Economy

Highlights Duration: Our Fed Policy Loop provides a framework for understanding last week's equity market correction and its implications for future Fed policy. So far, the equity sell-off is not severe enough to deter the Fed. Maintain below-benchmark portfolio duration. Credit: With the Fed lifting rates and the market still not priced for the likely pace of hikes, it is highly likely that we will witness further periods where corporate spreads and Treasury yields rise in unison. We recommend steps investors can take to insulate their portfolios from this risk. Inflation: The macroeconomic environment remains highly inflationary. The unemployment rate is very low and wage growth is rising. However, recent trends suggest that the year-over-year growth rate in core CPI will stay close to its current level, near the Fed's target, for the next six months. This will not alter the Fed's "gradual" +25 bps per quarter rate hike pace. Feature Chart 1The Second Rate Shock Of 2018 Last week's equity market rout was the second time this year that stocks reacted negatively to a sharp rise in bond yields (Chart 1). As was the case in February, our Fed Policy Loop remains the appropriate framework for understanding the relationship between bond yields and the stock market (Chart 2).1 It can be explained as follows: Chart 2The Fed Policy Loop Step 1: The perception of easy Fed policy fuels strong performance in the stock market. Rising stock prices and "easing financial conditions" cause economic growth to strengthen and sow the seeds of inflation. Step 2: Equity investors catch a whiff of inflation and start to price-in a more restrictive monetary environment. This leads to a stock market correction. Step 3: Falling stock prices and "tightening financial conditions" cause the Fed to downgrade its economic outlook and adopt a more dovish policy stance. Return To Step 1. The Equity Correction For Bond Investors At this juncture, the important question for bond investors is whether financial conditions have tightened enough to prompt a slower pace of rate hikes from the Fed. If so, then it might be appropriate to buy the dip in the bond market. We think such a move would be premature, for two reasons. First, the increase in bond yields that spooked the equity market was concentrated at the long-end of the curve and was fueled by Fed Chairman Powell's comment that the funds rate is "a long way from neutral." A steeper yield curve offsets some of the financial conditions tightening caused by falling stock prices (Chart 3). This is because it signals that monetary policy is becoming more accommodative - the fed funds rate is further below neutral than previously thought. This intuition is confirmed by the bounce in gold, a move that often coincides with an upward rerating of the neutral fed funds rate.2 Chart 3Steeper Curve Will Reassure The Fed Second, the amount of financial market pain that the Fed can tolerate depends on the economic environment. Our Fed Monitor is an indicator that is designed to signal whether the Fed should be hiking or cutting interest rates (Chart 4). It consists of 44 variables that can be grouped into three categories: Chart 4The BCA Fed Monitor Economic growth indicators (Chart 4, panel 3). Inflation indicators (Chart 4, panel 4). Financial conditions indicators (Chart 4, bottom panel). The overall Fed Monitor is currently deep in positive territory, signaling that rate hikes are appropriate. This is true despite the fact that the financial conditions component of the monitor has been falling (tightening) since the beginning of the year. Last week's equity market drop will not be reflected in the indicator until the end of the month, so further downside in the financial conditions component is forthcoming. But so far, tighter financial conditions have barely made a dent in the overall Fed Monitor because they have been offset by rising economic growth and stronger inflation. The conclusion is that the Fed is able to tolerate more market pain when growth is strong and inflation is high. Viewed through this lens, it is clear that a lot more market pain is required before the Fed backs away from its +25 bps per quarter rate hike pace. In fact, the Fed likely views some tightening of financial conditions as desirable, as long as the tightening doesn't severely impede the economic outlook. Just last week New York Fed President John Williams said: Normalization of the monetary policy, I think, has the added benefit of reducing somewhat, on the margin, some of the risk of imbalances in financial markets.3 While a few weeks ago, Fed Governor Lael Brainard noted: The past few times unemployment fell to levels as low as those projected over the next year, signs of overheating showed up in financial-sector imbalances rather than in accelerating inflation.4 In other words, the Fed is increasingly cognizant of the fact that higher interest rates might be necessary to prevent excessive risk-taking in financial markets, even if inflation stays well contained near target. Unless financial conditions tighten so much that they cause the reading from our Fed Monitor to hook down, the Fed will be inclined to view the market correction as healthy. It is also important to note that while a large increase in long-maturity Treasury yields prompted last week's stock market action, the short-end of the yield curve didn't move much at all. In fact, overnight index swap forwards show that the market is just barely priced for three rate hikes during the next 12 months. According to our golden rule of bond investing, if you expect the Fed to lift rates by more than what is priced in for the next 12 months, you should keep portfolio duration low.5 Bottom Line: Last week's equity market sell-off is not enough to prompt the Fed to back away from its +25 bps per quarter rate hike pace. Investors should maintain below-benchmark portfolio duration. On The Correlation Between Yields And Spreads It wasn't just the stock market that struggled to digest higher Treasury yields last week. Corporate bond spreads also widened, particularly in the high-yield credit tiers (Chart 5). As with equities, this is the second time in 2018 that credit spreads widened sharply alongside higher Treasury yields. Chart 5Credit Also Struggling With Higher Rates Credit spreads and Treasury yields tend to be negatively correlated, a feature that benefits bond investors by reducing the volatility in corporate bond yields and total returns. But, as evidenced by last week's price moves, the correlation does occasionally turn positive. This is particularly damaging during sell-offs when both the rate and spread components of corporate bond yields rise. Chart 6 shows the frequency of negative and positive yield/spread correlations since 1994, using 3-month investment horizons. It shows that yields and spreads were negatively correlated in 64% of 3-month periods. Yields fell alongside tighter spreads in 23% of cases, while yields and spreads rose together only 13% of the time. Chart 6The Correlation Between Yields And Spreads Is Typically Negative Since those periods when both yields and spreads rise in unison are particularly damaging for bond investors, it is worth exploring them in more detail. Table 1 lists all 13 quarters since 1994 when junk spreads and duration-matched Treasury yields rose together. Using the logic of our Fed Policy Loop, we also identify three risk factors that might be associated with those periods. The main idea being that yields and spreads are likely to rise together in periods when the market starts to price-in much more restrictive monetary policy, and an earlier end to the economic recovery. The three risk factors we identify are: Table 1Periods When Both Treasury Yields And Junk Spreads Rose Since 1994 Whether the Fed raised interest rates during the investment horizon. Whether our 12-month Fed Funds Discounter increased during the investment horizon, meaning that the market priced-in a more aggressive near-term rate hike path. Whether the 5-year/5-year forward TIPS breakeven inflation rate rose during the investment horizon. Higher long-dated inflation expectations could cause the Fed to respond with a more restrictive monetary policy. The single most important risk factor is whether the Fed raised rates during the investment horizon. Nine of the 13 episodes coincided with a Fed rate hike, and three of the four episodes that didn't coincide with a rate hike occurred between Q2 2013 and Q4 2015. The fed funds rate was pinned at zero during that period, but the Fed was starting to turn hawkish by backing away from QE and preparing for liftoff. This leaves the second quarter of 2007 as the only true outlier. The Fed did not lift rates during this period, but it is clear that markets were spooked by overly restrictive Fed policy all the same. The 2/10 Treasury slope was only 7 bps at the start of the quarter, signaling that monetary policy was already quite restrictive. Meanwhile, long-dated inflation expectations rose during the quarter and the market went from discounting 60 bps of rate cuts during the next 12 months to only 17 bps. An inflationary shock when monetary policy is already restrictive is an environment where yields and spreads are very likely to rise at the same time. An upward move in our 12-month discounter is also associated with periods of rising yields and spreads in 9 out of 13 cases. This risk factor didn't work in Q4 2005 or Q2 2006, but once again it is quite clear that markets were spooked by overly restrictive monetary policy in those periods. The yield curve was inverted in both of those quarters, and the Fed lifted rates despite an inverted yield curve. That combination sends a clear signal to markets that the Fed is trying to choke off the recovery. The 12-month discounter also failed to send the correct signal in Q3 1999 and Q2 2000. In those cases the culprit appears to be a large jump in long-dated inflation expectations while the Fed was in the midst of a rate hike cycle. Since rate hikes should dampen inflation, rising inflation expectations suggest that rate hikes might need to speed up. Thinking about the current environment, we are very much in the danger zone where yields and spreads could rise at the same time. The Fed is in the midst of a rate hike cycle and the market is still not priced for quarterly rate hikes to continue for the next 12 months. Finally, long-dated TIPS breakeven inflation rates are almost back to the 2.3% to 2.5% range that is consistent with "well-anchored" inflation expectations (Chart 7). The higher long-dated breakevens get, the more likely it is that the Fed will respond forcefully to further increases. Chart 7Almost Re-Anchored With all three of our risk factors present, it is highly likely that we will see more episodes where credit spreads widen and Treasury yields rise. The risk will only dissipate once the full extent of the Fed's rate hike cycle is reflected in the Treasury curve, but we are not there yet. While this is not a great environment for bond investors, there are steps investors can take to limit the damage from periods of rising spreads and yields. First, investors should maintain portfolio duration at below-benchmark. Second, while it is too early in the cycle to completely abandon credit, a more defensive posture is advisable. We recommend only a neutral allocation to spread product, focused on the higher-quality credit tiers.6 To the extent possible, investors should also seek to focus their spread exposure at the long-end of the maturity spectrum, while also limiting overall portfolio duration by favoring the short-end of the Treasury curve.7 Inflation Uptrend On Hold Lost in the shuffle amidst last week's market turmoil, the consumer price index (CPI) for September was released and it delivered a soft month-over-month print for the second month in a row. The top panel of Chart 8 shows that the year-over-year trend in core CPI rose rapidly earlier in the year, but now appears to be leveling off. We do not envision a meaningful deceleration in core CPI, but it seems likely that the year-over-year rate of change will stay near current levels for the next six months. Chart 8Core Inflation & Pipeline Pressures Our Pipeline Inflation Indicator remains consistent with rising inflationary pressures in the economy, but it has softened of late. This is mostly due to weaker commodity prices (Chart 8, bottom panel). Further, our Base Effects Indicator - based on rates of change in the core CPI that have already been realized - is now consistent with a lower year-over-year core CPI growth rate six months from now (Chart 9).8 Chart 9Expect Year-Over-Year Core CPI To Flatten-Off, Or Even Decline Looking at the main components of core CPI, the last two monthly prints have been dragged down by the core goods component, with most of the weakness in apparel and used vehicles (Chart 10). This could reverse in the near-term as core goods prices catch up with import prices, which have been rising for some time. However, non-oil import prices have decelerated recently, on the back of a stronger dollar. In other words, any near-term increase in core goods inflation will probably not last very long. Chart 10Core CPI Components The core services excluding shelter component continues to have the most potential upside, since it is highly geared to rising wage growth. Shelter inflation, the largest component of core CPI, has been flat for some time and our models suggest this will continue to be the case for the next six months. Bottom Line: The macroeconomic environment remains highly inflationary. The unemployment rate is very low and wage growth is rising. However, recent trends suggest that the year-over-year growth rate in core CPI will stay close to its current level, near the Fed's target, for the next six months. This will not alter the Fed's "gradual" +25 bps per quarter rate hike pace. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see BCA U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com. 2 Please see BCA U.S. Bond Strategy Weekly Report, "A Signal From Gold?" dated May 1, 2018, available at usbs.bcaresearch.com. 3https://www.bloomberg.com/news/articles/2018-10-10/williams-says-fed-rate-hikes-helping-curb-financial-risk-taking 4https://www.federalreserve.gov/newsevents/speech/brainard20180912a.htm 5 Please see BCA U.S. Bond Strategy Special Report, "The Golden Rule Of Bond Investing," dated July 24, 2018, available at usbs.bcaresearch.com. 6 Please see BCA U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty," dated June 19, 2018, available at usbs.bcaresearch.com. 7 Please see BCA U.S. Bond Strategy Weekly Report, "Out Of Sync," dated July 3, 2018, available at usbs.bcaresearch.com. 8 Please see BCA U.S. Bond Strategy Weekly Report, "The Powell Doctrine Emerges," dated September 4, 2018, available at usbs.bcaresearch.com. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Rising U.S. bond yields will continue to put downward pressure on global stocks in the near term, but will not trigger an equity bear market until rates reach restrictive territory. We are still at least 12 months away from that point. The blowout in Italian bond yields has further to go, which will also weigh on global risk assets. Nevertheless, we would buy BTPs for a tactical trade if the 10-year yield rose above 4%, because at that level EU policymakers will call out the fire engines. We downgraded global equities from overweight to neutral in June, while maintaining our bias for DM stocks over EM stocks. Barring any major new developments, we would turn bullish again if global stocks were to fall by 8% from current levels. Remain cyclically underweight interest rate duration. We would move to neutral on duration if the U.S. 10-year yield were to rise to 3.7%. We are still bullish on the dollar, but would shift to neutral if the DXY rose above 100. Feature Bond Yields: Up, Up, And Away Global risk assets remained on the back foot this week. The MSCI All-Country World stock market index has now fallen by 6.3% in dollar terms since last Wednesday. Even the mighty S&P 500 has finally buckled under the pressure. The vulnerability of U.S. stocks had been accumulating beneath the surface for some time, as evidenced by the fact that the advance-decline line has been deteriorating since the late summer. The small cap Russell 2000 is down 11.3% from its August 31st highs (Charts 1A& 1B). Chart 1ABreadth Deteriorated In The Lead-Up To The Correction Chart 1BStocks Under Pressure Bond yields usually fall when equities swoon. This time around, it is the increase in bond yields itself that has undermined stocks. In the U.S., yields have risen in response to better-than-expected growth, a wider budget deficit, rising oil prices, and an increasingly hawkish Fed. In Italy, worries about debt sustainability have been the primary driver of rising yields. Neither factor spells doom for global risk assets. However, a period of indigestion is likely over the coming weeks, which could see global equities go down before they go up again. The U.S. Economy: Too Much Winning? We have argued for much of this year that investors were underappreciating the extent to which the Federal Reserve can raise rates without choking off growth. The past few weeks have seen a growing recognition among investors that the Fed may be behind the curve in normalizing monetary policy. This has led to a steepening in the expected path of U.S. short-term rates, which, together with an increase in the term premium, have pushed up yields at the longer-dated maturities. Both better economic data and Fedspeak contributed to the bond sell-off. On the data front, the non-manufacturing ISM index clocked in at 61.6. The all-important employment component of the index hit a record high. Confirming the encouraging labor market signal from the ISM, the unemployment rate fell to a 48-year low of 3.68% in September. While average hourly earnings ticked down to 2.75% on a year-over-year basis, this was entirely due to base effects. On a month-over-month basis, average hourly earnings have risen by 0.3% for three straight months. If this trend continues, the year-over-year rate will rise to 3.2% by the end of this year. Tellingly, recent wage growth has been concentrated among workers at the bottom of the income distribution (Chart 2). This is important because not only do the wages of low-income workers correlate better with labor market slack than those of high-income workers, but low-income workers are also more likely to spend the bulk of their paychecks. Chart 2Wage Growth Has Accelerated At The Bottom Of The Income Distribution Higher wage growth will boost consumer spending. Indeed, it is probable that consumption will rise more than income, given that the personal savings rate has plenty of scope to fall from the current elevated level of 6.6%. Rising wages will incentivize companies to invest more in labor-saving technologies, translating into an increase in capital spending.1 Add in ongoing fiscal stimulus, and we have a recipe for an overheated economy. Starstruck No More As of today, the market has priced in one Fed rate hike in December but only two rate hikes in 2019 (Chart 3). Investors expect no rate hikes in 2020 and beyond. That still seems implausible to us, which suggests that the bond sell-off has further to go. Chart 3The Market Still Thinks The Fed Can't Raise Rates Above 3% In contrast to the past, the Fed no longer seems interested in talking down rate expectations. Speaking with Judy Woodruff at The Atlantic Festival, Chairman Powell stated the Fed "may go past neutral, but we are a long way from neutral at this point, probably."2 Even uber-dove Chicago Fed President Charles Evans appears to have jettisoned his worries about deflation, noting in a speech last Wednesday that "I am more comfortable with the inflation outlook today than I have been for the past several years."3 The Fed has also increasingly downplayed the importance of estimates of the neutral rate of interest, the concept on which the long-term "dots" in the Summary of Economic Projections are based. The Fed's new mantra is that economic data, rather than some theoretical model, should guide monetary policy. Ironically, it was New York Fed President John Williams, who developed one of the most widely used models of r-star, the eponymously named Holston-Laubach-Williams model, that best articulated the Fed's position. At a speech last Monday, Williams argued that the neutral rate of interest, or r-star, has "gotten too much attention in commentary about Fed policy." He went on to say that "Back when interest rates were well below neutral, r-star appropriately acted as a pole star for navigation. But, as we have gotten closer to the range of estimates of neutral, what appeared to be a bright point of light is really a fuzzy blur, reflecting the inherent uncertainty in measuring r-star."4 Trump And Bonds President Trump was quick to blame the Fed for this week's stock market sell-off. Within the span of 24 hours, he used the words "crazy," "loco," "ridiculous," "too cute," "too aggressive," and "big mistake" to describe recent Fed policy. We doubt Trump's rhetoric will have any immediate effect on Fed decision-making. But even if it did sway the Fed to slow the pace of rate hikes, the result will be higher bond yields, not lower yields. This is simply because any further delays in raising rates will lead to even more overheating, and ultimately, higher inflation and the need for higher rates down the road. Bond Sell-Off Will Produce A Correction In Stocks, Not A Bear Market At the height of this week's bond sell-off, the 10-year Treasury yield breached its 200-month moving average for the first time since ... October 1987 (Chart 4). While that sounds pretty ominous, keep in mind that the 10-year yield had reached almost 10% on the eve of the 1987 stock market crash, or about 6% in real terms. Chart 4Two Lines Meet After Three Decades As my colleague, Doug Peta, discussed two weeks ago, it is the level of interest rates that tends to matter more for stocks rather than the change in rates.5 Specifically, equity returns tend to be lowest at times when monetary policy is already in restrictive territory (Chart 5 and Tables 1 and 2). That was the case in 1987. It is not the case today. Chart 5The Fed Funds Rate Cycle Table 1Tight Policy Is Hazardous To Stocks' Health... Table 2...Especially In Real Terms The fact that stocks do worse in environments where monetary policy is tight makes perfect sense. A restrictive monetary policy is usually a prelude to a recession. As Chart 6 illustrates, bear markets and recessions almost always coincide, with the latter usually leading the former by about six-to-twelve months. None of our favorite leading recession indicators are flashing red now (Chart 7). Even the yield curve has steepened in recent weeks. Chart 6Recessions And Bear Markets Usually Overlap Still, higher long-term bond yields do reduce the long-term attractiveness of stocks compared with bonds. The S&P 500 earnings yield has risen modestly since 2016 due to the fact that earnings have grown somewhat more quickly than equity prices. However, the U.S. real 10-year yield has surged by almost 120 basis points over this period. On balance, this has caused the equity risk premium to decline (Chart 8).6 In order to bring the equity risk premium back down to mid-2016 levels, the S&P 500 would need to fall by about 15% from today's levels. We do not expect stocks to fall by that much, partly because the economic environment is more robust than back then, but a further drop of 5%-to-10% from current levels is certainly plausible. Chart 7A U.S. Recession Is Not Imminent Chart 8Stocks Versus Bonds Italy: Heading For A Debt Crisis? The rise in Treasury yields has reduced the attractiveness of other global government bond markets, causing them to sell off in sympathy. Notably, German bund yields have increased by 33 basis points since their May lows (Chart 9). Chart 9Global Bond Yields Moving Higher Rising German bund yields are bad news for Italy. All things equal, a higher "risk free" bund yield implies a higher Italian bond yield. To make matters worse, as Italian borrowing costs have risen, the perceived likelihood that Italy will be unable to repay its debt has increased. This has caused the spread between German bunds and Italian BTPs to widen, thereby magnifying the effect on Italian bond yields from the increase in risk-free yields. All this has happened at the worst possible moment. Italy's populist government and the European Commission are locked in a battle of wills over next year's budget. The Italian government is targeting a fiscal deficit of 2.4% of GDP for 2019, compared with a deficit of 0.8% that the outgoing caretaker government had proposed in May. Strictly speaking, the new deficit target is still consistent with the 3% limit under the Maastricht Treaty. Nevertheless, it is still causing consternation in Brussels. There are at least three reasons for this: While the government's program has a lot of specifics about how it will increase the deficit - more public investment; a universal minimum income scheme; the ability to retire earlier than under current law; corporate tax cuts; no VAT hike in 2019, etc. - it does not specify which items in the budget will be cut. The program also provides few details on revenue measures, other than proposing a one-off tax amnesty, which will arguably reduce tax receipts over the long haul. The proposed budget assumes real GDP growth of 1.5% in 2019. This is higher than the May projection of 1.4%, and well above the IMF's most recent projection of 1%. The government's real GDP projections for 2020-21 are also about 0.7 percentage points above the IMF's estimates. While Italy's proposed fiscal deficit is below the Maastricht Treaty limit, its current debt-to-GDP ratio of 132% is well above the ceiling of 60% (Chart 10). This implies that Italy should be aiming for a smaller deficit target than what it is currently proposing. Chart 10Italy's Public Debt Mountain We expect the Italian government to ultimately acquiesce to the EU's demands, but not before the bond vigilantes have pushed them into a corner. For their part, the EU establishment would love nothing more than to embarrass the Five Star-Lega coalition in order to send a message to voters across Europe about the dangers of voting for populist parties. This means that the Italian 10-year yield may need to break above 4% - the level at which Italian banks would likely be technically insolvent based on the market value of their BTP holdings - before a compromise is reached. We would put on a tactical trade to buy 10-year BTPs at that level, but not before then. Investment Conclusions Goldilocks will survive, but the next couple of months will be challenging. Our soon-to-be-launched MacroQuant model is signaling a bearish outlook for stocks over the next 30 days (Chart 11). On the bond side, the model currently pegs the fair value for the U.S. 10-year yield at 3.7% (Chart 12). Bond sentiment is quite bearish at the moment, which makes a brief countertrend bond rally quite likely. However, the cyclical trend in yields remains to the upside. Chart 11MacroQuant* Recommends That Caution Is Warranted Towards Equities Chart 12MacroQuant Sees 10-Year Treasury Yields Still Below Fair Value We stated last week that investors should consider scaling back risk if they are currently overweight risk assets. We continue to favor this more cautious stance. For the first time in over a decade, short-term U.S. rates are above the dividend yield on the S&P 500 (Chart 13). Holding a bit more cash is finally an attractive option, at least for U.S.-based investors. Chart 13Cash Anyone? If the sell-off in global equities continues, it will present a buying opportunity, given that the next major global economic downturn is probably at least another two years away. Barring any major new developments, we would turn bullish on stocks again if the MSCI All-Country World Index were to fall by 12% 10% 8% from current levels.7 We would recommend that investors move from an underweight to a neutral interest rate duration position in global bond portfolios if the U.S. 10-year Treasury yield rose to 3.7%. We are still bullish on the dollar, but would shift to neutral if the DXY rose above 100. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 It is true that additional investment spending will raise aggregate supply, but normally it takes a while for that to happen. For example, it may take a few years to build an office tower or a new factory. Corporate R&D investment may not generate tangible benefits for a long time, especially in cases where the research is focused on something complicated (i.e., the design of new computer chips or pharmaceuticals). And even if investment spending could be transformed into additional productive capacity instantaneously, aggregate demand would still rise more than aggregate supply, at least temporarily. Here is the reason: The nonresidential private-sector capital stock is about 120% of GDP in the United States. As such, a one percent increase in investment spending would raise the capital stock by four-fifths of a percentage point. Assuming a capital share of income of 40% of national income, a one percent increase in the capital stock would lift output by 0.4%. Thus, a one-dollar increase in business investment would boost aggregate demand by one dollar in the year it is undertaken, while increasing supply by only 4/5*0.4 = roughly 32 cents. 2 Please see "WATCH: Powell says Fed is focused on 'controlling the controllable,' not politics," PBS News Hour, October 3, 2018; and Jeff Cox, "Powell says we're 'a long way' from neutral on interest rates, indicating more hike are coming," CNBC, October 3, 2018. 3 Charles Evans, "Monetary Policy 2.0?" OMFIF City Lecture on the U.S. Economic Outlook, London, England, October 3, 2018. 4 John C. Williams, "Remarks at the 42nd Annual Central Banking Seminar," Bank for International Settlements, October 1, 2018. 5 Please see U.S. Investment Strategy Special Report, "When Will Higher Rates Hurt Stocks?" dated September 24, 2018; and Special Report, "Revisiting The Fed Funds Rate Cycle," dated September 3, 2018. 6 For this exercise, we define the equity risk premium as the difference between the S&P 500 earnings yield (the inverse of the forward P/E ratio) and the real 10-year bond yield (using CPI swaps as our measure of expected inflation). 7 The perils of writing a report during a week when markets are moving fast. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Historically, the dollar exhibits positive seasonality in October and November. Technical and valuation indicators suggest that this year will be no exception. Continuing divergence between U.S. and global growth, rising interest rates, and Italian risks point in this direction as well. However, long positioning in the dollar along with the rebound in the China Play Index are creating non-negligible risks to this bullish dollar view. As a result, investors should overweight dollar exposure in their portfolio, but hedge the above risks by buying NZD/USD and selling EUR/JPY. Feature Through most of September, the dollar traded on the heavy side. However, in the last two trading days of the month, the greenback managed to regain some composure. As October and November have historically been strong months for the DXY (Chart I-1), this week we review if this seasonal pattern will once again hold. The balance of evidence suggests that the historical norm is likely to repeat itself, and that the dollar will continue to rally for the next six months or so, though there are a few risks that should be hedged against. Chart I-1Entering A Seasonally Strong Period For The Dollar Technicals: No Obstacle For A Strong Dollar An argument rooted in seasonality is a reasoning based on technical factors. Currently, technical indicators continue to paint a supportive backdrop for the greenback. First, by the beginning of the summer, based on its 13-week rate-of-change measure, the dollar index had reached overbought levels. Faced with this hurdle, the dollar's rally essentially took a pause, with the DXY rising only 0.5% since June 28, compared to its 6.4% rally between April 10 and June 28. However, through this side-move, the dollar's overbought conditions resolved themselves, and now the greenback's 13-week rate of change is back in neutral territory (Chart I-2, top two panels). Normally, a sideways correction tends to be a sign that a currency's underlying support remains strong. On the other hand, the euro's oversold correction is also now complete, but the euro has remained on a slightly more pronounced downward path over the same period (Chart I-2, bottom two panels). Chart I-2Short-Term Overbought Conditions Have Been Cleared Second, the fractal dimension measure for the trade-weighted dollar shows that despite the recent phase of dollar strength that began in September, the dollar's uptrend is not yet ready to exhaust itself (Chart I-3). The fractal dimension is a measure of groupthink promoted by Dhaval Joshi, head of BCA's European Investment Strategy. It compares the short-term and long-term variance of any asset to gauge if long-term and short-term investors are holding the same positions. If they do, risks are high that a paucity of buyers (or sellers in bear markets) may develop, resulting in a trend reversal as all investors are already similarly positioned. This fractal dimension flagged a yellow card for the dollar in June, but it was only followed by the sideways move described above. Now that the dollar is gaining some vigor, the recent pickup in this indicator suggests that this rally can run further. Chart I-3No Groupthink In The Dollar Third, while the dollar needed to digest some short-term overbought conditions, cyclical indicators like the Coppock Oscillator are still nowhere near overbought (Chart I-4, top two panels). By the spring of 2018, the dollar had reached massively oversold territory on a cyclical basis, and it is now in the midst of a powerful rebound. If history is any guide, once the Coppock Oscillator turns, it is likely to move much more than it has so far, indicating that the dollar rally has legs. However, the euro's Coppock Oscillator looks like it still possesses ample downside, as downdrafts never end at the current level of readings (Chart I-4, bottom two panels). Chart I-4Cyclical Oscillators Still Favor The USD Bottom Line: Technical indicators are currently not arguing against the normal seasonal strength in the USD. The short-term overbought conditions present at the beginning of the summer have evaporated, the dollar's trading action does not show meaningful evidences of groupthink, and a key cyclical momentum measure has further upside. Short-Term Valuations: No Obstacle Here Either An additional factor that might prevent the dollar's normal seasonal strength from realizing itself is the current valuation picture. Here again, there is little to worry about. As Chart I-5 illustrates, our Fundamental Intermediate Term Model and our Intermediate-Term Timing Model do not show any mispricing in the USD. The dollar is trading in line with our two augmented interest rate parity valuation metrics - two indicators that have historically been useful in spotting potential periods of USD risk. Chart I-5No Evident Mispricing In The Dollar Economic And Financial Market Developments Still Support The Dollar With no danger for the dollar from a technical and valuation standpoint, economic and financial market developments will likely hold the key to the dollar's outlook. First, economic divergences remains fully at play. As Chart I-6 illustrates, the U.S. economy is handily outperforming the rest of the world as the ISM Manufacturing Index has not been dragged down by the weakness observed outside the U.S. Historically, the gap between the ISM and the world's PMI leads the dollar's gyrations as the greenback is ultimately the factor forcing U.S. and global growth to converge. This time around, the growth gap suggests that the dollar has a few more months of strength ahead of itself. Moreover, Arthur Budaghyan writes in BCA's Emerging Market Strategy service that China's deleveraging campaign will continue to hinder global export growth (Chart I-7) - a sector of the economy with little weight in the U.S. This means that the growth gap between the U.S. and the rest of the world may widen further. Chart I-6Economic Divergences Support The Dollar Chart I-7China Deleveraging Points To Weaker Trade Second, the U.S.'s economic strength may be a problem for a large swath of the global economy. It is often assumed that strong U.S. growth lifts global demand through exports, undoing some of China's negative impact in the process. However, this does not take into account that U.S. rates determine the global cost of capital. The U.S. economy is currently much stronger than the rest of the world, and the U.S. private sector is not as burdened by debt as is the case outside the U.S. (Chart I-8). This makes the U.S. more capable of handling higher interest rates than the rest of the world. As a result, this year, the rise in both 10-year Treasury yields and TIPS yields has been met with pain in assets levered to global growth, like the German DAX and EM stock prices, as well as EM and commodity currencies (Chart I-9). Chart I-8The U.S. Has A More Robust Balance Sheet Chart I-9Higher U.S. Yields Hurt Assets Levered To Global Growth This is in sharp contrast with the U.S. The market and the Federal Reserve are coming to grips with the reality that the U.S. neutral rate is increasing, courtesy of robust household balance sheets, strong capex intentions, rising inflationary pressures and a large dose of fiscal stimulus. Thus, despite the rise in interest rates, the U.S. yield curve has started to steepen anew, even as global asset markets have been suffering (Chart I-10). Fed Chairman Jerome Powell has even given his subtle acquiescence to this move. Indeed, last week he argued that the Fed's policy might still be quite accommodative as the neutral rate may be sitting well above the current level of the fed funds rate. Chart I-10The U.S. Yield Curve Is Steepening Anew Third is the question of Italy. Italian yields continue to rise both in absolute terms and relative to German bunds. Some of this reflects the stress created by higher global real yields, which hurt the outlook for Italian growth and hence point toward a worsening debt load, which requires a higher risk premium in BTPs. But there is more to the widening in Italian spreads. Italy is setting its budget for next year, and is engaging in a war of words with Brussels. The Five Star Movement / Lega Nord Coalition wants to set a 2.4% of GDP deficit for 2019, much more than the previously agreed 0.8% penciled by the previous government this past spring. This is still within the 3% limit of the EU's Growth and Stability pact, but the European Commission and investors are concerned as Italy's public debt-to-GDP is already 133% - and this 2.4% deficit rests on extremely rosy growth assumptions. As a result, markets are punishing Italian bonds. This is a problem because when Italian yields rise, Italian banks suffer. Dhaval Joshi has argued in BCA's European Investment Strategy that a move in BTP yields to 4% could render the whole Italian banking system insolvent, as it would wipe out excess capital of EUR30 billion.1 Since the entire German, French, Spanish, Dutch, Austrian, Belgian, Greek, Irish and Portuguese banking systems still have low capital reserves, their combined EUR 479 billion exposure to Italy is fast becoming a Sword of Damocles. As a result, a war of words between Rome and Brussels - one that could last until December - could cause further tumult in European bank shares, and force the European Central Bank to stay on the defensive longer than it wishes to. This would hurt the euro and by symmetry, help the dollar. Bottom Line: Economic and financial market developments still support the dollar. The outperformance of U.S. growth relative to the rest of the world is likely to continue to be felt in the form of a stronger dollar in the coming months, especially as global exports remains negatively affected by China's deleveraging. Moreover, rising U.S. borrowing costs are so far having a limited impact on U.S. growth, but generating potent headwinds for activity outside the U.S. Finally, Italy is likely to remain a sore spot for Europe over the next two to three months, one that may weigh on the ECB's ability to provide any hawkish guidance this year. Risks To The View The view that the dollar can continue to rally is not without impediments. The first and most obvious one is that speculators have already aggressively bought the dollar (Chart I-11, top panel). This makes the greenback vulnerable to any unexpected improvement in global growth. Chart I-11Risks For The Dollar The second impediment is that a temporary reprieve in the global growth slowdown could well be materializing as we speak. G10 economic surprises have regain some vigor, and the diffusion index of BCA's Global Leading Economic Indicator has been rebounding (Chart I-11, bottom two panels). The third risk is that the China Play Index we introduced 10 weeks ago is rebounding (Chart I-12). This indicator, based on AUD/JPY, Swedish industrial stocks denominated in dollars, iron ore prices, Brazilian stocks and EM high-yield bonds, is very sensitive to Chinese reflation, or at the very least to how investors expect Chinese reflation to evolve going forward. This may reflect the fact that the People's Bank of China has injected liquidity into the banking system by cutting the Reserve Requirement Ratio four times this year, or that local government borrowings have increased. Chart I-12Investors May Be Betting On Chinese Reflation However, these three factors remain risks, not our base case. After all, net speculative positions in the dollar can stay elevated for extended periods, and the Chinese stimulus that is helping the China Play Index and maybe even the G10 surprise index still pales in comparison to the size of the aggregate deleveraging that is causing total social financing to weaken. Another risk to monitor is Fed Chairman Powell. The likelihood that he dials down his hawkish rhetoric on the elevated neutral fed funds rate in the coming weeks is significant. This could cause a temporary setback in Treasury yields and global rates - one that is likely to be welcomed by global risk assets but that may cause temporary indigestion for the dollar. Bottom Line: Three key risks could invalidate our thesis that the dollar strengthens this fall. They are: the large overhang of speculative longs in the greenback, a potential temporary stabilization in global growth, and markets pricing in Chinese stimulus. Additionally, Fed Chairman Powell may walk back some of his hawkish comments from last week, which would impact global bond yields and help global risk assets, but weigh on the dollar. Investment Implications Faced with this outlook, what should investors do? We continue to recommend holding a cyclically bullish dollar stance. Long DXY makes sense at this juncture, with upside toward 102 by Q1 2019, Implying a fall in EUR/USD below 1.10. However, the risks highlighted above are also non-negligible. This means that holding some hedges makes perfect sense. This summer, we recommended selling USD/CAD. As Chart I-13 illustrates, the loonie has been the best performing G10 currency - the only one that managed to eke out a gain against the greenback this summer (top panel of Chart I-13). This means that mean-reversion is not likely to be the CAD's friend going forward. It may thus not be the best instrument anymore to hedge against USD weakness. Instead, Chart I-13 proposes that the three currencies best placed to benefit from any mean reversion if the USD weakens are the SEK, the AUD, and especially the NZD. The NZD is extremely oversold now, which suggests that it could benefit greatly if the dollar were to experience any period of weakness. Moreover, the NZD has traditionally been highly levered to EM asset prices and Asian growth conditions. As a result, if the rebound in the China Play Index ends up hurting the USD, the NZD is likely to be the prime beneficiary. Chart I-13G10 Currency Returns Moreover, the kiwi money markets are currently pricing in a 12% probability of interest rate cuts by the Reserve Bank of New Zealand over the coming four months. While a lack of inflation means that the environment is not propitious for the RBNZ to increase rates, a rate cuts seems farfetched: the Official Cash Rate remains well below the average level of growth experienced over the past three years, whether in nominal or real terms. In other words, monetary policy remains extremely accommodative, despite the fact that the output gap is closed and the unemployment rate stands below full employment (Chart I-14). Chart I-14The RBNZ Will Not Cut Rates Finally, shorting EUR/JPY may well prove to be the best protection if the Fed's leadership guides bond yields lower. As Chart I-15 shows, EUR/JPY performs well when bond yield rise, which explains why this cross has managed to strengthen despite the recent weakness in EM asset prices this year. Hence, if a dollar correction is not driven by global growth converging upward toward the U.S., but instead is driven by the Fed backtracking from its recent hawkish rhetoric, then EUR/JPY will suffer considerably. Chart I-15Short EUR/JPY: A Hedge Against Falling Bond Yields As a result, we recommend investors with long USD exposure hedge their bets by taking on a bit of long NZD/USD exposure and some short EUR/JPY exposure as well. Bottom Line: Since the seasonal and cyclical outlook is favorable to the greenback, it makes sense for investors to maintain a dollar-bullish bias in their portfolio. However, the tactical risks to the dollar created by a potential rebound in non-U.S. growth or a potentially dovish Fed are meaningful. As a result, some hedges should be maintained to mitigate net positive exposure to the dollar. We recommend buying NZD/USD and selling EUR/JPY in order to achieve optimal protection from these risk factors. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see European Investment Strategy Weekly Report, titled "Italy, Bond Vigilantes, And Bubbles", dated October 4, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: The unemployment rate surprised positively, coming in at 3.7%. Moreover, initial jobless claims also surprised positively, coming in at 207 thousand. However, while nonfarm payrolls underperformed expectations, coming in at 134 thousand, this miss was compensated by important positive revisions to 270 thousand for August. DXY has risen by roughly 1.4% this week. Overall, we continue to be positive on the dollar, given that inflationary pressures in the U.S. will continue to put upward pressure on interest rates. Moreover, China is tightening monetary conditions, which will continue to act as a drag on global growth. This environment will benefit the green back until at least the beginning of 2019. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 The Dollar And Risk Assets Are Beholden To China's Stimulus - August 3, 2018 Rhetoric Is Not Always Policy - July 27, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been mixed: Retail sales yearly growth surprised to the upside, coming in at 1.8%. However, core inflation underperformed expectations, coming in at 0.9%. Finally, both the composite and manufacturing Markit PMI, also surprised negatively, coming in at 54.1 and 53.2 respectively. Rising U.S. yields as well as renewed concerns about Italy have lowered EUR/USD by roughly 2% this past couple of weeks. We are negative on the euro on a cyclical basis, given that euro area inflationary dynamics are tightly linked to global economic activity, which will likely be armed by China's monetary tightening. Thus, inflation, and consequently rates, will stay low in the euro area for the time being. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 Time To Pause And Breathe - July 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been positive: Machinery orders yearly growth outperformed expectations, coming in at 12.6%. Moreover, the leading economic Index also surprised to the upside, coming in at 104.4. Finally, overall household spending yearly growth also surprised to the upside, coming in at 2.8%. USD/JPY has been falling for the past week and a half. We are negative on the yen on a cyclical basis, given that YCC is likely to stay in place for the foreseeable. After all, Japanese inflation expectations remain moribund. Moreover, the expected negative fiscal shock next year will also weigh on aggregate demand. All of these factors, combined with slowing global growth will continue to widen rate differentials, which will create upside in USD/JPY. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Manufacturing production yearly growth surprised to the upside, coming in at 1.3%. However, Halifax house prices yearly growth underperformed expectations, coming in at 2.5%. Finally, Markit Services PMI underperformed expectations, coming in at 53.9. GBP/USD has been flat since the middle of September. The European Union has been much more conciliatory than anticipated, causing the pound to rally. However, we will continue to watch the negotiations closely, given that very little geopolitical risk is currently priced into the pound at the moment, which means it will continue to be whipshawed with inevitable setbacks in the negotiations. We remain long GBP vol. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 AUD/USD has fallen by roughly 2.5% over the past couple of weeks, mostly due to the spike in U.S. real yields and the fall in emerging market assets. We continue to be bearish on the Australian dollar, as the Australian economy is the most sensitive G10 currency to policy tightening in China. Moreover, the Australian economy has a very indebted household sectors, which makes it difficult for the RBA to hike rates in the current environment. Investors who wish to express this bearish view on the AUD can do so by shorting AUD/CAD, as the CAD will likely benefit from rising oil prices. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has fallen by nearly 3%. Overall, we are bearish the kiwi, as continued tightening by both the fed and Chinese authorities will keep putting pressure on risk assets like the NZD. Moreover, the momentum in volatility continues to be a negative sign for high yield currencies like NZD. That being said, once volatility momentum becomes negative high carry trades like NZD/CHF will prove to be attractive. Moreover, investors looking to hedge their long dollar positions should look to buy the NZD, as rate expectations in New Zealand have likely hit a bottom. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mixed: While the net change in employment outperformed expectations significantly, coming in at 63.3 thousand, the devil was in the detail; full time employment contracted by 17 thousand jobs. On the other hand, the participation rate also surprised to the upside, coming in at 65.4%. However, housing starts surprised negatively, coming in at 189 thousand. USD/CAD has gone up by roughly 1.2% the past 2 weeks. We are closing our short USD/CAD trade this week, as we think the tactical upside for the CAD is now limited. Investors looking to hedge their long dollar exposure should instead look to buy the kiwi. That being said we continue to be positive on the Canadian dollar against the Australian dollar, as oil will further outperform base metals. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been negative: Headline inflation underperformed expectations, coming in at 1%. Moreover, the SVMW Purchasing manager's Index also surprised negatively, coming in at 59.7. Finally, real retail sales yearly growth also underperformed expectations, coming in at 0.3%. EUR/CHF has risen by roughly 1.7% this past two weeks. Overall, we are bearish on the franc on a long-term basis, as inflationary forces are too tepid in Switzerland for the SNB to move away from its ultra-dovish monetary policy. Moreover, the strength in the franc over the past few months will likely drive prices down, adding further fuel to the SNB's easy money campaign. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Headline and core inflation both outperformed expectations, coming in at 3.4% and 1.9% respectively. Moreover, manufacturing output growth also surprised to the upside, coming in at -0.1%. However, register unemployment surprised negatively, ticking up to 2.3%. USD/NOK has risen by roughly 1% the past couple of weeks, in spite of rising oil prices. We have long argued that USD/NOK is more sensitive to real rate differentials than to oil prices. Given that we expect real U.S. rates to have additional upside, we continue to be bullish on this cross. That being said, the NOK could outperform other commodity currencies like the AUD and the NZD, as the relative performance of oil in the commodity space will provide a cyclical lift to the NOK against these currencies. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been mixed: Retail sales yearly growth outperformed expectations, coming in at 2%. Moreover, consumer confidence also surprised to the upside, coming in at 103.6. However, manufacturing PMI underperformed expectations, coming in at 55.2. USD/SEK has risen by roughly 2.7% the past couple of weeks. Overall, we are bullish on the krona on a long term basis, as monetary policy is too easy in Sweden given Sweden's current inflationary backdrop, which means that the path of least resistance for rates is up. Nevertheless, the policy tightening by Chinese authorities could continue to weigh on global growth. This means that the SEK could have some downside on a 3 to 6 month horizon. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Highlights This Special Report was written with our colleagues in BCA Research's Geopolitical Strategy, led by Marko Papic. In it, we explore the evolution of Russia's role in European natural gas markets vis-a-vis the fast-growing U.S. natural gas production and Liquefied Natural Gas (LNG) export capabilities. So what? Rise of U.S. LNG exports to Europe will benefit gas producers and LNG merchants with access to U.S. supplies. Russia will grow ever-more dependent on China, while retaining a market share in Europe. Why? Exports of U.S. LNG to Europe are set to surge over the next decade. Russia will not be completely displaced, as American LNG fills the gap in European natural gas production. But U.S. LNG will lead to the end of oil-indexing of long-term natural gas contracts, hurting Russian state coffers on the margin... ... And forcing Russia further into the arms of China. Also... A tighter Trans-Atlantic partnership - soon to involve a deep energy relationship - and a budding Sino-Russian alliance will further divide the world into two camps, producing a Bifurcated Capitalism that may define this century. Feature Russia's obituaries have been written and re-written many times since the end of the Cold War. And yet, Moscow continues to play an outsized role in global affairs that is belied by quantitative measures of its power (Chart 1). Chart 1From Bipolarity To Multipolarity How so? The fall of the Soviet Union was precipitated by the country's sclerotic managed economy, its failure to escape the middle income trap, and its disastrous military campaign in Afghanistan. But before it died, the Soviet Union sowed the seeds for its resurrection. The $100-130 billion (in 2018 USD) spent on building a natural gas pipeline infrastructure into Western Europe was the elixir that revived Russian power. Just as Russia emerged from its lost decade in the 1990s, it caught a break. Western Europe's natural gas demand rose. At the same time, China's epic industrialization created a once-in-a-century commodity bull market (Chart 2). With demand for its resources buoyed on both sides of the Eurasian landmass, Russia once again saw revenue fill its coffers (Chart 3). With material wealth came the ability to rebuild its hard power and put up a fight against an expansionary Western alliance encroaching on its sphere of influence. Chart 2Chinese Industrialization... Chart 3...Filled Russian Coffers Is there an existential risk to Russia's business model looming in the form of surging U.S. liquefied natural gas (LNG) export capability (Chart 4)? Not yet. Thanks to a massive drop in European domestic production, U.S. LNG exports will fill a growing supply gap, but will not replace Russia's natural gas exports in the medium term. All the same, the once-lucrative European market no longer holds as much promise as it once did with the arrival of the U.S. LNG supplies. Chart 4U.S. LNG Exports Will Surge In order for Russian natural gas exports to Europe to be permanently displaced, Europe would have to build out new LNG capacity beyond 2020, restart domestic production by incentivizing shale development, or turn to alternative energy sources with large base-load potential, such as nuclear power. None of these are on the horizon. With ~15% of its government revenue sourced from natural gas sales, Russia is as much of a one-trick pony as there is in macroeconomics. While we do not foresee that pony heading off to the glue factory, Russia will face some considerable risks in the future, starting with the shift away from the rigid oil-indexed contracts it favors (which lock the price of natural gas to that of oil). As such, the risk to Russia is not that it loses market share in Europe's energy market, but that this market share yields much smaller income in the future, as gas-on-gas pricing competition increases. The U.S. Shale Revolution Goes Global Our commodity team has presented a compelling case for why investors should expect an increase in U.S. LNG exports beyond the current EIA forecast.1 Increasing volumes of associated natural gas production in the Permian Basin in west Texas, which will have to be transported from the basin so as not to curtail oil production, will drive a large part of the expected growth in LNG exports. Our commodity team expects that a major LNG export center will be developed in south Texas, in Corpus Christi, over the next five years, just as the U.S. surpasses 10 Bcf/d of exports in the middle of the next decade.2 At the same time, global LNG demand is expected to rise at an impressive 1.7% annual rate to 2040 (Chart 5). A few key markets will lead this trend (Chart 6). Based on BCA Commodity & Energy Strategy calculations, world LNG export capacity is expected to go from 48 Bcf/d in 2017 to 61 Bcf/d by 2022 (Chart 7). The majority of the new capacity (53%) will come from the U.S., while 18% will come from Australia and 15% from Russia. Chart 5Global LNG Demand Growth Likely Outpaces Current Expectations Chart 6Supply - Demand Imbalances Will Fuel LNG Demand Globally Chart 7LNG Export Capacity Growth The pickup in Australian export capacity is already impressive. While being a relatively small natural gas producer - the eighth largest, accounting for 3% of world output - it has already become the second largest LNG exporting country in the world with over 7.5 Bcf/d of exports. The bulk of new liquefaction facilities will be operational in 2019. Most of Australia's LNG trade lies with Asia, given its geography. The U.S., whose LNG export terminals will be located in the Gulf of Mexico, only has 3 Bcf/d of liquefaction capacity today. Most of its LNG exports also go to Asia (Table 1), but that may change as the current capacity expansion will see exports rise to just over 9 Bcf/d in 2020.3 Furthermore, American gas will compete with surging Australian LNG exports and a build-up of Russian pipeline export capacity to China, which is set to start delivering gas to the country in 2019. Table 1U.S. LNG Exports By Country Europe, on the other hand, has massive regasification capacity slack and thus requires only minimal capex to begin importing large volumes of U.S. LNG. Europe has 23 Bcf/d regasification capacity, with a very low utilization rate of just 27%. This means that it has ~ 16 Bcf/d capacity available, more than enough to absorb all of expectant U.S. ~ 6-7 Bcf/d exports in the next couple of years.4 Bottom Line: The U.S. shale revolution is going global, with U.S. LNG exports set to surge over the next 5-10 years. While some of that capacity will find its way to Asia, those markets will also be flooded with Australian LNG and Russian piped natural gas. Europe, on the other hand, is filing just a quarter of its LNG import capacity, making a Trans-Atlantic gas alliance a match made in heaven. From Cold War To Gas War? If half of the currently proposed, pre-FID, LNG export projects were built in the U.S., American capacity would grow to potentially ~26 Bcf/d by 2030. Europe would need only one or two extra LNG import terminals to build over the next two decades to absorb this volume, as its current capacity is able to import nearly every molecule coming out of North America (Chart 8). Chart 8Europe Has Plenty Of Regasification Capacity Will this new U.S. LNG displace Europe's imports of Russian natural gas? The short answer is no. By 2030, Europe's supply-gap (i.e. domestic supply minus domestic consumption) is estimated to reach 36 Bcf/d. The U.S. could cover a large part of this gap if only half of the proposed pre-FID projects are constructed. However, if Europe's demand remains stable over this period, Europe will still import roughly 20 Bcf/d of Russian natural gas, which in 2017 amounted to 35% of Europe's natural gas consumption. If the U.S. fills 100% of the increase in Europe's supply-gap, it means new Russian natural gas production (the IEA and BP expect Russian production to keep increasing until 2030) will not be sent to Europe. Hence, even if it does not displace old Russian exports, it will limit Russia's ability to export its new natural gas. Europe's demand for natural gas is not likely to be stable. Despite sclerotic growth and generally weak population growth, European governments have tried to incentivize natural gas consumption due to its low emission of CO2 (Table 2). As such, investors should expect further displacement of coal and nuclear power generation in favor of natural gas. Table 2Natgas Emits Less CO2 Thus, U.S. exports will simply replace Europe's domestic production, which is facing considerable declines. The U.K. North Sea production will decrease 5% annually due to the lack of capex and the large number of fields reaching a mature state. Meanwhile, the Netherlands is phasing-out its Groningen field by 2030. Finally, Norwegian gas production is likely to stagnate after reaching record levels in 2017. The second reason that Europe will not be able to sever its relationship with Russia is that its LNG import terminals are largely located in countries that are not massively dependent on Russian imports (Map 1). The two major LNG terminals serving Central and Eastern Europe are the Swinoujscie terminal in Poland - finished in 2015 - and the Adria project in Croatia, to be completed in 2020. Map 1European Natural Gas Geography The Polish LNG terminal will do little to alleviate the dependency of countries further East - Belarus, Ukraine, Bulgaria, Hungary, and Slovakia - from Russia as it currently satisfies only one third of Poland's natural gas needs, and is projected to reach 50% by 2022 once the expansion is completed. This could significantly cut Russian exports to Poland, but not completely end them.5 The Croatian LNG terminal will likely make a very small dent in the overall reliance of the Balkans on Russian natural gas, as once it satisfied Croatian demand, little will be left over for the rest of the region. Beyond these two terminals, Europe will have to invest in pipeline infrastructure in order to reverse the flow of pipelines currently taking gas from the East to the West. At some point in the distant future, we could see a scenario where American natural gas flows even through Cold War era, Soviet-built pipelines deep into Central and Eastern Europe. But given the steep declines in West European natural gas production, this day will come after 2030. Bottom Line: Dreams of displacing Russian natural gas in Europe with American are overstated. European imports of U.S. LNG are likely to skyrocket, but that will merely replace the massive decline in West European and North Sea production. What does that mean for geopolitics? It means that Russia will continue to have a role to play in Europe, but its share of European imports will decline. As such, Europe will have options. If it builds more LNG import terminals, it could expand those options beyond American LNG imports. However, Russian geopolitical influence will not be displaced completely. Russian Coffers Will Take A Hit Although Russian natural gas will continue to course through Europe's veins, its state coffers are nonetheless going to take a hit. European governments are actively diversifying away from Russia via U.S. LNG imports, and buyers generally are shortening the tenor of contracts as they seek more flexible pricing.6 The growth in the global LNG market, fueled by surging U.S. production, will ultimately allow Asian and European markets to diversify away from oil-indexed pricing - which tends to be priced higher than gas-on-gas pricing - and expand access to U.S. supplies.7 The EU has co-financed or committed to co-finance LNG infrastructure projects valued at ~ 640mm euros to secure U.S. LNG. Ultimately, as more and more U.S. LNG moves toward Europe, markets will move toward short- and long-term contracts priced in USD/MMBtu (indexed to Henry Hub, LA, prices), much like Brent crude oil priced in USD/bbl. European markets have already seen this shift, as illustrated in Chart 9. Chart 9European Gas-On-Gas Pricing Is Rising The totality of U.S. export prices is determined by gas-on-gas pricing - i.e., gas priced in USD/MMBtu as a function of gas supply-demand fundamentals. These contracts are without the restrictions found in many oil-indexed contracts. In the U.S., the presence of a deep futures market delivering natural gas to Henry Hub, LA, allows flexible long-term financing and short- and long-term contracting that can be hedged by buyers and sellers. According to Royal Dutch Shell, the spot LNG market doubled from 2010 to 2017, accounting for ~ 25% of all transactions, most of it due to the prodigious increase in U.S. LNG supply. While in Europe the share of LNG spot and short-term deals is small relative to the overall market, it is growing (Chart 10). With U.S. LNG volumes becoming increasingly available in Europe, market participants will be inclined to turn to the LNG spot market to buy or sell outside contracted volumes. This will deepen the development of European natgas markets: in any fully developed market, spot trading is followed by forward contracting, then futures trading using contracts settling against a spot price.8 Chart 10Expect More LNG Spot Trading Russia is a low-cost gas producer in Europe and will be committed to maintaining its market in Europe. However, with U.S. LNG export capacity potentially reaching ~14 Bcf/d by 2025, from ~3 Bcf/d today, it is entirely likely that Russia will find itself in a price war defending existing market share in Europe at lower prices. Its preferred way of doing business, via oil price indexed contracts, will be challenged overnight by a surge in U.S. LNG imports. Bottom line: The EU and its member states are actively diversifying gas supply sources away from Russia via U.S. LNG purchases. This will lower the marginal price of all gas bought and sold in Europe, all else equal, resulting in lower margins for all sellers of gas and better prices for consumers. Ultimately, the European natural gas market will resemble every other fully developed commodity market, operating on razor-thin margins. This means whatever rents were available in this market will be dissipated as competition increases. Investment And Geopolitical Implications The immediate investment implication of these developments is that gas producers and LNG merchants with access to U.S. shale-gas supplies, processing trading, and risk-management capabilities should be favored in this evolving market. Beyond the short term, however, we expect several ongoing geopolitical developments to be ossified by the flood of American LNG steaming towards European shores: Sino-Russian alliance deepens: As Russian natural gas exports to Europe stagnate, its pipeline infrastructure build-out will increase its exports to China to 3.8 Bcf/d by 2019. China will become the growth market for Russian energy producers, deepening the move between the two former Cold War foes to stabilize their relationship. Although it may seem obvious that Russia would retain leverage in such a relationship - given that it can "turn off the lights" to Beijing at whim - we actually think that Beijing will hold all the cards.9 Europe will have an incentive to keep diversifying its natural gas supplies. Meanwhile, Chinese demand is likely to keep growing. As such, China will become Russia's main option for revenue growth. And as the old adage goes, the customer is always right. Trans-Atlantic alliance deepens: Despite the fears that the "Trump Doctrine" would lead to American isolationism - fears that we shared in 2017 - the growing U.S.-European LNG connection will ensure that the Trans-Atlantic alliance - forged 70 years ago in blood - will be saved via brisk energy trade.10 A growing European energy deficit with the U.S. will also resolve - or at least alleviate - the main source of marital problems in the relationship: Europe's trade surplus. Bifurcation of capitalism: A key theme of BCA's Geopolitical Strategy is that the age of globalization will yield to the world's segmentation into spheres of influence.11 A deepening Trans-Atlantic alliance, when combined with a budding Sino-Russian relationship, will lead to a Bifurcated Capitalism system where the Trans-Atlantic West faces off against the Eurasian East. What would such a Bifurcated Capitalism mean for investors? Time will tell. But it may mean that thirty years of global capitalism (1985 to roughly today) may give way to something more common in human history: a world dissected into spheres of influence where flows of capital, goods, and people within spheres are relatively smooth and unencumbered, yet flows between the spheres are heavily impeded. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Pavel Bilyk, Research Associate Commodity & Energy Strategy pavelb@bcaresearch.com 1 Please see "U.S. Set To Disrupt Global LNG Market," published by BCA Research's Commodity & Energy Strategy October 4, 2018. It is available at ces.bcaresearch.com. 2 Please see "The Price of Permian Gas Pipeline Limits," by Stephen Rassenfoss, in the Journal of Petroleum Technology, published July 19, 2018. 3 Following a two-year pause in project Final Investment Decisions (FIDs) from 2016 to 2017, potential FIDs in 2018 and 2019 could increase the U.S. capacity to ~ 14 Bcf/d by 2025. This will make the U.S. the second-largest exporter of LNG in the world, surpassing Australia. This new wave of investment is yet to be finalized. Therefore, final decisions in 2H18 and 2019 will be crucial to determine the medium-term potential of U.S. LNG. 4 Cheniere Energy, the largest U.S. LNG exporter, expects ~ 50% of its exports to go to Europe, according to S&P Global Platts. Please see "US LNG vs Pipeline Gas: European Market Share War?" published April 2017 by Platts. 5 Additionally, if the Baltic Pipe Project, moving gas from Norway to Poland, reaches FID in 2019, this would help Poland diversify its energy supply from Russia, as the country would cover close to all its domestic demand via its production + LNG and new pipeline imports. 6 Please see "US and Russia step up fight to supply Europe's gas," published by the Financial Times August 3, 2017. See also "Russia's gas still a potent weapon," also published by the FT, re the so-called collateral damage suffered by Europe when Russia cut off gas supplies to Ukraine in January 2009. 7 For the EU, supply diversification is a particularly important goal. On July 25, 2018, the European Commission and the U.S. issued a joint statement, in which the EU agreed to import more LNG from the U.S. "to diversify and render its energy supply more secure. The EU and the U.S. will therefore work to facilitate trade in liquefied natural gas," according to a press release issued August 9, 2018, by the Commission. Re Japan's diversification strategy, please see "Feature: US LNG sources fit with Japan's desire for route diversity: minister," published by S&P Global Platts September 27, 2018. 8 Please see Darrell Duffie, Futures Markets (1988), Prentice-Hall; and Jeffrey C. Williams, The Economic Function of Futures Markets (1986), Cambridge University Press. Longer-term deals already are being signed under flexible Henry Hub futures-based indexing terms in the U.S. This is occurring because the U.S. LNG market is able to tap into futures liquidity that supports hedging by natgas producers and consumers. Please see "Vitol-Cheniere Pact Shows Long-Term LNG Deals Aren't Dead," published by bloomberg.com September 17, 2018. 9 Please see BCA Geopolitical Strategy Special Report, "The Embrace Of The Dragon And The Bear," dated April 11, 2014, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "The Trump Doctrine," dated February 1, 2017, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, and Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com.

Highlights Asset allocation: Go long industrial commodities versus equities on a 6-month horizon. If an inflationary impulse is dominating, beaten-down industrial commodities have more upside than richly valued equities; and if a disinflationary impulse is dominating, its main casualty will be equities. Currencies: Take profits on long EUR/CNY. Maintain a broadly neutral stance to EUR, with short EUR/JPY counterbalancing long EUR/USD. Equity sectors: overweight basic materials versus the market. And within the basic materials sector, overweight basic resources versus chemicals. Chart of the WeekChina's 6-Month Credit Impulse Provides A Perfect Explanation For Commodity Inflation Feature Equity markets are entering the crossfire between two opposing forces: an inflationary impulse coming from the global economy; and a disinflationary impulse as higher bond yields threaten to deflate the very rich valuations of equities and other risk-assets. As this battle plays out in the coming months a good strategy is to go long commodities versus equities. The logic is simple: if the inflationary impulse from the economy is dominating, then beaten-down industrial commodities have more upside than richly valued equities; and if the disinflationary impulse from higher bond yields is dominating, then commodities have less downside than equities, because commodities have a much weaker valuation link with bond yields. Therefore, going long industrial commodities versus equities on a 6-month horizon should be a good strategy however the battle between inflationary and disinflationary impulses plays out. Inflationary Impulse Battles Disinflationary Impulse Chart I-2 shows the credit impulse oscillations in the euro area, U.S., and China since the start of the millennium, all expressed in dollars to allow a comparison between the three major economies. It is a fascinating chart because the change in the dominant oscillation - the one with the highest amplitude - perfectly illustrates the shift in global economic power and influence from Europe and the U.S. to China. Chart I-2The Shift In Economic Power From Europe And The U.S. To China Through 2000-08 the impulses in the euro area and the U.S. dominated. But during the global financial crisis that all changed: the credit stimulus from China dwarfed the responses from the western economies. Then through 2009-12 the impulse oscillations from the three major economies were briefly the same size, before China took on the undisputed mantle of dominant impulse, which it has held consistently since 2013. The world's three major economies are now all in 'up' oscillations according to their credit impulses. This means the global economy will experience an inflationary impulse for the next couple of quarters or so. However, battling the inflationary impulse is a disinflationary impulse. As the inflationary impulse pushes up bond yields, it threatens to deflate the very rich valuations of equities (and other risk-assets). Crucially, this disinflationary force is particularly vicious when bond yields are rising from ultra-low levels. We have described this dynamic exhaustively in previous reports, so we will not go into the detail here. But in a nutshell, both parts of an equity's required return - the risk-free component and the risk premium - go up together when bond yields are rising from ultra-low levels. Meaning that rising yields deflate equity valuations exponentially (Chart I-3).1 Chart I-3At Low Bond Yields The Valuation Of Equities Changes Exponentially But Which Inflationary Impulse? At our recent investment conference in Toronto, the three speakers on the China panel gave three different conclusions on China: aggressively bullish, moderately bullish, and bearish! The aggressive bull pointed out that the 3-month credit impulse has gone vertical (Chart I-4); the moderate bull pointed out that the 6-month credit impulse appears to be turning up (Chart I-5); while the bearish argument was that the level of the 12-month credit and fiscal impulse remains depressed. Chart I-4The 3-Month Impulse Is Up Sharply... Chart I-5But The 6-Month Impulse Is Just Turning So which narrative should we use? The answer is the one that provides the best explanatory power for the cycles that we actually observe in the economic and financial market data. As we described in our Special Report The Cobweb Theory And Market Cycles, the theory and evidence powerfully identifies the 6-month credit impulse as the one with the best explanatory power for the oscillations that we actually observe in the economy and markets - because the 6-month period aligns most closely with the lag between credit demand and credit supply.2 In any case, as we use the 6-month impulse to powerful effect in Europe, consistency demands that we must use the 6-month impulses in U.S. and China too. For the sceptics, the Chart of the Week should finally obliterate any lingering doubts. China's 6-month impulse gives a spookily perfect explanation for the industrial commodity inflation cycle. The important takeaway right now is that if the 6-month impulse is turning up, so will industrial commodity inflation. What Does All Of This Mean For Investors? This brings us to our central message. As we have just seen, an up-oscillation in 6-month impulses, especially in China, will lift industrial commodity inflation. But it will likely have a much smaller influence on developed market equities which, in these circumstances, will be under the strong constraining spell of higher bond yields. On this basis the asset allocation recommendation is to go long industrial commodities versus equities on a 6-month horizon (Chart I-6). Chart I-6Go Long Commodities Vs. Equities Interestingly, technical analysis also supports this recommendation over the next three months or so. Our tried and tested measure of excessive trending and groupthink suggests that the recent underperformance of industrial commodities relative to developed market equities is extreme and at a point which indicates a countertrend move, or at least a trend exhaustion (Chart I-7). Chart I-7The Underperformance Of Industrial Commodities Is Technically Stretched For currencies, the foregoing analysis and charts means it is time to take profits in our long position in the euro versus the Chinese yuan. This leaves us with a broadly neutral exposure to the euro, with a short position versus the yen counterbalancing a long position versus the dollar. As for European equities, many years ago they were a pure play on events in Europe. Today, this might still be true for European 'tail-events' such as the euro sovereign debt crisis, or a potential 'no deal' Brexit. However, for the most part, European equity markets are tightly integrated with global equity markets - at least in direction if not level. Given that industrial commodity inflation takes its cue from the 6-month credit impulse - especially in China - it is hardly surprising that the European basic materials sector follows exactly the same cycle, both in absolute terms (Chart I-8) and relative to the broader equity market (Chart I-9). Therefore the equity sector recommendation is to overweight basic materials versus the market. Chart I-8China's 6-Month Credit Impulse Drives Europe's Basic Material Equities In Absolute Terms... Chart I-9...And In Relative Terms Interestingly, there is also a play within the basic materials sector. The basic resources sector which represents the miners and extractors of raw materials should fare better than the chemicals sector which uses these raw materials as an input (Chart I-10). Hence, overweight basic resources versus chemicals. Chart I-10Overweight Basic Resources Vs. Chemicals Readers may argue that most of the foregoing charts illustrate the same cycle. But that's precisely the point! Never forget that financial markets follow the Pareto principle: the most important 20 percent of analysis explains 80 percent of the moves across all asset classes across all geographies across all times. The key to successful investing is to find the most important 20 percent of analysis. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Reports 'Trapped: Have Equities Trapped Bonds?' September 13, 2018 and 'The Rule Of 4 For Equities And Bonds' August 2, 2018 available at eis.bcaresearch.com 2 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' January 11, 2018 available at eis.bcaresearch.com Fractal Trading Model* It was a busy week for our trades. Long basic resources versus chemicals achieved its profit target, but short U.S. telecom versus U.S. autos hit its stop-loss. Meanwhile, short trade-weighted dollar reached the end of its 65 day holding period broadly flat. All three trades are now closed. In line with the main body of the report, this week's trade recommendation is to go long industrial commodities (represented by the CRB industrials index) versus equities (represented by the MSCI World Index in USD). The profit target is 2% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart 11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations