BCA Indicators/Model

The GAA DM Equity Country Allocation model is updated as of June 29, 2018. The model has reduced weights in Italy, the U.S., the Netherlands and France to beef up weights in Spain, Australia, Canada, Switzerland and Germany. After these adjustments, Australia is now upgraded to overweight from neutral and Italy is downgraded to neutral from overweight, 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 Chart 1, Chart 2 and Chart 3, the overall model outperformed its benchmark by 34 bps in June, largely driven by the Level 2 model which outperformed its benchmark by 87 bps. The Level 1 model performed in line with its benchmark in June. Since going live, Level 2 and Level 1 have outperformed their respective benchmarks by 171 bps and 5bps, resulting in overall model outperformance of 47 bps. 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 June 30, 2018. 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 Following our Quarterly Update that was released yesterday, the model corroborates the defensive stance with an aggregate underweight of 5.8% in cyclical sectors. The switch to a defensive mode was driven by a weaker growth outlook. The upgraded sectors were consumer staples and health care. Additionally, the model has turned more negative on the two largest sectors - financials and technology. Resources-based sectors remain unattractive on the back of weaker growth outlook. 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.

Highlights Global Growth: The divergence between strong U.S. and weak non-U.S. growth will increase in the coming months and culminate in wider credit spreads. The Fed's reaction to wider credit spreads will determine how Treasuries perform. High-Yield: High-Yield bonds will deliver excess returns in line with the historical average as long as default losses occur at close to historically low levels. This points to an unfavorable risk/reward balance in junk. Credit Curve: Investors should maintain a below-benchmark duration bias in their overall bond portfolios, but should lengthen maturities within their corporate bond allocations as much as possible while also maintaining a balanced or slightly up-in-quality allocation across credit tiers. Feature Chart 1Growth Divergence Redux Growth Divergence Redux Growth Divergence Redux Two factors influenced our recent decision to reduce the recommended exposure to credit risk in our U.S. bond portfolio.1 First, our indicators show that we are in the late stages of the credit cycle, meaning that small positive excess returns are the best case scenario for corporate bonds. Second, a large divergence in growth has emerged between the United States and the rest of the world, much like in 2014/15 (Chart 1). As was the case in 2014/15, such a divergence will put upward pressure on the U.S. dollar and eventually lead to a period of turmoil in U.S. risk assets - i.e. wider credit spreads and lower equity prices. Whether this turmoil translates into a playable rally in U.S. Treasuries will depend on how the Fed responds. First Spreads, Then (Maybe) Yields Chart 2The 2015 Template The 2015 Template The 2015 Template Using the 2015 episode as a template, we see that credit spreads widened sharply beginning in mid-2015. But despite the risk-off sentiment in credit markets, Treasury yields stayed roughly flat (Chart 2). This should not be too surprising. Since the weakness in global growth was concentrated outside the United States and a significant proportion of corporate profits are driven by foreign demand, a non-U.S. growth shock will have a more immediate impact on the U.S. corporate sector than it will on overall U.S. aggregate demand. Most of the latter is driven by the U.S. consumer who actually stands to benefit from a stronger dollar. Treasury yields and the Federal Reserve take their cues from overall GDP growth, not corporate profits. In fact, we contend that the 2015 widening in credit spreads was exacerbated by the fact that the Fed maintained its focus on overall U.S. growth and continued to signal a relatively steady pace of rate hikes. Spreads widened even further as the notion that the Fed would not bail out corporate bond investors took hold. Eventually, credit spreads widened enough by early 2016 that the Fed was forced to conclude that tighter financial conditions weighed significantly on the growth outlook. It then signaled a slower pace for rate hikes (Chart 2, panel 2), and only then did Treasury yields fall (Chart 2, bottom panel). The Fed's retreat also marked the peak in corporate bond spreads. We envision a similar pattern playing out this time around. Weaker foreign growth will first impact corporate credit, and eventually financial conditions may tighten so much that the Fed is forced to back away from its "gradual" 25 bps per quarter rate hike pace. However, with inflation much closer to target than in 2015, the Fed will be more reluctant to respond. A Less Responsive Fed Our Fed Monitor shows why this is the case (Chart 3). The Monitor is composed of indicators related to economic growth, inflation and financial conditions. It is designed so that a reading above zero signals that the Fed should be hiking rates and a reading below zero signals that it should be cutting. If we consider the three components of the Fed Monitor individually, it is clear that we have recently seen a fairly substantial tightening of financial conditions (Chart 3, bottom panel), but this has barely made a dent in the overall Monitor. The reason is that the components related to economic growth and inflation are on solid footing, and they are offsetting the message from the financial conditions component. In other words, with the output gap much narrower and inflation much closer to target than in 2015, the Fed will need to see more market pain before putting rate hikes on hold. Even if financial conditions tighten so much that a pause in rate hikes is justified, it is highly unlikely that such a delay will last for more than a quarter or two. The end result could be that Treasury yields see only limited downside, even as credit spreads widen. Chart 3Fed Can Tolerate More Market Pain Fed Can Tolerate More Market Pain Fed Can Tolerate More Market Pain China To The Rescue? Another possibility is that we never even reach the point of significant market turmoil and much tighter financial conditions. Non-U.S. growth might recover in the months ahead, ushering in a renewed synchronized global recovery that prevents corporate bond spreads from widening. The most likely driver of such a revival would be significant policy easing from China that puts a floor under global growth before U.S. financial markets feel much pain. Chart 4 shows that China did ease monetary conditions dramatically in 2015 as U.S. credit spreads widened. That easing was achieved through a combination of lower real interest rates, stronger credit growth and a weaker exchange rate. The evidence also suggests that Chinese authorities have started to devalue the renminbi in recent weeks, but so far the weakness is limited and overall monetary conditions have not eased at all. If China is attempting to spur a rebound in global growth, a lot more easing will be required in the coming months and it is not at all obvious that policymakers are willing to go down that path.2 If China does engage in a significant currency devaluation, it will obviously increase the foreign demand for U.S. Treasuries. However, in general, we think that foreign demand will exert less downward pressure on U.S. Treasury yields than it did during the 2014/15 period. This has less to do with Chinese official demand than with the simple fact that U.S. government bonds are now a much less attractive investment vehicle for conventional non-U.S. fixed income investors. After we account for the cost of currency hedging on a 3-month horizon, a typical European investor who wants to gain exposure to the U.S. bond market without taking currency risk is faced with a lower realized yield from a 10-year U.S. Treasury note than from a 10-year German bund (Chart 5). This was not the case at all in 2014/15 when hedged U.S. yields offered a huge advantage over bunds. Japanese investors are faced with a similar quandary. The 10-year U.S. Treasury yield hedged into yen still looks attractive relative to a 10-year JGB, but the yield advantage is nowhere near the levels seen in 2014/15 (Chart 5, panel 3). Chart 4Policy Easing In China? Policy Easing In China? Policy Easing In China? Chart 5Less Foreign Demand For USTs Less Foreign Demand For USTs Less Foreign Demand For USTs U.S. bonds are much less enticing for foreign investors on a currency hedged basis because the Fed has raised rates seven times since 2015, while European and Japanese interest rates are still at the floor. This large rate divergence means that investors must pay a lot more to swap foreign currency for dollars. Essentially, foreign investors are faced with an unpalatable choice. They can gain access to elevated un-hedged U.S. Treasury yields only if they are willing to take on the substantial currency risk. If not, then they are better off keeping their money at home. The end result should be less foreign demand for U.S. bonds. Bottom Line: The divergence between strong U.S. and weak non-U.S. growth will increase in the coming months and culminate in wider credit spreads. The Fed's reaction to wider credit spreads will determine how Treasuries perform. High-Yield: The Good News Is Priced In Our measure of the excess spread available in the High-Yield index after accounting for default losses has recently widened to 260 bps, slightly above its long-run historical average (Chart 6). This tells us that if default losses during the next 12 months are in line with our expectations, we should expect excess high-yield returns of 260 bps over duration-matched Treasuries, assuming also that there are no capital gains/losses from spread tightening/widening. While the default-adjusted spread suggests that junk bonds are fairly valued relative to history, it's important to also consider the balance of risks surrounding our default loss assumptions. To calculate the default-adjusted spread we start with the Moody's baseline default rate projection for the next 12 months. It is currently 1.99% (Chart 6, panel 2). Then, we project the recovery rate based on its historical relationship with the default rate. This gives us a forecasted recovery rate of 48% (Chart 6, panel 3). Combined, the forecasted default rate and recovery rate give us expected high-yield default losses of 1.03% for the next 12 months (Chart 6, bottom panel). The only historical period to show significantly lower default losses was 2007, a time when non-financial corporate balance sheets were in much better shape than they are today. This is not to suggest that our default forecasts are unrealistically low. The economic and corporate landscape is consistent with a relatively low default rate. But that outlook can change quickly, and the historical record shows that the risk that we are underestimating future default losses is far greater than the risk that we are overestimating them. Gross non-financial corporate leverage is highly correlated with the default rate over time (Chart 7, top panel). It has flattened off during the past few quarters, but is likely to rise modestly in the second half of the year. As we have discussed in prior reports, corporate revenue growth is elevated but close to peaking, and labor costs are just now starting to ramp up. Even a small moderation in profit growth will be enough for leverage to start moving higher.3 Chart 6High-Yield Expected Returns High-Yield Expected Returns High-Yield Expected Returns Chart 7Macro Drivers Of The Default Rate Macro Drivers Of The Default Rate Macro Drivers Of The Default Rate Interest coverage is also still consistent with a low default rate (Chart 7, panel 2). But the combination of peaking profit growth and rising interest rates clearly biases it lower going forward. Other indicators that correlate strongly with corporate defaults, such as layoff announcements and C&I lending standards, also remain supportive for the time being (Chart 7, bottom 2 panels). Bottom Line: High-Yield bonds will deliver excess returns in line with the historical average as long as default losses occur at close to historically low levels. This points to an unfavorable risk/reward balance in junk. Considering The Credit Curve Two weeks ago we examined the risk/reward proposition of moving down in quality within an allocation to investment grade corporate bonds.4 We concluded that a move down the rating scale has a greater positive impact on risk-adjusted portfolio performance when excess return volatility and index duration-times-spread (DTS) are low. With index DTS currently elevated, now is not the best time to move down-in-quality. This week we perform a similar analysis using the maturity buckets of the investment grade corporate bond index. Charts 8-11 show four excess return Bond Maps. The horizontal axes of these maps show the number of months of average spread widening required for each maturity bucket to underperform duration-matched Treasuries by the return threshold indicated in the chart's title. Buckets plotting further to the left require more months of spread widening, and are thus less risky. Chart 8Investment Grade Corporate Excess Return ##br##Bond Map: +/- 50 BPs Threshold Out Of Sync Out Of Sync Chart 9Investment Grade Corporate Excess Return ##br##Bond Map: +/- 100 BPs Threshold Out Of Sync Out Of Sync Chart 10Investment Grade Corporate Excess Return##br## Bond Map: +/- 200 BPs Threshold Out Of Sync Out Of Sync Chart 11Investment Grade Corporate Excess Return ##br##Bond Map: +/- 300 BPs Threshold Out Of Sync Out Of Sync The vertical axes of the maps show the number of months of average spread tightening required for each maturity bucket to outperform duration-matched Treasuries by the return threshold indicated in the chart's title. Buckets plotting closer to the top require fewer months of spread tightening, and thus provide greater potential reward. Much like what we found with the different credit tiers, the maturity buckets tend to cluster together when we set a low return threshold. The risk/reward trade-off becomes more linear as the return threshold increases. We can therefore conclude that shorter maturities offer similar return potential to longer maturities when return volatility is low, along with less risk. The risk-adjusted advantage in low maturity buckets disappears as we transition into higher volatility environments. At the moment, average index DTS is elevated compared to other non-recession periods. There is no obvious advantage to maintaining a bias toward the short maturity buckets. Fundamental Drivers In addition to the risk/reward trade-offs shown in our Bond Maps, we also identify two fundamental drivers of relative performance across the corporate maturity spectrum. First, we notice that while long maturities offer a substantial spread advantage over short maturities, the advantage is entirely driven by differences in duration (Chart 12). Logically, if the duration difference between the short and long ends of the curve were to decline, then the option-adjusted spread term structure would flatten. In fact, this is exactly what should transpire as Treasury yields rise (Chart 12, bottom panel). The second factor that can influence the credit spread curve is the outlook for default losses. Short-maturity spreads widen more than long-maturity spreads when default losses increase. This is because only the highest quality firms are able to issue long maturity debt. Chart 13 shows that, after controlling for differences in duration, the credit spread curve is inversely correlated with default losses. Higher default losses coincide with a flatter spread curve, and vice-versa. A model of the credit spread curve (duration-adjusted) versus expected default losses shows that the curve is currently fairly valued relative to our optimistic default loss assumptions (Chart 13, bottom panel). In other words, if default losses were to surprise to the upside, then the credit spread curve would appear too steep. Chart 12IG Term Structure Is Steep IG Term Structure Is Steep IG Term Structure Is Steep Chart 13Rising Defaults Flatten The Spread Curve Rising Defaults Flatten The Spread Curve Rising Defaults Flatten The Spread Curve All in all, our outlook for higher Treasury yields and the negative balance of risks surrounding our default loss forecast both suggest that investors should favor the long-end of the maturity spectrum within an allocation to investment grade corporate bonds. Bottom Line: Investors should maintain a below-benchmark duration bias in their overall bond portfolios, but should lengthen maturities within their corporate bond allocations as much as possible while also maintaining a balanced or slightly up-in-quality allocation across credit tiers. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Now What?", dated June 27, 2018, available at cis.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights May's soft durable goods orders report is probably not a precursor of weaker capex. Despite shortages of inventory and rising rates, housing should add to GDP growth this year and next, and keep economic growth well above its long-term potential. BCA's Commodity & Energy Strategy service notes that oil markets are becoming increasingly concerned about possible supply disruptions. Oil price volatility is set to rise. Feature Despite a late-week rally, U.S. equities finished the week lower as investors worried about global trade, higher oil prices, and an economic slowdown in China. 10-Year Treasury yields fell even as inflation returned to the Fed's target. The trade-weighted dollar moved higher last week, and rose 5% in the second quarter. Last week's economic data skewed to the softer side of expectations, but despite the recent run of disappointing data, Q2 GDP growth is still tracking well above 3.0%. Chart 1Core Inflation Is At The Fed's Target Core Inflation Is At The Fed's Target Core Inflation Is At The Fed's Target Supply bottlenecks are a hallmark of late-cycle economic expansions. In recent months, the Fed's Beige Book identified supply shortages in the labor and product markets in the U.S.1 Many of these economic pinch points are in the energy sector, where businesses are running out of labor, rail and trucking capacity, and in some cases, roads.2 Capacity constraints are also an issue in the overseas oil markets and will lead to increased volatility. Moreover, there are signs that a growing scarcity of some raw materials may be affecting overall business capital spending in the U.S. Low inventories of new and existing homes for sale are factors in the soft activity in the housing sector. The tighter labor and product markets are pushing up U.S. inflation. At 1.96% year-over-year, the May reading on core PCE, the Fed's preferred measure of inflation, is near a cycle high and has returned to the central bank's target (Chart 1). Moreover, there were a record number of inflation words in the Fed's latest Beige Book. In the past, increased remarks about inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may still climb.3 Fed policymakers have signaled that they will not mind an overshoot of the 2% inflation target. However, with core PCE inflation at 2% and the unemployment rate well below the Fed's estimate of full employment, the FOMC will be slower to defend the stock market in the event of a swoon. Bottom Line: Product and labor markets continue to tighten and push inflation higher, raising the odds that the central bank will take a more aggressive stance in the next 12 months. Last week,4 we downgraded our 12-month recommendation on global equities and credit from overweight to neutral. Capital Spending Update Business capital spending remains upbeat, but may be near a peak. Core durable goods orders dipped by 0.2% m/m in May. The monthly data can be unreliable and it is more useful to look at the year-over-year rates of change. But even here, there is a softening trend. From a recent high of 12.9% y/y, the annual growth rate in core durable goods orders has slowed to 6.6% y/y. Nonetheless, we do not believe that a major down-cycle in U.S. capex has started. The regional Fed surveys of investment intentions remain at lofty levels (Chart 2, panel 2). In addition, managements' attitudes toward capital spending are still upbeat, according to the latest surveys from Duke University, the Conference Board and the Business Roundtable. However, there was a slight downtick in the Business Roundtable metric in Q2 because of the uncertainty surrounding tariffs (Chart 2, panel 1). Moreover, in his post FOMC meeting press conference last month, Fed Chair Powell noted that companies may be delaying decisions on investment spending due to uncertainty around trade policy.5 A tight labor market and accelerating wages mean that firms should look for ways to boost output through productivity-enhancing capex. Furthermore, the 2017 Tax Cuts and Jobs Act allowed for accelerated depreciation, which increased the immediate tax incentive for investment spending. Chart 3 illustrates that through Q1 2018, corporate outlays for dividends ran slightly ahead of previous cycles, while capex and buybacks were about average. BCA will continue to monitor this mix. The lack of business spending on share repurchases is surprising given the spike in buyback announcements in the wake of the tax legislation. (Chart 4, panel 1). However, the bottom panel of Chart 4 indicates that net equity withdrawal is muted and in a downtrend despite the elevated buyback announcements. Chart 2Capex Indicators Still Solid... Capex Indicators Still Solid... Capex Indicators Still Solid... Chart 3Comparison Of Corporate Outlays Across Four Economic Expansion Phases Running Out Of Room Running Out Of Room The positive reading on BCA's Capital Structure Preference Indicator supports our stance that buybacks will add to EPS growth this year (Chart 5, second panel). This indicator is defined as the equity risk premium minus the default-adjusted yield in high-yield corporate bonds. When the indicator is above zero, there is a financial incentive for firms to issue debt and buy back shares. Conversely, firms are incentivized to issue stock and retire debt when the indicator is below zero. The indicator is currently positive, although not as high as it was in 2015. Chart 4Still Some Room To Run For Buybacks Still Some Room To Run For Buybacks Still Some Room To Run For Buybacks Chart 5Buybacks Adding To EPS Growth Buybacks Adding To EPS Growth Buybacks Adding To EPS Growth Bottom Line: May's soft durable goods orders report is probably not a precursor of weaker capex. Corporate managers will look to escalate productivity via capital spending in the next few years as an offset to tight labor markets and scarce resources. The upswing in capital spending is another sign that the U.S. economy is in the late stages of the business cycle.6 Housing Slack Still On Decline The latest soundings on home construction and sales show that inventories of new and existing homes are close to record lows (Chart 6, panel 1 and 2) and that homeownership rates are in a clear uptrend albeit at near historical lows (panel 3), boosted by the tight labor market and rising incomes (panel 4). Most indicators show that the housing market continues to grow along the typical path of the classic boom/bust residential real estate cycle (Chart 7). As such, we expect residential investment will add to GDP growth this year and support housing-related investments. Chart 6Housing Fundamentals##BR##Are Stout Housing Fundamentals Are Stout Housing Fundamentals Are Stout Chart 7Still Plenty Of Gas Left##BR##In The Tank For Housing Still Plenty Of Gas Left In The Tank For Housing Still Plenty Of Gas Left In The Tank For Housing Even so, our past work7 indicated that housing reached a zenith several quarters before other sectors of the economy. BCA's view is that the 10-year treasury rate will peak at 3.80%.8 Nonetheless, housing affordability remains well above average and will be supportive of housing investment even if rates climb by 100 bps (Chart 8). Furthermore, mortgage payments as a share of median income will stay below average if rates escalate by 100 or even 200 bps (panel 2). However, a 200 bp increase in mortgage rates, admittedly an extreme scenario, would crimp housing affordability and nudge the mortgage payment as a share of median income above its long-term average (panels 1 and 2). Homebuilders' costs are rising. The Beige Books released this year pointed out that homebuilders face fierce competition for labor and input costs are rising. In addition, the Beige Book notes slow sales are due to a lack of inventory in some regions of the U.S.9 The implication is that home prices may rise if homebuilders pass on the higher labor and material costs to buyers. There is a shortage of demand for mortgage loans, despite the favorable lending conditions (Chart 9). In addition, first-time homebuyers, a key source of demand for existing homes, has turned from a tailwind to a modest headwind in recent years (Chart 10). Chart 8Housing Affordability Under##BR##Various Rate Assumptions Housing Affordability Under Various Rate Assumptions Housing Affordability Under Various Rate Assumptions Chart 9Easy To Get A Mortgage,##BR##But Mortgage Demand Is Softening Easy To Get A Mortgage But Mortgage Demand Is Softening Easy To Get A Mortgage But Mortgage Demand Is Softening Chart 10Is First Time Homebuyers##BR##Support For Housing Waning? Is First Time Homebuyers Support For Housing Waning? Is First Time Homebuyers Support For Housing Waning? Bottom Line: The housing market remains in an uptrend. A shortage of inventory may be hurting sales, but rising rates are not a threat to affordability. Rising costs for labor and raw materials may cut into homebuilder profits and a recent downshift in first-time homebuyers is a concern. Nonetheless, housing should add to GDP growth this year and next, and keep economic growth well above its long-term potential. In late May, BCA's U.S. Equity Strategy team upgraded the S&P 500 homebuilders industry group to neutral from underweight, citing lower bond yields, solid homebuilder fundamentals and compelling valuations.10 From a macro perspective, we will continue to closely monitor residential investment as we assess the onset of the next recession. Protect Or Defend? BCA's Protector Portfolio does not protect in sideways equity markets. In last week's report,11 we identified 10 periods since 1950 when the S&P 500 equity markets moved sideways for at least 5 months in a narrow range. Table 1 shows the performance of our Defensive and Protector Portfolios12 when U.S. equities are range bound. Our analysis is constrained by data limitations. Table 1S&P Defensives And BCA Protector Portfolios In Sideways Equity Markets Running Out Of Room Running Out Of Room On average, investors have been better off in the S&P 500 than in our Protector Portfolio during sideways phases that have occurred since 1986. Our portfolio outperformed the S&P 500 in only one (2004) of the seven sideways periods. On average, the S&P 500 returned 22% while the Protector Portfolio posted a 2.8% decline. Moreover, the portfolio lost value in the 1988 and 2015 sideways episodes (Chart 11A). Chart 11AS&P Defensives In##BR##Sideways Equity Markets S&P Defensives In Sideways Equity Markets S&P Defensives In Sideways Equity Markets Chart 11BBCA's Protector Portfolio In##BR##Sideways Equity Markets BCA's Protector Portfolio In Sideways Equity Markets BCA's Protector Portfolio In Sideways Equity Markets On the other hand, our Defensive Portfolio outperformed both the S&P 500 and the Protector Portfolio during the three sideways periods since its inception in 1995 (Chart 11B). Consistent with our shift in broad asset allocation this month, we have adjusted our global equity sector allocation to be more defensive. Materials and Industrials were downgraded to underweight, while Healthcare and Telecoms were upgraded (Consumer Staples was already overweight). Financials was downgraded to benchmark because the flattening term structure is expected to pressure net interest margins.13 Bottom Line: BCA's Protector Portfolio has underperformed the S&P 500 and defensive equities in sideways periods for U.S. equities. We recommend that investors put the proceeds from the sale of equity positions into cash. Nonetheless, investors seeking protection against a potential equity market sell-off should look to our Protector Portfolio over defensive-sector positioning. We do not currently recommend these portfolios for all clients, but we may do so if our key sell-off triggers are breached. If macro developments evolve as expected, then we will shift to an outright bearish stance on risk assets later this year or early 2019 in anticipation of a global recession in 2020. Absent a recession, we would move to underweight stocks if a wider trade war develops. Conversely, we would consider temporarily shifting our 12-month recommendation back to overweight if global equities sell-off by more than 15% in the next few months. This would be the case if our economic indicators remain constructive and the Fed either cuts rates or signals that it is on hold. Signs Of Stress In Oil West Texas Intermediate (WTI) oil futures hit a fresh 4-year high last week, despite OPEC 2.0's decision to pump more oil. BCA's Commodity & Energy Strategy service notes that oil markets are becoming increasingly concerned about possible supply disruptions.14 BCA's view is that the Kingdom of Saudi Arabia (KSA) and the core members of OPEC 2.0 - i.e. the seven states in the 24-state coalition that actually can increase production - are attempting to get ahead of an almost certain tightening of the global oil market. Our base case is that OPEC 2.0's core states will front-load their production increase with approx. 800k b/d added to the market in 2H18 and just over 210k b/d in 1H19.15 This will lift the core's total output by about 1.1mm b/d by the end of 1H19 versus 1H18. The increased output from core OPEC 2.0 is, however, offset by losses in the rest of OPEC 2.0 of approx. 530k b/d in 2H18 and just under 640k b/d in 1H19. This leaves OPEC 2.0's net output up by about 275k b/d in 2H18 and down by about 430k b/d in 1H19 compared with 1H18 levels (Chart 12). We keep demand growth at 1.7mm b/d in 2018 and 2019. Our oil strategists' base case is augmented with three possible scenarios: Venezuela's production collapses to 250k b/d from its current 1.3mm b/d, which would allow it to support the demand for domestically refined product and nothing more; A reduction in our forecasted increase in U.S. shale production arising from pipeline bottlenecks; and Both of these two scenarios occur simultaneously between October 2018 and September 2019. Chart 13 illustrates that our revised "ensemble" forecast, an average of the scenarios noted above, for 2H18 Brent stands at $70/bbl, versus $76/bbl last month, reflecting the front-loaded increase in OPEC 2.0 production The global benchmark will likely return to $77/bbl next year, against our previous expectation of $73/bbl. We continue to expect WTI to trade $6/bbl under Brent during the next 18 months. Chart 12OPEC 2.0's Core's Production Increase##BR##Offset By Non-Core Losses OPEC 2.0's Core's Production Increase Offset By Non-Core Losses OPEC 2.0's Core's Production Increase Offset By Non-Core Losses Chart 13Updated Ensemble Forecast Reflects##BR##Venezuela Deterioration, Shale Bottlenecks Updated Ensemble Forecast Reflects Venezuela Deterioration, Shale Bottlenecks Updated Ensemble Forecast Reflects Venezuela Deterioration, Shale Bottlenecks Elevated oil price volatility is a headwind for risk assets. The instability in crude oil markets will continue for the next 18 months, particularly if unplanned outages continue to occur. We identified seven prior periods of increasing oil price volatility. Chart 14 shows that three of these episodes of higher realized oil uncertainty occurred after the economy reached full employment (1998, 2001 and 2008). Two overlapped with recessions (2001 and 2008). Another three coincided with the Russian default crisis of 1998, the accounting scandals and Iraq war in 2002/2003, the U.S. debt downgrade, Arab Spring, the European debt crisis in 2011, and the China-led manufacturing slowdown in 2015. All of these events, at the margin directly or indirectly, affected oil supply demand or both. Because these were shocks of one sort or another-financial, geopolitical or economic-they raised markets' perceptions of risk on the upside and downside for oil prices. Chart 14Risk Assets During Oil Market Volatility Risk Assets During Oil Market Volatility Risk Assets During Oil Market Volatility Risk assets underperformed, other than in the 2002-2003 period of heightened oil market fluctuations associated with the General Strike in Venezuela, which took that country's production to zero for a brief period. The dollar fell in the first three phases of oil price volatility in Chart 14, but increased in the past four. Higher oil volatility tends to coincide with falling oil prices, but a price shock that lifts prices also can accompany higher volatility. Bottom Line: BCA's Commodity & Energy Strategy team notes that oil supply outages are mounting and will lead to more turbulence. Moreover, risk assets tend to underperform as oil volatility escalates. We are neutral on the energy sector. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report titled "Cleanup On Aisle Two", published June 4, 2018. Available at usis.bcaresearch.com. 2 Please see BCA Research's Energy Sector Strategy Weekly Report "Permian Pipeline Constraints Pose Risks To 2019 Shale Production Growth", published June 13, 2018. Available at nrg.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report titled "Cleanup On Aisle Two", published June 4, 2018. Available at usis.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report titled "Sideways", published June 25, 2018. Available at usis.bcaresearch.com. 5 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20180613.pdf 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," published October 16, 2017. Available at usis.bcaresearch.com. 7 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Tightening Up", published May 14, 2018. Available at usis.bcaresearch.com. 8 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Bond Bear Still In Tact," published June 5, 2018. Available at usbs.bcaresearch.com. 9 https://www.federalreserve.gov/monetarypolicy/beigebook201805.htm 10 Please see BCA Research's U.S. Equity Strategy Weekly Report "Seeing The Light", published May 29, 2018. Available at uses.bcaresearch.com. 11 Please see BCA Research's U.S. Investment Strategy Weekly Report "Sideways", published June 25, 2018. Available at usis.bcaresearch.com. 12 Please see BCA Research's U.S. Investment Strategy Weekly Report "A Golden Opportunity", published March 5, 2018. Available at usis.bcaresearch.com. 13 Please see BCA Research's Bank Credit Analyst Monthly Report "July 2018", published June 28, 2018. Available at bca.bcaresearch.com. 14 Please see BCA Research's Commodity & Energy Strategy Weekly Report " OPEC 2.0 Scrambles To Reassure Markets", published June 28, 2018. Available at ces.bcaresearch.com. 15 OPEC 2.0 is the coalition led by Saudi Arabia (KSA) and Russia. This past week it agreed to boost production by 1mm b/d beginning in July. The core consists of KSA, Russia, Iraq, UAE, Kuwait, Oman and Qatar.

With the group stage of the 2018 FIFA World Cup in the books, it is time to assess the performance of our forecast and re-run the model for the playoff stage of the competition. As a reminder, our approach includes micro (player level) and macro (team level) factors to forecast game matches. For data, we relied on the database of player statistics used in Electronic Arts (EA) Sports FIFA computer simulation, eschewing the conventional wisdom of relying on overall team rankings. Because our report was penned in May, not all 32 teams had made official their final list of 23 players. We therefore relied on our own expertise (soccertise, if you will) to determine the most likely team composition for the tournament. We have since re-ran the group stage model with the rosters announced by all 32 team federations, with Chart 1 showing the difference in predicted results.1 Chart 1Probability Of Proceeding To The Knockout Stage Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts To forecast match outcomes, we developed two separate models, one for the group stage and one for the knockout phase. In this report, we will only briefly touch on the composition of the two models and focus instead on their performance. Clients wishing to study our model in depth can read the original special report, The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup.2 Step One: The Group Stage Model Overall, our group stage model performed adequately. We forecast 60% of the total games correctly and got 14 out of the 16 teams passing to the next round right. In addition, we correctly ranked 12 of those teams according to their group seeding. If we average the model estimated probability of each team we said would make it to the knockout phase, we had a conviction of ~71% in our model. To simulate the group stage matches, we developed an Ordered Probit (OP) model estimated on past World Cup group stage games. Based on our sample of group-stage matches from the past three World Cups, we found that the best explanatory variables for this stage of the competition are: Team Average Player Rating Average Age - Forwards Average Number of Caps - Defenders Speed Positions Average Rating Our model had one major flaw, giving Germany the highest probability of passing to the next stage (Table 1). However, it picked up the weakness in Argentina by assigning them only the 10th highest ranking of proceeding to the next stage. Other notable successes were the strong performances of Belgium, England, Russia, Denmark, and Mexico. Group-by-group, we had an essentially flawless track record in groups A, B, C, E, and G. The decision to award Russia a "home advantage bonus" proved prescient. After all, history tells us that hosting the World Cup provides a clear advantage to almost any team (Table 2). We are also particularly proud of our correct forecast in Group E, the true "group of death." Our assessment of Switzerland's quality ultimately carried the day. Table 1Group Stage Ranking Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts Table 2Home Advantage Is Real Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts Our Group D forecast misfired by expecting Argentina to go through in first place. To the model's credit, it only gave Argentina 47% probability to beat Iceland, 49% to beat Nigeria, and a paltry 43% to defeat Croatia (Table 3). While we had Argentina going all the way to the quarterfinals, we did flag their weaknesses in our qualitative assessment, calling them the "greatest underperformer in the last three decades of international football."3 Ultimately, our model had Spain dispatching La Albiceleste easily, giving Argentina only 10% chance of an upset. Table 3Group D Summary Results Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts There was no moral victory with our Group F forecast. We gave Mexico only a 21% probability of defeating Germany and an even lower 11% probability that South Korea would do the same (Table 4). We should have been more in tune with history, especially given that there appears to exist somewhat of a "winners' curse" when it comes to World Cup performance (Table 5). Table 4Group F Summary Results Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts Table 5The World Cup 'Champions' Curse' Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts What explains this curse? We suspect that World Cup winners hesitate to replace heroes from the previous campaign with fresh blood. In the case of Germany in 2018, the team left the 22-year old Manchester City phenom Leroy Sané off the team but stuck with the uninspiring Mesut Ozil and the mummified Sami Khedira. Because the World Cup is on a four-year cycle, nostalgia can be a fatal flaw. Germany stuck to much the same team while its peers refreshed their rosters with youth and in-form talent. In addition, a number of crucial players from Germany's 2014 victory retired or are no longer part of the national team, including Philipp Lahm, Bastian Schweinsteiger, Lukas Podolski, and Miroslav Klose Finally, our Group H forecast misfired as well (Table 6). However, we correctly flagged the group as essentially unforecastable. Picking Colombia to top the group was a good call, at the very least. Table 6Group H Summary Results Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts Chart 2 shows the probabilities we assigned to each team to clear the knockout stage. Generally speaking, we are satisfied with the results. However, we do have to apologize to our Swedish clients, our model has clearly failed them by the greatest margins. Chart 2With Apologies To Our Swedish And Japanese Clients! Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts Step Two: The Knockout Stage Model The knockout stage is somewhat easier to model given that the set of possible outcomes is reduced to only {loss; win}. This difference with the group stage is not only relevant for the math behind our model. It is also relevant for the strategy teams employ during the games. Therefore, we simulated this part of our analysis using a probit model estimated on a sample of only knockout stage games from the 2006, 2010, and 2014 World Cups. In this stage of the competition, we found the following factors to be the most important: Team Average Player Rating Club Level Synergy Player GINI Coefficient Average Rating - Midfielders Team Average Rating As with the group stage, the overall rating of the team - based on the average of individual rankings from the EA Sports database - is the most powerful explanatory variable. Despite the higher marginal effect of the rating variables in the knockout stage sample, the standard deviation and average of these variables are significantly smaller than in the group stage.4 In other words, the gap in player quality between teams in the group stage is often vast. However, the knockout stage culls the minnows, narrowing the gap in overall player quality between teams. At this stage of the competition, our model has to be supplemented with variables that test for teamwork and synergy. Club Level Synergy Teams with more players playing in the same club tend to perform better in the knockout stages. This is evident from all the World Cup winners in our sample.5 Given the limited practice time that national teams have ahead of the tournament, the year-round experience of playing with teammates in club competition can provide a huge advantage. Especially for football teams from countries with major leagues - such as Germany, Spain and Italy. Their players are more likely to cluster on the major clubs in those leagues, whereas players from smaller footballing nations have to ply their trade in dispersed leagues and teams across the globe. Great Man Theory (Player GINI Coefficient) Teams win games, but heroes win World Cups. To test whether superstars are relevant to winning games, we designed a player quality GINI measure. We find that teams with a higher GINI coefficient outperform those with a lower measure. It seems that having a superstar, or two or three, surrounded with role players is a superior strategy to having balanced talent across all positions. This variable only becomes significant in the knockout stages, where the overall talent level between teams narrows. While more skilled teams tend to be more balanced (Chart 3), once we normalize for skill, a higher GINI becomes a predictor of success. Chart 3The Great Man Theory At Play Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts Average Rating - Midfielders Once we decompose the different positions in the field, we find that the midfield is more important to success than other positions in the knockout matches. Research has shown that midfielders, particularly those forming the "spine" of the team, are the most involved in a team's passing play, regardless of the tactics or strategy used.6 Precise and creative passing is key in knockout matches where tactically disciplined defenses are difficult to unlock. Defensive prowess in the midfield is also paramount to prevent the opposition from developing their attack.7 Lessons Learned From The Group Stage Have we learned anything thus far from group play that would make us modify our four predictive variables? Yes, two observations stick out as potentially dangerous to our assumptions. The Pressing Renaissance Liverpool manager Jürgen Klopp has internationalized Genenpressing -counter pressing - during his tenure at Anfield. When Klopp's team loses the ball, players immediately attack the space where the opponents have won possession, allowing the rest of the team to re-set the defense. But the point is not to just recover on defense, but rather to win the ball right after the team has lost it. This is when the opponent is at their most vulnerable as they are looking to pass and get out of their own defensive zone. Chart 4Is Tiki-Taka Dead? Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts This frantic pace of football, which Klopp himself termed "Heavy Metal Football," requires fitness, discipline, and superior tactical awareness. It also requires defenders to play up the field, which opens them to counter attacks. The Genenpress is a perfect antidote to possession football. However, it is difficult for national football teams to replicate as it requires discipline that can only be achieved through meticulous training. Or, at least, that was the conventional view until this World Cup. In Russia, goals scored out of open play are considerably down (Chart 4), suggesting that possession football has seen a fall in its ROI. Small national teams, that in the past would have been content to sit back and absorb the pressure, are now zone pressing like the finely synchronized European clubs. Morocco, Iran, Iceland, and especially Mexico in its stunning victory over Germany all employed the press well enough to either stun opponents or threaten to do so. This augurs poor results for possession heavy teams in the knockout stage, particularly our favorite Spain. The Return Of The "Big 9" There was a time, not long ago, when football analysts thought that the hulking center-forward was extinct. Instead of big strikers, teams opted for either an extra midfielder or a winger-type forward like Spain's David Villa or Germany's Mario Götze, heroes of the past two World Cups. In 2018, this is not the case. With the proliferation of pressing, scoring from open play becomes more difficult, which means that both set pieces and long ball passes become more important, increasing the value of the big center-forward.8 Table 7 shows the top scorers through the group stages in 2014, Table 8 shows the data in 2018. What is striking is the 7-centimeter difference in the median height of the top-scorers in the group stages of the two competitions. Table 7Top Scorer 2018 By Height In The Group Stage Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts Table 8Top Scorer 2014 By Height In The Group Stage Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts Luckily for our top-pick Spain, it sports probably the most lumbering, hulking, mean, brute of a center-forward in modern football, Diego Costa of Atletico Madrid. As such, it may still have the requisite combination of strength and possession play to defeat Heavy Metal Football. In addition, its defenders are more than capable of skipping over the press by targeting Costa with long balls. Knockout Stage: Results Table 9 shows our model's forecast for the round of 16, while Chart 5 gives the conditional probability of advancing to the quarter-finals. Conditional probability takes into account the original probability of passing the group stage. Table 9The Magnificent Eight Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts Chart 5Conditional Probability Of Passing To The Quarter-Final Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts We fully agree with our model when it comes to the Spain-Russia matchup. The model is correctly dismissive of the hosts, who were "brought to earth" by their matchup against Uruguay. Russia's run of good fortune will run out against our favorite, Spain. The model is also correct to favor Croatia over Denmark. However, this represents a "trap" game for the Vatreni, who after dispatching Argentina 3-0 may be looking "beyond" Danes to the quarter-final matchup with Spain. Look for Denmark to "muddy" the game up and turn it into a classic UEFA heavyweight fight. We also have nothing to add to the England-Colombia matchup and agree that the former is favored to pass to the quarterfinals. The model may be overly dismissive of Mexico, however. Brazil has looked shaky in group games, so we would give Mexico more than 3% probability, especially given that El Tri will be buoyed by its surprisingly well represented fan base in Russia. We also think that the model is far too confident in Portugal's chances against Uruguay. Ronaldo's talent should be enough to push Portugal through, but 70% probability of a victory may be too high. The model is also far too pessimistic when it comes to the France-Argentina matchup. It is highly unlikely that Argentina will be able to squeak through against the extremely physical Les Bleus. The one matchup where we truly are torn is in the Sweden-Switzerland matchup. Our model is correct to be cautious, essentially styling the matchup a "too-close-to-call" affair, but still giving Sweden the nod. This is hard to justify after the inspired play of Switzerland against Brazil and Serbia. However, Sweden has the momentum, having defeated a fired-up Mexico 3-0 in a must-win game for El Tri. Switzerland, on the other hand, only managed a tie against Costa Rica. Quarter-Finals Making it into the quarter-finals of the World Cup is an extraordinary success reserved for only eight footballing nations. At this point, teams have played four intense and decisive games over three weeks. Fatigue sets in, especially given that the superstars are playing at the end of a grueling club season in what is normally their off-season. Our model bets strongly on Spain and England (Table 10), while Brazil and France are expected to have tight games against strong opponents. Belgium and Portugal are left to wonder what might have been, although for Belgium the pain will be greater. Not only will they yet again fail to meet expectations, but also they will waste the highest conditional probability of advancing to the next stage of the four teams that do not advance (Chart 6). Table 10The Final Four Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts Chart 6Conditional Probability Of Passing To The Semi-Final Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts France Vs. Portugal: Setting The Record Straight The loss to Portugal in the final of the 2016 Euro, on home soil no less, still stings for France. The loss was particularly painful given that Portugal's superstar, Real Madrid's Cristiano Ronaldo, had to leave the game due to an injury and spent the majority of the game hopping on one leg, yelling instructions to his teammates from the sidelines. Our model gives France a 56% probability of winning the game. The French team is superior in every facet of the game, other than in the speed positions (Diagram 1). France also sports the game's best defensive midfielder, Chelsea's N'Golo Kanté, to whom it will fall on to neutralize Portugal's Great Man. The duo of Kanté and Paul Pogba reminds us of the legendary Claude Makélélé and Patrick Vieira partnership that took France to the 2006 finals. French coach Didier Deschamps has also benefited from the overall improvement in the French Ligue 1, calling upon players that play together in the local league. We expect a tight match, with intense man-on-man coverage of Ronaldo. France will dominate the ball, slowly building chances against Portugal's defense. In 2016, a young and inexperienced French team wasted a plethora of chances against Portugal's version of the Maginot Line. Since then, superstars Ousmane Dembélé (F.C. Barcelona) and Kylian Mbappé (Paris Saint Germain) have joined the French rankes. We do not see history repeating itself. Brazil Vs. Belgium: Red Devils Don't Dance Samba Our model sees Brazil as the favorite against Belgium, but not by an extraordinary margin. As with the France-Portugal matchup, the underdog has a solid chance - in this case one-in-three - of winning the game. What makes Belgium so dangerous is their solid midfielder rating and the extremely physical Romelu Lukaku in the front. However, the two Brazilian center backs Thiago Silva and Miranda have been more than reassuring in the group stage and are more than capable of dealing with Lukaku or Hazard. The problem for the Red Devils is that they trail Brazil by a lot in the other facets of the game (Diagram 2). Its defense is particularly suspect. Diagram 1Les Bleus Vs. A Selecao Das Quinas Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts Diagram 2A Selecao Vs. The Red Devils Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts Spain Vs. Croatia: Winner Gets The Mediterranean Croatia has been a revelation at this year's tournament. Its high midfield line of Ivan Perišic (Inter Milan), Ivan Rakitic (F.C. Barcelona), Luka Modric (Real Madrid), and super-sub Mateo Kovacic (Real Madrid) may be one of the best mid-fields at the tournament. It wreaked havoc against Argentina, rendering Messi useless. Juventus forward Mario Mandzukic supplies the threat at the front and Inter defensive midfielder Marcelo Brozovic cleans up the mistakes at the back. Our model is overly dismissive of Croatia, giving Spain a ludicrous 93% to win the game. But just as the biggest threat to Croatia is overlooking the unassuming Danes in the round of 16, so too Spain may be in for a fight of its life against the stacked Vatreni. Croatia has a team with enough quality to match its 1998 fourth-place performance. We predict that, if these two teams really do meet in the quarter-finals, that it could be the match of the century. Ultimately, Spain comes on top on all the rating measures against Croatia (Diagram 3). We fear, however, that the gap is overstated. Croatia's starting 11 against Argentina sported seven players from Europe's top four-five clubs. This is more than enough to challenge Spain. Yes, Croatia's defense is shaky, but if it ends up dominating the midfield against Spain - we know, a sacrilegious thought! - its defenders may have a night off. Sweden Vs. England: Who Will Shock The World? This was not supposed to be England's year. The Lions are the youngest team (average age 26) and the least experienced (average caps 20). This was supposed to be the World Cup where England finally breaks out into the elite-eight and sets the stage for a 2022 campaign as a favorite. Instead, England will face off against Sweden, ranked 24 in the FIFA World Ranking. Our model gives England an 84% probability to defeat Sweden, even higher than the odds it assigns to its round-of-16 matchup against Colombia (68%), largely due to a considerable mismatch in quality (Diagram 4). Diagram 3La Furia Roja Vs. Vatreni Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts Diagram 4Blagult Vs. The Three Lions Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts Sweden is in much the same situation. Nobody expected Sweden to do much at this world cup, including our model. We originally assigned Sweden a solid 22.7% probability of getting out of its group (still behind Mexico at 62.4% and Germany at 91.4%). Once we updated our model with Sweden's final roster and updated player data, that probability collapsed to 10.9%! And yet, here is Sweden, in the quarter-finals with a chance to emerge as one of the four best footballing countries in the world. We are well aware of Sweden's extraordinary history. As with everything else - the economy, finance, culture, food, design, art, history, music - Sweden punches way above its weight. When it qualifies for the tournament, it almost always gets out of the group stage. It came second - at home - in 1958, fourth in 1938, and third in 1950 and 1994. The experienced Sweden will go into its matchup with England with nothing to lose. Whereas the weight of England's underwhelming track record - and the hysterics of its media - could be too much for the young Lions to bear. We would not bet on it, but Sweden could be the shock of this tournament.9 Semi-Finals Our model sees Spain as a lock for the finals, but throws its hands up for the Brazil-France matchup (Table 11). If we were to put money on either Brazil or France getting to the finals, it would be an obvious call. Brazil's conditional probability of getting to the big game is a solid 36% compared to just 11% for France (Chart 7). This is because Les Bleus have a terrifying road to the Finals, having to go through Portugal, Argentina, and Brazil. While Brazil is clearly the safer pick to get through to the finals, we still like France to win the game. Table 11And Then There Were Two Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts Chart 7Conditional Probability Of Passing To The Final Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts France Vs. Brazil: Painful Memories Of the remaining four teams, France is actually the most accomplished remaining club, having practically coasted to the finals of the Euro 2016. Brazil's latest title, meanwhile, is a distant 2007 Copa América victory. In terms of quality, the two teams are even on forwards. Brazil takes a big advantage in speed positions and defenders, but the two teams are essentially equal in the midfield (Diagram 5). The French squad also displays better results on the club synergy variable, the second-best reading for the teams in the knockout stage behind Spain. This is the result of improvements to its domestic league. Meanwhile, Brazil's top players continue to be dispersed across a number of different top clubs. In terms of momentum, France wins big. It survived a challenge from a tricky Australia and dangerous Peru. Its performances have not been pretty, but it has been clinical. Brazil, on the other hand, proved to be vulnerable against Switzerland, which stymied it with physical play. Newsflash: France is one of the most physical teams at the World Cup. Brazil will avenge its disastrous result from 2014 with a solid showing in Russia. Its pride will be reestablished and memories of the 7-1 drubbing softened. However, it will fail yet again against a European power. Spain Vs. England: Where Is Francis Drake When You Need Him?! Spain's superiority across the pitch makes it the overwhelming favorite against England (Diagram 6). To this we should add experience, both in age and in big-game performance. Diagram 5Les Bleus Vs. A Selecao Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts Diagram 6La Furia Roja Vs. The Three Lions Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts The revamped Spain is much better at scoring goals, which will be a problem for England's untested defense. In 2010, the year of Spain's last title, the team relied heavily on what made F.C. Barcelona unbeatable in Europe: heavy possession of the ball and gameplay built on crisp passes. This still holds true today, as tiki-taka has become part of Spain's footballing DNA. However, after underperforming in the 2014 World Cup and at the 2016 Euro, new coach Julen Lopetegui has slowly improved overall play. This has particularly involved raising the quality of the Spanish attack. As Spain discovered in the last two major competitions, it is not enough to have possession for 80% of the game if one cannot do anything with the ball. England's group stage games against Tunisia, Panama, and Belgium tell us absolutely nothing about its big-game performance. Judging by their effort, Tunisia and Panama may have been the two weakest teams at this World Cup. England's premier matchup against Belgium turned into a warmup, as both teams rested their starters. Its games against Colombia and Sweden would be tough, but nowhere near the type of a test that Spain will represent. As such, we see the Spanish Armada prevailing this time around. The Finals: Spain Vs. France BCA's Two-Step World Cup model predicts that, on July 15, 2018, the world will see Spain dispatch France in the finals of the world's sporting pilgrimage (Diagram 7). Our model gives Spain an 83% probability of beating France. It is undeniable that Spain has superior quality across the pitch save for in attack (Diagram 8). However, its midfield has not yet "clicked." Other than the play of Isco, the Spanish midfield has been underwhelming. If this continues into the knockout round, the team could be in trouble against physical France. Diagram 7The Road To Glory Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts What of the game for third place? Surprisingly, it may be the game of the tournament!10 Sure, third place means little. However, this game will mean a lot for the young England. Brazil could overlook the game, despite its better quality (Diagram 9). For Brazil, yet another third-place matchup will be seen as a failure. But England will see in the game a launching pad for an exciting 2020 Euros and 2022 World Cup. Diagram 8La Furia Roja Vs. Les Bleus Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts Diagram 9A Selecao Vs. The Three Lions Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts Chart 8Conditional Probability Of Immortality Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts How does our forecast compare with current betting odds? Chart 8 shows that our model gives Spain an extraordinarily high probability of winning the tournament. Spain has not shown the quality thus far that would justify such a high conviction level. Updating The 2018 World Cup Forecasts Updating The 2018 World Cup Forecasts 1 We have also uploaded the most recent player statistics from the Electronic Arts database. 2 Please see BCA Research Special Report, "The Most Important Of All Unimportant Forecasts: 2018 FIFA World Cup," dated May 23, 2018, available at gps.bcaresearch.com. 3 We went on to say that, "in another twenty years of unfulfilled promises, fans will look back at its past success the way we think of Uruguay's two World Cups, won in 1930 and 1950." 4 Remember that the marginal effect represents the impact of a 1-unit change in the rating variable on the probability of winning. This is why we need to be careful when comparing both stages' marginal effect. A 1-unit change in the rating variable is less frequent, but extremely important in the knockout stage, hence the higher coefficient. 5 In 2006, Italy had 10 players form either Juventus or AC Milan; in 2010, Spain had 12 players from either F.C. Barcelona or Real Madrid; and in 2014, Germany had 11 players from either Bayern Munich or Borussia Dortmund. 6 Please see M. Clemente et al, "Midfielder as the prominent participant in the building attack: A network analysis of national teams in FIFA World Cup 2014," International Journal of Performance Analysis in Sport 15:2 (2015), 704-722. 7 Please see F. M. Clemente et al, "Using Network Metrics in Soccer: A Macro-Analysis," Journal of Human Kinetics 45 (2015), 123-134. 8 Think of Spain's first goal at this World Cup: a long pass to Diego Costa who then bullies his way against five defenders to a score. 9 In which case, someone should check that Zlatan is ok. 10 This would not be the first time that the third-place game steals the spotlight. Going back to 1978, the third-place game has outscored the final by a considerable margin. Teams usually enter the game with no pressure and therefore commit to a flowing, attacking style of play. Some of the most exciting games in World Cup history were played for third place: think Germany's 3-2 win over Uruguay in 2010, or Turkey's thrilling 3-2 win against South Korea.

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

Feature Valuations, whether for currencies, equities or bonds, are always at the top of the list of the determinants of any asset's long-term performance. This means that after large FX moves like those experienced so far this year, it is always useful to pause and reflect on where currency valuations stand. In this optic, this week we update our set of long-term valuation models for currencies that we introduced In February 2016 in a Special Report titled, "Assessing Fair Value In FX Markets". Included in these models are variables such as productivity differentials, terms-of-trade shocks, net international investment positions, real rate differentials and proxies for global risk aversion.1 These models cover 22 currencies, incorporating both G-10 and EM FX markets. Twice a year, we provide clients with a comprehensive update of all these long-term models in one stop. The models are not designed to generate short- or intermediate-term forecasts. Instead, they reflect the economic drivers of a currency's equilibrium. Their purpose is therefore threefold. First, they provide guideposts to judge whether we are at the end, beginning or middle of a long-term currency cycle. Second, by providing strong directional signals, they help us judge whether any given move is more likely to be a countertrend development or not, offering insight on its potential longevity. Finally, they assist us and our clients in cutting through the fog, and understanding the key drivers of cyclical variations in a currency's value. The U.S. Dollar Chart 1Dollar: Back At Fair Value Dollar: Back At Fair Value Dollar: Back At Fair Value 2017 was a terrible year for the dollar, but the selloff had one important positive impact: it erased the dollar's massive overvaluation that was so evident in the direct wake of U.S. President Donald Trump's election. In fact, today, based on its long-term drivers, the dollar is modestly cheap (Chart 1). Fair value for the dollar is currently flattered by the fact that real long-term yields are higher in the U.S. than in the rest of the G-10. Investors are thus betting that U.S. neutral interest rates are much higher than in other advanced economies. This also means that the uptrend currently evident in the dollar's fair value could end once we get closer to the point where Europe can join the U.S. toward lifting rates - a point at which investors could begin upgrading their estimates of the neutral rate in the rest of the world. This would be dollar bearish. For the time being, we recommend investors keep a bullish posturing on the USD for the remainder of 2018. Not only is global growth still slowing, a traditionally dollar-bullish development, but also the fed funds rate is likely to be moving closer to r-star. As we have previously showed, when the fed funds rate rises above r-star, the dollar tends to respond positively.2 Finally, cyclical valuations are not a handicap for the dollar anymore. The Euro Chart 2The Euro Is Still Cheap The Euro Is Still Cheap The Euro Is Still Cheap As most currencies managed to rise against the dollar last year, the trade-weighted euro's appreciation was not as dramatic as that of EUR/USD. Practically, this also means that despite a furious rally in this pair, the broad euro remains cheap on a cyclical basis, a cheapness that has only been accentuated by weakness in the euro since the first quarter of 2018 (Chart 2). The large current account of the euro area, which stands at 3.5% of GDP, is starting to have a positive impact on the euro's fair value, as it is lifting the currency bloc's net international investment position. Moreover, euro area interest rates may remain low relative to the U.S. for the next 12 to 18 months, but the 5-year forward 1-month EONIA rate is still near rock-bottom levels, and has scope to rise on a multi-year basis. This points toward a continuation of the uptrend in the euro's fair value. For the time being, despite a rosy long-term outlook for the euro, we prefer to remain short EUR/USD. Shorter-term fair value estimates are around 1.12, and the euro tends to depreciate against the dollar when global growth is weakening, as is currently the case. Moreover, the euro area domestic economy is not enjoying the same strength as the U.S. right now. This creates an additional handicap for the euro, especially as the Federal Reserve is set to keep increasing rates at a pace of four hikes a year, while the European Central Bank remains as least a year away from lifting rates. The Yen Chart 3Attractive Long-Term Valuation, But... Attractive Long-Term Valuation, But... Attractive Long-Term Valuation, But... The yen remains one of the cheapest major currencies in the world (Chart 3), as the large positive net international investment position of Japan, which stands at 64% of GDP, still constitutes an important support for it. Moreover, the low rate of Japanese inflation is helping Japan's competitiveness. However, while valuations represent a tailwind for the yen, the Bank of Japan faces an equally potent headwind. At current levels, the yen may not be much of a problem for Japan's competitiveness, but it remains the key driver of the country's financial conditions. Meanwhile, Japanese FCI are the best explanatory variable for Japanese inflation.3 It therefore follows that any strengthening in the yen will hinder the ability of the BoJ to hit its inflation target, forcing this central bank to maintain a dovish tilt for the foreseeable future. As a result, while we see how the current soft patch in global growth may help the yen, we worry that any positive impact on the JPY may prove transitory. Instead, we would rather play the yen-bullish impact of slowing global growth and rising trade tensions by selling the euro versus the yen than by selling the USD, as the ECB does not have the same hawkish bias as the Fed, and as the European economy is not the same juggernaut as the U.S. right now. The British Pound Chart 4Smaller Discount In The GBP Smaller Discount In The GBP Smaller Discount In The GBP The real-trade weighted pound has been appreciating for 13 months. This reflects two factors: the nominal exchange rate of the pound has regained composure from its nadir of January 2017, and higher inflation has created additional upward pressures on the real GBP. As a result of these dynamics, the deep discount of the real trade-weighted pound to its long-term fair value has eroded (Chart 4). The risk that the May government could fall and be replaced either by a hard-Brexit PM or a Corbyn-led coalition means that a risk premia still needs to be embedded in the price of the pound. As a result, the current small discount in the pound may not be enough to compensate investors for taking on this risk. This suggests that the large discount of the pound to its purchasing-power-parity fair value might overstate its cheapness. While the risks surrounding British politics means that the pound is not an attractive buy on a long-term basis anymore, we do like it versus the euro on a short-term basis: EUR/GBP tends to depreciate when EUR/USD has downside, and the U.K. economy may soon begin to stabilize as slowing inflation helps British real wages grow again after contracting from October 2016 to October 2017, which implies that the growth driver may move a bit in favor of the pound. The Canadian Dollar Chart 5CAD Near Fair Value CAD Near Fair Value CAD Near Fair Value The stabilization of the fair value for the real trade-weighted Canadian dollar is linked to the rebound in commodity prices, oil in particular. However, despite this improvement, the CAD has depreciated and is now trading again in line with its long-term fair value (Chart 5). This lack of clear valuation opportunity implies that the CAD will remain chained to economic developments. On the negative side, the CAD still faces some potentially acrimonious NAFTA negotiations, especially as U.S. President Donald Trump could continue with his bellicose trade rhetoric until the mid-term elections. Additionally, global growth is slowing and emerging markets are experiencing growing stresses, which may hurt commodity prices and therefore pull the CAD's long-term fair value lower. On the positive side, the Canadian economy is strong and is exhibiting a sever lack of slack in its labor market, which is generating both rapidly growing wages and core inflation of 1.8%. The Bank of Canada is therefore set to increase rates further this year, potentially matching the pace of rate increase of the Fed over the coming 24 months. As a result of this confluence of forces, we are reluctant to buy the CAD against the USD, especially as the former is strong. Instead, we prefer buying the CAD against the EUR and the AUD, two currencies set to suffer if global growth decelerates but that do not have the same support from monetary policy as the loonie. The Australian Dollar Chart 6The AUD Is Not Yet Cheap The AUD Is Not Yet Cheap The AUD Is Not Yet Cheap The real trade-weighted Australian dollar has depreciated by 5%, which has caused a decrease in the AUD's premium to its long-term fair value. The decline in the premium also reflects a small upgrade in the equilibrium rate itself, a side effect of rising commodity prices last year. However, despite these improvements, the AUD still remains expensive (Chart 6). Moreover, the rise in the fair value may prove elusive, as the slowdown in global growth and rising global trade tensions could also push down the AUD's fair value. These dynamics make the AUD our least-favored currency in the G-10. Additionally, the domestic economy lacks vigor. Despite low unemployment, the underemployment rate tracked by the Reserve Bank of Australia remains nears a three-decade high, which is weighing on both wages and inflation. This means that unlike in Canada, the RBA is not set to increase rates this year, and may in fact be forced to wait well into 2019 or even 2020 before doing so. The AUD therefore is not in a position to benefit from the same policy support as the CAD. We are currently short the AUD against the CAD and the NZD. We have also recommended investors short the Aussie against the yen as this cross is among the most sensitive to global growth. The New Zealand Dollar Chart 7NZD Vs Fair Value NZD Vs Fair Value NZD Vs Fair Value After having traded at a small discount to its fair value in the wake of the formation of a Labour / NZ first coalition government, the NZD is now back at equilibrium (Chart 7). The resilience of the kiwi versus the Aussie has been a key factor driving the trade-weighted kiwi higher this year. Going forward, a lack of clearly defined over- or undervaluation in the kiwi suggests that the NZD will be like the Canadian dollar: very responsive to international and domestic economic developments. This gives rise to a very muddled picture. Based on the output and unemployment gaps, the New Zealand economy seems at full employment, yet it has not seen much in terms of wage or inflationary pressures. As a result, the Reserve Bank of New Zealand has refrained from adopting a hawkish tone. Moreover, the populist policy prescriptions of the Ardern government are also creating downside risk for the kiwi. High immigration has been a pillar behind New Zealand's high-trend growth rate, and therefore a buttress behind the nation's high interest rates. Yet, the government wants to curtail this source of dynamism. On the international front, the kiwi economy has historically been very sensitive to global growth. While this could be a long-term advantage, in the short-term the current global growth soft patch represents a potent handicap for the kiwi. In the end, we judge Australia's problems as deeper than New Zealand's. Since valuations are also in the NZD's favor, the only exposure we like to the kiwi is to buy it against the AUD. The Swiss Franc Chart 8The SNB's Problem The SNB's Problem The SNB's Problem On purchasing power parity metrics, the Swiss franc is expensive, and the meteoric rise of Swiss unit labor costs expressed in euros only confirms this picture. The problem is that this expensiveness is justified once other factors are taken into account, namely Switzerland's gargantuan net international investment position of 128% of GDP, which exerts an inexorable upward drift on the franc's fair value. Once this factor is incorporated, the Swiss franc currently looks cheap (Chart 8). The implication of this dichotomy is that the Swiss franc could experience upward pressure, especially when global growth slows, which is the case right now. However, the Swiss National Bank remains highly worried that an indebted economy like Switzerland, which also suffers from a housing bubble, cannot afford the deflationary pressures created by a strong franc. As a result, we anticipate that the SNB will continue to fight tooth and nail against any strength in the franc. Practically, we are currently short EUR/CHF on a tactical basis. Nonetheless, once we see signs that global growth is bottoming, we will once again look to buy the euro against the CHF as the SNB will remain in the driver's seat. The Swedish Krona Chart 9What The Riksbank Wants What The Riksbank Wants What The Riksbank Wants The Swedish krona is quite cheap (Chart 9), but in all likelihood the Riksbank wants it this way. Sweden is a small, open economy, with total trade representing 86% of GDP. This means that a cheap krona is a key ingredient to generating easy monetary conditions. However, this begs the question: Does Sweden actually need easy monetary conditions? We would argue that the answer to this question is no. Sweden has an elevated rate of capacity utilization as well as closed unemployment and output gaps. In fact, trend Swedish inflation has moved up, albeit in a choppy fashion, and the Swedish economy remains strong. Moreover, the country currently faces one of the most rabid housing bubbles in the world, which has caused household debt to surge to 182% of disposable income. This is creating serious vulnerabilities in the Swedish economy - dangers that will only grow larger as the Riksbank keep monetary policy at extremely easy levels. A case can be made that with large exposure to both global trade and industrial production cycles, the current slowdown in global growth is creating a risk for Sweden. These risks are compounded by the rising threat of a trade war. This could justify easier monetary policy, and thus a weaker SEK. When all is said and done, while the short-term outlook for the SEK will remained stymied by the global growth outlook, we do expect the Riksbank to increase rates this year as inflation could accelerate significantly. As a result, we recommend investors use this period of weakness to buy the SEK against both the dollar and the euro. The Norwegian Krone Chart 10The NOK Is The Cheapest Commodity Currency In The G-10 The NOK Is The Cheapest Commodity Currency In The G-10 The NOK Is The Cheapest Commodity Currency In The G-10 The Norwegian krone has experienced a meaningful rally against the euro and the krona this year - the currencies of its largest trading partners - and as such, the large discount of the real trade-weighted krone to its equilibrium rate has declined. On a long-term basis, the krone remains the most attractive commodity currency in the G-10 based on valuations alone (Chart 10). While we have been long NOK/SEK, currently we have a tactical negative bias towards this cross. Investors have aggressively bought inflation protection, a development that tends to favor the NOK over the SEK. However, slowing global growth could disappoint these expectations, resulting in a period of weakness in the NOK/SEK pair. Nonetheless, we believe this is only a short-term development, and BCA's bullish cyclical view on oil will ultimately dominate. As a result, we recommend long-term buyers use any weakness in the NOK right now to buy more of it against the euro, the SEK, and especially against the AUD. The Yuan Chart 11The CNY Is At Equilibrium The CNY Is At Equilibrium The CNY Is At Equilibrium The fair value of the Chinese yuan has been in a well-defined secular bull market because China's productivity - even if it has slowed - remains notably higher than productivity growth among its trading partners. However, while the yuan traded at a generous discount to its fair value in early 2017, this is no longer the case (Chart 11). Despite this, on a long-term basis we foresee further appreciation in the yuan as we expect the Chinese economy to continue to generate higher productivity growth than its trading partners. Moreover, for investors with multi-decade investment horizons, a slow shift toward the RMB as a reserve currency will ultimately help the yuan. However, do not expect this force to be felt in the RMB any time soon. On a shorter-term horizon, the picture is more complex. Chinese economic activity is slowing as monetary conditions as well as various regulatory and administrative rules have been tightened - all of them neatly fitting under the rubric of structural reforms. Now that the trade relationship between the U.S. and China is becoming more acrimonious, Chinese authorities are likely to try using various relief valves to limit downside to Chinese growth. The RMB could be one of these tools. As such, the recent strength in the trade-weighted dollar is likely to continue to weigh on the CNY versus the USD. Paradoxically, the USD's strength is also likely to mean that the trade-weighted yuan could experience some upside. The Brazilian Real Chart 12More Downside In The BRL More Downside In The BRL More Downside In The BRL Despite the real's recent pronounced weakness, it has more room to fall before trading at a discount to its long-term fair value (Chart 12). More worrisome, the equilibrium rate for the BRL has been stable, even though commodity prices have rebounded. This raises the risk that the BRL could experience a greater decline than what is currently implied by its small premium to fair value if commodity prices were to fall. Moreover, bear markets in the real have historically ended at significant discounts to fair value. The current economic environment suggests this additional decline could materialize through the remainder of 2018. Weak global growth has historically been a poison for commodity prices as well as for carry trades, two factors that have a strong explanatory power for the real. Moreover, China's deceleration and regulatory tightening should translate into further weakness in Chinese imports of raw materials, which would have an immediate deleterious impact on the BRL. Additionally, as we have previously argued, when the fed funds rate rise above r-star, this increases the probability of an accident in global capital markets. Since elevated debt loads are to be found in EM and not in the U.S., this implies that vulnerability to a financial accident is greatest in the EM space. The BRL, with its great liquidity and high representation in investors' portfolios, could bear the brunt of such an adjustment. The Mexican Peso Chart 13The MXN Is A Bargain Once Again The MXN Is A Bargain Once Again The MXN Is A Bargain Once Again When we updated our long-term models last September, the peso was one of the most expensive currencies covered, and we flagged downside risk. With President Trump re-asserting his protectionist rhetoric, and with EM bonds and currencies experiencing a wave of pain, the MXN has eradicated all of its overvaluation and is once again trading at a significant discount to its long-term fair value (Chart 13). Is it time to buy the peso? On a pure valuation basis, the downside now seems limited. However, risks are still plentiful. For one, NAFTA negotiations are likely to remain rocky, at least until the U.S. mid-term elections. Trump's hawkish trade rhetoric is a surefire way to rally the GOP base at the polls in November. Second, the leading candidate in the polls for the Mexican presidential elections this summer is Andres Manuel Lopez Obrador, the former mayor of Mexico City. Not only could AMLO's leftist status frighten investors, he is looking to drive a hard bargain with the U.S. on NAFTA, a clear recipe for plentiful headline risk in the coming months. Third, the MXN is the EM currency with the most abundant liquidity, and slowing global growth along with rising EM volatility could easily take its toll on the Mexican currency. As a result, to take advantage of the MXN's discount to fair value, a discount that is especially pronounced when contrasted with other EM currencies, we recommend investors buy the MXN versus the BRL or the ZAR instead of buying it outright against the USD. These trades are made even more attractive by the fact that Mexican rates are now comparable to those offered on South African or Brazilian paper. The Chilean Peso Chart 14The CLP Is At Risk The CLP Is At Risk The CLP Is At Risk We were correct to flag last September that the CLP had less downside than the BRL. But now, while the BRL's premium to fair value has declined significantly, the Chilean peso continues to trade near its highest premium of the past 10 years (Chart 14). This suggests the peso could have significant downside if EM weakness grows deeper. This risk is compounded by the fact that the peso's fair value is most sensitive to copper prices. Prices of the red metal had been stable until recent trading sessions. However, with the world largest consumer of copper - China - having accumulated large stockpiles and now slowing, copper prices could experience significant downside, dragging down the CLP in the process. An additional risk lurking for the CLP is the fact that Chile displays some of the largest USD debt as a percent of GDP in the EM space. This means that a strong dollar could inflict a dangerous tightening in Chilean financial conditions. This risk is even more potent as the strength in the dollar is itself a consequence of slowing global growth - a development that is normally negative for the Chilean peso. This confluence thus suggests that the expensive CLP is at great risk in the coming months. The Colombian Peso Chart 15The COP Is Latam's Cheapest Currency The COP Is Latam's Cheapest Currency The COP Is Latam's Cheapest Currency The Colombian peso is currently the cheapest currency covered by our models. The COP has not been able to rise along with oil prices, creating a large discount in the process (Chart 15). Three factors have weighed on the Colombian currency. First, Colombia just had elections. While a market-friendly outcome ultimately prevailed, investors were already expressing worry ahead of the first round of voting four weeks ago. Second, Colombia has a large current account deficit of 3.7% of GDP, creating a funding risk in an environment where liquidity for EM carry trades has decreased. Finally, Colombia has a heavy USD-debt load. However, this factor is mitigated by the fact that private debt stands at 65% of Colombia's GDP, reflecting the banking sector's conservative lending practices. At this juncture, the COP is an attractive long-term buy, especially as president-elect Ivan Duque is likely to pursue market-friendly policies. However, the country's large current account deficit as well as the general risk to commodity prices emanating from weaker global growth suggests that short-term downside risk is still present in the COP versus the USD. As a result, while we recommend long-term investors gain exposure to this cheap Latin American currency, short-term players should stay on the sidelines. Instead, we recommend tactical investors capitalize on the COP's cheapness by buying it against the expensive CLP. Not only are valuations and carry considerations favorable, Chile has even more dollar debt than Colombia, suggesting that the former is more exposed to dollar risk than the latter. Moreover, Chile is levered to metals prices while Colombia is levered to oil prices. Our commodity strategists are more positive on crude than on copper, and our negative outlook on China reinforces this message. The South African Rand Chart 16The Rand Will Cheapen Further The Rand Will Cheapen Further The Rand Will Cheapen Further Despite its more than 20% depreciation versus the dollar since February, the rand continues to trade above its estimate of long-term fair value (Chart 16). The equilibrium rate for the ZAR is in a structural decline, even after adjusting for inflation, as the productivity of the South African economy remains in a downtrend relative to that of its trading partners. This means the long-term trend in the ZAR will continue to point south. On a cyclical basis, it is not just valuations that concern us when thinking about the rand. South Africa runs a deficit in terms of FDI; however, portfolio inflows into the country have been rather large, resulting in foreign ownership of South African bonds of 44%. Additionally, net speculative positions in the rand are still at elevated levels. This implies that investors could easily sell their South African assets if natural resource prices were to sag. Since BCA's view on Chinese activity as well as the soft patch currently experienced by the global economy augur poorly for commodities, this could create potent downside risks for the ZAR. We will be willing buyers only once the rand's overvaluation is corrected. The Russian Ruble Chart 17The Ruble Is At Fair Value The Ruble Is At Fair Value The Ruble Is At Fair Value There is no evidence of mispricing in the rubble (Chart 17). Moreover the Russian central bank runs a very orthodox monetary policy, which gives us comfort that the RUB, with its elevated carry, remains an attractive long-term hold within the EM FX complex. On a shorter-term basis, the picture is more complex. The RUB is both an oil play as well as a carry currency. This means that the RUB is very exposed to global growth and liquidity conditions. This creates major risks for the ruble. EM FX volatility has been rising, and slowing global growth could result in an unwinding of inflation-protection trades, which may pull oil prices down. This combination is negative for both EM currencies and oil plays for the remainder of 2018. Our favorite way to take advantage of the RUB's sound macroeconomic policy, high interest rates and lack of valuation extremes is to buy it against other EM currencies. It is especially attractive against the BRL, the ZAR and the CLP. The only EM commodity currency against which it doesn't stack up favorably is the COP, as the COP possesses a much deeper discount to fair value than the RUB, limiting its downside if the global economy were to slow more sharply than we anticipate. The Korean Won Chart 18Despite Its Modest Cheapness, The KRW Is At Risk Despite Its Modest Cheapness, The KRW Is At Risk Despite Its Modest Cheapness, The KRW Is At Risk The Korean won currently trades at a modest discount to its long-term fair value (Chart 18). This suggests the KRW will possess more defensive attributes than the more expensive Latin American currencies. However, BCA is worried over the Korean currency's cyclical outlook. The Korean economy is highly levered to both global trade and the Chinese investment cycle. This means the Korean won is greatly exposed to the two largest risks in the global economy. Moreover, the Korean economy is saddled with a large debt load for the nonfinancial private sector of 193% of GDP, which means the Bank of Korea could be forced to take a dovish turn if the economy is fully hit by a global and Chinese slowdown. Moreover, the won has historically been very sensitive to EM sovereign spreads. EM spreads have moved above their 200-day moving average, which suggests technical vulnerability. This may well spread to the won, especially in light of the global economic environment. The Philippine Peso Chart 19Big Discount In The PHP Big Discount In The PHP Big Discount In The PHP The PHP is one of the rare EM currencies to trade at a significant discount to its long-term fair value (Chart 19). There are two main reasons behind this. First, the Philippines runs a current account deficit of 0.5% of GDP. This makes the PHP vulnerable in an environment where global liquidity has gotten scarcer and where carry trades have underperformed. The second reason behind the PHP's large discount is politics. Global investors remain uncomfortable with President Duterte's policies, and as such are imputing a large risk premium on the currency. Is the PHP attractive? On valuation alone, it is. However, the current account dynamics are expected to become increasingly troubling. The economy is in fine shape and the trade deficit could continue to widen as imports get a lift from strong domestic demand - something that could infringe on the PHP's attractiveness. However, on the positive side, the PHP has historically displayed a robust negative correlation with commodity prices, energy in particular. This suggests that if commodity prices experience a period of relapse, the PHP could benefit. The best way to take advantage of these dynamics is to not buy the PHP outright against the USD but instead to buy it against EM currencies levered to commodity prices like the MYR or the CLP. The Singapore Dollar Chart 20The SGD's Decline Is Not Over The SGD's Decline Is Not Over The SGD's Decline Is Not Over The Singapore dollar remains pricey (Chart 20). However, this is no guarantee of upcoming weakness. After all, the SGD is the main tool used by the Monetary Authority of Singapore to control monetary policy. Moreover, the MAS targets a basket of currencies versus the SGD. Based on these dynamics, historically the SGD has displayed a low beta versus the USD. Essentially, it is a defensive currency within the EM space. The SGD has historically moved in tandem with commodity prices. This makes sense. Commodity prices are a key input in Singapore inflation, and commodity prices perform well when global industrial activity and global trade are strong. This means that not only do rising commodity prices require a higher SGD to combat inflation, higher commodity prices materialize in an environment where this small trading nation is supported by potent tailwinds. Additionally, Singapore loan growth correlates quite closely with commodity prices, suggesting that strong commodity prices result in important amounts of savings from commodity producers being recycled in the Singaporean financial system. To prevent Singapore's economy from overheating in response to these liquidity inflows, MAS is being forced to tighten policy through a higher SGD. Today, with global growth softening and global trade likely to deteriorate, the Singaporean economy is likely to face important headwinds. Tightening monetary policy in the U.S. and in China will create additional headwinds. As a result, so long as the USD has upside, the SGD is likely to have downside versus the greenback. On a longer-term basis, we would expect the correction of the SGD's overvaluation to not happen versus the dollar but versus other EM currencies. The Hong Kong Dollar Chart 21The HKD Is Fairly Valued The HKD Is Fairly Valued The HKD Is Fairly Valued The troughs and peaks in the HKD follow the gyrations of the U.S. dollar. This is to be expected as the HKD has been pegged to the USD since 1983. Like the USD, it was expensive in early 2017, but now it is trading closer to fair value (Chart 21). Additionally, due to the large weight of the yuan in the trade-weighted HKD, the strength in the CNY versus the USD has had a greater impact on taming the HKD's overvaluation than it has on the USD's own mispricing. Moreover, the HKD is trading very close to the lower bound of its peg versus the USD, which has also contributed to the correction of its overvaluation. Even when the HKD was expensive last year, we were never worried that the peg would be undone. Historically, the Hong Kong Monetary Authority has shown its willingness to tolerate deflation when the HKD has been expensive. The most recent period was no different. Moreover, the HKMA has ample fire power in terms of reserves to support the HKD if the need ever existed. Ultimately, the stability created by the HKD peg is still essential to Hong Kong's relevance as a financial center for China, especially in the face of the growing preeminence of Shanghai and Beijing as domestic financial centers. As a result, while we could see the HKD become a bit more expensive over the remainder of 2018 as the USD rallies a bit further, our long-term negative view on the USD suggests that on a multiyear basis the HKD will only cheapen. The Saudi Riyal Chart 22The SAR Remains Expensive The SAR Remains Expensive The SAR Remains Expensive Like the HKD, the riyal is pegged to the USD. However, unlike the HKD, the softness in the USD last year was not enough to purge the SAR's overvaluation (Chart 22). Ultimately, the kingdom's poor productivity means that the SAR needs more than a 15% fall in the dollar index to make the Saudi economy competitive. However, this matters little. Historically, when the SAR has been expensive, the Saudi Arabia Monetary Authority has picked the HKMA solution: deflation over devaluation. Ultimately, Saudi Arabia is a country that imports all goods other than energy products. With a young population, a surge in inflation caused by a falling currency is a risk to the durability of the regime that Riyadh is not willing to test. Moreover, SAMA has the firepower to support the SAR, especially when the aggregate wealth of the extended royal family is taken into account. Additionally, the rally in oil prices since February 2016 has put to rest worries about the country's fiscal standing. On a long-term basis, the current regime wants to reform the economy, moving away from oil and increasing productivity growth. This will be essential to supporting the SAR and decreasing its overvaluation without having to resort to deflation. However, it remains to be seen if Crown Prince Mohamed Bin Salman's ambitious reforms can in fact be implemented and be fruitful. Much will depend on this for the future stability of the riyal. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com 2 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Yen: QQE Is Dead! Long Live YCC!", dated January 12, 2018, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary

While copper prices remain comfortably within the $2.90 to $3.30/lb range they've occupied this year, the rising threat of a Sino - U.S. trade war spilling into the global trading system, along with slowing credit and monetary stimulus in China, will continue to roil copper markets. Refined copper prices - like most commodities - are highly sensitive to the level of world copper demand and EM imports, particularly out of Asia, which are closely tied to income. EM income growth is expected to remain strong; however, a global trade war, or a significant slowing in trade that reduces investment in EM markets and stymies income growth will be bearish for copper prices. Highlights Energy: Overweight. Going into tomorrow's OPEC 2.0 meeting in Vienna, the Kingdom of Saudi Arabia (KSA) and Russia apparently were divided on how much crude oil production needed to be restored to the market. Increases of as little as 300k to 600k b/d and as much as 1.5mm b/d are flying around the market in the lead-up to the meeting.1 Meanwhile, China threatened to impose tariffs on oil imports from the U.S. if President Trump goes ahead with additional tariffs. The increased Sino - American acrimony on trade issues raises the likelihood China will significantly increase oil imports from Iran, in our estimation, which will exacerbate tensions even further. Base Metals: Neutral. Copper treatment and refining charges (TC/RCs) soared at the end of last week following the closure of India's largest smelter. The Metal Bulletin TC/RC index went to an average of $85/MT at the end of last week, up from $82.25/MT. The pricing service also reported China's primary copper-smelting capacity is lower in June due to environmental constraints. Precious Metals: Neutral. Gold prices dropped below $1,300/oz following the FOMC meeting last week, as Fed officials - e.g., Dallas Fed President Robert Kaplan - nodded toward a fourth rate hike this year, even though his base case remained at three. Ags/Softs: Underweight. Grains and beans are down as much as 10% in the past week, on the back of additional tariffs announced by the Trump administration - 10% on $200 billion worth of Chinese imports. The new tariffs were a retaliatory move by the administration, and represent an escalation of tit-for-tat measures by both sides. Feature Chart of the WeekMajor Drivers of Copper Prices Still Supportive Major Drivers of Copper Prices Still Supportive Major Drivers of Copper Prices Still Supportive Rising EM incomes and expanding world trade volumes, particularly EM imports, have supported base metals prices for the past two years. This was partly aided by expansionary fiscal and monetary policy in China, the world's largest base-metals market, in 2016, which reversed overly restrictive monetary and fiscal policy in the two years prior. For the most part, these supportive underpinnings are still in place for EM commodity growth over the next two years (Chart of the Week). However, their stability increasingly is being threatened by rising Sino - American trade tensions, and the limited room for credit and fiscal expansion in China.2 Global Copper Demand And Trade In its most recent update of global growth, the World Bank is expecting the rate of growth globally to level off this year and next. However, the Bank expects income growth in EM and developing economies - the growth engines of commodity demand - to go from 4.3% last year to 4.5% this year, and 4.7% next year. EM growth will be dominated by South Asia (Chart 2).3 EM GDP growth is of particular importance to commodity markets, since this constitutes the bulk of commodity demand growth generally, particularly in base metals and oil. For the largest EM economies, the income elasticity of demand for copper is 0.70, meaning a 1% increase in income leads to a 0.70% increase in copper consumption. The Bank notes, "The seven largest emerging markets (EM7) accounted for almost all the increase in global consumption of metals, and two-thirds of the increase in energy consumption" over the past 20 years.4 In what the Bank refers to as Low Income Countries (LICs) - a grouping of smaller economies loaded with commodity producers - GDP is expected to grow 6% p.a. on average over the 2018 - 2020 period. Chart 2World Bank Expects Solid EM Growth Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets EM GDP growth fuels copper demand. Since 2000, a 1% increase in global copper consumption ex-China translates into an almost 2% increase in high-grade refined copper prices, based on results of our modeling. When we replace ex-China demand with China, we see a 1% increase in China's consumption translates into a 0.75% increase in high-grade copper prices over the 2000 - 2018 interval. China's growth is expected to slow going forward, in the wake of a managed slowdown, and due to the fact that, as its economy evolves, more of its growth will come from services and consumer demand, which are less commodity intensive. GDP growth also fuels trade, and vice versa. The Bank estimates the income elasticity of trade averaged 1.5% from 2000 - 07, and 1.2% from 2010 - 17, meaning a 1% increase in income has led to a roughly 1.4% growth in trade over this period. In our modeling, we've found a 1% increase in EM trade volumes translates into a 1.3% increase in high-grade copper prices, an elasticity in line with post-GFC trade growth. The other key variable in our modeling is the broad trade-weighted USD, which remains a highly important variable for copper prices. In both our global copper-demand and EM import volume models for copper prices, the level of the USD is an important explanatory variable - a 1% increase (decrease) in the USD TWIB translates into ~ 3% decrease (increase) in copper prices since 2000 in our estimates.5 Tight Credit Conditions In China Can Weigh On Copper ... We've been expecting China's managed slowdown in 2H18 to be offset by strong global demand, which, all else equal, would keep copper demand fairly stable.6 While we still do not expect a hard landing in China, the slowdown we've been expecting is showing up in weaker industrial production prints, disappointing retail sales in May, and most significantly, regulatory and liquidity tightening weighing on money and credit. Chinese demand makes up ~ 50% of global metal consumption, these markets would be especially vulnerable in the case of a significant slowdown. The fear of a more serious slump is founded on tighter financial conditions restricting capital spending, and GDP growth. Granger causality tests to determine the direction of causation between Chinese monetary variables and copper prices point to causality running from de-trended levels of all four measures of money and credit to copper prices (Table 1).7 Table 1Chinese Credit And Copper Prices: Evidence Of Causality Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets Furthermore, y/y changes in copper prices are more highly correlated with monetary variables expressed in terms of de-trended levels, than with those same variables expressed as y/y growth rates, or impulses (Chart 3). Across the four credit and money measures, this expression yields an average correlation coefficient of 0.56, compared with 0.38 and 0.37 when expressed as y/y growth rates and impulses as a percent of GDP, respectively. Our modeling also indicates that it generally takes two to three quarters for the full effect of a change in China's credit conditions to be transmitted to copper markets. When we restrict the sample size to the period from 2010 to now we get similar results to our longer intervals (Chart 4). However monetary variables are more highly correlated with copper prices in the shorter sample. Chart 3Chinese Credit Leads Copper Prices By 3 Quarters... Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets Chart 4...A Slightly Longer Lead Time Since 2010 Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets Correlations in the period since 2010 average 0.61, 0.57, and 0.45 for the de-trended levels, y/y growth rates, and impulses, respectively. This can be put down to the fact that China's role as a demand market for copper has been steadily growing over this period. Given that between 2000 and 2017, China's share of global copper demand swelled from 12% to 50%, it is only natural that the impact of its domestic economy on global copper prices also increased (Chart 5). Furthermore, the time lag between Chinese monetary variables and copper markets in the more recent sample increased slightly, with money and credit variables leading prices by 9-10 months, compared to 6-8 months in the full sample. Chart 5China's Growing Role In Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets Bottom Line: De-trended Chinese money and credit variables statistically cause, and are correlated with, y/y changes in copper prices. While these relationships have generally strengthened with China's growing role in the demand side of global copper markets, rolling correlations highlight that there are also extended periods of weak correlations, suggesting fundamental factors can overwhelm the impact of China's credit environment on global copper markets, as has been the case for the past two years. ...But Other Factors Can Take Over In estimating the effect of China's money and credit conditions on copper markets, we find that the relationship can be dominated by supply - demand fundamentals, and overall global macro conditions. More specifically, we find that in periods where DM equity markets outperform EM equity markets, the coefficients in our models with y/y copper prices as the dependent variable are on average 13% lower than the full sample period (Chart 6). Similarly, in periods where EM outperforms DM, the models' credit coefficients are on average 15% higher than the full sample period.8 Our modeling indicates the pre-2005 period as well as the post-2015 intervals as periods during which strong copper demand from growing DM economies weakened the long-term relationship between Chinese money and credit variables and copper prices. Given our expectation that DM demand will remain supportive, this will, to some extent, offset the negative implications of the deteriorating credit environment in China on copper demand and prices. Similarly, in periods characterized by backwardated copper markets, the magnitude of the impact of Chinese money and credit variables on copper prices is on average 35% lower than the full sample (Chart 7). On the other hand, when the copper market is in contango, the magnitude of the impact of Chinese financial variables is on average 13% higher than the full sample period. This highlights the importance of physical fundamentals, and the fact that in cases where they deviate from the direction of the Chinese credit environment - such as during a supply shock - the physical fundamentals weaken historical correlation relationships. Chart 6Credit-Copper Relationship Weakens When DM Outperforms EM ... Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets Chart 7... And When Markets Are Backwardated Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets To rank the top explanatory financial variables in terms of their effect on the evolution of copper prices, we estimated regression models with monetary variables, along with the broad trade-weighted U.S. dollar, and world excluding China copper demand as independent variables (Table 2). Table 2USD Usually Dominates Copper's Evolution Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets The results, which can be interpreted as the y/y percentage point (pp) change in copper prices from a one y/y pp increase in each of the three explanatory variables, indicate that Chinese credit has a similar effect as a one y/y pp increase in world excluding China copper demand, a not-unexpected result, given the rest of the world accounts for 50% of demand. On the other hand, the USD has an outsized effect on the copper market. In our modeling, we've found that, in general, a one pp increase (decrease) in the broad trade-weighted USD translates into a one pp change in copper prices, using y/y models.9 Will Copper Vs. USD Correlations Return To Equilibrium? Our House view calls for a stronger USD going forward. Despite our expectation that DM demand will remain supportive, absent supply-side shocks, a stronger USD along with deteriorating credit conditions in China will weigh on copper prices.10 Ongoing trade disputes will only further bear down on the copper market. Stronger EM GDP growth and the associated increase in copper consumption and trade volumes will offset the strong-USD effects, but a trade war would undermine this support. A caveat to this conclusion is that while credit growth has been generally restrained, the Chinese government - fearful that its policy measures to date are spiraling out of control - may partially reverse its efforts and attempt some easing.11 Bottom Line: The impact of Chinese credit conditions on copper prices is weakened in periods where DM stock prices outperform EM, and when the copper forward curve is backwardated. In terms of the relative magnitude of the effect of China's credit conditions, we find that it has a similar sized effect as the rest of the world's copper demand on the red metal's price, while the USD has a relatively larger effect. This implies that a stronger USD, coupled with tighter financial conditions in China, will compete with expanding EM GDPs and trade growth going forward. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 OPEC 2.0 is the name we've coined for the oil producer coalition lead by KSA and Russia. In November 2016, the coalition agreed to remove 1.8mm b/d of production. We estimate actual production cuts amount to 1.2mm b/d, while as much a 1.5mm b/d of production has been lost to depletion and a lack of maintenance drilling (e.g., infill and other forms of enhanced oil recovery). 2 Our colleague Peter Berezin, writing in this week's Global Investment Strategy, noting slowing industrial production, retail sales and fixed-asset investment, observes, China's "policy response has been fairly muted." Further, unlike 2015, when China stimulated its economy and lifted EM generally, this go-round, there is less room to maneuver owing to high debt levels and overcapacity. Please see BCA Research Global Investment Strategy Special Report "Three Policy Puts Go Kaput: Downgrade Global risk Assets To Neutral," dated June 20, 2018, available at gis.bcaresearch.com. 3 Please see "The Role of Major Emerging Markets in Global Commodity Demand" in the Bank's Global Economic Prospects, June 2018, beginning on p. 61. 4 The Bank's EM7 are Brazil, China, India, Indonesia, Mexico, the Russian Federation, and Turkey. They account for ~ 25% of global GDP, and some 60% of global metals consumption. The income elasticities of aluminum and zinc demand for this group are 0.80 and 0.30, respectively. Please see Table SF1.1 on p. 70 of the Bank's June report. 5 The R2 statistic measuring the goodness of fit between actual copper prices and the modeled prices is 94% for the copper-consumption model, and 96% for the EM trade model over the 2000 - 2018 interval. The USD TWIB was used as an explanatory variable in both models. 6 Please see BCA Research Commodity & Energy Strategy Weekly Report "China's Managed Slowdown Will Dampen Base Metals Demand," dated March 29, 2018, available at ces.bcaresearch.com. 7 Given that in levels, the money and credit variables display a deterministic upward trend, we removed the trend from the data in order to isolate the fluctuations around this trend. This de-trended series is what is significant to copper demand, and thus the evolution of copper prices. 8 We use a threshold OLS model to estimate the y/y model coefficients. The average change in the value of the coefficient is based on the coefficients in the models' outputs of the four money and credit measures. 9 The R2 statistics measuring the goodness of fit between actual y/y changes and those estimated in our models were ~63% in all four models. 10 We discussed this at length last week in BCA Research Commodity & Energy Strategy Weekly Report "Correlations Vs. USD Weaken," dated June 14, 2018, available at ces.bcaresearch.com. 11 Some preliminary signs of potential easing include (1) the PBOC's most recent monetary policy decision in which it did not follow the US Fed's interest rate decision by hiking rates, as it generally does, and (2) a reduction in the reserve requirement ratio. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Insert table images here Trades Closed in Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets

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

The GAA DM Equity Country Allocation model is updated as of May 31, 2018. No significant changes in the model's allocation this month, 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 underperformed its benchmark by 111 bps in May, largely driven by Level 2 model which underperformed by 300 bps. The model's largest overweight, Italy, turned out to be the worst performer in May as a result of Italian politics, an event that is difficult for a quantitative model to capture. Level 1 model outperformed by only 7 bps in May. Consequently, since going live, the outperformance of the Level 2 model, which allocates funds among 11 non-U.S. countries, has reduced to 52 bps, while the overall model has performed in line with the MSCI World benchmark. 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 Model (Chart 4) is updated as of May 31, 2018. 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 The largest shift was a move from underweight to overweight in the materials sector, driven by improving momentum. On the other hand, the overweight in energy was reduced by 1.7 percentage points. The aggregate model now has a small overweight on cyclicals versus defensives, although this is entirely in commodity-related cyclicals. The only other overweight sector is utilities, which saw a small decrease in its weight in the model. 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.

Highlights The risk/reward balance for risk assets remains unappealing this month, even though our base-case outlook sees them outperforming cash and bonds over the next 6-12 months. The number of items that could take equity markets to new highs appears to fall well short of the number of potential landmines that could take markets down. Tensions vis-à-vis North Korea have eased, but the U.S./China trade war is heating up. Trump's voter base and many in Congress want the President to push China harder. Eurozone "breakup risk" has reared its ugly head once again. The Italian President is trying to install a technocratic government, but the interim between now and a likely summer election will extend the campaign period during which the two contending parties have an incentive to continue with hyperbolic fiscal proposals. The next Italian election is not a referendum on exiting the EU or Euro Area. Nonetheless, the risks posed by the Italian political situation may not have peaked, especially since Italy's economic growth appears set to slow. We are underweight both Italian government bonds and equities within global portfolios. It is also disconcerting that we have passed the point of maximum global growth momentum. We expect growth to remain above-trend in the advanced economies, but the economic data will be less supportive of global risk assets than was the case last year. One reason for the economic "soft patch" is that the Chinese economy continues to decelerate. Our indicators suggest that growth will moderate further, with negative implications for the broader emerging market complex. Dearer oil may also be starting to bite, although prices have not increased enough to derail the expansion in the developed economies. This is especially the case in the U.S., where the shale industry is gearing up. Last year's "global synchronized growth" story is showing signs of wear. While the U.S. economy will enjoy a strong rebound in the second quarter, leading economic indicators in most of the other major countries have rolled over. Similar divergences are occurring in the inflation data. The international growth and inflation decoupling is probably not over, which means that long-dollar positions should continue to pay off in the coming months. U.S. inflation is almost back to target and the FOMC signaled that an overshoot will be tolerated. Policymakers will likely transition from "normalizing" policy to targeting slower economic growth once long-term inflation expectations return to the 2.3%-2.5% range. The advanced stage of the U.S. business cycle, heightened geopolitical risks and our bias for capital preservation keep us tactically cautious on risk assets again this month. Feature The major stock indexes are struggling, even though 12-month forward earnings estimates continue to march higher (Chart I-1). One problem is that a lot of good earnings news was discounted early in the year. The number of items that could take markets to new highs appear to fall well short of the number of potential landmines that could take markets down. Not the least of which is ongoing pain in emerging markets and the return of financial stress in Eurozone debt markets. Last month's Overview highlighted the unappealing risk/reward balance for risk assets, even though our base-case outlook sees them outperforming cash and bonds over the next 6-12 months. The advanced stage of the business cycle and our bias for capital preservation motivated us to heed the recent warnings from our growth indicators and 'exit' timing checklist. We also were concerned about a raft of geopolitical tensions. Fast forward one month and the backdrop has not improved. Our Equity Scorecard Indicator edged up, but is still at a level that historically was consistent with poor returns to stocks and corporate bonds (see Chart I-1 in last month's Overview). Our 'exit' checklist is also signaling that caution is warranted (Table I-1). Meanwhile, the "global synchronized expansion" theme that helped to drive risk asset prices higher last year is beginning to unravel and trade tensions are escalating. Chart I-1Struggling To Make Headway Struggling To Make Headway Struggling To Make Headway Table I-1Exit Checklist For Risk Assets June 2018 June 2018 U.S./Sino Trade War Is Back? The "on again/off again" trade war between the U.S. and China is on again as we go to press. Investors breathed a sigh of relief in mid-May when the Trump Administration signaled that China's minor concessions were sufficient to avoid the imposition of onerous new tariffs. However, the proposed deal did not go down well with many in the U.S., including some in the Republican Party. The President was criticized for giving up too much in order to retain China's help in dealing with North Korea. Trump might have initially cancelled the summit with Kim in order to send a message to China that he is still prepared to play hard ball on trade, despite the North Korean situation. We expect that U.S./North Korean negotiations will soon begin, and that Pyongyang will not be a major threat to global financial markets for at least the near term. It is a different story for U.S./China relations. Trump's voter base and many in Congress on both sides of the isle want the President to push China harder. This is likely to be a headwind for risk assets at least until the U.S. mid-term elections. The Return Of Eurozone Breakup Risk Turning to the Eurozone, "breakup risk" has reared its ugly head once again. Italian President Sergio Mattarella's decision to reject a proposed cabinet minister has led to the collapse of the populist coalition between the anti-establishment Five Star Movement (M5S) and the euroskeptic League. President Mattarella's choice for interim-prime minister, Carlo Cottarelli, is unlikely to last long. It is highly unlikely that he will be able to receive parliamentary support for a technocratic mandate, given the fact that he cut government spending during a brief stint in government from 2013-14. As such, elections are likely this summer. Chart I-2Italy: No Euro Support Rebound Italy: No Euro Support Rebound Italy: No Euro Support Rebound Investors continue to fret for two reasons. First, the interim period will extend the campaign period during which both M5S and the League have an incentive to continue with hyperbolic fiscal proposals. Second, M5S has suggested that it will try to impeach Mattarella, a long and complicated process that would heighten political risk, though it will likely fail in our view. As our geopolitical strategists have emphasized throughout 2017, Italy will eventually be the source of a major global risk-off event because it is the one outstanding major European country capable of reigniting the Euro Area break-up crisis.1 While a majority of Italians support the euro, they are less supportive than any other major European country, including Greece (Chart I-2). Meanwhile a plurality of Italians is confident that the future would be brighter if Italy were an independent country outside of the EU. That said, the next election is not a referendum on exiting the EU or Euro Area. The current conflict arises from the coalition wanting to run large budget deficits in violation of Europe's Stability and Growth Pact fiscal rules. Given that the costs of attempting to exit the Euro Area are extremely severe for Italy's households and savers, and that even the Five Star Movement has moderated its previous skepticism about the euro for the time being, it is likely going to require a recession or another crisis to cause Italy seriously contemplate an exit. We are still several steps away from such a move. Nonetheless, the risks posed by the Italian political situation may not have peaked. Italy's leading economic indicator points to slowing growth, which will intensify the populist push for aggressive fiscal stimulus. We are underweight both Italian government bonds and equities within global portfolios. Global Growth Has Peaked Chart I-3Past The Point Of Max Growth Momentum Past The Point Of Max Growth Momentum Past The Point Of Max Growth Momentum It is also disconcerting that we have passed the point of maximum global growth momentum, as highlighted by the indicators shown in Chart I-3. We expect growth to remain above-trend in the advanced economies, but the economic data will be less supportive of global risk assets than was the case last year. What is behind this year's loss of momentum? First, growth in 2017 was flattered by a rebound from the oil-related manufacturing recession of 2015/16. That rebound is now topping out, while worries regarding a trade war are undoubtedly weighing on animal spirits and industrial activity. Second, the Eurozone economy was lifted last year by the previous recapitalization of parts of the banking system, which allowed some pent-up credit demand to be satiated. This growth impulse also appears to have peaked, which helps to explain the sharp drop in some of the Eurozone's key economic indicators. Still, we do not expect European growth to slip back below a trend pace on a sustained basis unless the Italian situation degenerates so much that contagion causes significantly tighter financial conditions for the entire Eurozone economy. The third factor contributing to the global growth moderation is China. The Chinese economy surged in 2017 in a lagged response to fiscal and monetary stimulus in 2016, as highlighted by the Li Keqiang Index (LKI) and import growth (Chart I-4). Both are now headed south as the policy backdrop turned less supportive. Downturns in China's credit and fiscal impulses herald a deceleration in capital spending and construction activity (Chart I-4, bottom panel). The LKI has a strong correlation with ex-tech earnings and import growth. In turn, the latter is important for the broader EM complex that trade heavily with China. Weaker Chinese import growth has also had a modest negative impact on the developed world (Chart I-5). We estimate that, for the major economies, the contribution to GDP growth of exports to China has fallen from 0.3 percentage points last year to 0.1 percentage points now.2 Japan and Australia have been hit the hardest, but the Eurozone has also been affected. Interestingly, U.S. exports to China have bucked the trend so far. Chart I-4China Growth Slowdown... China Growth Slowdown... China Growth Slowdown... Chart I-5...Is Weighing On Global Activity ...Is Weighing On Global Activity ...Is Weighing On Global Activity China is not the only story because the slowdown in global trade activity in the first quarter was broadly based (Chart I-5). Nonetheless, softer aggregate demand growth out of China helps to explain why manufacturing PMIs and industrial production growth in most of the major developed economies have cooled. Our model for the LKI is still moderating. We do not see a hard economic landing, but our analysis points to further weakening in Chinese imports and thus softness in global exports and manufacturing activity in the coming months. Oil's Impact On The Economy... Finally, oil prices are no doubt taking a bite out of consumer spending power as Brent fluctuates just below $80/bbl. Our energy experts expect the global crude market to continue tightening due to robust growth and ongoing geopolitical tensions. Chief among these are the continuing loss of Venezuelan crude production and the re-imposition of U.S. sanctions on Iran. At the same time, we expect OPEC 2.0 to keep its production cuts in place in the second half of the year. Increasing shale output will not be enough to prevent world oil prices from rising in this environment, and we expect oil prices to continue to trend higher through 2018 and into early 2019 (Chart I-6). Brent could touch $90/bbl next year. There are a few ways to gauge the size of the oil shock on the economy. Chart I-7 shows the U.S. and global 'oil bill' as a share of GDP. We believe that both the level and the rate of change are important. Price spikes, even from low levels, do not allow energy users the time to soften the blow by shifting to alternative energy sources. Chart I-6Oil: Stay Bullish Oil: Stay Bullish Oil: Stay Bullish Chart I-7The Oil Bill The Oil Bill The Oil Bill The level of the oil bill is not high by historical standards. The increase in the bill over the past year has been meaningful, both for the U.S. and at the global level, but is still a long way from the oil shocks of the 1970s. U.S. consumer spending on energy as a share of disposable income, at about 4%, is also near the lowest level observed over the past 4-5 decades (Chart I-8). The 2-year swing in this series shows that rapid increases in energy-related spending has preceded slowdowns in economic growth, even from low starting points. The swing is currently back above the zero line but, again, it is not at a level that historically was associated with a significant economic slowdown. Chart I-8Oil's Impact On U.S. Consumer Spending Oil's Impact On U.S. Consumer Spending Oil's Impact On U.S. Consumer Spending Moreover, the mushrooming shale oil and gas industry has altered the calculus of oil shocks for the U.S. The plunge in oil prices in 2014-16 was accompanied by a manufacturing and profit mini recession in the developed countries, providing a drag on overall GDP growth. Chart I-9 provides an estimate of the contribution to U.S. growth from the oil and gas industry. We have included capital spending and wages & salaries in the calculation, and scaled it up to include spillover effects on other industries. Chart I-9Oil's Impact On Consumer Spending And Shale Oil's Impact On Consumer Spending And Shale Oil's Impact On Consumer Spending And Shale The oil and gas contribution swung from +0.5 percentage points in 2012 to -0.4 percentage points in 2016. The contribution has since become only slightly positive again, but it is likely to rise further unless oil prices decline in the coming months. We have included the annual swing in consumer spending on energy as a percent of GDP in Chart I-9 (inverted) for comparison purposes. At the moment, the impact on growth from the shale industry is roughly offsetting the negative impact on consumer spending. The bottom line is that the rise in oil prices so far is enough to take the edge off of global growth, but it is not large enough to derail the expansion in the developed countries. This is especially the case in the U.S., where the shale industry is gearing up. ...And Asset Prices As for the impact on asset prices, it is important to ascertain whether rising oil prices represent more restrictive supply or expanding demand. A mild rise in oil prices might simply be a symptom of increased demand caused by accelerating global growth. Higher oil prices are thus reflective of robust demand, and thus should not be seen as a threat. In contrast, the 1970s experience shows that supply restrictions can send the economy into a tailspin. In order to separate the two drivers of prices, we regressed WTI oil prices on global oil demand, inventories and the U.S. dollar. By excluding supply-related factors such as production restrictions, the residual of the regression model gives an approximate gauge of supply shocks (panel 2, Chart I-10). This model clearly has limitations, but it also has one key benefit: it estimates not just actual disruptions in supply, but also the premium built into prices due to perceived or expected future supply disruptions. For example, the 1990 price spike appears as quite a substantial deviation from what could be explained by changes in demand alone. Similar negative supply shocks are evident in 2000 and 2008. Chart I-10Identifying Supply Shocks In The Oil Market Identifying Supply Shocks In The Oil Market Identifying Supply Shocks In The Oil Market We then examined the impact that supply shocks have on subsequent period returns for both Treasury and risk assets. We divided the Supply Shock Proxy into four quartiles corresponding to the four zones shown in Chart I-10: strong positive shock, mild positive shock, mild negative shock and strong negative shock; the last of these corresponds to the region above the upper dashed line, which we have shaded in the chart. The performance of risk assets does not vary significantly across the bottom three quartiles of the supply shock indicator (Chart I-11). However, performance drops off precipitously in the presence of a strong negative supply shock. This is consistent with the "choke point" argument: investors are initially unconcerned with a modest appreciation in oil prices. It is only when prices are driven sharply above the level consistent with the current demand backdrop that risk assets begin to discount a more pessimistic future. The total returns to the Treasury index behave in the opposite manner (Chart I-12). Treasury returns are below average when the oil shock indicator is below one (i.e. positive supply shock) and above average when oil prices rise into negative supply shock territory. In other words, an excess of oil supply is Treasury bearish, as it would tend to fuel more robust economic growth. Conversely, a supply shock that drives oil prices higher tends to be Treasury bullish. This may seem counterintuitive because higher oil prices can be inflationary and thus should be bond bearish in theory. However, large negative oil supply shocks have usually preceded recessions, which caused Treasurys to rally. Chart I-11Effect On Risk Assets June 2018 June 2018 Chart I-12Effect On Treasurys June 2018 June 2018 The model clearly shows that the drop in oil prices in 2014/15 was a positive supply shock, consistent with the oil consumption data that show demand growth was fairly stable through that period. The model indicator has moved up toward the neutral line in recent months, suggesting that the supply side of the market is tightening up, but it is still in "mild positive supply shock" territory. The latest data point available is April, which means that it does not capture the surge in oil prices over the past month. Some of the recent jump in prices is clearly related to the cancelled Iran deal and other supply-related factors, although demand continues to be supportive of prices. The implication of this model is that it will probably require a significant further surge in prices, without a corresponding ramp up in oil demand, for the model to signal that supply constraints are becoming a significant threat for risk assets. A rise in Brent above US$85 would signal trouble according to this model. As for government bonds, rising oil prices are bearish in the near term, irrespective of whether it reflects demand or supply factors. This is because of the positive correlation between oil prices and long-term inflation expectations. The oil bull phase will turn bond-bullish once it becomes clear that energy prices have hit an economic choke point. Desynchronization Last year's "global synchronized growth" story is showing signs of wear. First quarter U.S. GDP growth was underwhelming, but the long string of first-quarter disappointment points to seasonal adjustment problems. Higher frequency data are consistent with a robust rebound in the second quarter. Forward looking indicators, such as the OECD and Conference Board's Leading Economic Indicators, continue to climb. This is in contrast with some of the other major economies, such as the Eurozone, U.K., Australia and Japan (Chart I-13). First quarter real GDP growth was particularly soft in Japan and the Eurozone, and one cannot blame seasonal adjustment in these cases. Chart I-13Growth & Inflation Divergences Growth & Inflation Divergences Growth & Inflation Divergences The divergence in economic performance likely reflects Washington's fiscal stimulus that is shielding the U.S. from the global economic soft patch. Moreover, the U.S. is less exposed to the oil shock and the China slowdown than are the other major economies. Similar divergences are occurring in the inflation data. While U.S. inflation continues to drift higher, it has lost momentum in the euro area, Japan and the U.K. (Chart I-13). Renewed stresses in the Italian and Spanish bond markets have sparked a flight-to-quality in recent trading days, depressing yields in safe havens such as U.S. Treasurys and German bunds. Nonetheless, prior to that, the divergence in growth and inflation was reflected in widening bond yield spreads as U.S. Treasurys led the global yields higher. Long-term inflation expectations have risen everywhere, but real yields have increased the most in the U.S. (prior to the flight-to-quality bond rally at the end of May). This is consistent with the growth divergence story and with our country bond allocation: overweight the U.K., Australia and Japan, and underweight U.S. Treasurys within hedged global portfolios. The dollar lagged earlier this year, but is finally catching up to the widening in interest rate spreads. The international growth and inflation decoupling is probably not over, which means that long-dollar positions should continue to pay off in the coming months. Expect More Pain In EM Dollar strength and rising U.S. bond yields are a classic late-cycle combination that often spells trouble for emerging market assets. We do not see the recent selloff across EM asset classes as a buying opportunity since markets have only entered the first stage of the classic final chapter; EM assets underperform as U.S. bond yields and the dollar rise, but commodity prices are resilient. In the second phase, U.S. bond yields top out, but the U.S. dollar continues to firm and commodity prices begin their descent. If the current slowdown in Chinese growth continues, as we expect, it will begin to weigh on non-oil commodity prices. Thus, emerging economies may have to deal with a deadly combination of rising U.S. interest rates, a stronger greenback, falling commodity prices and slowing exports to China (Chart I-14). Which countries are most exposed to lower foreign funding? BCA's Emerging Market Strategy services has ranked EM countries based on foreign funding requirements (Chart I-15). The latter is calculated as the current account balance plus foreign debt that is due in the coming months. Chart I-14EM Currencies Exposed To China Slowdown EM Currencies Exposed To China Slowdown EM Currencies Exposed To China Slowdown Chart I-15Vulnerability Ranking: Dependence On Foreign Funding June 2018 June 2018 Turkey, Malaysia, Peru and Chile have the heaviest foreign funding requirements in the next six months. These mostly stem from foreign debt obligations by their banks and companies. Even though most companies and banks with foreign debt will not default, their credit spreads will likely widen as it becomes more difficult to service the foreign debt.3 It is too early to build positions even in Turkish assets. Our EM strategists believe that it will require an additional 15% depreciation in the lira versus an equal-weighted basket of the dollar and euro, in combination with 200-250 basis points hike in the policy rate, and a 20% drop in share prices in local currency terms, to create a buying opportunity in Turkish financial instruments. FOMC Expects Inflation Overshoot Escalating turmoil in EM financial markets could potentially lead the Federal Reserve to put the rate hike campaign on hold. However, that would require some signs of either domestic financial stress or slowing growth. The FOMC is monitoring stress in emerging markets and in the Eurozone, but is sticking with its "gradual" tightening pace for now (i.e. 25 basis points per quarter). May's FOMC minutes signaled a rate hike in June. However, the minutes did not suggest that the Fed is getting more hawkish, despite the Staff's forecast that growth will remain above trend and that the labor market will continue to tighten at a time when core inflation is already pretty much back to target. Some inflation indicators, such as the New York Fed's Inflation Gauge, suggest that core inflation will overshoot. The minutes signaled that policymakers are generally comfortable with a modest overshoot of the 2% inflation target because many see it as necessary in order to shift long-term inflation expectations higher, into a range that is consistent with meeting the 2% inflation target on a "sustained" basis (we estimate this range to be 2.3-2.5% for the 10-year inflation breakeven rate). The fact that the FOMC took a fairly dovish tone and did not try to guide rate expectations higher contributed to some retracement of the Treasury selloff in recent weeks. Nonetheless, an inflation overshoot and rising inflation expectations will ultimately be bond-bearish, especially when the FOMC is forced to clamp down on growth as long-term inflation expectations reach the target range. As discussed in BCA's Outlook 2018, one of our key themes for the year is that risk assets are on a collision course with monetary policy because the FOMC will eventually have to transition from simply removing accommodation to targeting slower growth. Timing that transition will be difficult, and depends importantly on how much of an inflation overshoot the FOMC is prepared to tolerate. Is 2½% reasonable? Or could inflation go to 3%? The makeup of the FOMC has changed, but we expect Janet L. Yellen4 to shed light on this question when she speaks at the BCA Annual Investment Conference in September. Investment Conclusions The risks facing investors have shifted, but we do not feel any less cautious than we did last month. Geopolitical tensions vis-à-vis North Korea have perhaps eased. But trade tensions are escalating and investors are suddenly faced with another chapter in the Eurozone financial crisis. The major fear in the first and second chapters was that bond investors would attack Italy, given the sheer size of that economy and the size of Italian government debt. That dreadful day has arrived. The profit backdrop in the major economies remains constructive for equity markets. However, even there, the bloom is coming off the rose. Global growth is no longer synchronized and the advanced economies have hit a soft patch with the possible exception of the U.S. While far from disastrous, our short-term profit models appear to be peaking across the major countries (Chart I-16). Chart I-16Profit Growth: Solid, But Peaking Profit Growth: Solid, But Peaking Profit Growth: Solid, But Peaking The typical U.S. late cycle dynamics are also threatening emerging markets, at a time when investors are generally overweight and many EM countries have accumulated a pile of debt. U.S. inflation is set to overshoot the target, the FOMC is tightening and the dollar is rising. Throw in slowing Chinese demand and the EM space looks highly vulnerable. If the global economic slowdown is pronounced and drags the U.S. down with it, then bonds will rally and risk assets will take a hit. If, instead, the soft patch is short-lived and growth re-accelerates, then the U.S. Treasury bear market will resume. Stock indexes and corporate bond excess returns would enjoy one last upleg in this scenario, but downside risks would escalate once the Fed begins to target slower economic growth. Either way, EM assets would be hit. Our base case remains that stocks will beat government bonds and cash on a 6-12 month horizon. However, the risk/reward balance is unattractive given the geopolitical backdrop. Thus, we remain tactically cautious on risk assets for the near term. We still expect that the 10-year Treasury yield will peak at close to 3½% before this economic expansion is over. Nonetheless, this would require a calming of geopolitical tensions and an upturn in the growth indicators in the developed world. The risk/reward tradeoff for corporate bonds is no better than for equities and we urge caution in the near term. On a 6-12 month cyclical horizon, we still expect corporate bonds to outperform government bonds, at least in the U.S. European corporates are subject to the ebb and flow of the Italian bond crisis, and face the added risk that the ECB will likely end its QE program later this year. Looking further ahead, this month's Special Report, beginning on page 19, analyzes the Eurozone corporate sector's vulnerability to the end of the cycle that includes rising interest rates and, ultimately, a recession. We find that domestic issuers into the Eurozone market are far less exposed than are foreign issuers. Mark McClellan Senior Vice President The Bank Credit Analyst May 31, 2018 Next Report: June 28, 2018 1 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 2016, available on gps.bcaresearch.com 2 This underestimates the impact on the major countries because it does not account for third country effects (i.e. trade with other countries that trade with China). 3 For more information, please see BCA Emerging Market Strategy Weekly Report, "The Dollar Rally And China's Imports," dated May 24, 2018, available on ems.bcaresearch.com 4 Janet L. Yellen, Chair, Board of Governors, Federal Reserve System (2014-2018). II. Leverage And Sensitivity To Rising Rates: The Eurozone Corporate Sector As interest rates rise, investors are looking for the leveraged pressure points in the global economy to identify the sectors most likely to show strain. We previously identified the U.S. corporate bond market as a definite candidate. This month we look at European corporates. European corporations are still well behind the U.S. in the leveraging cycle. Relative trends in corporate financial health have generally favored European credit quality relative to U.S. issuers. Below the surface, balance sheet repair in the Eurozone has been concentrated in domestic issuers; financial trends among foreign issuers have resembled those in the U.S. market. Foreign issuers are much more vulnerable to higher interest rates and an economic downturn. Interest- and debt-coverage ratios are likely to fall to levels that will spark a raft of downgrades for foreign firms issuing into the Eurozone market, in the event that interest rates rise and a recession follows. Investors should concentrate their European corporate bond portfolios in domestic securities. That said, trends in financial health are unlikely to be the key driver of corporate bond relative returns this year. More important will be the end of the ECB's asset purchase program. We recommend an underweight position in Eurozone IG and HY relative to Eurozone government bonds, and relative to U.S. corporates. Risk assets remain on a collision course with monetary policy, which is the main reason why the "return of vol" is a key theme in the BCA 2018 Outlook. In the U.S., rising inflation is expected to limit the FOMC's ability to cushion soft patches in the economic data or negative shocks from abroad. We expect that ECB tapering will add to market stress, especially now that Eurozone breakup risks are again a concern. We also believe that geopolitics will remain a major source of uncertainty and volatility. All this comes at a time when corporate bond spreads offer only a thin buffer against bad news. On a positive note, we remain upbeat on the earnings outlook in the major countries. The U.S. recession that we foresaw in 2019 has been delayed into 2020 by fiscal stimulus. The longer runway for earnings to grow keeps us nervously overweight corporate bonds, at least in the U.S. That said, corporates are no more than a carry trade now that the lows in spreads are in place for the cycle. We are keeping a close eye on a number of indicators that will help us to time the next downgrade to our global corporate bond allocation. Profitability is just one, albeit important, aspect of the financial backdrop. What about the broader trend in financial health? Does the trend justify wider spreads even if the economy and profits hold up over the next year? We reviewed U.S. corporate financial health in the March 2018 monthly Bank Credit Analyst, using our bottom-up sample of companies. We also stress-tested these companies for higher interest rates and a medium-sized recession. We concluded that the U.S. corporate sector's heavy accumulation of debt in this expansion will result in rampant downgrade activity during the next economic downturn. As interest rates rise, investors are looking for the leveraged pressure points in the global economy to identify the sectors most likely to show strain. The U.S. corporate bond market is a definite candidate. This month we extend the analysis to the European corporate sector. The European Corporate Health Monitor The bottom-up version of the Corporate Health Monitor (CHM) is a complement to our top-down CHM, which uses macro data from the ECB to construct an index of six financial ratios for the non-financial corporate sector. While useful as an indicator of the overall trend in corporate financial health, it does not shed light on underlying trends across credit quality, countries and sectors. It also fails to distinguish between domestic versus foreign issuers in the Eurozone market. A number of features of the European market limit the bottom-up analysis to some extent relative to what we are able to do for the U.S.: the Eurozone market is significantly smaller and company data typically do not have as much history; foreign issuers comprise almost 50% of the market, a much higher percentage than in the U.S.; and the Financial sector features more prominently in the Eurozone index, but we exclude it because our CHM methodology does not lend itself well to this sector. We analyzed only domestic issuers in our study of U.S. corporate health. However, we decided to include foreign issuers in our Eurozone analysis in order to maximize the sample size. Moreover, it is appropriate for some bond investors to consider the whole picture, given that important benchmarks such as Barclay's corporate indexes include both foreign and domestic issuers. The relative composition of domestic versus foreign, investment-grade versus high-yield, and industrial sectors in our sample are comparable with the weights used in the Barclay's index. The CHM is calculated using the median value for each of six financial ratios (Table II-1). We then standardize1 the median values for the six ratios and aggregate them into a composite index using a simple average. The result is an index that fluctuates between +/- 2 standard deviations. A rising index indicates deteriorating health, while a downtrend signals improving health. We defined it this way in order to facilitate comparison with trends in corporate spreads. Table II-1Definitions Of Ratios That Go Into The CHMs June 2018 June 2018 One has to be careful in interpreting our Eurozone Monitor. The bottom-up version only dates back to 2005. Thus, while both the level and change in the U.S. CHM provide important information regarding balance sheet health, for the Eurozone Monitor we focus more on the change. Whether it is a little above or below the zero line is less important than the trend. Top-Down Versus Bottom-Up Chart II-1 compares the top-down and bottom-up Eurozone CHMs for the entire non-financial corporate sector.2 The levels are different, although the broad trends are similar. Key differences that help to explain the divergence include the following: the top-down CHM defines leverage to be total debt as a percent of the market value of equity, while our bottom-up CHM defines it to be total debt as a percent of the book value of the company. The second panel of Chart II-1 highlights that the two measures of leverage have diverged significantly since 2012; the top-down CHM defines profit margins as total cash flow as a percent of sales. For data-availability reasons, our bottom-up version uses operating income/total sales; and most importantly, the top-down CHM uses ECB data, which includes only companies that are domiciled in the Eurozone. Thus, it excludes foreign issuers that make up a large part of our company sample and the Barclay's index. When we recalculate the bottom-up CHM using only domestic investment-grade issuers, the result is much closer to the top-down version (Chart II-2). Both CHMs have been in 'improving health' territory since the end of the Great Financial Crisis. The erosion in the profitability components during this period was offset by declining leverage, rising liquidity and improving interest coverage for domestic issuers. Chart II-1Top-Down Vs. Bottom-Up Top-Down Vs. Bottom-Up Top-Down Vs. Bottom-Up Chart II-2Top-Down Vs. Domestic Bottom-Up Top-Down Vs. Domestic Bottom-Up Top-Down Vs. Domestic Bottom-Up It has been a different story for foreign IG issuers (Chart II-3). These firms have historically enjoyed a higher return on capital, operating margins, interest coverage, debt coverage and liquidity. Nonetheless, heavy debt accumulation has undermined their interest- and debt-coverage ratios in absolute terms and relative to their domestic peers until very recently. In other words, while domestic issuers have made an effort to clean up their balance sheets since the Great Recession, financial trends among foreign issuers look more like the trends observed in the U.S. No doubt, this is in part due to U.S. companies issuing Euro-denominated debt, but there are many other foreign issuers in our sample as well. Some analysts prefer total debt/total assets to the leverage measure we use in constructing our CHMs. However, the picture is much the same; leverage among IG domestic and foreign firms has diverged dramatically since 2010 (Chart II-4). Chart II-3Bottom-Up: Domestic Vs. Foreign IG Bottom-Up: Domestic Vs. Foreign IG Bottom-Up: Domestic Vs. Foreign IG Chart II-4Diverging Leverage Trends Diverging Leverage Trends Diverging Leverage Trends Over the past year or so there has been some reversal in the post-Lehman trends; domestic health has stabilized, while that of foreign issuers has improved. Leverage among foreign companies has leveled off, while margins and the liquidity ratio have bounced. The results for high-yield (HY) issuers must be taken with a grain of salt because of the small sample size. Chart II-5 highlights that the HY CHM is improving for both domestic and foreign issuers. Impressively, leverage is declining for both the domestic and foreign components. The return on capital, interest coverage, and debt coverage have also improved, although only for foreign issuers. Chart II-5Bottom-Up: Domestic Vs. Foreign HY Bottom-Up: Domestic Vs. Foreign HY Bottom-Up: Domestic Vs. Foreign HY Corporate Sensitivity The bottom line is that, while there have been some relative shifts below the surface, the European corporate sector's finances are generally in good shape in absolute terms and relative to the U.S. This is particularly the case for domestic issuers that have yet to catch the equity buyback bug. However, less accommodative monetary policy and rising borrowing rates have focused investor attention on corporate sector vulnerability. Downgrade risk will mushroom if corporate borrowing rates continue rising and, especially, if the economy contracts. If there is a recession in Europe in the next few years it will likely be as a result of a downturn in the U.S. We expect a traditional end to the U.S. business cycle; the Fed overdoes the rate hike cycle, sending the economy into a tailspin. The U.S. downturn would spill over to the rest of the world and could drag the Eurozone into a mild contraction. We estimated the change in the interest coverage ratio for the companies in our bottom-up European sample for a 100 basis-point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt (i.e. the coupons reset only for the bonds, notes and loans that mature in the next three years). We make the simplifying assumptions that all debt and loans maturing in the next three years are rolled over, but that companies do not take on net new obligations. We also assume that EBIT is unchanged in order to isolate the impact of higher interest rates. The 'x' in Chart II-6 denotes the result of the interest rate shock only. The 'o' combines the interest rate shock with a recession scenario, in which EBIT contracts by 15%. The interest coverage ratio declines sharply when rates rise by 100 basis points, but the ratio moves to a new post-2000 low only for foreign issuers. The ratio for domestic issuers falls back to the range that existed between 2009 and 2013. The median interest coverage ratio drops further when we combine this with a 15% earnings contraction in the recession scenario. Again, the outcome is far worse for foreign than it is for domestic issuers. Chart II-7 presents a shock to the median debt coverage ratio. Since debt coverage (cash flow divided by total debt) does not include interest payments, we show only the recession scenario result that reflects the decline in profits. Once again, foreign issuers appear to be far more exposed to an economic downturn than their domestic brethren. Chart II-6Interest Coverage Shocks Interest Coverage Shocks Interest Coverage Shocks Chart II-7Debt Coverage Shock Debt Coverage Shock Debt Coverage Shock Indeed, the results for foreign issuers are qualitatively similar to the shocks we previous published for our bottom-up sample of IG corporates in the U.S. (Chart II-8 and Chart II-9). In both cases, higher interest rates and contracting earnings will take the interest coverage and debt coverage ratios into uncharted territory. Chart II-8U.S. Interest Coverage Shocks U.S. Interest Coverage Shocks U.S. Interest Coverage Shocks Chart II-9U.S. Debt Coverage Shock U.S. Debt Coverage Shock U.S. Debt Coverage Shock Conclusions European corporations are still well behind the U.S. in the leveraging cycle. Relative trends in corporate financial health have generally favored European credit quality relative to U.S. issuers, where balance sheet activity has focused on lifting shareholder value since the last recession. Below the surface, balance sheet repair in the Eurozone has been concentrated in domestic issuers; financial trends among foreign issuers have resembled those in the U.S. market. There has been a small convergence of financial health between Eurozone domestic and foreign issuers over the past year or so, but the latter are still much more vulnerable to higher interest rates and an economic downturn. Interest- and debt-coverage ratios are likely to fall to levels that will spark a raft of downgrades for foreign firms issuing into the Eurozone market, in the event that interest rates rise and a recession follows. Investors should concentrate their European corporate bond portfolios in domestic securities. That said, trends in financial health are unlikely to be the key driver of corporate bond returns relative to European government bonds or to U.S. corporates this year. More important will be the end of the ECB's asset purchase program later in 2018. We expect spreads to widen as this important liquidity tailwind fades. For the moment, our Global Fixed Income Strategy service recommends an underweight position in Eurozone IG and HY relative to Eurozone government bonds, and relative to U.S. corporates. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Standardizing involves taking the deviation of the series from the 18 quarter moving average and dividing by the standard deviation of the series. 2 Note that a rising CHM indicates deteriorating health to facilitate comparison with quality spreads. III. Indicators And Reference Charts The divergence between the U.S. corporate earnings data and our equity-related indicators continued in May. We remain cautious, despite the supportive profit backdrop. The U.S. net earnings revisions ratio fell a bit in May, but it remains well in positive territory. Forward earnings continued their ascent, and the net earnings surprise index rose further to within striking distance of the highest levels in the history of the series. Normally, an earnings backdrop this strong would justify an overweight equity allocation within a balanced portfolio. Unfortunately, a lot of good earnings news is discounted based on our Composite Valuation Indicator and extremely elevated 5-year bottom-up earnings growth expectations (see the Bank Credit Analyst Overview, May 2018). Moreover, our equity indicators are sending a cautious signal. Our U.S. Willingness-to-Pay indicator continued to decline in May. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. U.S. flows have clearly turned negative for equities, although flows into European and Japanese markets are holding up for now. Our Revealed Preference Indicator (RPI) for stocks remained on its 'sell' signal in May, for the second month in a row. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. Moreover, our composite equity Technical Indicator is on the verge of breaking down and our Monetary Indicator moved further into negative territory in May. Meanwhile, market froth has not been completely extinguished according to our Speculation Indicator (which is a negative sign for stocks from a contrary perspective). As for bonds, the powerful rally at the end of May has undermined valuation, but the 10-year Treasury is not yet in expensive territory. Our technical indicator suggests that previously oversold conditions are easing, but bonds are a long way from overbought. This means that yields have room to fall further in the event of more bad news on Italy or on the broader geopolitical scene. The dollar has not yet reached overbought territory according to our technical indicator. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst