also fail to measure up empirically, inverting even earlier than the habitually premature 3-month/10-year. 4 August 16, 2017 Global ETF Strategy Special Report, "A Guide To Spotting And Weathering Bear Markets."

Feature GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of July 31, 2018. The quant model lifted its U.S. allocation to be in line with the benchmark weight at the expense of Spain. No major changes in other country weights, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights GAA Quant Model Updates GAA Quant Model Updates As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 59 bps in July, largely driven by Level 2 model which outperformed its benchmark by 146 bps. Level 1 model slightly unperformed its MSCI world benchmark by 5 bps in July. Since going live, the overall model has outperformed its benchmarks by 132 bps, driven by the Level 2 outperformance of 375 bps offset by the 2 bps of Level 1 underperformance. Table 2Performance (Total Returns In USD %) GAA Quant Model Updates GAA Quant Model Updates Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) GAA U.S. Vs. Non U.S. Model (Level 1) GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Mode (Chart 4) is updated as of July 31, 2018. Following the developments on the trade front and increasing worries of a growth slowdown, the model continues to maintain a defensive bias with an aggregate overweight of 5.8% relative to cyclical sectors. The relative tilts within cyclicals and defensives remain the same as the previous month. However, both discretionary and financials are going through unfavorable technical and momentum indicators. Energy remains the only resource based sector with an overweight, primarily driven by attractive long-term valuations. Chart 4Overall Model Performance Overall Model Performance Overall Model Performance Table 3Allocations GAA Quant Model Updates GAA Quant Model Updates Table 4Performance Since Going Live GAA Quant Model Updates GAA Quant Model Updates For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," dated July 27, 2016, available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Aditya Kurian, Senior Analyst adityak@bcaresearch.com

The Golden Rule: During the next 12 months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market? In this report we demonstrate that an investor who can correctly answer that question will very likely make the right bond market call. We call this framework for market analysis the golden rule of bond investing. Exceptions: We identify a few periods when applying the golden rule correctly would not have led to the right market call. Such periods are rare, but they tend to occur when the market "fights the Fed". One such episode occurred as recently as 2017. Total Return Forecasts: We use the golden rule framework to generate total return forecasts for Treasury indexes of all different maturities and many different spread product indexes. It's easy to get lost in the sea of financial market news. Last week alone saw the suggestion of additional tariffs, weak housing data, strong consumer data, falling commodity prices and steep Chinese currency depreciation. It's not always obvious what's important for bond markets and what isn't. While there is no miracle solution to this problem, we propose one helpful question that investors should always ask themselves to help discern the signal from the noise. During the next 12 months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market? If you are able to answer that question correctly you will make the correct bond market call most of the time, and any new piece of information should be judged on how it impacts your answer. In fact, the framework of viewing everything through the lens of answering the above question works so well that we call it the golden rule of bond investing. In this Special Report we illustrate the empirical success of the golden rule. We also draw on historical evidence to consider periods when the rule failed. Finally, we translate the golden rule into a method for forecasting total returns, and we generate total return forecasts for many different bond indexes, encompassing both Treasuries and spread product. Testing The Golden Rule's Performance Chart 1 on page 1 shows how well the golden rule has worked during the past 28 years. The top panel shows the 12-month fed funds rate surprise - the difference between the expected change in the fed funds rate that was priced into the market at the beginning of the 12-month investment horizon and the change in the fed funds rate that was ultimately delivered. A reading above zero indicates that the market expected a larger increase (or smaller decrease) than actually occurred, a reading below zero indicates that the market expected a smaller increase (or larger decrease) than actually occurred. The bottom panel shows 12-month excess returns from the Bloomberg Barclays Treasury Master Index relative to a position in cash. Chart 1The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record If the golden rule works, then dovish fed funds rate surprises (positive values in Chart 1, shown shaded) will coincide with positive Treasury excess returns, and vice-versa. Chart 1 shows that this has indeed generally been the case. Digging a little deeper, we find a strong positive relationship between 12-month Treasury excess returns and the 12-month fed funds rate surprise (Chart 2) and a similarly strong relationship using Treasury index price return instead of the excess return versus cash (Chart 3). Dovish fed funds rate surprises coincide with positive 12-month Treasury excess returns 87% of the time for an average excess return of +3.9%. They also coincide with positive Treasury price returns 76% of the time for an average price return of +2.1%. Hawkish surprises coincide with negative 12-month Treasury excess returns 61% of the time for an average excess return of -0.3%. They also coincide with negative Treasury price returns 72% of the time for an average price return of -1.9% (Table 1). Chart 2Treasury Index Excess Return & ##br##Fed Funds Rate Surprises (1990 - Present) The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Chart 3Treasury Index Price Return & ##br##Fed Funds Rate Surprises (1990 - Present) The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Table 112-Month Treasury Index Returns And Fed Funds Rate Surprises (1990 - Present) The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Total Treasury returns also factor in coupon income, and are therefore often positive even when the price return is negative. Still, Table 1 shows that Treasury index total returns average +7.1% in periods with a dovish fed funds rate surprise and only +3.4% in periods with a hawkish surprise. Further, 65% of negative total return periods occurred when there was a hawkish fed funds rate surprise. Of course, the golden rule is no panacea. The results presented above are impressive, but they assume that investors are able to correctly predict whether the market is over- or under-pricing the Fed. Making that determination remains a tall order. The key insight to be gleaned from the golden rule is that if a piece of information does not alter your opinion about the future path of the fed funds rate relative to expectations, then it should probably be ignored. The golden rule is certainly not the "be all and end all", but it is a very useful first step. Learning From Failures While Table 1 shows that correctly determining the 12-month fed funds rate surprise allows us to make the correct bond market call most of the time, it also shows that it doesn't always work. To understand why the golden rule might fail, it is useful to think about why it works in the first place. To do this, let's first consider that any Treasury yield can be thought of as consisting of three components: Treasury Yield = Fed Funds Rate + Expectations For Future Change In The Fed Funds Rate + Term Premium Based on this formula, it is obvious that if rate expectations and the term premium are held constant, a higher fed funds rate translates directly into a higher Treasury yield, and vice-versa. This is one reason why the fed funds rate surprise correlates with Treasury returns. The second reason that the fed funds rate surprise correlates with Treasury returns is that the expectations component of the above formula also tracks the fed funds rate surprise. In other words, investors are more likely to revise their rate expectations higher when the Fed is already in the process of delivering hawkish surprises. They are also more likely to revise their rate expectations lower when the Fed is delivering dovish surprises. This dynamic is illustrated in Chart 4. The top panel shows the correlation between the 12-month fed funds rate surprise and changes in rate expectations as measured by our 12-month fed funds discounter. The two lines are mostly positively correlated, though they do occasionally diverge. The largest divergences appear near inflection points in monetary policy - e.g. when the Fed switches from hiking rates to cutting. Such inflection points are often prompted by economic recession. Chart 4When The Golden Rule Doesn't Work When The Golden Rule Doesn't Work When The Golden Rule Doesn't Work The bottom panel of Chart 4 shows the much tighter correlation between the 12-month fed funds rate surprise and the change in the average yield on the Treasury Master index. These two lines also occasionally diverge, but only during periods when rate expectations move strongly in the opposite direction of what is suggested by the rate hike surprise. Crucially, the abnormal change in rate expectations has to be so large that it more than offsets the impact from the change in the fed funds rate itself. Such periods are rare, though we did experience one as recently as last year. Chart 5The 2017 Example The 2017 Example The 2017 Example The 2017 Episode Treasury returns in 2017 provide a textbook example of one of the rare periods when the golden rule failed. The Treasury Master Index returned +1.5% in excess of cash, even though the Fed lifted rates 25 bps more than the market expected at the beginning of the year. The reason for the divergence is that even though the Fed was in the process of lifting rates by more than what the market anticipated, the market continued to doubt the Fed's resolve and revised its expectations lower. At the beginning of 2017 the market was priced for 51 bps of rate hikes for the year. Then, just as the Fed started to lift rates more quickly than that expectation would suggest, core inflation plunged (Chart 5). The market started to price-in that the Fed would react to falling inflation by turning more dovish, but as it revised its expectations lower the Fed continued to hike. The end result is that the impact of the downward revision to rate hike expectations more than offset the upward pressure on yields from Fed rate hikes, and the Treasury index outperformed cash for the year. Forecasting Total Returns One final application of the golden rule is that it can be used as a framework for generating total return forecasts for different bond indexes. To illustrate how this is achieved we will walk through how we calculate such a forecast for the Treasury Master Index. First, we note that the current reading from our 12-month fed funds discounter is 79 bps. This means that the market expects 79 bps of Fed rate hikes during the next 12 months. If we assume that the Fed will lift rates by 100 bps during the next 12 months, then we have a hawkish fed funds rate surprise of 21 bps. As an aside, Chart 6 shows that we have consistently witnessed hawkish fed funds rate surprises since mid-2017, and our 12-month discounter has increased, as is typically the case. But this also means that the bar for further hawkish rate surprises is now much higher. Chart 6Market Has Underestimated ##br##The Fed In Recent Years Market Has Underestimated The Fed In Recent Years Market Has Underestimated The Fed In Recent Years We already demonstrated the strong correlation between the 12-month fed funds rate surprise and the 12-month change in the average yield from the Treasury index (see Chart 4). This allows us to translate our assumed fed funds rate surprise into an expected change in the index yield. In this case, that expected change in yield is +19 bps. With an expected yield change in hand, it is relatively simple to calculate an expected total return using the index's yield, duration and convexity: Expected Total Return = Yield - (Duration*Expected Change In Yield) + 0.5*Convexity*E(ΔY2) E(ΔY2) = 1-year trailing estimate of yield volatility In our scenario where we assume the Fed lifts rates by 100 bps during the next 12 months, the above formula spits out an expected total return of +1.60% for the Treasury Master Index. Table 2 shows total return forecasts using this same method but with many different rate hike assumptions. For example, if we assume only 50 bps of Fed rate hikes during the next 12 months we get an expected Treasury Index total return of +3.37%. Table 2 also displays total return forecasts for different maturity buckets within the Treasury Master index. These forecasts are all generated using the same method, but we correlate the 12-month fed funds rate surprise with different Treasury yields in each case. One caveat here is that the correlation between the fed funds rate surprise and the change in Treasury yield declines as we move into longer maturities (Appendix A). This is because long-dated yields are less directly connected to near-term changes in the fed funds rate. As such, there is more uncertainty surrounding the total return forecasts for long maturity sectors. Table 2Treasury Index Total Return Forecasts The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Spread Product Total Return Forecasts With one additional assumption we can also apply our return forecasting method to different spread product indexes. That additional assumption is for the expected change in the average index spread. Using Table 3, you can simply pick a column based on the number of Fed rate hikes you expect during the next 12 months and pick a row based on whether you think spreads will remain flat, widen or tighten. Table 3Spread Product Total Return Forecasts The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing For example, if the Fed lifts rates by 100 bps during the next 12 months and investment grade corporate bond spreads stay flat, we would expect investment grade corporate bond index total returns of +2.9%. For each sector, the spread widening scenario assumes that the average index spread widens to its highest level since the beginning of 2016 and the spread tightening scenario assumes the average index spread tightens to its lowest level since the beginning of 2016. All the spread scenarios are depicted graphically in Appendix B. For the High-Yield sector we make the additional adjustment of subtracting expected 12-month default losses from the average index yield. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Appendix A Chart 7Change In 1-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Corporate Bond Spread Scenarios Corporate Bond Spread Scenarios Chart 8Change In 2-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Government-Related Spread Scenarios Government-Related Spread Scenarios Chart 9Change In 3-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Structured Product Spread Scenarios Structured Product Spread Scenarios Chart 10Change In 5-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Chart 11Change In 7-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Chart 12Change In 10-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Chart 13Change In 30-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Appendix B Chart 14Corporate Bond Spread Scenarios Corporate Bond Spread Scenarios Corporate Bond Spread Scenarios Chart 15Government-Related Spread Scenarios Government-Related Spread Scenarios Government-Related Spread Scenarios Chart 16Structured Product Spread Scenarios Structured Product Spread Scenarios Structured Product Spread Scenarios

With a number of our sentiment indicators breaking out (all panels), we took the opportunity to refresh our cyclical indicators in this week's Cyclical Indicator Update. Some highlights are our S&P industrials and our S&P financials cyclical indicators which are pushing to new highs despite headwinds from a rising U.S. dollar and a flattening yield curve, respectively, underscoring our overweight recommendations for both sectors. On the negative front, our S&P real estate indicator has maintained its three-year slide and remains very near all-time lows; we reiterate our underweight recommendation in that sector. Please see this week's Cyclical Indicator Update for more details. Cyclical Indicator Update Cyclical Indicator Update

Please note that our next publication will be a joint special report with BCA’s Geopolitical Service that will be published on Wednesday, August 1st instead of our usual Monday publishing schedule. Further, there will be no publication on Monday, August 6th. We will be returning to our normal publishing schedule thereafter. Highlights We continue to explore a cyclical over defensive portfolio bent, and the capex upcycle along with higher interest rates are our key investment themes for the remainder of the year. A number of sentiment indicators have broken out (Chart 1), and our sense is that the SPX will also hit fresh all-time highs in the coming quarters. While buybacks vaulted to uncharted territory in Q1/2018 (Chart 2), our profit growth model suggests that EPS will continue to expand at a healthy clip for the rest of the year (Chart 3) and 10% EPS growth is achievable in calendar 2019. Positive macro forces remain in place with the ISM - manufacturing and non-manufacturing - surveys reaccelerating. Beneath the surface, the new-orders-to-inventories ratio is gaining traction and even the trade-related subcomponents (new export orders and imports) are ticking higher. High backlogs also suggest that SPX revenue growth will remain upbeat (Chart 4). Non-farm payrolls are expanding on a month-over-month basis for 93 consecutive months, a record (Chart 5), at a time when the real fed funds rate remains near the zero line (Chart 6). As a result, the economy is overheating. Corporate selling price inflation is skyrocketing, according to our gauge, with our diffusion index catapulting to multi-decade highs. This represents a positive margin backdrop as wage inflation remains muted (Chart 7). While at first sight, valuations appear dear, a simple thought experiment suggests that soon they will deflate1 (Chart 8). And, on a forward price-to-earnings-to-growth (PEG) basis, valuations have sunk to one standard deviation below the historical mean (Chart 9). Two key risks that we are closely monitoring that can put our cyclically positive equity market view offside are: a sustained rise in the U.S. dollar infiltrating profit growth (Chart 10), and corporate balance sheet degradation short-circuiting the broad equity market (Chart 11). Chart 1Sentiment Is Breaking Out Sentiment Is Breaking Out Sentiment Is Breaking Out Chart 2Buybacks Are Soaring Buybacks Are Soaring Buybacks Are Soaring Chart 3Earnings Growth Hasnt Slowed... Earnings Growth Hasnt Slowed... Earnings Growth Hasnt Slowed... Chart 4...And Backlogs Suggest They Wont ...And Backlogs Suggest They Wont ...And Backlogs Suggest They Wont Chart 5Record Jobs Growth... Record Jobs Growth... Record Jobs Growth... Chart 6...And Still-Loose Monetary Policy ...And Still-Loose Monetary Policy ...And Still-Loose Monetary Policy Chart 7Wage Growth Is Trailing Pricing Power Flexing Its Muscles Wage Growth Is Trailing Pricing Power Flexing Its Muscles Wage Growth Is Trailing Chart 8The Market Is Not That Expensive... The Market Is Not That Expensive... The Market Is Not That Expensive... Chart 9...By Several Measures ...By Several Measures ...By Several Measures Chart 10A Strong Dollar Is A Risk A Strong Dollar Is A Risk A Strong Dollar Is A Risk Chart 11Corporate Sector Leverage Is Too High Corporate Sector Leverage Is Too High Corporate Sector Leverage Is Too High Feature S&P Industrials (Overweight) While our industrials CMI remains very near 20-year highs, it has lost its upward momentum this year due almost entirely to the strength of the U.S. dollar, though sliding global PMI surveys have also started to weigh (second panel, Chart 13). Combined with heightened fears of a trade war, the internationally geared S&P industrials have come under pressure. Chart 12S&P Industrials (Overweight) S&P Industrials S&P Industrials Chart 13Positive Industrial Growth Backdrop Positive Industrial Growth Backdrop Positive Industrial Growth Backdrop Still, demand growth has been resilient and continues to soar as the capex upcycle has not yet run its course and the implications for top line and profit growth are unambiguously positive (third and bottom panels, Chart 13). Should some let up emerge from the current break down of international trade, we would expect earnings to resume their role as the fundamental driver for industrials. Our valuation gauge has rapidly declined this year as extreme bearishness is not reflected by the strong profit backdrop. From a technical perspective, S&P industrials have been the most oversold since the Great Recession. S&P Energy (Overweight, High-Conviction) Our energy CMI has continued to push higher from the extremely depressed levels of 2016 and 2017. Still, the much better cyclical environment has started to get reflected in relative share prices with the S&P energy index besting all other GICS1 sectors in Q2. We recently refined our energy sector sub-surface positioning that sustains the broad energy complex in the overweight column, and we reiterated its high-conviction status. We believe the steep recovery in underlying commodity prices, which the market has thus far failed to show much confidence in, has started to restore some semblance of normality in the exploration & production (E&P) stocks space (top panel, Chart 15). Chart 14S&P Energy (Overweight, High Conviction) S&P Energy S&P Energy Chart 15A Capex Boom As Oil Reignites A Capex Boom As Oil Reignites A Capex Boom As Oil Reignites Similar to the broad energy complex that integrateds dominate, oil & gas E&P producers are a capital expenditure upcycle play, which remains a key BCA theme for the year (second panel, Chart 15). Accordingly, we raised the S&P oil & gas E&P index to an overweight stance. Simultaneously, weakening crack spreads (third panel, Chart 15) and rising gasoline inventories (bottom panel, Chart 15) have given us cause for concern for refiners. As a result, we trimmed the S&P oil & gas refining & marketing index to underweight, though this did not shake our high-conviction overweight position on the broad S&P energy index. Our Valuation Indicator (VI) remains near deeply undervalued territory, and indicates an attractive entry point for fresh capital. Our Technical Indicator (TI) has fully recovered from oversold levels and now sends a neutral message. S&P Financials (Overweight) The pace of improvement in our financials cyclical macro indicator (CMI) has not abated. However, the usual tight correlation between the CMI and the relative performance of the S&P financials index has broken down. An important culprit has been the heavyweight S&P banks sub-index and its transition from a correlation with the 10-year UST yield and toward the 10/2 yield curve slope earlier this year (top and second panels, Chart 17). While the former is still up year-over-year, the latter has continued to flatten and the result is likely a squeeze on banks' net interest margins, a key profit driver; we recently booked gains of 6% and removed it from the high-conviction overweight list, and the S&P banks index is currently on downgrade watch. Chart 16S&P Financials (Overweight) S&P Financials S&P Financials Chart 17Growth And Credit Quality Offset A Flat Yield Curve Growth And Credit Quality Offset A Flat Yield Curve Growth And Credit Quality Offset A Flat Yield Curve Still, our key three reasons for being overweight the S&P financials index remain unchanged. Rising yields and the accompanying higher price of credit are a boon to financials and a core BCA theme for 2018 remains higher interest rates. The global capex upcycle, another of BCA's key themes for 2018, has paused for breath, though it has been replaced by soaring U.S. demand. This exceptional willingness of U.S. CEOs to expand their balance sheets should mean capital formation will proceed at well above-trend pace, and further underpin C&I loan growth (third panel, Chart 17). Lastly, a low unemployment rate drives both expanding consumer credit and much better credit quality. At present, the unemployment rate is testing all-time lows, sending an unambiguously positive message for financials profitability (bottom panel, Chart 17). Market bearishness has more than offset the positive fundamentals and the S&P financials index has underperformed in 2018; the result has been a steep fall in our VI to nearly one standard deviation below normal. The bearishness is also reflected in our TI which has recently collapsed into oversold territory. S&P Consumer Staples (Overweight) Our consumer staples CMI has moved sideways since our last update, near a depressed level. This is reflected in the share price performance; defensives in general and staples in particular have been woefully unloved this year. However, we believe positive macro undercurrents have made bargain basement prices in consumer staples an exceptional deal, particularly for investors willing to withstand short term volatility for a long-term investment gain. We recently pointed out that, while non-discretionary demand is losing share versus overall outlays, spending on essentials as a percentage of disposable income is gaining steam. The bearish read on this would be that 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 (top panel, Chart 19). Chart 18S&P Consumer Staples (Overweight) S&P Consumer Staples S&P Consumer Staples Chart 19Staples Are Poised For A Recovery Staples Are Poised For A Recovery Staples Are Poised For A Recovery Meanwhile consumer staples exports are flying in the face of a rising U.S. dollar, which has typically presaged relative earnings gains (second panel, Chart 19). Considering the already-strong industry return on equity, any relative earnings gains should result in a valuation rerating (third panel, Chart 19). Both our VI and TI concur; as they are both more than a standard deviation below fair value. S&P Health Care (Neutral) Earlier this month, we lifted the S&P pharma and biotech indexes to neutral and, given that these sectors command roughly a 50% weighting in the S&P health care sector, these upgrades also lifted the health care sector to a neutral portfolio weighting. Sentiment has moved squarely against the sector and the bar for upward surprises has been lowered enough to create fertile ground for upside surprises. As shown in the second panel of Chart 21, health care long-term EPS growth expectations have never been lower in the history of the I/B/E/S/ data. This is contrarily positive, particularly given how our VI has remained under pressure and our TI has sunk. Chart 20S&P Health Care (Neutral) S&P Health Care S&P Health Care Chart 21Peak Pessimism In Health Care Peak Pessimism In Health Care Peak Pessimism In Health Care Still, our health care CMI has been treading water at relatively low levels, but our S&P health care earnings model suggests that at least a bottom in profit growth has formed (bottom panel, Chart 21). S&P Technology (Neutral) We lifted the S&P technology index to neutral earlier this year to capitalize on one of BCA's key themes for 2018: synchronized global capex upcycle, of which the broad tech sector is a core beneficiary (second panel, Chart 23).2 Software and tech hardware & peripherals are the two key sub-indexes we prefer and have also put on our high-conviction overweight list. Chart 22S&P Technology (Neutral) S&P Technology S&P Technology Chart 23A Capex Upcycle Should Sustain High Valuations A Capex Upcycle Should Sustain High Valuations A Capex Upcycle Should Sustain High Valuations There is still pent up demand for tech spending that is being unleashed following over a decade of severe underinvestment. In addition, consumer spending on tech goods is also at the highest level since the history of the data, underscoring that end demand is upbeat (third panel, Chart 23). On the global demand front, EM Asian exports are climbing at the fastest clip in ten years; tech sales and EM Asian exports are historically joined at the hip and the current message is positive (bottom panel, Chart 23). The technology CMI has also turned positive this year after falling for the previous three, though an appreciating dollar and higher interest rates continue to suppress an otherwise exceptionally robust macro environment. Valuations, while still in the neutral zone, have reached their highest level in a decade. This may prove risky should inflation mount faster than expected; a de-rating phase in technology would likely follow. Our TI is in overbought territory, though it has been at this high level for several years. S&P Utilities (Neutral) Our utilities CMI appears to have found a bottom, arresting the linear downtrend of the previous decade. Declining earnings have steadied out as the industry has found some discipline; new investment has declined and turbine & generator inventories have ticked up (second panel, Chart 25). The result of declining investment has been a slight improvement in capacity utilization, albeit still at a relatively low level (third panel, Chart 25). Chart 24S&P Utilities (Neutral) S&P Utilities S&P Utilities Chart 25Earnings Are Looking For A Bottom Earnings Are Looking For A Bottom Earnings Are Looking For A Bottom The uptick in capacity utilization has driven a surge in industry pricing power, despite flat natural gas prices which have historically been the industry price setter; this could be the precursor to a recovery in sector earnings (bottom panel, Chart 25). Still, as with other defensive sectors, utilities have underperformed cyclical sectors in the last year; this has been exacerbated by utilities trading as fixed income proxies. Our VI does not provide much direction as it has been in the neutral zone for the past year, underscoring our benchmark allocation recommendation. Our TI fell steeply earlier this year, though it has recovered and offers a neutral reading. S&P Materials (Neutral) The materials CMI has come under pressure as the Fed has continued to tighten monetary policy. A further selloff in bonds remains the BCA view for 2018, implying rising real rates will weigh on the sector for at least the remainder of the year. The heavyweight chemicals component of the materials index typically sees earnings (and hence stock prices) underperform as real interest rates are moving higher (real rates shown inverted, top panel, Chart 27). Chart 26S&P Materials (Neutral) S&P Materials S&P Materials Chart 27This Time Is Different For Chemicals This Time Is Different For Chemicals This Time Is Different For Chemicals On the operating front, chemicals sector productivity has made solid gains over the past year and the sell-side bearishness for much of the past decade has finally reversed (second panel, Chart 27). Further, overcapacity, the usual death knell of the chemicals cycle, seems to be a thing of the past as the industry has massively scaled back on capital deployment on the heels of a mega global M&A cycle (third panel, Chart 27). Net, operating improvements might offset macro headwinds. Our VI echoes this neutral message and sits on the fair value line. Our TI is somewhat more bullish and is edging toward an oversold position. S&P Real Estate (Underweight) Our real estate CMI looks to have found a bottom earlier this year, though the only time it has been worse was during the Great Financial Crisis. Real estate stocks are continuing to behave like fixed income proxies, as they have since the overhang from the GFC gave way to a yield focus (top panel, Chart 29). In the context of a tightening monetary backdrop, we would need compelling operating or valuation reasons to maintain even a benchmark allocation in the sector; these are both absent. Chart 28S&P Real Estate (Underweight) S&P Real Estate S&P Real Estate Chart 29Dark Clouds Forming Dark Clouds Forming Dark Clouds Forming On the operating front, the commercial real estate (CRE) sector is waving a red flag. The occupancy rate has clearly crested and rents are headed down with it, warning of declining sector cash flows (second panel, Chart 29). While CRE credit quality shows no signs of deterioration, at this stage of the cycle and given weak industry profit fundamentals we would caution against extrapolating such good times far into the future (third panel, Chart 29). We recently initiated a trade to capitalize on relative CRE weakness by going long the S&P homebuilding index/short the S&P REITs index.3 Such overwhelming bearishness would suggest the sector would be relatively cheap, but our VI suggests that REITs are fairly valued. Our TI is has been unwinding an oversold position and is now in neutral territory. S&P Consumer Discretionary (Underweight) In early March, we identified three key factors that we expected to weigh on the consumer discretionary sector: a rising fed funds rate, quantitative tightening and higher prices at the pump. As highlighted in Chart 31, all of these factors remain intact and underlie the two-year decline in the consumer discretionary CMI. Chart 30S&P Consumer Discretionary (Underweight) S&P Consumer Discretionary S&P Consumer Discretionary Chart 31The Amazon Effect The Amazon Effect The Amazon Effect Further, 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 (fed funds rates shown inverted, top panel, Chart 31). 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 31). Meanwhile, our VI has broken out to nearly its highest level ever which we believe is largely a function of the decreasing diversification of the S&P consumer discretionary index as AMZN now represents nearly a quarter of its market value, and about to get even larger in the upcoming introduction of the Communications Services GICS1 sector, but only comprises 3% of this sector's net income. Our TI agrees with our VI and is well into overbought territory. S&P Telecommunication Services (Underweight) Our telecom services CMI, bounced off its 30-year low earlier this year, but not nearly enough for a bullish position to be established. Rather, our bearish thesis remains unchanged: A combination of still-tepid pricing power weighing on earnings (second panel, Chart 33), weak consumer spending (bottom panel, Chart 33) and higher Treasury yields (which are negatively correlated with high-dividend yielding telecom services stocks, top panel, Chart 33), should all keep relative performance suppressed. Chart 32S&P Telecommunication Services (Underweight) S&P Telecommunication Services S&P Telecommunication Services Chart 33Pricing Power Is Still On Hold Pricing Power Is Still On Hold Pricing Power Is Still On Hold Valuations have fallen significantly - our VI continues to touch new lows - and our TI has been indicating a persistently oversold position, but we think the industry is in a de-rating phase, implying the new valuation paradigm has a degree of permanence. Size Indicator (Favor Large Vs. Small Caps) Our size CMI has fallen back to the boom/bust line. Keep in mind that this CMI is not designed as a directional trend predictor, but rather as a buy/sell oscillator; the current message is neutral. Despite the neutral CMI reading, we downgraded small caps earlier this year,4 and moved to a large cap preference, based on the diverging (and unsustainable) debt levels of small caps vs. their large cap peers (top and second panels, Chart 35). We expect the divergence in leverage and stock price to be rationalized as it usually has: via a fall in the latter. Chart 34Size Indicator (Favor Large Vs. Small Caps) Style View Style View Chart 35Small Cap Leverage Is Critical Small Cap Leverage Is Critical Small Cap Leverage Is Critical Our call has thus far been slightly offside as small caps have been outperforming: investors have sought the trade-friction free shelter that small caps offer compared with internationally exposed large caps. Extreme optimism also reigns throughout the small cap world (third panel, Chart 35). However, we continue to think a turn is merely a matter of time; the NFIB's "good time to expand" reading is at its highest level in the history of the survey (bottom panel, Chart 35) which means small cap CEOs are more likely to push their already-stretched balance sheets closer to the breaking point. Our TI is telling us that small caps are overbought, but the VI continues to offer a neutral message. Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Insight Report, "How Expensive Is The SPX?" dated July 6, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Buying Opportunity," dated April 9, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com.

Highlights Rising non-OPEC production and the Trump administration's successful efforts at jawboning OPEC into increasing oil production - including a not-so-subtle threat that American protection of the Cartel's Gulf Arab producers would be withheld if production weren't ramped - will keep oil prices under pressure in 2H18. Markets could become chaotic in 2019: Iran's capacity to close the Strait of Hormuz - discussed below in this Special Report written jointly by BCA's Commodity & Energy Strategy and Geopolitical Strategy - cannot be dismissed. An extended closure of the Strait - our most dire scenario - could send prices on exponential trajectories: In one simulation, above $1,000/bbl. We are keeping our forecast for 2H18 Brent at $70/bbl, unchanged from June, and lowering our 2019 expectation by $2 to $75/bbl. We expect WTI to trade $6/bbl below Brent. Rising geopolitical uncertainty will widen the range in which oil prices trade - i.e., it will lift volatility. Energy: Overweight. We are moving to a tactically neutral weighting, while maintaining our strategic overweight recommendation. We are closing our Dec18 Brent $65 vs. $70/bbl call spread but are retaining long call-spread exposures in 2019 along the Brent forward curve. Base Metals: Neutral. Contract renegotiations at Chile's Escondida copper mine are yet to be resolved. The union rejected BHP's proposal late last week, and threatened to vote for a strike unless substantial changes were made. Failure to reach a labor deal at the Escondida mine led to a 44-day strike last year, and an extension of the contract. This agreement expires at the end of this month. Precious Metals: Neutral. Increasing real rates in the U.S. and a stronger USD are offsetting safe-haven demand for gold, which is down 10% from its 2018 highs of $1360/oz. Ags/Softs: Underweight. The Chinese agriculture ministry lowered its forecast for 2018/19 soybean imports late last week to 93.85 mm MT from 95.65 mm MT. This is in line with its adjustment to consumption this year, now forecast at 109.23 from 111.19 mm MT. Tariffs are expected to incentivize Chinese consumers to prefer alternative proteins - e.g., rapeseed - and to replace U.S. soybean imports with those from South America. Feature U.S. President Donald Trump jawboned OPEC Cartel members - particularly its Gulf Arab members - into raising production. This was accompanied with a none-too-subtle threat implying continued U.S. protection of the Gulf Arab states was at risk if oil production were not lifted.1 OPEC, particularly KSA, responded by lifting production and pledging to keep it at an elevated level. In addition, non-OPEC production growth has been particularly strong this year, and will remain so. These combined production increases will contribute to a modest rebuilding of inventories in 2H18, as markets prepare for the loss of as much as 1 MMb/d of Iranian oil exports beginning in November (Chart of the Week). Chart of the WeekOECD Inventory##BR##Depletion Will Slow OECD Inventory Depletion Will Slow OECD Inventory Depletion Will Slow Chart 2Global Balances Will Loosen,##BR##As Higher Supply Meets Steady Demand Global Balances Will Loosen, As Higher Supply Meets Steady Demand Global Balances Will Loosen, As Higher Supply Meets Steady Demand Estimated 2H18 total OPEC production rose a net 130k b/d, led by a 180k b/d increase on the part of KSA, which will average just under 10.6 MMb/d in the second half of the year. Non-OPEC production for 2H18 was revised upward by 180k b/d in our balances models - based on historical data from the U.S. EIA and OPEC - led by the U.S. shales, which were up close to 700k b/d over 1Q18 levels. This led to a combined increase in global production of 310k b/d in 2H18. With demand growth remaining at 1.7 MMb/d y/y for 2018 and 2019, we expect the higher output from OPEC and non-OPEC sources to loosen physical balances in 2H18 (Chart 2 and Table 1).2 Table 1BCA Global Oil Supply - Demand Balances (MMb/d) (Base Case Balances) U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic In and of itself, increased production will reverse some of the depletion of OECD inventories targeted by OPEC 2.0 in its effort to rebalance the market. All else equal, this would be bearish for prices. However, we are keeping our price forecast for 2H18 unchanged from last month - $70/bbl for Brent in 2H18 - and lowering our expectation for Brent to $75/bbl in 2019. This adjustment in next year's expectation reflects our belief that this round of increased production by OPEC 2.0 arguably is being undertaken specifically to rebuild storage ahead of the re-imposition of export sanctions by the U.S. against Iran. Re-imposing sanctions unwinds a deal negotiated by the U.S. and its allies in 2015, which relaxed nuclear-related sanctions against Iran in exchange for commitments to scale back its involvement across the Middle East in the affairs of Arab states with restive Shia populations.3 The re-imposition of sanctions by the U.S. against Iran has set off a round of diplomatic barbs and thrusts on both sides. President Trump declared he wanted Iran's oil exports to go to zero, which was followed by Iran's threat to close the Strait of Hormuz. This set oil markets on edge, given that close to 20% of the world's oil flows through the Strait on any given day.4 Geopolitics Reasserts Itself In The Gulf Oil prices will become increasingly sensitive to geopolitical developments, particularly in the Gulf, now that the U.S. and its allies - chiefly KSA - and Iran and its allies are preparing to square off diplomatically, and possibly militarily. This will lead to a wider range in which oil will trade - i.e., we expect more significant deviations from fundamentally implied values, as markets attempt to price in highly uncertain outcomes to political events.5 Tensions around the Strait of Hormuz - discussed below - will remain elevated post-sanctions being re-imposed, even if we only see threats to traffic through this most-important oil transit. Chart 3 shows that in periods when the error term of our fundamental econometric model increases, it typically coincides with higher implied volatilities. Specifically, the confidence interval around our fundamental-based price forecast widens in times of heightened uncertainty and volatility. The larger the volatility, the larger the squared deviation between our fitted Brent prices against actual prices.6 This indicates the probability of ending 2H18 exactly at our $70/bbl target is reduced as mounting upside - e.g. faster-than-expected collapse in Venezuelan crude exports, rising tensions around the Strait of Hormuz or larger-than-expected Permian pipeline/production bottlenecks - and downside - e.g. escalating U.S.-Sino trade war tensions, increasing Libyan and Nigerian production - risks push the upper and lower bounds around our forecast further apart. Chart 3Increasing Sensitivity To Geopolitics Will Widen Crude's Price Range Increasing Sensitivity To Geopolitics Will Widen Crude's Price Range Increasing Sensitivity To Geopolitics Will Widen Crude's Price Range This directly translates into a wider range in which prices will trade - uncertainty is high, and, while it is being resolved, markets will remain extremely sensitive to any information that could send prices on an alternative path (Chart 4). Chart 4Greater Geopolitical Uncertainty Widens Oil Price Trading Range Greater Geopolitical Uncertainty Widens Oil Price Trading Range Greater Geopolitical Uncertainty Widens Oil Price Trading Range Risks related to a closure of the Strait are not accounted for in our forecasts. However, given the magnitude of the risks implied by even the remote possibility of a closure, we expect markets will put a risk premium into prices. In an attempt to frame out price estimates from a short (10-day) and long (100-day) closure, we provide some cursory simulation results below.7 Can Iran Close The Strait Of Hormuz? The Strait of Hormuz, through which some 20% of global oil supply transits daily, is the principal risk that will keep markets hyper-vigilant going forward.8 A complete closure of the Strait of Hormuz (Map 1) would be the greatest disruption of oil production in history, three times more significant than the supply loss following the Islamic Revolution in 1979 (Chart 5). By our estimate, a 10-day closure at the beginning of 2H19 could pop prices by ~ $25/bbl. A 100-day closure could send prices above $1,000/bbl in our estimates. Map 1Iran Threatens Gulf Shipments Again U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic Chart 5Geopolitical Crises And Global Peak Supply Losses U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic So, the question naturally arises, can Iran's forces close the Strait? Iran's ability is limited by structural and military factors, but it could definitely impede traffic through the globe's most crucial energy chokepoint. There are two scenarios for the closure of the Strait: (i) Iran does so preemptively in retaliation to crippling economic sanctions; or (ii) Iran does so in retaliation to an attack against its nuclear facilities. Either scenario is possible in 2019, as the U.S. intends to re-impose sanctions against Iranian oil exports on November 9, a move that could lead to armed conflict if Iran were to retaliate (Diagram 1).9 Diagram 1Iran-U.S. Tensions Decision Tree U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic SCENARIO I - Preemptive Closure In the past, Tehran has threatened to preemptively close the Strait of Hormuz whenever tensions regarding its nuclear program arose. The threats stopped in mid-2012, as U.S. and Iranian officials engaged in negotiations over the country's nuclear program. However, on July 4 of this year, Iran's nominally moderate President Hassan Rouhani pledged that Tehran would retaliate to an oil export embargo by closing the Strait. Rouhani's comments were reinforced on July 5 by the commander of Iran's elite Revolutionary Guards, whose forces patrol the Strait, Mohammad Ali Jafari. Could Iran actually impede traffic through the Strait of Hormuz?10 Yes. Our most pessimistic scenario posits that Iran could close the waterway for about three or four months. This is based on three military capabilities: mines, land-based anti-ship cruise missiles (ASCM), and a large number of small boats for suicide-like attack waves. In our pessimistic scenario, we assume that Iran would be able to deploy about 700 mines and threaten the Strait by firing only one anti-ship cruise missiles (ASCM) operated via land-based batteries or ship per day, in order to prolong the threat.11 In that way, Iran could draw out the threat indefinitely. The length of closure is based on how long it would take the U.S. naval assets in the region to clear the mines, establish a Q-route - corridor within which the probability of hitting a mine is below 10% - and locate ASCM radars and batteries. The pessimistic scenario is unlikely to occur because of several countermeasures that the U.S. and its regional allies could employ - anti-mine operations, meant to clear a so-called Q route allowing safe passage of oil tankers under U.S. naval escort; punitive retaliation, which would inflict punitive damage on Iran's economy and infrastructure; and, lastly, Iran would not want to risk exposing its radar-guided anti-ship missiles to U.S. suppression of enemy air-defense (SEAD) operations that seek and destroy radars. Despite Iran's growing capability, we still posit that its forces would only be able to close the Strait of Hormuz for between three-to-four months. However, the more likely, "optimistic," scenario is that the closure itself lasts 7-10 days, while Iran then continues to threaten, but not actually close, the Strait for up to four months. It would be worth remembering that the U.S. has already retaliated against a potential closure, precisely 30 years ago. Midway through the Iran-Iraq war, both belligerents began attacking each other's tankers in the Gulf. Iran also began to attack Kuwaiti tankers after it concluded that the country was assisting with Iraq's war efforts. In response, Kuwait requested U.S. assistance and President Ronald Reagan declared in January 1987 that tankers from Kuwait would be flagged as American ships. After several small skirmishes over the following year, the USS Samuel B Roberts hit a mine north of Qatar. The mine recovered was linked to documents found by the U.S. during an attack on a small Iranian vessel laying mines earlier in 1987. The U.S. responded by launching Operation Praying Mantis on April 18, 1988. During the operation, which only lasted a day, the U.S. navy seriously damaged Iran's naval capabilities before it was ordered to disengage as the Iranians quickly retreated. Specifically, two Iranian oil platforms, two Iranian ships, and six gunboats were destroyed. The USS Wainwright also engaged two Iranian F-4s, forcing both to retreat after one was damaged. From this embarrassing destruction of Iran's naval assets, the country realized that conventional capabilities stood little chance against a far superior U.S. navy. As a result, Iran has strengthened its asymmetrical sea capabilities, such as the use of small vessels, and has made evident that the use of mines would be integral to its engagements with foreign navies in the Gulf. However, the switch to asymmetrical warfare means that Iran would likely threaten, rather than directly close, the Strait. From an investment perspective, the threat to shipping would have to be priced-in via higher insurance rates. According to research by the University of Texas Robert S. Strauss Center, the insurance premiums never rose above 7.5% of the price of vessel during the 1980s Iran-Iraq war and actually hovered around 2% throughout the conflict. Rates for tankers docking in Somali ports, presumably as dangerous of a shipping mission as it gets, are set at 10% of the value of the vessel. A typical very large crude carrier (VLCC) is worth approximately $120 million. Adding the market value of two million barrels of crude would bring its value up to around $270 million at current prices. If insurance rates were to double to 20%, the insurance costs alone would add around $30 per barrel, $15 per barrel if rates stayed at the more reasonable 10%. This is without factoring in any geopolitical risk premium or direct loss of supply of Iran's output due to war. Bottom Line: Iran's military capabilities have increased significantly since the 1980s when it last threatened the shipping in the Strait. Iran has also bolstered its asymmetric capabilities since 2012, while the U.S. has largely remained the same in terms of anti-mine capabilities. If Iran had the first-mover advantage in our preemptive closure scenario, the most likely outcome would be that it could close the Strait for up to 10 days and then threaten to close it for up to four months in total. SCENARIO II - Retaliatory Closure A retaliatory closure is possible in the case of a U.S. (or Israeli) attack against Iran's nuclear facilities. Following from the military analysis of a preemptive closure, we can ascertain that a retaliatory closure would be far less effective. The U.S. would deploy all of its countermeasures to Iranian closure tactics as part of its initial attack. If Iran loses its first-mover advantage, it is not clear how it would lay the mines that are critical to closing the Strait. Iran's Kilo class submarines, the main component of a covert mine-laying operation, would be destroyed in port or hunted down in a large search-and-destroy mission that would "light up" the Strait of Hormuz with active sonar pings. The duration of the closure could therefore be insignificant, even non-existent. The only potential threat is that of Iran's ASCM capability. Iran would be able to use its ASCMs in much the same way as in the preemptive scenario, depending on the rate of fire and rate of discovery by U.S. assets. Bottom Line: It makes a big difference whether Iran closes the Strait of Hormuz preemptively or as part of a retaliation to an attack. The U.S. would, in any attack, likely target Iran's ability to retaliate against global shipping in the Persian Gulf. As such, Tehran's asymmetric advantages would be lost. Putting It All Together - Can Iran Close The Strait? Our three scenarios are presented in Table 2. Iran has the ability to close the Strait of Hormuz for up to three-to-four months. That "pessimistic" scenario, however, is highly unlikely. The more likely scenarios are the "preemptive optimistic" and retaliatory scenarios. Table 2Closing The Strait Of Hormuz: Scenarios U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic Assessing the price implications of these scenarios is extremely difficult. Even though the "preemptive optimistic" and the "retaliatory" scenarios are short-lived, up to 20% of the world's daily demand would be removed from the market in the event the Strait of Hormuz was closed. Of course, the U.S. would release barrels from its 660mm-barrel Strategic Petroleum Reserve (SPR) - likely the full maximum of 30 million barrels authorized under law, released over 30 days for a 1 MMb/d release - and Europe would also release ~ 1 MMb/d or so from its crude and product stocks. China likely would tap its SPR as well for 500k b/d. In addition, there is ~ 2 MMb/d of spare capacity in OPEC, which could be brought on line in 30 days (once the Strait is re-opened), and delivered for at least 90 days. How and when a closure of the Strait of Hormuz occurs cannot be modeled, since, as far as prices are concerned, so much depends on when it occurs, and its duration. For this reason, and the extremely low probability we attach to any closure of the Strait, we do not include these types of simulations in our analysis of the various scenarios we include in our ensemble. That said, it is useful to frame the range implied by the scenarios above. We did a cursory check of the impact of scenarios 1 and 2 above, in which we assume 19 MMb/d flow through the Strait is lost for 10 days and 100 days due to closure by Iran in July 2019. We assume this will be accompanied by a 2 MMb/d release from various SPRs globally. In scenario 1, the 10-day closure of the Strait lifts price by $25/bbl, and is resolved in ~ 2 months, with prices returning to ~ $75/bbl for the remainder of the year. In scenario 2, the Strait is closed for 100 days, and this sends prices to $1,500/bbl in our simulation. This obviously would not stand and we would expect the U.S. and its allies - supported by the entire industrialized world - would launch a powerful offensive to reopen the Strait. This would be extremely destructive to Iran, which is why we give it such a low probability. Bottom Line: While the odds of a closure of the Strait of Hormuz are extremely low - to the point of not being explicitly modeled in our balances and forecasts - framing the possible outcomes from the scenarios considered in this report reveals the huge stakes involved. A short closure of 10 days could pop prices by $25/bbl before flows are restored to normal and inventory rebuilt, while an extended 100-day closure could send prices to $1,500/bbl or more. Because the latter outcome would result in a massive offensive against Iran - supported by oil-consuming states globally - we view this as a low-probability event. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 President Trump's tweets calling for higher oil production have consistently been directed at the original OPEC Cartel, as seen July 4: "The OPEC monopoly must remember that gas prices are up & they are doing little to help. If anything, they are driving prices higher as the United States defends many of their members for very little $'s. This must be a two way street. REDUCE PRICING NOW!" Since the end of 2016, we have been following the production and policy statements of OPEC 2.0, the name we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. 2 We will be exploring the rising risks to our demand projections in future research. Still, we are in broad agreement with the IMF's most recent assessment of global economic growth, which remains at 3.9% p.a. Please see "The Global Expansion: Still Strong but Less Even, More Fragile, Under Threat," published July 16, 2018, on the IMF's blog. 3 We discuss this at length in the Special Report we published with BCA's Geopolitical Strategy on June 7, 2018, entitled "Iraq Is The Prize In U.S. - Iran Sanctions Conflict." It is available at ces.bcaresearch.com. 4 In an apparent recognition of what it would mean for world oil markets if Iran's exports did go to zero - particularly with Venezuela so close to collapse, which could take another 800k b/d off the market - U.S. Secretary of State Mike Pompeo announced waivers to the sanctions would be granted, following Trump's remarks at the beginning of July. See "Pompeo says US could issue Iran oil sanctions waivers" in the July 10, 2018, Financial Times. The Trump administration, however, is keeping markets on their toes, with Treasury Secretary Steven Mnuchin telling the U.S. Congress, "We want people to reduce oil purchases to zero, but in certain cases, if people can't do that overnight, we'll consider exceptions." See "Iran sues US for compensation ahead of re-imposition of oil sanctions," published by S&P Global Platts on July 17, 2018, on its spglobal.com/platts website. 5 Technically, this means the confidence interval around the target is now wider, which implies high probability of going above $80/bbl as well as the probability of going under $70/bbl. Still, the 2019 risks are skewed to the upside, in our view. 6 Given that our model is based solely on a variety of fundamental variables - i.e. supply-demand-inventory - the deviations can be interpreted as movements in the risks premium/discount. 7 This exercise does not include any estimate of oil flows through KSA's East-West pipeline, and possible exports therefrom. The rated capacity of the 745-mile line is 5 MMb/d, possibly 7 MMb/d. KSA's Red Sea loading capacity and the capacity of the Suez Canal and Bab el Mandeb under stress - i.e., the volumes either can handle with a surge of oil-tanker traffic - is not considered either. 8 This is the U.S. EIA's estimate. The EIA notes that in 2015 the daily flow of oil through the Strait accounted for 30% of all seaborne-traded crude oil and other liquids. Natural gas markets also could be affected by a closure: In 2016, more than 30% of global liquefied natural gas trade transited the Strait. Please see "Three important oil trade chokepoints are located around the Arabian Peninsula," published August 4, 2017, at eia.gov. 9 We encourage our clients to read our analysis of potential Iranian retaliatory strategies, penned by BCA's Geopolitical Strategy team. Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 10 Analysis of Iran's military strategy and U.S. counterstrategy used in this paper relies on research from three heavily cited papers. Eugene Gholz and Daryl Press are skeptical of Iran's ability to close the Strait in their paper titled "Protecting 'The Prize': Oil and the National Interest," published in Security Studies Vol. 19, No. 3, 2010. Caitlin Talmadge gives Iran's capabilities far more credit in a paper titled "Closing Time: Assessing the Iranian Threat to the Strait of Hormuz," published in International Security Vol. 33, No. 1, Summer 2008. Eugene Gholz also led a project at the University of Texas Robert S. Strauss Center for International Security and Law that published an extensive report titled "The Strait of Hormuz: Political-Military Analysis of Threats to Oil Flows." 11 In the Strauss Center study, the most likely number is 814 mines, if Iran had a two-week period to do so covertly. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic Trades Closed in 2018 Summary of Trades Closed in 2018 U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic

Highlights The fundamental case to buy the dollar and sell non-U.S. risk assets is currently extremely obvious. This suggests that investors likely have already placed their bets. As such, the case for a counter-trend correction espoused last week has grown. The impact of tariffs on the dollar seems more dependent on the dollar's momentum than economics. As a result, getting a handle on how the greenback's momentum will evolve seems crucial. The behavior of Chinese assets, various currency pairs and other assets suggests the dollar may experience a significant loss of momentum that could prompt a correction of DXY to 92. The Canadian dollar seems the best place to take advantage of this move. Feature The currency market does not feel right. We do not mean that it is sick; however, we cannot help but feel a great level of discomfort right now. The economic environment clearly supports a stronger dollar. Global liquidity is weak, global growth has weakened, the yuan has been very soft and trade wars are on the front page of newspapers as the Trump administration has announced an additional $200 billion of potential new tariffs on Chinese exports. Hence, the bullish-dollar negative-EM story seems like a "no brainer." However, there rarely, if ever, is such thing as a "no-brainer" in the FX market. When fundamentals point as obviously in one direction as they do today, the narrative is likely to be appreciated by the vast majority of market participants. As a result, the bets are likely to have been placed. This risk seems especially acute today. Hence, we recommend investors temporarily move away from the dollar-bullish thesis. Occam's Razor At first glance, the recent wave of strength in the dollar seems to have been prompted by the new wave of trade war intensification. While China has not announced new tariffs on the U.S., the renminbi has continued to depreciate, evocating memories harkening back to August 2015 and the emerging market calamity that culminated in January 2016. While the risk created by a lower CNY is real, the dollar has had a schizophrenic approach to pricing in the impact of tariffs. In the first half of 2018, announcements of tariffs were greeted by a weaker dollar. However, since May, the same type of news has been greeted by a stronger dollar. An economic argument can be made as to why this is the case. In early 2018, global rates were still at rock-bottom levels, with the GDP-weighted average policy rate in the G-10 outside the U.S. being at 0.2%. Moreover, U.S. inflation was still tepid, but the fed funds rate was 1.5%. As result, if tariffs were to slow growth, only the Fed had room to ease. Moreover, since as of early 2018 global growth still looked to be on the upswing, it was argued that global monetary conditions were still accommodative enough than non-U.S. growth would barely be affected. Today, global growth is already showing signs of sagging, with weakness in Korean exports vindicating this analysis (Chart I-1). This means that growth outside the U.S. is perceived as more vulnerable to tariffs than was the case back in the first quarter of this year, especially as the amount of tariffs imposed on the world has grown. While the U.S. will also suffer from these tariffs, it is in better position to weather their impact. As such, since FX determination goes beyond just rate differentials and is also affected by growth differentials, the greater risk to non-U.S. growth is what is lifting the dollar. This narrative makes sense and is probably playing a role in the dollar's strength. However, we suspect something much simpler is exerting an even greater influence on the greenback: momentum. As we have long been arguing, the dollar is the epitome of momentum currencies in the G-10 (Chart I-2).1 Chart I-1Global Growth Slowdown Global Growth Slowdown Global Growth Slowdown Chart I-2USD Is A Momentum Currency That Sinking Feeling That Sinking Feeling Among all the momentum strategies we have tested, the one that works best at capturing the momentum continuation effect in the USD is tracking crossovers of the 20-day and 130-day moving averages. When the 20-day moving average is above the 130-day one, the dollar has an upward bias that is tradeable, and vice versa when the faster moving average lies below the slower one. Through most of 2017 all the way until May 9, 2018, the 20-day moving average for the dollar was in fact underneath the 130-day moving average. However, since May 10, it has been above (Chart I-3). Here is where things get interesting. When the moving average crossover strategy was sending a bearish signal for the greenback, tariff announcements would weaken the dollar; but since the crossover has been in bullish territory, tariff announcements have been lifting the dollar (Chart I-4). Chart I-3Favorable Momentum ##br##Backdrop On The Dollar Favorable Momentum Backdrop On The Dollar Favorable Momentum Backdrop On The Dollar Chart I-4Momentum Drives The Dollar's ##br##Reaction To Tariffs Momentum Drives The Dollar's Reaction To Tariffs Momentum Drives The Dollar's Reaction To Tariffs What does this mean for investors going forward? So long as the dollar is in a bullish momentum configuration, trade announcements will support the greenback. However, on this front we could expect a period of temporary calm after the storm (a low-conviction call, to be clear). The Trump team just announced an enormous tariffs package, Europe and Canada have put in place their own retaliation tariffs, the NATO meeting is over and the CNY has fallen by 6.4% since April 11. For the dollar to strengthen further, the onus thus falls back on momentum itself and market signals. But, as we highlighted last week, we are concerned that the dollar momentum could actually weaken from current levels. Bottom Line: Trade war risks seem to have been supporting the USD and weakened EM assets. However, the picture is not that clear-cut. Until May, moving average crossovers for the dollar were sending a bearish signal; during that time frame, tariff announcements were welcomed by a weak dollar. Since May, the dollar's moving average crossovers have been sending a bullish signal; since that time, tariff announcements have been welcomed by a strong dollar, which in turn has weighed on non-U.S. risk assets. Thus, with a likely period of calm on the trade front in the coming weeks, the outlook for momentum is likely to determine the trend in the dollar and in the price of risk assets outside the U.S. Reading The Market Tea Leaves At this point, having a sense of how momentum is likely to evolve is crucial. This is where that sinking feeling comes into play. Fundamentals seem to give a clear picture, but when the picture is so clear, a trap often lies ahead. The first clue to this trap comes from the Zew expectations survey. The Zew is a survey of market professionals, asking them their view on growth, and so on. These views are likely to be reflected in current market pricing. What is interesting is that this global growth survey has been tanking violently. The perception is thus that global growth is decelerating fast. Indeed, global growth has slowed, but as the global PMI illustrates - a variable that moves coincidently with the global Zew - it is not falling nearly as fast as expectations are (Chart I-5). This creates a risk for the dollar bulls - bulls who need further growth weakness to justify additional dollar strength. China is at the epicenter of the global growth slowdown. Interestingly, the Shanghai Composite Index is already testing the lows it experienced in early 2016 (Chart I-6). However, the Chinese economic picture is not as dire as was the case back then. PPI inflation is at 4.6% today, while it hit -5.9% at its nadir in November 2015. Thus, real interest rates faced by borrowers are 9.9% lower than they were back then. Moreover, the Li-Keqiang index of industrial activity is rebounding smartly. Finally, while FX reserves are contracting, they are not falling at the pace of US$108 billion a month endured in the worst months of 2015, which means that liquidity conditions in China are not experiencing the same tightening as back then. In fact, the Chinese repo rate is currently falling, supporting this notion (Chart I-7). This combination of economic indicators and financial market prices suggests that ample bad news is already priced into Chinese assets and thus China-linked assets for now. Chart I-5Analysts Know Growth Is Slowing Analysts Know Growth Is Slowing Analysts Know Growth Is Slowing Chart I-6Chinese Shares As Sick As In Early 2016 Chinese Shares As Sick As In Early 2016 Chinese Shares As Sick As In Early 2016 Chart I-7Some Reflation In China? Some Reflation In China? Some Reflation In China? Chinese shares expressed in USD-terms are also interesting. Not only are they re-testing their 2016 lows, but by the end of June their RSI oscillator had hit more deeply oversold levels than in January 2016 (Chart I-8). Very saliently, despite this week's announcement of a potential $200 billion of new tariffs imposed on China, Chinese shares expressed in U.S. dollars are not making new lows, and the RSI is slowly rebounding. This resilience is surprising, considering the magnitude of the bad news. Copper too is interesting. It seems that Dr. Copper has had a bit of a hangover lately, as its response speed has slowed considerably. Copper used to be a very reliable leading indicator, but since 2015 it seems to have become a coincident indicator of EM equities (Chart I-9). The recent 16% decline in the price of copper seems to be a catch-up to the weakness already evident in EM assets and EM currencies more than an early signal of additional problems to come for these markets. In fact, it may even indicate an intermediate capitulation in the price of these assets. Chart I-8Chinese Shares In USD: A Rebound Soon? Chinese Shares In USD: A Rebound Soon? Chinese Shares In USD: A Rebound Soon? Chart I-9Dr. Copper Is Hungover Dr. Copper Is Hungover Dr. Copper Is Hungover Other than these assets directly linked to China, since the end of June Treasury yields have also not been able to fall lower, and have proven very resilient in the face of the latest wave of CNY weakness and Trump tariffs (Chart I-10, top panel). Additionally, the euro/yen exchange rate, which is normally very levered to global growth conditions, has not only been rallying but breaking out of a downward trend in place since the beginning of 2018 (Chart I-10, second panel). Moreover, the extraordinarily pro-cyclical AUD/JPY cross bottomed in March and looks barely affected by the recent tumult (Chart 10, third panel). Finally, the growth-sensitive EUR/CHF is currently also strengthening, not weakening (Chart I-10, bottom panel). The behavior of all these market prices is inconsistent with an imminent new upswing in the dollar. The behavior of these variables is instead consistent with the movement of our favorite leading indicator of global growth: EM carry trades. We have used the EM carry trade to flag risks to global growth that have gripped the dollar and non-U.S. risk assets in recent months. However, despite the bad news piled onto the global economy, the performance of EM carry trades funded in yen seems to be trying to form a bottom (Chart I-11). This could indicate that we may be in for a period of temporary stabilization in global growth - a phenomenon that would weigh on the dollar's momentum. Without this ally, the dollar should correct meaningfully and non-U.S. risk assets should stage a rally. When thinking of a target for the dollar, a correction toward 92 on the DXY, implying a rebound of just under 1.20 on EUR/USD, seems very likely. At these levels, it will be time to re-evaluate whether the thesis we espoused last week - that this correction is a counter-trend move - is still valid or not. Also, we would expect commodity currencies to benefit even more than the euro in the context of this correction. Commodity currencies are especially levered to China, and Chinese stocks seem well positioned for a significant rebound. Moreover, as Chart I-12 illustrates, commodity currencies have been stronger than the relative performance of Swedish stocks vis-à-vis U.S. ones suggests, implying some underlying support. Finally, the yen and Swiss franc should prove the greatest losers in this environment. Chart I-10Despite Bad News, These Pro-Cylical Prices Are Resilient Despite Bad News, These Pro-Cylical Prices Are Resilient Despite Bad News, These Pro-Cylical Prices Are Resilient Chart I-11Stabilization In EM Carry Trades Stabilization In EM Carry Trades Stabilization In EM Carry Trades Chart I-12Important Divergence Important Divergence Important Divergence In terms of factors we continue to monitor, the price of gold remains a key variable. While the trend line we flagged last week has been re-tested, the yellow metal has not been able to punch through it. Meanwhile, EM bonds and junk bonds too have not suffered much in the face of the recent tariffs, and the rebound that has materialized since early July still seems in place. If any of these development change, the rebound in EM assets will peter off, and the dollar greenback will continue its march higher without much of a pause. Bottom Line: Fundamentals are making an extremely clear case that the dollar will strengthen further in the coming months, and that non-U.S. risk assets are in for a dive. However, when fundamentals are as clear as they are today, especially after the market moves we have seen in recent months, they rarely translate into the price action one would anticipate. The behavior of Chinese shares, of bond yields and of various currency pairs, including EM carry-trades, suggests instead that the dollar is likely to lose momentum. However, the life blood of any dollar rally is this very momentum. As such, we worry that despite apparently massively favorable fundamentals, the dollar could experience a correction toward 92 before being able to move higher as the fundamentals currently suggest. Commodity currencies could enjoy the greatest dividend from this counter-trend move. A Few Words On The CAD The Bank of Canada was anticipated to deliver a dovish hike this week, increasing rates to 1.5%, but also downgrading the path of additional expected rates. The BoC did deliver a hike, but it stuck to its guns and did not temper future interest rate expectations. Within the BoC's analytical framework, this move makes sense. Despite incorporating both tariff and NAFTA risks into its forecast, the BoC has barely changed its growth expectations for Canada. Essentially, the hit to Canadian exports will be balanced out by the hit to Canadian imports created by Canada's own retaliatory tariffs on the U.S. This means that the lack of excess capacity in the Canadian economy remains as salient a problem for the BoC as it was before NAFTA risks entered the picture. This warrants higher rates. The economic backdrop seems to indeed be in agreement with the BoC. This summer's Business Outlook Survey showed that Canadian businesses continue to find it increasingly difficult to meet demand and that labor shortages are still prevalent and becoming more intense, highlighting the upside risk to wages (Chart I-13). Higher wages are thus likely to buffet Canadian households from the risk created by higher policy rates. Moreover, higher wages also stoke inflationary pressures, while core inflation is already at target. In this environment, a real short rate at -0.4% makes little sense. The CAD looks like the best vehicle to take advantage of a rebound in commodity currencies. The CAD is currently trading at a deep discount to its fair value (Chart I-14) and the Canadian dollar proved surprisingly resilient in the face of a 7% decline in Brent prices on Wednesday. Additionally, speculators have accumulated large short bets on the Canadian currency. With the BoC being the only central bank among G-10 commodity producing nations that is lifting rates, this would create an additional impetus for the loonie to rebound and outperform other commodity currencies. Chart I-13Canadian Capacity Pressures ##br##Point To A Hawkish BoC Canadian Capacity Pressures Point To A Hawkish BoC Canadian Capacity Pressures Point To A Hawkish BoC Chart I-14Loonie Is ##br##Cheap Loonie Is Cheap Loonie Is Cheap Bottom Line: The BoC has resumed its hiking campaign because the economy is at full capacity and inflationary pressures continue to build up, while monetary policy remains too accommodative. As a result, the cheap CAD currently seems the best G-10 currency to take advantage of the correction in the USD. We are selling USD/CAD this week. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, titled “Riding The Wave: Momentum Strategies In Foreign Exchange Markets”, dated December 8, 2017, 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 positive: JOLTS Job Openings climbed to 6.638 mn in May, beating expectations; Headline producer prices increased by 3.4% annually, the most in 11 years; Core producer prices increased by 2.8% in annual terms; Core consumer prices increased by 2.3% annually in June, in line with expectations, however, the month-on-month number was a bit soft; Continuing jobless claims underperformed, while initial jobless claims came in lower than expected. New threats from the White House of tariffs for USD 200 billion worth of Chinese imports circulated the media networks. At this point in time, almost 90% of U.S. imports from China are under threat of tariffs. The risks surrounding these tariffs going forward is likely to add substantially more pressure on emerging markets and commodity currencies down the road. Meanwhile, the U.S. is experiencing a robust economy with higher inflation supported by more expensive raw materials, higher lumber and housing prices, and a tight trucking market. This should keep the Fed in line with its hawkish bias, and the greenback afloat, even if on the short-run, much of this seem well discounted, raising the risk of a tactical correction in the DXY. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data was mixed: The German trade balance increased to EUR 20.3 billion on the back of a 1.8% annual export growth and a 0.7% annual import growth; The Sentix Investor Confidence increased to 12.1 in July from 9.3 in June, and beating the expected 8.2; French and Italian industrial output both underperformed expectations, coming in at -0.2% and 0.7% in monthly terms, respectively; The Economic Sentiment from the ZEW Survey came in less than expected for both Germany and the euro area, at -24.7 and -18.7 respectively; A slight misunderstanding between policymakers at the ECB emerged as the interpretation of interest rates being held "through the summer of 2019" proved contentious. Some officials say an increase as early as July 2019 is possible, while others rule out a move until autumn. We believe the latter is more likely, given the euro's negative reaction to the U.S.' announcement of additional tariffs of USD 200 billion imports from China, and also due to the current slowdown within the common area. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been positive: Machinery orders yearly growth outperformed expectations, coming in at 16.5%. Moreover, labor cash earnings yearly growth also surprised to the upside, coming in at 2.1%. Finally, housing starts yearly growth also outperformed expectations, coming in at 1.3%. USD/JPY has rallied by more than 1.4% this week. Even amid the increasing trade tensions and risk-off sentiment, the yen has been unable to rally against the dollar, as the momentum for the greenback is too strong for the yen to overcome. Overall, we favor the yen over the euro, however if the dollar were to correct at current levels, EUR/JPY would likely suffer in the process. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 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 Recent data in the U.K. has been mixed: Manufacturing production yearly growth underperformed expectations, coming in at 1.1%. Moreover, Industrial production yearly growth also surprised negatively, coming in at 0.8%. However, mortgage approvals outperformed expectations, coming in at 64.526 thousand. Finally, Markit Services PMI also surprised positively, coming in at 55.1. GBP/USD has remained flat this week. Overall, we expect cable to continue to fall, as the dollar should continue its upward momentum for the time being. That being said, on the remainder of 2018, the pound will probably outperform the euro, as the U.K. is less exposed to the effects of Chinese tightening than Europe. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was mixed: NAB Business Confidence and Conditions both underperformed expectations, coming in at 6 and 15 respectively; Westpac Consumer Confidence increase to 3.9% in July from 0.3%; Home Loans grew by 1.1%, much better than the expected -1.9%. The Aussie sold off substantially as the U.S. threatened China with further tariffs amounting to USD 200 bn worth of goods. Adding to the sell-off were copper prices, which fell by almost 3%, also triggered by the tariff announcement. Furthermore, as the Australian economy remains mired in slack, the RBA is unlikely to hike in an environment with no real wage growth. As such, the AUD is unlikely to see much durable upside this year and is likely to lag other commodity currencies in the event of a dollar correction. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 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 NZD/USD has been flat this week. Even if it can rebound on the back of USD correction, we expect this currency to ultimately fall, given that the current environment of trade tensions and Chinese tightening will weigh on high yielding currencies like the NZD. Additionally, the policies implemented by the new government like lower immigration and a dual mandate will structurally lower the neutral rate in New Zealand, which will create further downside on the NZD. However, the NZD should outperform the AUD cyclically, as Australia is more exposed to a slowdown in the Chinese industrial cycle, given that copper has a higher beta than dairy products. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Canadian data was decent: Housing starts grew by 248,100 year-on-year, beating expectations of 210,000; Building permits increased by 4.7% in monthly terms. The Bank of Canada this week hiked interest rates to 1.5%. The Bank displayed quite a hawkish stance in its statement and Monetary Policy report, noting a stronger than expected U.S. economy, high export growth, robust inflation, and a tight labor market. In addition, the Bank incorporated the newly implemented tariffs into its policy function. Nevertheless, recent comments by Governor Poloz imply a "data dependent" approach, which is consistent with policy responses to internal inflationary pressures. We therefore expect the CAD to continue to outperform all G10 currencies except USD. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: The KOF leading indicator outperformed expectations, coming in at 101.7. Moreover, the SVME PMI also outperformed expectations, coming in at 61.6. However, the unemployment rate underperformed expectations, coming in at 2.6%. Finally, headline inflation came in at 1.1%, in line with expectations. EUR/CHF has been flat since last week. Overall, we expect this cross to continue to go up, given that the SNB will keep intervening in the currency markets to keep the franc low enough for the economy to reach the central bank inflation mandate. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been positive: Retail sales yearly growth outperformed expectations, coming in at 1.8%. Moreover, headline inflation surprised positively, coming in at 2.6%, while core inflation came in at 1.1%, in line with expectations. Finally, registered unemployment, came in at 2.2%, in line with expectations. USD/NOK has gone up by roughly 0.6% this week. While it has short-term downside, we continue to be cyclically bullish on this cross, as the upside to oil prices is limited at this point, while a tightening fed should continue to put upward pressure on the U.S. dollar. That being said, the NOK will likely outperform the AUD and the NZD, given that the constrained supply of oil will help it to outperform other commodities. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The minutes from the July meeting highlighted some reservation by officials given the current economic background. The forecast is that slow rate rises will be initiated towards the end of the year. However, the majority of the Executive Board emphasized that monetary policy proceeds cautiously with hikes, given the volatile development of the exchange rate and the increased risks associated with Italy and trade protectionism. The majority also advocated for the extension of the mandate that facilitates foreign exchange intervention. However, Governors Ohlsson and Flodén argued against this view, even supporting hikes earlier as inflation is already at target. The SEK is very cheap on several valuation metrics, and thus is ripe for an up move, which is likely when the majority of the Riksbank officials aligns with a hawkish view. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Robert Robis, Chief Fixed Income Strategist Highlights Q2 Performance Breakdown: The return for the Global Fixed Income Strategy (GFIS) recommended model bond portfolio was flat (hedged into U.S. dollars) in the second quarter of 2018, outperforming the custom benchmark index by +13bps. This pushed the 2018 year-to-date performance back into positive territory. Winners & Losers: Nearly the entire outperformance came from our overweight stance on U.S. high-yield corporates versus our underweight tilt on emerging market corporates. Successful government bond country allocation (overweight U.K. & Australia, underweight Italy) helped offset the drag on performance from our overweight stance on U.S. investment grade corporates. Scenario Analysis: Our recent decision to downgrade overall spread product exposure, even as we maintain a below-benchmark duration stance, should help boost the expected alpha of the model portfolio over the next year. Feature This week, we present the performance numbers for the BCA Global Fixed Income Strategy (GFIS) model bond portfolio in the second quarter of 2018. As a reminder to existing readers (and for new clients), the portfolio is a part of our service that is meant to complement the usual macro analysis of global fixed income markets. The model portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors, by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. In this report, we update our estimates of future portfolio performance, using the scenario analysis framework that we introduced three months ago.1 After our recent decision to downgrade global spread product exposure, our model portfolio is now expected to outperform the custom benchmark index over the next year in both our base case and plausible stress test scenarios. Q2/2018 Model Portfolio Performance Breakdown: Country & Credit Selection Pays Off The total return of the GFIS model bond portfolio was flat (hedged into U.S. dollars) in the second quarter of the year, which outperformed our custom benchmark index by +13bps.2 The first half of the quarter was driven by gains from our below-benchmark duration tilt, as the 10-year U.S. Treasury yield hit a peak of 3.13%. As yields drifted a bit lower in the latter half of Q2 in response to some cooling of global economic growth amid rising concerns on U.S. trade policy, the gains from duration reversed. At the same time, the outperformance from the spread product portion of our model portfolio started to kick in (Chart of the Week), even as credit spreads in all markets widened. Chart of the WeekSpecific Country & Credit Allocations##BR##Boosted Q2 Performance Specific Country & Credit Allocations Boosted Q2 Performance Specific Country & Credit Allocations Boosted Q2 Performance Table 1GFIS Model Bond Portfolio##BR##Q2-2018 Overall Return Attribution GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +5bps of outperformance versus our custom benchmark index while the latter outperformed by +8bps (Table 1). The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. Chart 2GFIS Model Bond Portfolio##BR##Q2/2018 Government Bond Performance Attribution By Country GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound Chart 3GFIS Model Bond Portfolio##BR##Q2/2018 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound The main individual sectors of the portfolio that drove the excess returns were the following: Biggest outperformers Overweight U.S. high-yield B-rated corporates (+5bps) Overweight U.S. high-yield Caa-rated corporates (+2bps) Overweight Japanese government bonds (JGBs) with maturities up to ten years (+3bps) Underweight emerging market U.S. dollar-denominated corporate debt (+5bps) Underweight Italian government bonds (+4bps) Overweight U.K. Gilts (+1bp) Overweight Australian government bonds (+1bp) Biggest underperformers Overweight U.S. investment grade Financials (-2bps) Overweight U.S. investment grade Industrials (-2bps) Underweight JGBs with maturities beyond ten years (-5bps) Underweight French government bonds with maturities beyond ten years (-2bps) Two unusual trends stand out in the Q2 performance numbers: First, our overweight stance on U.S. high-yield debt was able to deliver positive alpha but a similar tilt on U.S. investment grade did not, even as U.S. corporate credit spreads widened during the quarter. It is odd for an asset class (high-yield) that is typically more volatile to outperform during a period of credit spread widening. Although that outcome did justify our view that U.S. investment grade corporates have been offering far less cushion to a period of spread volatility than U.S. junk bonds. Second, the flattening pressures on global government bond yield curves resulted in underperformance from the very long ends of curves in core Europe and Japan, even though the latter regions were the best performing bond markets in our model bond portfolio universe. This can be seen in Chart 4, which presents the benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio. The returns are hedged into U.S. dollars (we do not take active currency risk in this portfolio) and also adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color-coded the bars in each chart to reflect our recommended investment stance for each market during the second quarter.3 Chart 4Ranking The Winners & Losers From The Model Portfolio In Q2/2018 GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound As can be seen in the chart, the best performers were government bonds in Germany, France and Japan. The fact that our excess return from those countries was only a combined +2bps, even with an aggregate overweight exposure to all three, suggests that our duration allocation within the maturity buckets of those countries was a meaningful drag on performance. Yet in terms of the overall success rate of our individual country and sector calls, the news was positive in Q2. We've been overweight U.K. Gilts and Australian government bonds, which were some of the top performers in Q2. On the other side, we have been underweight emerging market corporate debt and Italian sovereign debt, which were the worst performers in the quarter. Bottom Line: The GFIS model bond portfolio outperforming the custom benchmark index by +13bps. This pushed the 2018 year-to-date performance back into positive territory. Nearly the entire outperformance came from our overweight stance on U.S. high-yield corporates versus our underweight tilt on emerging market corporates. Future Drivers Of Portfolio Returns After Our Recent Changes Looking ahead, the performance of the model bond portfolio will have different drivers in the third quarter and beyond after the recent changes to BCA's recommended strategic asset allocations.4 We downgraded global equity and spread product exposure to neutral, based on our concern that the backdrop for global growth, inflation and monetary policy was turning less supportive for risk assets, particularly given the potential new economic shock from the "U.S. versus the world" trade tensions. In terms of the specific weightings in the GFIS model bond portfolio, we still prefer owning U.S. corporate debt versus equivalents in Europe and emerging markets. Thus, while we downgraded our recommended allocation to U.S. and investment grade corporates to neutral from overweight, we also cut our weightings to euro area corporates, as well as to all emerging market hard currency debt (see the table on page 12, which shows the model bond portfolio changes that were made back on June 26th). The latter changes were necessary to maintain the relatively higher exposure to U.S. corporate debt versus non-U.S. corporates, although it does leave the model portfolio with a small overall underweight stance to global spread product (Chart 5). Importantly, we are maintaining a below-benchmark stance on overall portfolio duration, even as we grow more cautious on credit exposure. This is because we still see potential medium-term upward pressure on bond yields coming from tightening monetary policies (Fed rate hikes, ECB tapering of bond purchases) and increasing inflation expectations. The majority of global central bankers are dealing with tight labor markets and slowly rising inflation rates. While global growth has cooled a bit from the rapid pace seen in 2017, it has not been by enough to have policymakers shift to a more dovish bias. Throughout the first half of 2018, we have been deliberately targeting a modest tracking error for our model portfolio, given the historical richness (low yields, tight spreads) of so many parts of the global bond universe. Our estimate of the tracking error is now below the 40-60bp range that we have been targeting (Chart 6), but we are willing to live with this given the higher degree of uncertainty at the moment.5 Chart 5New Spread Product Allocation:##BR##Neutral U.S., Underweight Non-U.S. GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound Chart 6Staying Defensive With##BR##The Risk Budget Staying Defensive With The Risk Budget Staying Defensive With The Risk Budget Importantly, the changes to our asset allocation recommendations should help boost the expected return of the model portfolio over the next year. In our Q1/2018 portfolio review published in April, we introduced a framework for estimating total returns for all government bond markets and spread product sectors, based on common risk factors. For credit, returns are estimated as a function of changes in the U.S. dollar, the Fed funds rate, oil prices and market volatility as proxied by the VIX index (Table 2A). For government bonds, non-U.S. yield changes are estimated using recent historical yield betas to changes in U.S. Treasury yields (Table 2B). This framework allows us to conduct scenario analysis based on projected returns of each asset class in the model bond portfolio universe by making assumptions on those individual risk factors. Table 2AFactor Regressions Used To Estimate##BR##Spread Product Yield Changes GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound Table 2BEstimated Government Bond Yield##BR##Betas To U.S. Treasuries GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound With these tools, we can forecast returns for each bond sector under different scenarios. We can then use those forecasts to predict the expected return for our model bond portfolio under those same scenarios, but with our current relative allocations. In Tables 3A & 3B. we show three differing scenarios, with all the following changes occurring over a one-year horizon. Table 3AScenario Analysis For The GFIS Model Portfolio GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound Table 3BU.S. Treasury Yield Assumptions For The Scenario Analysis GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound Our Base Case: the Fed delivers another 100bps of rate hikes, the U.S. dollar rises +5%, oil prices rise by +10%, the VIX index increases by five points from current levels, and U.S. Treasury yields rise by 20-40bps across the curve. A Very Hawkish Fed: the Fed delivers 150bps of rate hikes, the U.S. dollar rises by +10%, oil prices rise by +10%, the VIX index increases by ten points from current levels and there is a sharp bear flattening of the U.S. Treasury curve. A Very Dovish Fed: the Fed only hikes rates by 25bps, the U.S. dollar falls by -5%, oil prices fall by -20%, the VIX index increases by fifteen points from current levels and there is a modest bull steepening of the U.S. Treasury curve (in this scenario, the Fed puts the rate hiking cycle on hold because of a sharp selloff in U.S. financial markets). The top half of Table 3A shows the expected returns for all three scenarios under our more bullish asset allocation prior to the changes made on June 26th, while the bottom half shows the expected performance of the model portfolio after our downgrade to global spread product. Importantly, the model bond portfolio is now expected to outperform the custom benchmark index in not only the base case scenario (+25bps of outperformance) but also in the two alternative scenarios of a very hawkish Fed (+46bps) and a very dovish Fed (+6bps). Those positive outcomes are not surprising, given that all three scenarios have some degree of risk aversion (higher VIX) that would play into our now-reduced exposure to credit risk in the portfolio. Our negative view on duration risk (Chart 7) also helps boost excess returns versus the benchmark in two of the three scenarios. Interestingly, these outcomes all occur despite the fact that the portfolio is now running with a negative carry (i.e. a lower total yield versus the benchmark index) after the reduction in spread product exposure (Chart 8). Although given our views that market volatility, bond yields and credit spreads are more likely to move higher in the next 6-12 months, we think that carry considerations now play a secondary role in portfolio construction. The time to try and earn carry is during stable markets, not volatile markets. Chart 7The Model Portfolio Is Not Chasing Yield The Model Portfolio Is Not Chasing Yield The Model Portfolio Is Not Chasing Yield Chart 8Staying Below-Benchmark On Overall Duration Staying Below-Benchmark On Overall Duration Staying Below-Benchmark On Overall Duration Bottom Line: Our recent decision to downgrade overall spread product exposure, even as we maintain a below-benchmark duration stance, should help boost the expected alpha of the model portfolio over the next year. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start", dated April 10th 2018, available at gfis.bcareseach.com. 2 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 3 For Italy, Germany & France, the bars have two colors since the portfolio weights were changed in mid-May, when we cut the recommended stance on Italy to underweight and raised the allocations to Germany & France as an offset. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Time To Take Some Chips Off The Table: Downgrade Global Spread Product Exposure To Neutral", dated June 26th 2018, available at gfis.bcaresearch.com. 5 In general, we aim to target a tracking error no greater than 100bps. We think this is reasonable for a portfolio where currency exposure is fully hedged and less than 5% of the portfolio benchmark is in bonds with ratings below investment grade. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound GFIS Model Bond Portfolio Q2/2018 Performance Review: A Solid Rebound Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns