Emerging Markets

Highlights Macro Outlook: Global growth is decelerating and the composition of that growth is shifting back towards the United States. Policy backdrop: The specter of trade wars represents a real and immediate threat to risk assets. Meanwhile, many of the "policy puts" that investors have relied on have been marked down to a lower strike price. Global equities: We downgraded global equities from overweight to neutral on June 19th. Investors should favor developed market equities over their EM counterparts. Defensive stocks will outperform deep cyclicals, at least until the dollar peaks early next year. Government bonds: Treasury yields may dip in the near term, but will rise over a 12-month horizon. Overweight Japan, Australia, New Zealand, and the U.K. relative to the U.S., Canada, and the euro area. Credit: The current level of spreads points to subpar returns over the next 12 months. We have a modest preference for U.S. over European corporate bonds. Currencies: EUR/USD will fall into the $1.10-to-1.15 range during the next few months. The downside risks for the pound and the yen are limited. Avoid EM and commodity currencies. The risk of a large depreciation in the Chinese yuan is rising. Commodities: Favor oil over metals. Gold will do well over the long haul. Feature I. Macro Outlook Back To The USA The global economy experienced a synchronized expansion in 2017. Global real GDP growth accelerated to 3.8% from 3.2% in 2016. The euro area, Japan, and most emerging markets moved from laggards to leaders in the global growth horse race. The opposite pattern has prevailed in 2018. Global growth has slowed, a trend that is likely to continue over the next few quarters judging by a variety of leading economic indicators (LEIs) (Chart 1). The U.S. has once again jumped ahead of its peers: It is the only major economy where the LEI is still rising (Chart 2). The latest tracking data suggest that U.S. real GDP growth could reach 4% in the second quarter, more than double most estimates of trend growth. Chart 1Global Growth Is Slowing Again Chart 2U.S. Is Outshining Its Peers Such a lofty pace of growth cannot be sustained. For the first time in over a decade, the U.S. economy has reached full employment. The unemployment rate stands at a 48-year low of 3.75%. The number of people outside the labor force who want a job, as a percentage of the total working-age population, is back to pre-recession lows (Chart 3). For the first time in the history of the Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS), there are more job vacancies than unemployed workers (Chart 4). Chart 3U.S. Is Back To Full Employment Chart 4There Are Now More Vacancies Than Jobseekers Mainstream economic theory states that governments should tighten fiscal policy as the economy begins to overheat in order to accumulate a war chest for the next inevitable downturn. The Trump administration is doing the exact opposite. The budget deficit is set to widen to 4.6% of GDP next year on the back of massive tax cuts and big increases in government spending (Chart 5). Chart 5The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The Fed In Tightening Mode As the labor market overheats, wages will accelerate further. Average hourly earnings surprised to the upside in May. The Employment Cost Index for private-sector workers - one of the cleanest and most reliable measures of wage growth - rose at a 4% annualized pace in the first quarter. The U.S. labor market has finally moved onto the 'steep' side of the Phillips curve (Chart 6). Rising wages will put more income into workers' pockets who will then spend it. As aggregate demand increases beyond the economy's productive capacity, inflation will rise. The New York Fed's Underlying Inflation Gauge, which leads core CPI inflation by 18 months, has already leaped to over 3% (Chart 7). The prices paid components of the ISM and regional Fed purchasing manager surveys have also surged (Chart 8). Chart 6Wage Inflation Will Accelerate Chart 7U.S. Inflation: Upside Risks (Part I) Chart 8U.S. Inflation: Upside Risks (Part II) The Fed has a symmetric inflation target. Hence, a temporary increase in core PCE inflation to around 2.2%-to-2.3% would not worry the FOMC very much. However, a sustained move above 2.5% would likely prompt an aggressive response. The fact that the unemployment rate has fallen 0.7 percentage points below the Fed's estimate of full employment may seem like a cause for celebration, but this development has a dark side. There has never been a case in the post-war era where the unemployment rate has risen by more than one-third of a percentage point without this coinciding with a recession (Chart 9). The Fed wants to avoid a situation where the unemployment rate has fallen so much that it has nowhere to go but up. Chart 9Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle As such, we think that the bar for the Fed to abandon its once-per-quarter pace of rate hikes is quite high. If anything, the risk is that the Fed expedites monetary tightening in order to keep real rates on an upward trajectory. Jay Powell's announcement that he will hold a press conference at the conclusion of every FOMC meeting opens the door for the Fed to move back to its historic pattern of hiking rates once every six weeks. Housing And The Monetary Transmission Mechanism Economists often talk about the "monetary transmission mechanism." As Ed Leamer pointed out in his 2007 Jackson Hole symposium paper succinctly entitled, "Housing Is The Business Cycle," housing has historically been the main conduit through which changes in monetary policy affect the real economy.1 A house will last a long time, and the land on which it sits - which in many cases is worth more than the house itself - will last forever. Thus, changes in real interest rates tend to have a large impact on the capitalized value of one's home. Today, the U.S. housing market is in pretty good shape (Chart 10). Construction activity was slow to increase in the aftermath of the Great Recession. As a result, the vacancy rate stands at ultra-low levels. Home prices have been rising briskly, but are still 13% below their 2005 peak once adjusted for inflation. On both a price-to-rent and price-to-income basis, home prices do not appear overly stretched. Mortgage-servicing costs, expressed as a share of disposable income, are near all-time lows. The homeownership rate has also been trending higher, thanks to faster household formation and an improving labor market. Lenders remain circumspect (Chart 11). The ratio of mortgage debt-to-disposable income has barely increased during the recovery, and is still 31 percentage points below 2007 levels. The average FICO score for new mortgages stands at a healthy 761, well above pre-recession standards. Chart 10U.S. Housing Is In Pretty Good Shape Chart 11Mortgage Lenders Remain Circumspect The Urban Institute Housing Credit Availability Index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, is nowhere close to dangerous levels. This is particularly the case for private-label mortgages, whose default risk has hovered at just over 2% during the past few years, down from a peak of 22% in 2006. If Not Housing, Then What? Since the U.S. housing sector is in reasonably good shape, the Fed may need to slow the economy through other means. Here's the rub though: Other sectors of the economy are not particularly sensitive to changes in interest rates. Decades of empirical data have clearly shown that business investment is only weakly correlated with the cost of capital. Unlike a house, most business investment is fairly short-lived. A computer might be ready for the recycling heap in just a few years. The Bureau of Economic Analysis estimates that the depreciation rate for nonresidential assets is nearly four times higher than for residential property (Chart 12). During the early 1980s, when the effective fed funds rate reached 19%, residential investment collapsed but business investment was barely affected (Chart 13). Chart 12U.S.: Depreciation Rate For Business ##br##Investment Is Much Larger Than For Residential Property Chart 13Residential Investment Collapsed In ##br##Response To Higher Interest Rates In The Early 80s... While Business Investment Was Barely Affected Rising rates could make it difficult for corporate borrowers to pay back loans, which could indirectly lead to lower business investment. That said, a fairly pronounced increase in rates may be necessary to generate significant distress in the corporate sector, given that interest payments are close to record-lows as a share of cash flows (Chart 14). In addition, corporate bonds now represent 60% of total corporate liabilities. Bonds tend to have much longer maturities than bank loans, which provides a buffer against default risk. A stronger dollar would cool the economy by diverting some spending towards imports. However, imports account for only 16% of GDP. Thus, even large swings in the dollar's value tend to have only modest effects on the economy. Likewise, higher interest rates could hurt equity prices, but the wealthiest ten percent of households own 93% of all stocks. Hence, it would take a sizable drop in the stock market to significantly slow GDP growth. The conventional wisdom is that the Fed will need to hit the pause button at some point next year. The market is pricing in only 85 basis points in rate hikes between now and the end of 2020 (Chart 15). That assumption may be faulty, considering that housing is in good shape and other sectors of the economy are not especially sensitive to changes in interest rates. Rates may need to go quite a bit higher before the U.S. economy slows materially. Chart 14U.S. Corporate Sector Interest Payments ##br##At Near Record-Low Levels As A Share Of Cash Flows Chart 15Market Expectations Versus The Fed Dots Global Contagion Investors and policymakers talk a lot about the neutral rate of interest. Unfortunately, the discussion is usually very parochial in nature, inasmuch as it focuses on the interest rate that is consistent with full employment and stable inflation in the United States. But the U.S. is not an island unto itself. Even if a bit outdated, the old adage that says that when the U.S. sneezes the rest of the world catches a cold still rings true. What if there is a lower "shadow" neutral rate which, if breached, causes pain outside the U.S. before it causes pain within the U.S. itself? Eighty per cent of EM foreign-currency debt is denominated in U.S. dollars. Outside of China, EM dollar debt is now back to late-1990s levels both as a share of GDP and exports (Chart 16). Just like in that era, a vicious cycle could erupt where a stronger dollar makes it difficult for EM borrowers to pay back their loans, leading to capital outflows from emerging markets, and an even stronger dollar. The wave of EM local-currency debt issued in recent years only complicates matters (Chart 17). If EM central banks raise rates, this could help prevent their currencies from plunging. However, higher domestic rates will make it difficult for local-currency borrowers to pay back their loans. Damned if you do, damned if you don't. Chart 16EM Dollar Debt Is High Chart 17EM Borrowers Like Local Credit Too China To The Rescue? Don't Count On It When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive new stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. Today, Chinese growth is slowing again. May data on industrial production, retail sales, and fixed asset investment all disappointed. Our leading indicator for the Li Keqiang index, a widely followed measure of economic activity, is in a clear downtrend (Chart 18). Property prices in tier one cities are down year-over-year. Construction tends to follow prices. So far, the policy response has been muted. Reserve requirements have been cut and some administrative controls loosened, but the combined credit and fiscal impulse has plunged (Chart 19). Onshore and offshore corporate bond yields have increased to multi-year highs. Bank lending rates are rising, while loan approval rates are dropping (Chart 20). Chart 18Chinese Growth Is Slowing Anew Chart 19China: Policy Response To Slowdown ##br##Has Been Muted So Far Chart 20China: Credit Tightening There is no doubt that China will stimulate again if the economy appears to be heading for a deep slowdown. However, the bar for a fresh round of stimulus is higher today than it was in the past. Elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities will be willing to respond with the usual barrage of infrastructure spending and increased bank lending. The economy needs to feel more pain before policymakers come to its aid. Rising Risk Of Another RMB Devaluation Chart 21China: Currency Wars Are Good And ##br##Easy To Win Even if China does stimulate the economy, it may try to do so by weakening the currency rather than loosening fiscal and credit policies. Chart 21 shows that the yuan has fallen much more over the past week than one would have expected based on the broad dollar's trend. The timing of the CNY's recent descent coincides with President Trump's announcement of additional tariffs on $200 billion of Chinese goods. Global financial markets went into a tizzy the last time China devalued the yuan in August 2015. The devaluation triggered significant capital outflows, arguably only compounding China's problems. This has led commentators to conclude that the authorities would not make the same mistake again. But what if the real mistake was not that China devalued its currency, but that it did not devalue it by enough? Standard economic theory says that a country should always devalue its currency by a sufficient amount to flush out expectations of a further decline. China was too timid, and paid the price. Capital controls are tighter in China today than they were in 2015. This gives the authorities more room for maneuver. China is also waging a geopolitical war with the United States. The U.S. exported only $188 billion of goods and services to China, a small fraction of the $524 billion in goods and services that China exported to the United States. China simply cannot win a tit-for-tat trade war with the United States. In contrast, a currency war from China's perspective may be, to quote Donald Trump, "good and easy to win." The Chinese simply need to step up their purchases of U.S. Treasurys, which would drive up the value of the dollar. Trump And Trade Needless to say, any effort by the Chinese to devalue their currency would invite a backlash from the Trump administration. However, since China is already on the receiving end of punitive U.S. trade actions, it is not clear that the marginal cost to China would outweigh the benefits of having a more competitive currency. The truth is that there may be little that China can do to fend off a trade war. Protectionism is popular among American voters, especially among Trump's base (Chart 22). Donald Trump ran on a protectionist platform, and he is now trying to deliver on his promise of a smaller trade deficit. Whether he succeeds is another story. Trump's macroeconomic policies are completely at odds with his trade agenda. Fiscal stimulus will boost aggregate demand, which will suck in more imports. An overheated economy will prompt the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. All of this will result in a wider trade deficit. What will Trump tell voters two years from now when he is campaigning in Michigan and Ohio about why the trade deficit has widened under his watch? Will he blame himself or America's trading partners? No trophy for getting that answer right. Trump seems to equate countries with companies: Exports are revenues and imports are costs. If a country is exporting less than it is importing, it must be losing money. This is deeply flawed reasoning. I run a current account deficit with the place where I eat lunch and they run a capital account deficit with me - they give me food and I give them cash - but I don't go around complaining that they are ripping me off. A trade war would be much more damaging to Wall Street than Main Street. While trade is a fairly small part of the U.S. economy, it represents a large share of the activities of the multinational companies that comprise the S&P 500. Trade these days is dominated by intermediate goods (Chart 23). The exchange of goods and services takes place within the context of a massive global supply chain, where such phrases as "outsourcing," "vertical integration" and "just-in-time inventory management" have entered the popular vernacular. Chart 22Free Trade Is Not In Vogue In The U.S. Chart 23Trade In Intermediate Goods Dominates This arrangement has many advantages, but it also harbors numerous fragilities. A small fire at a factory in Japan that manufactured 60 per cent of the epoxy resin used in chip casings led to a major spike in RAM prices in 1993. Flooding in Thailand in 2011 wreaked havoc on the global auto industry. The global supply chain is highly vulnerable to even small shocks. Now scale that up by a factor of 100. That is what a global trade war would look like. The Euro Area: Back In The Slow Lane Euro area growth peaked late last year. Real final demand grew by 0.8% in Q4 of 2017 but only 0.2% in Q1 of 2018. The weakening trend was partly a function of slower growth in China and other emerging markets - net exports contributed 0.41 percentage points to euro area growth in Q4 but subtracted 0.14 points in Q1. Domestic factors also played a role. Most notably, the euro area credit impulse rolled over late last year, taking GDP growth down with it (Chart 24).2 It is too early to expect euro area growth to reaccelerate. German exports contracted in April. Export expectations in the Ifo survey sank in June to the lowest level since January 2017, while the export component of the PMI swooned to a two-year low. We also have yet to see the full effect of the Italian imbroglio on euro area growth. Italian bond yields have come down since spiking in April, but the 10-year yield is still more than 100 basis points higher than before the selloff (Chart 25). This amounts to a fairly substantial tightening in financial conditions in the euro area's third largest economy. And this does not even take into account the deleterious effect on Italian business confidence. Chart 24Peak In Euro Area Credit Impulse Last Year##br## Means Slower Growth This Year Chart 25Uh Oh Spaghetti-O If You Are Gonna Do The Time, You Might As Well Do The Crime At this point, investors are basically punishing Italy for a crime - defaulting and possibly jettisoning the euro - that it has not committed. If you are going to get reprimanded for something you have not done, you are more likely to do it. Such a predicament can easily create a vicious circle where rising yields make default more likely, leading to falling demand for Italian debt and even higher yields (Chart 26). The fact that Italian real GDP per capita is no higher now than when the country adopted the euro in 1999, and Italian public support for euro area membership is lower than elsewhere, has only added fuel to investor concerns (Chart 27). Chart 26When A Lender Of Last Resort Is Absent, Multiple Equilibria Are Possible Chart 27Italy: Neither Divine Nor A Comedy The ECB could short-circuit this vicious circle by promising to backstop Italian debt no matter what. But it can't make such unconditional promises. Recall that prior to delivering his "whatever it takes" speech in 2012, Mario Draghi and his predecessor Jean-Claude Trichet penned a letter to Silvio Berlusconi outlining a series of reforms they wanted to see enacted as a condition of ongoing ECB support. The contents of the letter were so explosive that they precipitated Berlusconi's resignation after they were leaked to the public. One of the reforms that Draghi and Trichet demanded - and the subsequent government led by Mario Monti ultimately undertook - was the extension of the retirement age. Italy's current leaders promised to reverse that decision during the election campaign. While they have softened their stance since then, they will still try to deliver on much of their populist agenda over the coming months, much to the consternation of the ECB and the European Commission. It was one thing for Mario Draghi to promise to do "whatever it takes" to protect Italy when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. Italy's Macro Constraints Much has been written about what Italy should be doing, but the fact is that there are no simple solutions. Italy suffers from an aging population that is trying to save more for retirement. Italian companies do not want to invest in new capacity because the working-age population is shrinking, which limits future domestic demand growth. Thus, the private sector is a chronic net saver, constantly wanting to spend less than it earns (Chart 28). Italy is not unique in facing an excess of private-sector savings. However, Italy is unique in that the solutions available to most other countries to deal with this predicament are not available to it. Broadly speaking, there are two ways you can deal with excess private-sector savings. Call it the Japanese solution and the German solution. The Japanese solution is to have the government absorb excess private-sector savings with its own dissavings. This is tantamount to running large, sustained fiscal deficits. Italy's populist coalition Five Star-Lega government tried to pursue this strategy, only to have the bond vigilantes shoot it down. The German solution is to ship excess savings out of the country through a large current account surplus (in Germany's case, 8% of GDP). However, for Italy to avail itself of this solution, it would need to have a hypercompetitive economy, which it does not. Unlike Spain, Italy's unit labor costs have barely declined over the past six years relative to the rest of the euro area, leaving it with an export base that is struggling to compete abroad (Chart 29). Chart 28The Italian Private Sector Wants To Save Chart 29Italy: More Work Needs To Be Done On The Labor Competitiveness Front Since there is little that can be done in the near term that would improve Italy's competitiveness vis-à-vis the rest of the euro area, the only thing the ECB can do is try to improve Italy's competitiveness vis-à-vis the rest of the world. This means keeping monetary policy very loose and hoping that this translates into a weak euro. II. Financial Markets Downgrade Global Risk Assets From Overweight To Neutral Investors are accustomed to thinking that there is a "Fed put" out there - that the Fed will stop raising rates if growth slows and equity prices fall. This was a sensible assumption a few years ago: The Fed hiked rates in December 2015 and then stood pat for 12 months as the global economic backdrop darkened. These days, however, the Fed wants slower growth. And if weaker asset prices are the ticket to slower growth, so be it. The "Fed put" may still be around, but the strike price has been marked down to a lower level. Likewise, worries about growing financial and economic imbalances will limit the efficacy of the "China stimulus put" - the tendency for the Chinese government to ease fiscal and credit policy at the first hint of slower growth. The same goes for the "Draghi put." The ECB is hoping, perhaps unrealistically so, to wind down its asset purchase program later this year. This means that a key buyer of Italian debt is stepping back just when it may be needed the most. The loss of these three policy puts, along with additional risks such as rising protectionism, means that the outlook for global risk assets is likely to be more challenging over the coming months. With that in mind, we downgraded our 12-month recommendation on global risk assets from overweight to neutral last week. Fixed-Income: Stay Underweight Chart 30U.S. Corporate Bonds: Leverage-Adjusted Value A less constructive stance towards equities would normally imply a more constructive stance towards bonds. Global bond yields could certainly fall in the near term, as EM stress triggers capital flows into safe-haven government bond markets. However, if we are really in an environment where an overheated U.S. economy and rising inflation force the Fed to raise rates more than the market expects, long-term bond yields are likely to rise over a 12-month horizon. As such, asset allocators should move the proceeds from equity sales into cash. The U.S. yield curve might still flatten in this environment, but it would be a bear flattening - one where long-term yields rise less than short-term rates. Bond yields are strongly correlated across the world. Thus, an increase in U.S. Treasury yields over the next 12 months would likely put upward pressure on bond yields abroad, even if inflation remains contained outside the United States. BCA's Global Fixed Income Strategy service favors Japan, Australia, New Zealand, and the U.K. over the U.S., Canada, and euro area bond markets. Investors should also pare back their exposure to spread product. Our increasing caution towards equities extends to the corporate bond space. BCA's U.S. Corporate Health Monitor (CHM) remains in deteriorating territory. With profits still high and bank lending standards continuing to ease, a recession-inducing corporate credit crunch is unlikely over the next 12 months. Nevertheless, our models suggest that both investment grade and high yield credit are overvalued (Chart 30). In relative terms, our fixed-income specialists have a modest preference for U.S. over European credit. The near-term growth outlook is more challenging in Europe. The ECB is also about to wind down its bond buying program, having purchased nearly 20% of all corporate bonds in the euro area over the course of only three years. Currencies: King Dollar Is Back The U.S. dollar is a counter-cyclical currency, meaning that it tends to do well when the global economy is decelerating (Chart 31). If the Chinese economy continues to weaken, global growth will remain under pressure. Emerging market currencies will suffer in this environment especially if, as discussed above, the Chinese authorities engineer a devaluation of the yuan. Momentum is moving back in the dollar's favor. Chart 32 shows that a simple trading rule - which goes long the dollar whenever it is above its moving average and shorts it when it is below - has performed very well over time. The dollar is now trading above most key trend lines. Chart 31Decelerating Global Growth Tends To Be##br## Bullish For The Dollar Chart 32The Dollar Trades On Momentum Some commentators have argued that a larger U.S. budget deficit will put downward pressure on the dollar. However, this would only happen if the Fed let inflation expectations rise more quickly than nominal rates, an outcome which would produce lower real rates. So far, that has not happened: U.S. real rates have risen across the entire yield curve since Treasury yields bottomed last September (Chart 33). As a result, real rate differentials between the U.S. and its peers have increased (Chart 34). Chart 33U.S. Real Rates Have Risen Across ##br##The Entire Yield Curve Chart 34Real Rate Differentials Have Widened ##br##Between The U.S. And Its DM Peers Historically, the dollar has moved in line with changes in real rate differentials (Chart 35). The past few months have been no exception. If the Fed finds itself in a position where it can raise rates more than the market anticipates, the greenback should continue to strengthen. Chart 35Historically, The Dollar Has Moved In Line With Interest Rate Differentials True, the dollar is no longer a cheap currency. However, if long-term interest rate differentials stay anywhere close to where they are today, the greenback can appreciate quite a bit from current levels. For example, consider the dollar's value versus the euro. Thirty-year U.S. Treasurys currently yield 2.98% while 30-year German bunds yield 1.04%, a difference of 194 basis points. Even if one allows for the fact that investors expect euro area inflation to be lower than in the U.S. over the next 30 years, EUR/USD would need to trade at a measly 84 cents today in order to compensate German bund holders for the inferior yield they will receive.3 We do not expect EUR/USD to get down to that level, but a descent into the $1.10-to-$1.15 range over the next few months certainly seems achievable. Brexit worries will continue to weigh on the British pound. Nevertheless, we are reluctant to get too bearish on the pound. The currency is extremely cheap (Chart 36). Inflation has come down from a 5-year high of 3.1% in November, but still clocked in at 2.4% in April. Real wages are picking up, consumer confidence has strengthened, and the CBI retail survey has improved. In a surprise decision, Andy Haldane, the Bank of England's Chief Economist, joined two other Monetary Policy Committee members in voting for an immediate 25 basis-point increase in the Bank Rate in June. Perhaps most importantly, Brexit remains far from a sure thing. Most polls suggest that if a referendum were held again, the "Bremain" side would prevail (Chart 37). Rules are made to be broken. It is the will of the people, rather than legal mumbo-jumbo, that ultimately matters. In the end, the U.K. will stay in the EU. The yen is likely to weaken somewhat against the dollar over the next 12 months as interest rate differentials continue to move in the dollar's favor. That said, as with the pound, we think the downside for the yen is limited (Chart 38). The yen real exchange rate remains at multi-year lows. Japan's current account surplus has grown to nearly 4% of GDP and its net international investment position - the difference between its foreign assets and liabilities - stands at an impressive 60% of GDP. If financial market volatility rises, as we expect, some of those overseas assets will be repatriated back home, potentially boosting the value of the yen in the process. Chart 36The Pound Is Cheap Chart 37When Bremorse Sets In Chart 38The Yen's Long-Term Outlook Is Bullish Commodities: Better Outlook For Oil Than Metals The combination of slower global growth and a resurgent dollar is likely to hurt commodity prices. Industrial metals are more vulnerable than oil. China consumes around half of all the copper, nickel, aluminum, zinc, and iron ore produced around the world (Chart 39). In contrast, China represents less than 15% of global oil demand. The supply backdrop for oil is also more favorable than for metals. While Saudi Arabia is likely to increase production over the remainder of the year, this may not be enough to fully offset lower crude output from Venezuela, Iran, Libya, and Nigeria, as well as potential constraints to U.S. production growth due to pipeline bottlenecks. Additionally, a recent power outage has knocked about 350,000 b/d of Syncrude's Canadian oil sands production offline at least through July. The superior outlook for oil over metals means we prefer the Canadian dollar relative to the Aussie dollar. Chart 40 shows that the AUD is expensive compared to the CAD based on a Purchasing Power Parity calculation. Although the Canadian dollar deserves some penalty due to NAFTA risks, the current discount seems excessive to us. Accordingly, as of today, we are going tactically short AUD/CAD. Chart 39China Is A More Dominant Consumer ##br##Of Metals Than Oil Chart 40The Canadian Dollar Is Undervalued ##br##Relative To The Aussie Dollar The prospect of higher inflation down the road is good news for gold. However, with real rates still rising and the dollar strengthening, it is too early to pile into bullion and other precious metals. Wait until early 2020, by which time the Fed is likely to stop raising rates. Equities: Prefer DM Over EM One can believe that emerging market stocks will go up; one can also believe that the Fed will do its job and tighten financial conditions in order to prevent the U.S. economy from overheating. But one cannot believe that both of these things will happen at the same time. As Chart 41 clearly shows, EM equities almost always fall when U.S. financial conditions are tightening. Chart 41Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Our overriding view is that U.S. financial conditions will tighten over the coming months. As discussed above, the adverse effects of rising U.S. rates and a strengthening dollar are likely to be felt first and foremost in emerging markets. Our EM strategists believe that Turkey, Brazil, Argentina, South Africa, Malaysia, and Indonesia are most vulnerable. We no longer have a strong 12-month view on regional equity allocation within the G3 economies, at least not in local-currency terms. The sector composition of the euro area and Japanese bourses is more heavily tilted towards deep cyclicals than the United States. However, a weaker euro, and to a lesser extent, a weaker yen will cushion the blow from a softening global economy. In dollar terms, the U.S. stock market should outperform its peers. Getting Ready For The Next Equity Bear Market A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase again over the balance of the year. We predicted last week that the next "big move" in stocks will be to the downside. We would consider moving our 12-month recommendation temporarily back to overweight if global equities were to sell off by more than 15% during the next few months or if the policy environment becomes more market-friendly. Similar to what happened in 1998, when the S&P 500 fell by 22% between the late summer and early fall, a significant correction today could set the scene for a blow-off rally. In such a rally, EM stocks would probably rebound and cyclicals would outperform defensives. However, absent such fireworks, we will probably downgrade global equities in early 2019 in anticipation of a global recession in 2020. The U.S. fiscal impulse is set to fall sharply in 2020, as the full effects of the tax cuts and spending hikes make their way through the system (Chart 42).4 Real GDP will probably be growing at a trend-like pace of 1.7%-to-1.8% by the end of next year because the U.S. will have run out of surplus labor at that point. A falling fiscal impulse could take GDP growth down to 1% in 2020, a level often associated with "stall speed." Investors should further reduce exposure to stocks before this happens. The next recession will not be especially severe in purely economic terms. However, as was the case in 2001, even a mild recession could lead to a very painful equity bear market if the starting point for valuations is high enough. Valuations today are not as extreme as they were back then, but they are still near the upper end of their historic range (Chart 43). A composite valuation measure incorporating both the trailing and forward PE ratio, price-to-book, price-to-cash flow, price-to-sales, market cap-to-GDP, dividend yield, and Tobin's Q points to real average annual total returns of 1.8% for U.S. stocks over the next decade. Global equities will fare slightly better, but returns will still be below their historic norm. Long-term equity investors looking for more upside should consider steering their portfolios towards value stocks, which have massively underperformed growth stocks over the past 11 years (Chart 44). Chart 42U.S. Fiscal Impulse Set To Drop In 2020 Chart 43U.S. Stocks Are Pricey Chart 44Value Stocks: An Attractive Proposition Appendix A depicts some key valuation indicators for global equities. Appendix B provides illustrative projections based on the discussion above of where all the major asset classes are heading over the next ten years. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Edward E. Leamer, "Housing Is The Business Cycle," Proceedings, Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, (2007). 2 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. Euro area private-sector credit growth accelerated from -2.6% in May 2014 to 3.1% in March 2017, but has been broadly flat ever since. Hence, the credit impulse has dropped. 3 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The annual inflation differential of 0.4% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.49 after 30 years. If one assumes that the euro reaches that level by then, the common currency would need to trade at 1.49/(1.0194)^30=0.84 today. 4 We are not saying that fiscal policy will be tightened in 2020. Rather, we are saying that the structural budget deficit will stop increasing as the full effects of the tax cuts make their way through the system and higher budgetary appropriations are reflected in increased government spending (there is often a lag between when spending is authorized and when it takes place). It is the change in the fiscal impulse that matters for GDP growth. Recall that Y=C+I+G+X-M. If the government permanently raises G, this will permanently raise Y but will only temporarily raise GDP growth (the change in Y). In other words, as G stops rising in 2020, GDP growth will come back down. Appendix A Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Appendix B Appendix B Chart 1Market Outlook: Bonds Appendix B Chart 2Market Outlook: Equities Appendix B Chart 3Market Outlook: Currencies Appendix B Chart 4Market Outlook: Commodities Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Highlights Andrés Manuel López Obrador (AMLO) will most likely win the upcoming presidential election; His rising popularity has increased the likelihood that his left-wing party MORENA wins the lower Chamber of Congress; That said, his agenda is more "nationalist" than outright socialist; Moreover, there is no evidence that the Mexican median voter has abandoned their long-held centrist outlook; While the election and NAFTA renegotiations represent serious headwinds to Mexican assets, dedicated EM investors should stay overweight across all asset classes. Feature "I believe it is time to say that neither Chavismo... nor Trump... yes Mexicanism." Andrés Manuel López Obrador, March 2018 Mexican voters go to the polls on July 1 to elect a new president and Congress. The leading candidate for President, Andrés Manuel López Obrador (also known as AMLO), is likely to win. Our aggregate poll-of-polls shows that AMLO now has a 25% lead against his two challengers, Ricardo Anaya of the center-right National Action Party (PAN) and José Antonio Meade Kuribreña of the centrist (formerly center-left, now also center-right) Institutional Revolutionary Party (PRI). At this point, it is safe to call the presidential election for AMLO (Chart 1). A win for López Obrador will be an unprecedented political event in modern Mexican history. Although the roots of the PRI - Mexico's long-time ruling party - lie in labor, anti-Catholic, and socialist politics, no outwardly left-wing leader has won a national election since Plutarco Elías Calles in 1924. Over the past two decades, the main line of political competition in Mexico has been between the centrist PRI and center-right PAN, which ruled Mexico from 2000 to 2012 under the presidencies of Vicente Fox and Felipe Calderón. The outgoing President Enrique Peña Nieto shifted PRI towards the center-right to compete with PAN. In some way, this makes sense given that the median Mexican voter has traditionally been center, if not center-right, on economic policies (Chart 2). However, by shifting PRI so far to the right, Nieto has left space on the left for AMLO and his new party, the National Regeneration Movement (MORENA). Chart 1AMLO Is The Next President Of Mexico... Chart 2...But Mexicans Are Not Left-Wing Chart 3MORENA Can Win A Majority... What should investors expect from AMLO and MORENA? First, much will depend on whether MORENA will be able to garner a majority in Congress - both the Senate and the Chamber of Deputies. Polls are starting to show that the left-wing MORENA is surging and that there is a chance that it captures a majority (Chart 3). Second, there is a major question regarding what MORENA actually stands for, politically and economically. We argue that AMLO and MORENA's rise has more to do with the ongoing drug war and corruption problems and less with the economy. As such, the Mexican median voter will remain a constraint against overly left-leaning policy. Meanwhile, the judicial branch and the market itself will retain an important role in disciplining AMLO's most left-leaning tendencies. We do not expect AMLO to veer towards socialism, but rather to remain pragmatic in his decision making. We believe him when he says that he will neither emulate Hugo Chavez of Venezuela nor Donald Trump of the U.S. Can AMLO Dominate Mexico? The short answer to the critical question is that yes, AMLO can dominate Mexican politics. Given current polling, political constraints to the AMLO presidency may be weak. For the first time in twenty years, a Mexican president may not face pluralism in Congress. BCA's geopolitical methodology focuses on constraints over preferences. Investors often focus on policymaker preferences - largely because the media reports on them enthusiastically - but what generates geopolitical alpha are constraints. This is because preferences are ephemeral, optional, and subject to constraints. Constraints, on the other hand, are real, material, not optional, and definitely not subject to preferences. For most of his career, AMLO has campaigned on a policy platform that harkens to traditional left-wing Latin American politics. Before we examine his commitment to those policies, we would have to ask whether constitutional and legislative constraints will allow AMLO and MORENA to dominate Mexican politics. The Mexican constitution designates Congress as the primary legislative body. This includes power to promulgate laws, levy taxes, declare war, and regulate trade.1 The Mexican president can veto legislation, but the veto can be overturned by a two-thirds majority. In 2011, President Felipe Calderon ended the practice of a "pocket veto," which allowed presidents to kill legislation by simply refusing to sign them. Were AMLO to face an opposition-led Congress, he would have two strategies. First would be to veto - or threaten to veto - legislation and force Congress to work with him. Given current polling, it is unlikely that Congress would have a two-thirds majority to overturn AMLO's vetoes. However, this strategy would ensure that the constitutional reforms passed under Nieto remain in place, as the president would struggle to pass his own agenda. Second would be to try to bring one of the opposition parties on board with his legislative agenda, which would ensure its passage but also ensure that the resultant legislation was modified. Lower House - The Chamber Of Deputies What are the chances that AMLO can operate with a MORENA majority? There has not been a governing majority in the Mexican Chamber of Deputies since 1994 (Chart 4), with the share of votes by the largest party normally coming in under 40% (Chart 5). According to our calculations, based on previous elections, a party would need to get at least 42% of the vote share to achieve a majority (Chart 6). Chart 4...Breaking With Recent Tradition Of Pluralism Chart 5Can MORENA Be First To 40% In Two Decades? Chart 642%: The Magic Number For The Chamber Of Deputies Chart 7AMLO Can Lift MORENA Fortunes Can AMLO lift the fortunes of MORENA? Yes. According to our calculations, the relationship between the vote share for the presidential candidate and his party is strong (Chart 7). The coefficient is around 1, so 1% vote share for the presidential candidate means 1% vote share for his respective party (or parties, if they are in a coalition). Given that AMLO is currently polling at 47% in the latest polls, it is conceivable that MORENA - along with its coalition partners the left-wing Labor Party and socially conservative Social Encounter Party - could win a majority in the Chamber of Deputies. We would assign this scenario, given current polling, a 70% probability (Table 1). Especially given that, in Mexico, polls tend to underestimate the performance of the winning candidate (Chart 8). Table 1MORENA Is Set For A Majority In The Chamber Of Deputies Chart 8Polling Tends To Underestimate Winning Candidate Upper House - The Senate What about the Mexican Senate? Electoral rules make it more difficult for the dominant party to win the upper chamber because they guarantee representation for the party that comes in second in state-by-state races. MORENA is currently leading in the polls in 19 out of 32 Mexican states and trailing as second in another five. The electoral system awards two Senate seats to the outright winner of each state. The second-placed party gets one seat. The remaining thirty-two senators are distributed based on the party's national vote, irrespective of the state-specific elections. As such, MORENA is likely to capture, at minimum, around 56 seats in the Senate, were it to garner around 40% of the overall vote.2 This would be nine short of the 65-seat majority in the upper chamber. To win those extra nine seats, the hurdles are considerable. Even if we give MORENA victories in every state in which it is currently trailing and raise its national vote to 50%, it still comes one short of the 65-seat majority (Chart 9). Chart 9MORENA Will Face A Tougher Path In The Senate Our forecast for a MORENA-held Senate is therefore considerably lower than for the Chamber of Deputies. At this moment, the Senate is a "too-close-to-call" election. Much will depend on whether MORENA and AMLO can get more than 50% of the vote on July 1 and whether MORENA translates some specific state races into wins. The left-wing MORENA sits on the edge of a majority, but state-by-state polling in Mexico is woefully poor and thus the variability of the final result is great. Winning the Senate will require a genuine "wave" election that Mexico has not seen in years. If AMLO's party fails to win the majority in the Senate, the chamber will remain a hurdle to him throughout his six-year term as Mexico does not elect Senators in midterm elections. Judicial - Supreme Court Of Justice The final branch of government that can impose checks on the executive is the Mexican Supreme Court, officially referred to as the Supreme Court of Justice of the Nation. The Supreme Court has 11 judges who are appointed for 15 years. Given the current roster of judges on the Court, the new president of Mexico will have the opportunity to appoint only three new members of the Court over the next six years of his mandate. President López Obrador would have the first opportunity to do so already in late 2018, with another in 2019, and final one in 2021. And that only holds if MORENA has a majority in the Senate, as the president has to rely on a Senate vote to ultimately appoint his preferred court picks. This is important because the president of Mexico can call a referendum on his own. López Obrador and MORENA have in the past called for a referendum on energy reforms. Frequent appeals to voters on policy matters is also a fundamental thesis of the MORENA manifesto. According to the 2014 Mexican Federal Law of Popular Consultation, reforms can be called by the president, one third of either chamber plus a majority of the other, or support of at least 2% of voters through a mail-in campaign. As such, the hurdle for calling a referendum in Mexico is extremely low, giving AMLO the potential route to avoid an intransigent Congress. This is where the Supreme Court comes in. The 2014 law prohibits referenda on any issue of human rights, national security, elections, or fiscal matters. This means that the ability of the president and Congress to call referendums is limited to largely non-investment relevant issues. In 2014, for example, the Supreme Court ruled that a referendum on energy reforms was unconstitutional and therefore could not be held. Given the current composition of the Court, and limited ability of AMLO to change it, it is unlikely that the Court would do AMLO's or MORENA's bidding in the future. Bottom Line: The Mexican president is constrained by the constitution to take Congress's lead on promulgating laws. However, AMLO's surging popularity makes it possible that his left-wing MORENA wins the lower Chamber of Congress. Forecasting the Senate election is much more difficult, where the election is currently too-close-to-call. Overall, AMLO has a very good chance of winning the majority in both chambers, making him potentially the first president since Ernesto Zedillo to control Congress (Zedillo famously lost PRI's legislative majority in the 1997 midterm election). Despite possible control of both Chambers of Mexican Congress, there is no way that AMLO will be able to capture the judicial branch during his limited, six-year, term in office. As such, the fear that AMLO will rule via popular referendums is overstated. However, if his MORENA captures Congress, AMLO will be able to pass laws through the legislative chamber and will not need to rule via referendum anyway.3 How Left Is The Mexican Left? Chart 2 (on page 2) suggests that Mexicans have traditionally seen themselves as centrist on economic matters. Why would this have changed, in such a dramatic fashion, so as to give both AMLO and the upstart MORENA a potential electoral sweep on July 1? Is the economy in such dire straits that voters are willing to contemplate an economic paradigm shift in 2018? Chart 10Misery Index Is Inconclusive Chart 11Central Bank Induced Pain The short answer is no. The unemployment rate has been steadily declining under Nieto, although inflation surged over the past two years as the peso collapsed and is only now showing signs of easing (Chart 10). To fight inflation, the central bank tightened monetary policy, contracting consumer spending and capital expenditure in the process (Chart 11). Both are now showing signs of tepid recovery as hawkish monetary policy takes a backseat. However, fiscal and monetary tightening - combined with surging inflation - caused weak real wage growth for the past three years (Chart 12). Economic performance has therefore been tepid, not disastrous. The problem is that Nieto promised real change, ushering in his term with several major economic reforms that culminated in the 2013 energy reforms. These reforms, however, have been followed by disappointing economic results while the persistent ills of corruption and violence have actually gotten worse. These two ills, which have plagued Mexico for decades, are the real game changer in the coming election. After a peak in 2011, drug-related deaths dropped off. However, there has been a major increase in drug-related homicides over the past two years, with a record 29,168 in 2017 (Chart 13). Year 2018 is on track to be the deadliest year ever, on pace for 32,000 deaths. Since President Calderon launched the drug war in 2007, more than 210,000 drug-related homicides have occurred in the country. Chart 12Real Wages In A Downturn Since 2016 Chart 13Drug-War Deaths Are Rising Again In December 2017, AMLO proposed giving amnesty for drug cartel kingpins, saying he wanted dialogue. The proposal caused outrage in the international and domestic press but has clearly not dented his popularity. At the time of his comments, AMLO was up just 7% on his opponents, with the gap today at 25%! Jorge Castañeda, campaign chief of Ricardo Anaya - the torchbearer of Calderon's center-right PAN that initiated the drug war - recently suggested that his candidate would ditch the "totally useless" 12-year war on drugs. This means that AMLO's initial comment has forced his opponents to similarly adjust their views on the drug war. Merely voicing tough rhetoric and doubling down on more security-oriented policies does not return political dividends anymore. It would appear that AMLO's focus on the drug war and general corruption has struck a nerve with the Mexican "median voter." Polls show that both issues are the most salient with Mexican voters (Chart 14). Corrupt leaders, drug cartel violence, and crime score higher than income inequality, immigration, employment, healthcare, and education. Rising prices do make the list of major problems but they are normally ubiquitous as a concern in emerging markets. This is not to say that Mexican voters do not want economic change. Rather, we are pointing out that AMLO's popularity is not merely a show of support for his economic policies. He and the newly launched MORENA have an incorruptible image in a country plagued by corruption and offer new solutions to the scourge of the drug war that two mainstream parties - the PRI and the PAN - have spent over a decade fighting with limited success. Chart 14Security & Corruption Dominate The Election In terms of actual economic policy proposals, AMLO's and MORENA's bark may be worse than their bite. There are three critical policy proposals where we expect considerable moderation following the election: Referendums: As we pointed out above, AMLO has promised a new referendum on the 2013 energy reforms. MORENA's manifesto argues that the use of referendums would prevent the continued hijacking of institutions by oligarchies. In other words, the message is that investors should prepare for a constant stream of referendums. However, this will only be possible in non-investment relevant fields, given the role of the Mexican Supreme Court in the process as discussed above. Energy reforms: The likely pick for the Energy Secretary, Rocío Nahle, has been a vociferous opponent of Nieto's energy reforms. However, he has since toned down the rhetoric and has focused on a MORENA proposal to build two state-run refineries in order to curb imports of refined petroleum products from the U.S. (Chart 15). Several of AMLO's key economic advisers - such as Alfredo Romo and Abel Hibert - have suggested that reversal of energy reforms will not be on the table. Nonetheless, AMLO's administration is likely to stall private auctions once he comes to power, given that it is a featured electoral promise. However, it is not clear that this would set the stage for a curbing of foreign investments in other areas. In fact, AMLO's opposition to domestic oligopolies could specifically benefit foreign investors by breaking up entrenched economic interests. Industrial policy: AMLO and his economic advisers - including the likely finance and economic ministers Carlos Manuel Urzúa Macias and Graciela Márquez Colín - appear to be in favor of an activist government industrial policy. This return to the "import substitution" model may appear to be a step back in Mexico's economic development. However, if it is combined with fiscal prudence, as AMLO and his advisors promise, and a pro-investor outlook, which they still have to prove, the policy may not be a major risk for financial markets. Investors should also look to the issue of NAFTA renegotiations for a lead on how AMLO intends to govern. He has been a vociferous critic of the trade deal for years. However, nearly 70% of Mexicans support the trade deal. This has forced AMLO to modify his view towards NAFTA. He has promised to renegotiate the deal with President Trump, although he has complained about the renegotiation process taking place ahead of the Mexican elections by the outgoing government. In addition, AMLO's track record as mayor of Mexico City (2000-2006) does not raise any red flags. During that period, the city saw its municipal debt decline, foreign investment surge, and good amount of infrastructure projects implemented. Granted, his term coincided with a global bull market, but he did not have an overt anti-business bias despite his perpetual left-wing rhetoric. Bottom Line: López Obrador and his left-wing MORENA could represent an economic paradigm shift in Mexico. However, his brand of economics is more "nationalist" than left-wing; more "Mexicanism" than outright socialism. Opposition to foreign investment in the energy sector is a clear red flag for investors, but it does not extend to any other sector of the economy, at least not rhetorically in the election campaign. As such, it is a vestige of Mexican history, where the capture of state energy resources was a crucial pillar of the country's independence and sovereignty movement. Meanwhile, there is no evidence that the Mexican median voter has abandoned their long-held centrist outlook. Seven out of ten Mexican voters support NAFTA, while a plurality still supports globalization - at a much higher clip than their neighbors to the north (Chart 16)! AMLO and MORENA's success in the election is therefore due to their strident anti-corruption stance and due to the failures of the previous PRI and PAN administrations to effectively deal with the ongoing drug war. This means that, were AMLO to deviate too much into left-wing economic policies, the electorate would act as a constraint. Chart 15Refined Petroleum##br## Imports Will Fall Chart 16Mexicans Are More Supportive Of ##br##Globalization Than Americans Investment Conclusions Tactically speaking, Mexican elections and NAFTA renegotiations represent serious headwinds to Mexican assets. There is a high probability that MORENA wins both the Chamber of Deputies (70%) and the Senate (50%, too-close-to-call). We do not think that this scenario is priced in by the market at the moment. Meanwhile, NAFTA renegotiations have stalled and could result in a failure. As we argued last year, the probability of abrogation of the deal is at 50%, higher than what the market thinks.4 This is because President Trump has no constraints - either legal or political - to withdrawing from the deal.5 Particularly if he intends to renegotiate bilateral deals with Canada and Mexico after the midterms. AMLO, however, will face three constraints in governing even if he were to gain a majority in both Chambers of Congress: Judicial branch: There is no way for AMLO to stack the Mexican supreme court with left-leaning, loyalist, judges. As such, his plan to use referendums to rule will fail. Median voter: The median voter in Mexico is certainly not thrilled with the economic performance of the country, but long-term polling suggests that Mexicans remain committed to a free market economy and even to globalization. We suspect that AMLO's and MORENA's stellar rise is therefore a product of government corruption, the dominance of oligopolies, and the ongoing drug-war, which has definitively failed. Correctly identifying the basis for AMLO's and MORENA's success is crucial as it suggests that there is a limit to how far left AMLO can take the country before imperiling his political capital. Mexican midterm elections, due in 2021, are an important constraint if he loses the faith of the median voter. The market: The Mexican peso will be the vehicle by which the market expresses its displeasure with any future government policies. A downleg in the peso could be non-trivial, especially given the current broad-based upturn in the U.S. dollar. As a result, inflation will remain elevated and real incomes depressed. Bank of Mexico will have to respond by maintaining tight monetary policy or tightening policy further with negative ramifications for growth. This is not a scenario that AMLO will want, as it would imperil his control of the Chamber of Deputies ahead of the 2021 midterms. Therefore, financial markets will act as a major constraint on AMLO adopting left-wing or populist policies. Given AMLO's track record as mayor of Mexico City, his mix of centrist economic advisors, and a penchant for reversing previous rhetoric (such as on NAFTA and the energy reforms), we suspect that he is well aware of the above constraints. The focus of the administration will likely be on corruption and the drug war, while energy reforms will get a token review early in his presidency. Considering the headline risks, however, investors may take time to buy into this view. As such, we do not recommend holding Mexican assets on an absolute basis. On a relative basis to other emerging market economies, Mexico does have several cyclical advantages over its peers. The Mexican economy has already been going through the natural path of adjustment - demand retrenchment - following monetary and fiscal tightening during the past couple of years. This stands in contrast to many other emerging markets economies which have avoided harsh medicine in recent years. Yet presently, with their currencies plummeting, these developing nations will have no choice but to tolerate domestic demand retrenchment themselves. While most emerging markets are leveraged to China and metals, Mexico is more exposed to U.S. domestic demand and oil. In line with our view that U.S. growth will do much better than that of China, Mexican exports to the U.S., which represents 30% of Mexican GDP, will remain strong, benefitting the nation's growth and balance of payments. Consequently, our view is that Mexican risk assets will outperform their EM peers in the next 6-12 months: Chart 17MXN Is A Positive Carry Trade Relative To EM Chart 18Mexican Peso Is Cheap First, the Mexican peso is attractive. For the first time in many years, Mexican short term interest rates are above the majority of EM economies, even among high yielding emerging markets like South Africa and Brazil (Chart 17), making the Mexican peso a positive carry trade relative to its EM counterparts. More importantly, the Mexican peso is cheap. As illustrated on Chart 18, according to the real effective exchange rate based on unit labor cost, the Mexican peso is well below its historic mean in absolute terms. Second, local currency bond yields and USD sovereign spreads are elevated and offer great value relative to their respective EM benchmarks (Chart 19). Even if AMLO favors some left-wing policies, Mexico's local bonds' and credit markets' relative pricing already reflect this and are unlikely to underperform much versus their EM peers. Third, Mexico's bourse has dramatically underperformed the EM overall index since 2016 and a lot of bad news in relative terms might already be priced in. In addition, consumer staples and telecom stocks together account for 50% of the MSCI Mexico market cap, while the same sectors make up only 11% of the overall EM market cap. EM consumer staples have massively underperformed the EM benchmark since early 2016 (Chart 20 top panel) and odds are that this sector will outperform in the next 12 months as defensives outperforms cyclicals. This will bode well for Mexico's relative performance in common currency terms versus the EM equity benchmark which seems to be forming a major bottom (Chart 20 bottom panel). Chart 19Local Currency And Dollar Bonds Offer Value Chart 20Mexican Equites Are A Defensive Play Bottom Line: Headline risk from NAFTA renegotiations and Mexican election could cause tactical downside to the country's FX, equity, and bond markets. However, these may present buying opportunities for longer-term investors given the combination of our political and macroeconomic views. Dedicated EM investors should overweight Mexican equities, local currency bonds as well as sovereign credit relative to their EM benchmarks. Currency traders should stay long MXN versus an equally-weighted basket of BRL and ZAR. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Jesse Anak Kuri, Senior Analyst jesse.kuri@bcaresearch.com 1 Please see Section III of the Constitution of Mexico, available at OAS.org. 2 We get this number if MORENA wins the 19 states where it is currently leading, giving it 38 assured Senate seats. In addition, Morena is trailing as second-placed in the polls in another five states, giving it an additional five seats. Finally, we assume that MORENA wins 40% of the vote, giving it an additional 12 seats (40% of 32 would be 12.8). This combines for a grand total of 56 seats, nine seats short of a 65-seat majority. 3 Modifying the constitution, however, still requires two-thirds of Congress, which MORENA has no mathematical chance of winning. 4 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Are You 'Sick Of Winning' Yet?" dated June 20, 2018, available at gps.bcaresearch.com.

Highlights We have been cautious on asset allocation on a tactical (3-month) horizon for two months. The backdrop has deteriorated enough that we believe that caution is now warranted beyond a tactical horizon. Trim exposure to global stocks to benchmark and place the proceeds in cash on a cyclical (6-12 month) horizon. Government bonds remain at underweight. Our growth and earnings indicators are not flashing any warning signs. Indeed, while economic growth is peaking at the global level, it remains impressive in the U.S. Nonetheless, given the advanced stage of the economic cycle and the fact that a lot of good news is discounted in risk assets, we believe that it is better to be early and leave some money on the table than to be late. There are several risks that loom large enough to justify caution. First, the clash between monetary policy and the markets that we have been expecting is drawing closer. The FOMC may soon be forced to more aggressively tighten the monetary screws. The ECB signaled that it will push ahead with tapering. Perhaps even more important are escalating trade tensions, which could turn into a full-scale trade war with possible military implications. China has eased monetary policy slightly, but the broad thrust of past policy tightening will continue to weigh on growth. The RMB may be used to partially shield the economy from rising tariffs. Global bonds remain vulnerable. In the U.S., rate expectations in 2019 and beyond are still well below the path implied by a "gradual" tightening pace. In the Eurozone, there is also room for the discounted path of interest rates beyond the next year to move higher. Lighten up on both U.S. IG and HY corporate bonds, placing the proceeds at the short-end of the Treasury and Municipal bond curves. Duration should be kept short. We would consider upgrading if there is a meaningful correction in risk assets. More likely, however, we will shift to an outright bearish stance later this year or in early 2019 in anticipation of a global recession in 2020. Diverging growth momentum, along with the ongoing trade row, will continue to place upward pressure on the dollar. Shift to an overweight position in U.S. equities versus the other major markets on an unhedged basis. The risk of an oil price spike to the upside is rising. Feature The time to reduce risk-asset exposure on a cyclical horizon has arrived. Escalating risks and our assessment that equities and corporate bonds offered a poor risk/reward balance caused us to trim our tactical (3-month) allocation to risk assets to neutral two months ago. We left the 6-12 month cyclical view at overweight, because we expected to shed our near-term caution once the global slowdown ran its course, geopolitical risk calmed down a little, and EM assets stabilized. Nonetheless, the backdrop for global financial markets has deteriorated enough that we believe that caution is now warranted beyond a tactical horizon. It is not that there have been drastic changes in any particular area. Indeed, while profit growth is peaking at the global level, 12-month forward earnings continue to rise smartly in the major markets (Chart I-1). In the U.S., our corporate pricing power indicator is still climbing, forward earnings estimates have "gone vertical", and the net earnings revisions ratio is elevated (Chart I-2). The negative impact of this year's dollar strength on corporate profits will be trounced by robust sales activity. The U.S. economy is firing on all cylinders and growth appears likely to remain well above-trend in the second half of the year. Chart I-1Forward EPS Estimates Still Rising Chart I-2Some Mixed Signals For Stocks This economic and profit backdrop might make the timing of our downgrade seem odd at first glance. Nevertheless, valuations and the advanced stage of the economic and profit cycle mean that it is prudent to focus on capital preservation and be quicker to take profits than would be the case early in the cycle. BCA has recommended above-benchmark allocations to equities and corporate bonds for most of the time since mid-2009. There are several risks that loom large enough to justify taking some money off the table. One of our main themes for the year, set out in the 2018 BCA Outlook, is that markets are on a collision course with policy. This is particularly the case in the U.S. Real interest rates and monetary conditions still appear to be supportive by historical norms, but this cycle has been anything but normal and the level of real interest rates that constitute "neutral" today is highly uncertain. The fact that broad money growth has slowed in absolute terms and relative to nominal GDP is a worrying sign (Chart I-3). Dollar-based global liquidity is waning based on our proxy measure, which is particularly ominous for EM assets (bottom panel). Chart I-3Liquidity Conditions Are Deteriorating Moreover, our Equity Scorecard remained at 'two' in June, which is below a level that is consistent with positive excess returns in the equity market (please see the Overview section of the May 2018 Bank Credit Analyst). Our U.S. Willingness-to-Pay indicator reveals that investment flows are no longer favoring stocks over bonds in the U.S. (Chart I-2). Perhaps even more importantly for the near term are the escalating trade tensions, which could turn into a full trade war with possible military implications (see below). These and other risks suggest to us that the period of "prudent caution" may extend well into the 6-12 month cyclical horizon. For those investors not already at neutral on equities and corporate bonds, we recommend trimming exposure and placing the proceeds in cash rather than bonds. Fixed-income remains at underweight. There are risks on both sides for government bonds, but we believe that it is more likely that yields rise than fall. Trade Woes: Not Yet At Peak Pessimism The Trump Administration upped the ante in June by announcing plans to impose tariffs on another $200 billion of Chinese exports to the U.S., as well as to restrict Chinese investment in the U.S. We would expect China to retaliate if this is implemented but, at that point, China's proportionate response would cover more goods than the entire range of U.S. imports. Retaliation will therefore have to occur elsewhere. Tariffs are bad enough, but our geopolitical team flags the risk that trade tensions spill over into the South China Sea and other areas of strategic disagreement. The South China Sea or Taiwan could produce market-moving "black swan" geopolitical events this year or next.1 The Trump Administration has also launched an investigation into the auto industry, and has threatened to tear up the North American Free Trade Agreement (NAFTA). Congress will likely push hard to save the agreement because it is important for so many U.S. companies, especially those with supply chains that criss-cross the borders with Canada and Mexico. Still, Trump has the option of triggering the six-month withdrawal period as a negotiating tactic to increase the pressure on the two trading partners. This would really rattle equity markets. Many believe that Trump will back away from his aggressive negotiating tactics if the U.S. stock market begins to feel pain. We would not bet on that. The President's popularity is high, and has not been overly correlated with the stock market. Moreover, blue collar workers, Trump's main support base, do not own many stocks. The implication is that the President will be willing to take risks with the equity market in order to score points with his base heading into the mid-term elections. The bottom line is that we do not believe that investors have seen "peak pessimism" on the trade front. A trade war would result in a lot of stranded capital, forcing investors to mark down the value of the companies in their portfolios. Can Trump Reduce The Trade Gap? One of the Administration's stated goals is to reduce the U.S. trade deficit. It is certainly fair to ask China to pay for the intellectual property it takes from other countries. Broadly speaking, rectifying unfair trade practices is always a good idea. However, erecting a higher tariff wall alone is unlikely to either shrink the trade gap or boost U.S. economic growth, especially given that other countries are retaliating in kind. During the 2016 election campaign, then-candidate Trump proposed a 35% and 45% across-the-board tariff on Mexican and Chinese imports, respectively. We estimated at the time that, with full retaliation, this policy would reduce U.S. real GDP by 1.2% over two years, not including any knock-on effects to global business confidence.2 Cancelling NAFTA would be much worse. The bottom line is that nobody wins a trade war. Moreover, the trade deficit is more likely to swell than deflate in the coming years, irrespective of U.S. trade policy action. The flip side of the U.S. external deficit is an excess of domestic investment over domestic savings. The latter is set to shrivel given the pending federal budget deficit blowout and the fact that the household savings rate continues to decline and is close to all-time lows. This, together with an expected acceleration in business capital spending, pretty much guarantees that the U.S. external deficit will swell in the next few years. This month's Special Report, beginning on page 18, discusses the consequences of the deteriorating long-term fiscal outlook and the associated "twin deficits" problem. We conclude that a market riot point will be required to change current trends. But even if disaster is avoided for a few more years, the dollar will ultimately be a casualty. In the near term, however, trade friction and the decoupling of U.S. from global growth should continue to support the dollar. We highlighted the divergence in growth momentum in last month's Overview. Fiscal policy is pumping up the U.S. economy, while trade woes are souring confidence abroad. Coincident and leading economic indicators confirm that the divergence will continue for at least the near term (Chart I-4). Policy Puts We do not believe that the current 'soft patch' in the Eurozone and Japanese economies will turn into anything worse over the next year. We are much more concerned with the Chinese economy. May data on industrial production, retail sales, and fixed asset investment all disappointed. Property prices in tier 1 cities are down year-over-year. Our leading indicator for the Li Keqiang index, a widely followed measure of economic activity, is in a clear downtrend (Chart I-5). Chart I-4Growth Divergence To Continue Chart I-5China's Growth Slowdown The authorities will likely provide fresh stimulus if the trade war intensifies. Indeed, recent statements from the Ministry of Finance suggest that planned fiscal spending for the year will be accelerated/brought forward, and the PBOC has already made a targeted cut to the reserve requirement ratio and reduced the relending rate for small company loans. Chart I-6U.S. Small Business Is Ecstatic However, the bar for a fresh round of material policy stimulus is higher today than it was in the past; elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities can respond with monetary or fiscal stimulus. The most effective way for China to retaliate to rising U.S. tariffs is to weaken the RMB, but this too could be quite disruptive for financial markets and, thus, provides another reason for global investors to scale back on risk. Similarly, the bar is also rising in terms of the Fed's willingness to come to the rescue. Policymakers have signaled that they will not mind an overshoot of the inflation target. Nonetheless, the facts that core PCE inflation is closing in on 2% and that unemployment rate is well below the Fed's estimate of full employment, mean that the FOMC will be slower to jump to stock market's defense were there to be a market swoon. Small business owners are particularly bullish at the moment because of Trump's regulatory, fiscal and tax policies. The NFIB survey revealed that confidence soared to the second highest level in the survey's 45-year history (Chart I-6). Expansion plans are also the most robust in survey history. With the output gap effectively closed, increasing pressure on resource utilization should translate into faster wage gains and higher inflation. This was also quite apparent in the latest NFIB survey. Reports of higher compensation hit an all-time high as firms struggle to find qualified workers, and a growing proportion of small businesses plan to increase selling prices. Despite the signs of a very tight labor market, the FOMC's inconsistent macro projection remained in place in June. Policymakers expect continued above-trend growth for 2018-2020, but they forecast a flat jobless rate and core inflation at 3.5% and 2.1%, respectively. If the Fed is right on growth, then the overshoot of inflation will surely be larger than officials are currently expecting. Risk assets will come under downward pressure when the Fed is forced to shift into a higher gear and actively target slower economic growth. We expect the Fed to hike more aggressively next year than is discounted, and lift the consensus 'dot' for the neutral Fed funds rate from the current 2¾-3% range. Bonds remain vulnerable to this shift because rate expectations in 2019 and beyond are still well below the path implied by a "gradual" quarter-point-per-meeting tightening pace (Chart I-7). Chart I-7Market Expectations For Fed Funds Are Below A ''Gradual'' Pace At a minimum, rising inflation pressures have narrowed the Fed's room to maneuver, which means that the "Fed Put" is less of a market support. Italy Backs Away From The Brink Last month we flagged Italy as a reason to avoid risk in financial markets, but we are less concerned today. We believe that Italy will eventually cause more volatility in global financial markets, but for the short-term it appears that this risk has faded. The reason is that the M5S-Lega coalition has already punted on three of its most populist promises: wholesale change to retirement reforms, a flat tax of 15%, and universal basic income. The back-of-the-envelope cost of these three proposals is €100bn, which would easily blow out Italy's budget deficit to 7% of GDP. There was also no mention of issuing government IOUs that would create a sort of "parallel currency" in the country. If this is wrong and there is another blowout in Italian government spreads, investors should fade any resulting contagion to the peripheral countries. Greece, Portugal, Ireland and Spain - the hardest-hit economies in 2010 - have undertaken significant fiscal adjustment and, unlike Italy, have closed a lot of the competitiveness gap relative to Germany. Spread widening in these countries related to troubles in Italy should be considered a buying opportunity.3 ECB: Tapering To Continue The ECB looked through the recent Italian political turmoil and struck a confident tone in the June press conference. President Draghi described the first quarter cooling of the euro area economy as a soft patch driven mainly by external demand. We agree with the ECB President; in last month's Overview we highlighted several factors that had provided extra lift to the Eurozone economy last year. These tailwinds are now fading, but we believe that growth is simply returning to a more sustainable, but still above-trend, pace. That said, rising trade tensions are a wildcard to the economic outlook, especially because of Europe's elevated trade sensitivity. Draghi provided greater clarity on the outlook for asset purchases and interest rates. The pace of monthly purchases will slow from the current €30bn to €15bn in the final three months of year and then come to a complete end (Chart I-8). On interest rates, the ECB expects rates to remain at current levels "at least through the summer of 2019". This means that September 2019 could be the earliest timing for the ECB to deliver the first rate hike. Chart I-8ECB Balance Sheet Will Soon Stop Growing We agree with this assessment on the timing of the first rate increase. It will likely take that long for inflation to move into the 1½-2% range, and for long-term inflation expectations to surpass 2%. These thresholds are consistent with the ECB's previous rate hike cycles. Still, there is room for the discounted path of interest rates beyond the next year to move higher as Eurozone economic slack is absorbed. The number of months to the first rate hike discounted in the market has also moved too far out (24 months). Thus, we expect that bunds will contribute to upward pressure on global yields. Bond investors should be underweight the Eurozone within global fixed income portfolios. In contrast, we recommend overweight positions in U.K. gilts because market expectations for the Bank of England (BoE) are too hawkish. Investors should fade the central bank's assertion that policymakers now have a lower interest rate threshold for beginning to shrink the balance sheet. The knee-jerk rally in the pound and gilt selloff in June will not last. First, the OECD's leading economic indicator remains in a downtrend, warning that the U.K. economy faces downside risks (Chart I-9). Second, Brexit uncertainty will only increase into the March 2019 deadline. Prime Minister May managed to win a key parliamentary vote on the Withdrawal Bill in late June, but the Tories will face more tests ahead, including a vote on the Trade and Customs Bill. The fault lines between the hard and soft Brexiteers within the Tory party could bring an early end to May's government. Either May could be replaced with a hard Brexit prime minister, such as Brexit Secretary David Davis, or the U.K. could face a new general election. The latter implies the prospect of a Labour-led government. Admittedly, this will ensure a soft Brexit, but Jeremy Corbyn would almost surely herald far-left economic policies that will dampen business sentiment. As a result, we believe that the BoE is sidelined for the remainder of the year, which will keep a lid on gilt yields and sterling. Corporate Bonds: Poor Value And Rising Leverage Our newfound caution for equities on a 6-12 month investment horizon carries over to the corporate bond space. Corporate balance sheets have been deteriorating since 2015 Q1 based on our Corporate Health Monitor (CHM). The first quarter's improvement in the CHM simply reflected the tax cuts and thus does not represent a change in trend (Chart I-10). Chart I-9Fade BoE Hawkish Talk Chart I-10Q1 Improvement In Corporate ##br##Health To Reverse 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 I-10, 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 (bottom panel), last quarter's improvement in the Corporate Health Monitor will start to unwind. More importantly, the corporate sector has been leveraging aggressively, as we highlighted in our special reports that analysed company-level data from the U.S. and the Eurozone.4 We highlighted that investors and rating agencies are not too concerned about leverage at the moment, but that will change when growth slows. Interest- and debt-coverage ratios are likely to plunge to new historic lows (Charts I-11A and I-11B). Chart I-11ACorporate Leverage Will Come ##br##Back To Haunt Bondholders Chart I-11BCorporate Leverage Will Come ##br##Back To Haunt Bondholders Both U.S. investment grade (IG) and high-yield (HY) corporates are expensive, but not at an extreme, based on the 12-month breakeven spread.5 However, both IG and HY are actually extremely overvalued once we adjust for gross leverage (Chart I-12). Chart I-12U.S. Leverage - Adjusted ##br##Corporate Bond Valuation We have highlighted several other indicators to watch to time the exit from corporate bonds. These include long-term inflation expectations (when the 10-year TIPS inflation breakeven reaches the 2.3-2.5% range), bank lending standards for C&I loans, the slope of the yield curve, and real short-term interest rates or monetary conditions. While monetary conditions have tightened, the overall message from these indicators as a group is that it is still somewhat early to expect rising corporate defaults and sustained spread widening. That said, we have also emphasized that it is very late in the credit cycle and return expectations are quite low. Excess returns historically have been modest when the U.S. 3-month/10-year yield curve slope has been in the 0-50 basis point range. Similar to our logic behind trimming our equity exposure, the expected excess return from corporate bonds no longer justifies the risk. We recommend lightening up on both U.S. IG and HY corporate bonds, moving to benchmark and placing the proceeds at the short-end of the Treasury and Municipal bond curves. Duration should be kept short. Also downgrade EM hard currency sovereign and corporate debt to maximum underweight. We are already underweight on Eurozone corporates within European fixed-income portfolios due to the pending end to the ECB QE program. Conclusions The political situation in Italy and tensions vis-à-vis North Korea appear to be less of a potential landmine for investors, at least for the next year. Nonetheless, the risks have not diminished overall - they have simply rotated into other areas such as international trade. It is also worrying that the FOMC will have to become more aggressive in toning down the labor market. What makes the asset allocation decision especially difficult is that the economic and earnings backdrop in the U.S. is currently constructive for risk assets. Nonetheless, recessions and bear markets are always difficult to spot in real time. Given the advanced stage of the economic cycle and the fact that a lot of good news is discounted in risk assets, we believe that it is better to be early and leave some money on the table than to be late and go over the cliff. This does not mean that we will recommend a neutral allocation to risk assets for the remainder of the economic expansion. We would consider upgrading if there is a meaningful correction in equity and corporate bond prices at a time when our growth indicators remain positive. More likely, however, we will shift to an outright bearish stance on risk assets later this year or in early 2019 in anticipation of global recession in 2020. The divergence in growth momentum between the U.S. and the rest of the major economies, along with the ongoing trade row, will continue to place upward pressure on the dollar. We envision the following pecking order from weakest to strongest currency versus the greenback: dollar bloc and EM commodity currencies, non-commodity sensitive EM currencies, the euro and yen. The Canadian dollar is an exception; we are bullish versus the U.S. dollar beyond a short-term horizon due to expected Bank of Canada rate hikes. Tightening financial conditions are likely to culminate in a crisis in one or more EM countries; as a share of GDP, exports and international reserves, U.S. dollar debt is at levels not seen in over 15 years. Slowing Chinese growth and trade tensions just add to the risk in this space. The recent upturn in base metal prices will likely reverse if we are correct on the Chinese growth outlook. Oil is a different story, despite our bullish dollar view. OPEC 2.0 - the oil-producer coalition led by Saudi Arabia and Russia - agreed in June to raise oil output by 1 million bpd. The coalition aims to increase production to compensate for an over-compliance of previous deals to trim output, as well as production losses due to lack of investment and maintenance (Chart I-13). The bulk of the losses reflect the free-fall in Venezuela's output. Our oil experts believe that OPEC 2.0 does not have much spare capacity to lift output. Meanwhile, the trend decline in production by non-OPEC 2.0 states is being magnified by unplanned outages in places like Nigeria, Libya and Canada. While U.S. shale producers can be expected to grow their output, infrastructure constraints - chiefly insufficient pipeline capacity to take all of the crude that can be produced in the Permian Basin to market - will continue to limit growth in the short-term. In the face of robust demand, the risk to oil prices thus remains to the upside. A stronger dollar will somewhat undermine the profits of U.S. multinationals. U.S. equities also appear a little expensive versus Europe and Japan based on our composite valuation indicators (Chart I-14). Nonetheless, the sector composition of the U.S. stock market is more defensive than it is elsewhere and relative economic growth will favor the U.S. market. On balance, we no longer believe that euro area and Japanese equities will outperform the U.S. in local currency terms. Overweight the U.S. market on an unhedged basis. Chart I-13Oil Production Outlook Chart I-14Composite Equity Valuation Indicators 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. Mark McClellan Senior Vice President The Bank Credit Analyst June 28, 2018 Next Report: July 26, 2018 1 Please see Geopolitical Strategy Special Reports, "The South China Sea: Smooth Sailing?," March 28, 2017 and "Taiwan Is A Potential Black Swan," March 30, 2018, available at gps.bcaresearch.com. 2 Please see The Bank Credit Analyst Overview, dated December 2016, Box I-1. 3 Please see Geopolitical Strategy Special Report, "Mediterranean Europe: Contagion Risk Or Bear Trap?," June 13, 2018, available at gps.bcaresearch.com. 4 Please see The Bank Credit Analyst, March 2018 and June 2018, available at bca.bcaresearch.com. 5 The breakeven spread is the amount of spread widening that would have to occur over 12 months for corporates to underperform Treasurys. We focus on the breakeven spread to adjust for changes in the average duration of the index over time. II. U.S. Fiscal Policy: An Unprecedented Macro Experiment Congress is conducting a major economic experiment that has never been attempted in the U.S. outside of wartime; substantial fiscal stimulus when the economy is already at full employment. The budget deficit is on track to surpass 6% of GDP in a few years. It would likely peak above 8% in the case of a recession. The alarming long-term U.S. fiscal outlook is well known, but it has just become far worse. The combination of rising life expectancy and a decline in the ratio of taxpayers to retirees will place growing financial strains on the Social Security and Medicare systems. The federal government will be spilling far more red ink over the next decade than during any economic expansion phase since the 1940s. The debt/GDP ratio could surpass the previous peak set during WWII within 12 years. Shockingly large budget deficits in the past have sparked some attempt in Congress to limit the damage. Unfortunately, there will be little appetite to tighten the fiscal purse strings for the next decade. Voters have shifted to the left and politicians are following along. Factors that explain the political shift include disappointing income growth, income inequality, and rising political clout for Millennials, Hispanics and the elderly. Fiscal conservatism is out of fashion and this is unlikely to change over the next decade, no matter which party is in power. This means that a market riot will be required to shake voters and the political establishment into making the tough decisions necessary. While the U.S. is not at imminent risk of a market riot over the deteriorating fiscal trends, there are costs: in the long-term, the dollar will be weaker, borrowing rates will be higher and living standards will be lower than otherwise would be the case. Profligacy: (Noun) Unconstrained by convention or morality. Congress is conducting a major economic experiment that has never been attempted before in the U.S. outside of wartime; substantial fiscal stimulus at a time when the economy is already at full employment. Investors are celebrating the growth-positive aspects of the new fiscal tailwind at the moment, but it may wind up generating a party that is followed by a hangover as the Fed is forced to lean hard against the resulting inflationary pressures. Moreover, even in the absence of a recession, the federal government will likely be spilling far more red ink than during any economic expansion since the 1940s (Chart II-1). What are the long-term implications of this macro experiment? Will the U.S. continue to easily fund large and sustained budget deficits? Chart II-1U.S. Deficits Will Be Extremely Large For A Non-Recessionary Period Historically, shockingly large budget deficits sparked some attempt by Congress to limit the damage. Unfortunately, we argue in this Special Report that there will be little appetite to tighten the fiscal purse strings for the next decade. Voters have shifted to the left and politicians are following along. While the U.S. is not at imminent risk of a market riot over the deteriorating fiscal trends, the dollar will be weaker, borrowing rates will be higher and living standards will be lower than otherwise would be the case. On The Bright Side The Trump tax cuts, the immediate expensing of capital spending and a lighter regulatory touch have stirred animal spirits in the U.S. The Administration's trade policies are a source of concern, but CEO confidence is generally high. The NFIB survey highlights that small business owners are almost euphoric regarding the outlook. The IMF estimates that the tax cuts and less restrictive spending caps will provide a direct fiscal thrust of 0.8% in 2018 and 0.9% in 2019 (Chart II-2). The overall impact on the economy over the next 12-18 months could be larger to the extent that business leaders follow through on their newfound bullishness and ramp up capital spending. Chart II-2Lots Of Fiscal Stimulus In 2018 And 2019 Fiscal policy is a clear positive for stocks and other risk assets in the near term, as long as inflation is slow to respond. In addition to the near-term boost, there will be longer-term benefits from the 2017 tax act. Various provisions of the act affect the long-run productive potential of the U.S. economy, by promoting increases in investment and labor supply. Corporate tax cuts and the full expensing of business capital outlays should permanently increase the nation's capital stock relative to what it otherwise would be, leading to a slightly faster trend pace of productivity growth. Similarly, lower income taxes are projected to encourage more people to enter the workforce or to work longer hours. The CBO estimates that the tax act will boost the level of potential real GDP by 0.9% by the middle of the next decade. This may not sound like much, but it translates into almost a million extra jobs. The supply-side benefits of the 2017 tax act are therefore meaningful. Unfortunately, given the lack of offsetting spending cuts, it comes at the cost of a dramatically worse medium- and long-term outlook for government debt. The CBO estimates that the recent changes in fiscal policy will cumulatively add $1.7 trillion to the federal government's debt pile, relative to the previous baseline (Chart II-3). The annual deficit is projected to surpass $1 trillion in 2020, and peak as a share of GDP at 5.4% in 2022. Federal government debt held by the private sector will rise from 76% this year to 96% in 2028 in this scenario. Chart II-3Comparing To The Reagan Era The budget situation begins to look better after 2020 in the CBO's baseline forecast because a raft of "temporary provisions" are assumed to sunset as per current law, including some of the personal tax cuts and deductions included in the 2017 tax package. As is usually the case, the vast majority of these provisions are likely to be extended. The CBO performed an alternative scenario in which it extends the temporary provisions and grows the spending caps at the rate of inflation after 2020. In this more realistic scenario, the deficit reaches 7% of GDP by 2028 and the federal debt-to-GDP ratio hits 105% (Chart II-3). Moreover, there will undoubtedly be a recession sometime in the next five years. Even a mild downturn, on par with the early 1990s, could inflate the budget deficit to 8% or more of GDP. The Demographic Time Bomb Chart II-4The Withering Support Ratio The pressure that the aging population will place on federal coffers over the medium term is well known, but it is worth reviewing in light of Washington's new attitude toward deficit financing. The combination of rising life expectancy and a decline in the ratio of taxpayers to retirees will place growing financial strains on the Social Security and Medicare systems. In 1970, there were 5.4 people between the ages of 20 and 64 for every person 65 or older. That ratio has since dropped to 4 and will be down to 2.6 within the next 20 years (Chart II-4). Spending on entitlements (Social Security, Medicare, Medicaid, Income Security and government pensions) is on an unsustainable trajectory (Charts II-5 and II-6). In fiscal 2017, these programs absorbed 76% of federal revenues and the CBO estimates that this will rise to almost 100% by 2028, absent any change in law. If we also include net interest costs, total mandatory spending1 is projected to exceed total federal government revenues as early as next year, meaning that deficit financing will be required for all discretionary spending. Chart II-5Entitlements Will Explode ##br##Mandatory Spending Chart II-6All Discretionary Spending ##br##To Be Deficit Financed? The CBO last published a multi-decade outlook in 2017 (Chart II-7). The Federal debt/GDP ratio was projected to reach 150% by 2047. If we adjust this for the new (higher) starting point in 2028 provided by the CBO's alternative scenario, the debt/GDP ratio would top 164% in 2047. Chart II-7An Unsustainable Debt Accumulation To put this into perspective, the demands of WWII swelled the federal debt/GDP ratio to 106% in 1946, the highest on record going back to the early 1700s (Chart II-8). The debt ratio could rocket past that level before 2030, even in the absence of a recession. Chart II-8U.S. Debt In Historical Context These extremely long-term projections are only meant to be suggestive. A lot of things can happen in the coming years that could make the trajectory better or even worse. But the point is that current levels of taxation are insufficient to fund entitlements in their current form in the long run. Chart II-9 shows that outlays as a share of GDP have persistently exceeded revenues since the mid-1970s, except for a brief period during the Clinton Administration. The gap is set to widen over the coming decade. Something will have to give. Chart II-9U.S. Outlays And Revenues Forget Starving The Beast "Starve the Beast" refers to the idea that the size of government can be restrained through a low-tax regime that spurs growth and pressures Congress to cut spending and control the budget deficit. It has been the mantra of Republicans since the Reagan era. The 1981 Reagan tax cuts included an across-the-board reduction in marginal tax rates, taking the top rate down from 70% to 50%. Corporate taxes were slashed by $150 billion over a 5-year period and tax rates were indexed for inflation, among other changes. It was not surprising that the budget deficit subsequently ballooned. Outrage grew among fiscal conservatives, but Congress spent the next few years passing laws to reverse the loss of revenues, rather than aggressively attacking the spending side. Today, Congressional fiscal hawks are in retreat and the Republican Party under President Donald Trump is not as fiscally conservative as it once was. This trend reflects the pull toward the center of the economic policy spectrum in response to a shift to the left among voters. BCA's political strategists have highlighted that this is the "median voter theory" (MVT) in action.2 The MVT posits that parties and politicians will approximate the policy choices of the median voter in order to win an election or stay in power. Every U.S. presidential election involves candidates making a mad dash to the most popularly appealing positions. President Trump exhibited this process when he ran in the Republican primary on a platform of increased infrastructure spending and zero cuts to "entitlement" spending. The Great Financial Crisis, disappointingly slow growth, stagnating middle class incomes and the widening income distribution have resulted in a leftward shift among voters on economic issues. Adding to the shift is the rising political clout of the Millennial generation, which generally favors more government involvement in the economy and will become the major voting block as it ages in the 2020s. There also are important changes underway in the ethnic composition of the electorate. The rising proportion of Hispanic voters will on balance favor the Democrats, according to voting trends (Chart II-10). A previous Special Report by Peter Berezin, BCA's Chief Global Strategist, predicted that Texas will become a swing state in as little as a decade and a solid Democrat state by 2030.3 Chart II-10The Proportion Of Minority Voters Set To Grow President Trump's shift to the left on economic policy helped him to out-flank Clinton in the election, particularly in the Rust Belt, where his protectionist and anti-austerity message resonated. Even his anti-immigration appeal is mostly based on economic reasoning - i.e. jobs, rather than cultural factors. Trump has admitted that he is not all that concerned about taking the country deeper into hock. The Republican rank-and-file has generally gone along with Trump's agenda because he has delivered traditional Republican tax cuts and continues to rate highly among his supporters (his approval is around 90% among Republicans). Fiscal hawks within the GOP have been forced to the sidelines while Trump and moderate Republicans have passed bipartisan spending increases with Democratic assistance. Where's The Outrage? Chart II-11Entitlements Are Popular* The implication is that, unlike the Reagan years, we do not expect there will be a strong political force capable of leading a fight against budget deficits. After a decade of disappointing income growth, voters are in no mood for tax hikes. On the spending side, health care and pensions are still politically untouchable. A recent study by the Pew Research Center confirms that only a very small percentage of Americans of either political stripe would agree with cuts to spending on education, Medicare, Social Security, defense, infrastructure, veterans or anti-terrorism efforts (Chart II-11). It is therefore no surprise that a populist such as Trump has promised to defend entitlement programs. Moreover, the graying of America will make it increasingly difficult for politicians to tame the entitlement beast. An aging population might generally favor the GOP, but it will also solidify opposition towards cutting Medicare and Social Security. As for defense, U.S. military spending was 3.3% of GDP and almost 15% of total spending in 2017 (Chart II-12). Congress recently lifted the spending cap for defense expenditures, but it is still projected to fall as a share of total government spending and GDP in the coming years. It is conceivable that Congress could eventually trim the defense budget even faster, but spending is already low by historical standards and it is hard to see any future Congress gutting the military at a time when the global challenge from China and Russia is rising. Indeed, given the geopolitical atmosphere of great power competition, defense spending is more likely to rise. Chart II-12What's Left To Cut? So, what is left to cut? If entitlements and defense are off the table, that leaves non-defense discretionary spending as the sacrificial lamb. This category includes spending by the Departments of Agriculture, Education, Energy, Homeland Security, Health and Human Services, Justice, State and Veteran Affairs. Such spending has already declined sharply during the past several decades (Chart II-12). Non-defense discretionary spending amounted to $610 billion in 2017, which is only 15.3% of total federal spending. To put this into perspective, cutting every last cent of non-defense discretionary spending by 2022 would still leave a budget deficit of about 2½% of GDP. And it would be political suicide. The Departments of Education, Health and Human Services, Homeland Security, Justice and Veterans Affairs account for more than half of non-defense discretionary spending. But these programs are very popular among voters. And, at only 1.3% of total spending, eliminating all foreign aid won't make much difference. Either President Trump or Vice-President Mike Pence will be the GOP presidential candidate in 2020. Pence could be more fiscally conservative than Trump, but Congress is unlikely to remain GOP-controlled through 2024. Similarly, it is difficult to see the Democrats making more than a token effort to rein in the deficit if the party is in charge after 2020. Perhaps they will raise taxes on the rich and push the corporate rate back up a bit, but voters will probably not favor a full reversal of the Trump tax cuts. Democrats will not tackle entitlements either. In other words, we can forget about "starving the beast" as a viable option no matter which party is in power. There will be little appetite for fiscal austerity in the U.S. through to the mid-2020s at a minimum. International Comparison This all places the U.S. out of sync with other major industrialized countries, where structural budget deficits have been tamed in most cases and are expected to remain so according to the IMF's latest projections (Chart II-13). The U.S. cyclically-adjusted budget deficit is projected to be almost 7% of GDP in 2019, by far the highest among other industrialized countries except for Norway. Spain and Italy are expected to have relatively small structural deficits of 2½% and 0.8%, respectively, next year. Greece is running a small structural surplus! Including all levels of government, the IMF estimates that the U.S. general government gross debt/GDP ratio is projected to be well above that of the U.K., France, Germany, Spain and Portugal in 2023 (Chart II-14). It is expected to be on par with Italy at that time, although the newly-installed populist government there is likely to negotiate a loosening of the fiscal rules with Brussels, leading to higher debt levels than the IMF currently expects. The implication is that the U.S. government appears destined to become one of the most indebted in the developed world. Chart II-13U.S. Budget Deficit Stands Out Chart II-14International Debt Comparison The Fiscal Tipping Point Investors are not yet worried about the path of U.S. fiscal policy; the yield curve is quite flat, CDS spreads on U.S. Treasurys have not moved and the dollar is still overvalued by most traditional measures. The challenge is timing when a fiscally-induced crisis might occur. A warning bell does not ring when government debt or deficits reach certain levels. Fiscal trends generally do not suddenly spiral out of control - it is a gradual and insidious process reflected in multi-year deficits and slowly accumulating debt burdens. Eventually, a tipping point is reached where the only solution is drastic policy shifts or in extreme cases, default. Along the way, there are a number of signs that fiscal trends are entering dangerous territory. The relevance of the various signs will be different for each country, reflecting, among other things, the depth and structure of the financial system, the soundness of the economy, the dependence on foreign capital, and the asset preferences of domestic investors. Some key signs of building fiscal stress are given in Box II-1. None of the factors in Box II-1 appear to be a threat at the moment for the U.S. Moreover, comparisons with other countries that have hit the debt wall in the past are not that helpful because the U.S. is a special case. It has a huge economy and has political and military clout. The dollar is the world's main reserve currency and the country is able to borrow in its own currency. This suggests that the U.S. will be able to "get away with" its borrowing habit for longer than other countries have in the past. At the same time, financial markets are fickle and, even with hindsight, it not always clear why investors switch from acceptance to bearishness about a particular state of affairs. BOX II-1 Traditional Signs Of An Approaching Debt Crisis Government deficits absorb a rising share of net private savings, leaving little for new investment. Interest payments account for an increasingly large share of government revenues, squeezing out discretionary spending and requiring tough budget action merely to stop the deficit from rising. The government exhausts its ability to raise tax burdens. Traditional sources of debt finance dry up, requiring alternative funding strategies. Fears of inflation and/or default lead to a rising risk premium on interest rates and/ or a falling exchange rate. Political shifts occur as governments get blamed for eroding living standards, high taxes, and continued pressure to cut spending. The Costs Of Fiscal Profligacy Even if the U.S. is not near a fiscal tipping point, this does not mean that massive debt accumulation is costless: Interest Costs: Spending 3% of GDP on servicing the federal government's debt load over the next decade is not a disaster. Nonetheless, it does reduce the tax dollars available to fund entitlements or investing in infrastructure. Counter-Cyclical Fiscal Policy: Lawmakers would have less flexibility to use tax and spending policies to respond to unexpected events, such as natural disasters or recessions. As noted above, a recession in 2020 could generate a federal deficit of more than 8% of GDP. In that case, Congress may feel constrained in supporting the economy with even temporary fiscal stimulus. National Savings: Because government borrowing reduces national savings, then either capital spending must assume a smaller share of the economy or the U.S. must borrow more from abroad. Most likely it will be some combination of both. Crowding Out: If global savings are not in plentiful supply, then the additional U.S. debt issuance will place upward pressure on domestic interest rates and thereby "crowd out" business capital spending. This would reduce the nation's capital stock, leading to lower growth in productivity and living standards than would otherwise be the case. The CBO estimates that the positive impact on the capital stock from the changes to the corporate tax structure will overwhelm the negative impact from higher interest rates over the next decade. Nonetheless, the crowding out effect may dominate over a longer-time horizon. Academic studies suggest that every percentage point rise in the government's debt-to-GDP ratio adds 2-3 basis points to the equilibrium level of bond yields. If this is correct, then a rise in the U.S. ratio of 25 percentage points over the next decade in the CBO's baseline would lift equilibrium long-term bond yields by a meaningful 50-75 basis points. Much depends, however, on global savings backdrop at the time. External Trade Gap: If global savings are plentiful, then it may not take much of a rise in U.S. interest rates to attract the necessary foreign inflows to fund both the higher U.S. federal deficit and the private sector's borrowing requirements. Of course, this implies a larger current account deficit and a faster accumulation of foreign IO Us. Twin Deficits The U.S. has run a current account deficit for most of the past 40 years, which has cumulated into a rising stock of foreign-owned debt. The Net International Investment Position (NIIP) is the difference between the stock of foreign assets held by U.S. residents and the stock of U.S. assets held by foreign investors. The NIIP has fallen increasingly into the red over the past few decades, reaching 40% of GDP today (Chart II-15). The current account deficit was 2.4% at the end of 2017, matching the post-Lehman average. Nonetheless, this deficit is set to worsen as increased domestic demand related to the fiscal stimulus is partly satisfied via higher imports. Chart II-15Scenarios For The U.S. Net International Investment Position We estimate that a two percentage point rise in the budget deficit relative to the baseline could add a percentage point or more to the current account deficit, taking it up close to 4% of GDP. Upward pressure on the external deficit will also be accentuated in the next few years to the extent that the U.S. business sector ramps up capital spending. The implication is that the NIIP will fall deeper into negative territory at an even faster pace. A 2% current account deficit would be roughly consistent with stabilization in the NIIP/GDP ratio. But a 4% deficit would cause the NIIP to deteriorate to almost 80% of GDP by 2040 (Chart II-15). The sustainability of the U.S. twin deficits has been an area of intense debate among academics and market practitioners for many years. The U.S. has been able to get away with the twin deficits for so long in part because of the dollar's status as the world's premier reserve currency. The critical role of the dollar in international transactions underpins global demand for the currency. This has allowed the U.S. to issue most of its debt obligations in U.S. dollars, forcing the currency risk onto foreign investors. The worry is that foreign investors will at some point begin to question the desirability of an oversized exposure to U.S. assets within their global portfolios. We argued in our April 2018 Special Report 4 that the U.S. situation is not that dire that the U.S. dollar and Treasury bond prices are about to fall off a cliff because of sudden concerns about the unsustainability of the current account deficit. Even though the NIIP/GDP ratio will continue to deteriorate in the coming years, it does not appear that the U.S. is close to the point where foreign investors would begin to seriously question America's ability or willingness to service its debt. That said, the "twin deficits" and the downward trend in U.S. productivity relative to the rest of the world will ensure that the underlying long-term trend in the dollar will remain down (Chart II-16).5 Chart II-16Structural Drivers Of The U.S. Dollar Conclusions The long-term U.S. fiscal outlook was dire even before the Great Recession and the associated shift to the political left in America. Fiscal conservatism is out of fashion and this is unlikely to change before the mid-2020s, no matter which party is in power. This means that a market riot will be required to shake voters and the political establishment into making the tough decisions. Given demographic trends, it appears more likely that taxes will rise than entitlements cut. We do not foresee a crisis occurring in the next few years. Nonetheless, arguing that the U.S. fiscal situation is sustainable for the foreseeable future does not mean that it is desirable. There will be costs associated with current fiscal trends, even on a relatively short 5-10 year horizon. Interest costs will mushroom, potentially crowding out government spending in other areas. U.S. government debt has already been downgraded by S&P to AA+ in 2013, and the other two main rating agencies are likely to follow suit during the next recession as the deficit balloons to 8% or more. Investors may begin to demand a risk premium in order to entice them to continually raise their exposure to U.S. government bonds in their portfolios. Taxes will eventually have to rise to service the government debt, and some capital spending will be crowded out, both of which will undermine the economy's growth potential. Finally, the dollar will also be weaker than it otherwise would be in the long-term, representing an erosion in America's standard of living because everything imported is more expensive. Could Japan offer a roadmap for the U.S.? The Bank of Japan has effectively monetized 43% of the JGB market and has control over yields, at least out to the 10-year maturity. Moreover, Japan has enjoyed a "free lunch" so far because monetization has not resulted in inflation. The reason that Japan has enjoyed a free lunch is that it has suffered from a chronic lack of demand and excess savings in the private sector. The government has persistently run a deficit and fiscally stimulated the economy in order to offset insufficient demand in the private sector. The Bank of Japan purchased bonds and drove short-term interest rates down to zero. These policies have made very slow progress in eradicating lingering deflationary economic forces. However, if animal spirits in the business sector perk up, then inflation could make a comeback unless the policy stimulus is dialed down in a timely manner. In other words, the BoJ-financed fiscal "free lunch" should disappear at some point. The U.S. is in a very different situation. There is no lack of aggregate demand or excessive savings in the private sector. The economy is at full employment, and thus persistent budget deficits should turn into inflation much more quickly than was the case in Japan. In other words, the U.S. is unlikely to enjoy much of a "free lunch", whether the Fed monetizes the debt or not. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Mandatory spending refers to entitlements; that is, government expenditure programs that are required by current law. These include Social Security, Medicare, Medicaid, government pensions and other smaller programs. 2 Please see Geopolitical Strategy Monthly Report, "Introducing The Median Voter Theory," June 8, 2016, available at gps.bcaresearch.com. 3 Please see The Bank Credit Analyst, "America's Fiscal Fortune: Leave Your Wallet On The Way Out," June 2011, available at bca.bcaresearch.com. 4 Please see The Bank Credit Analyst Special Report, "U.S. Twin Deficits: Is The Dollar Doomed?," April, 2018, available at bca.bcaresearch.com. 5 In the near term, fiscal stimulus and increased business capital spending will likely boost the dollar. But this effect on the dollar will reverse in the long-term. III. Indicators And Reference Charts The divergence between the U.S. corporate earnings data and our equity-related indicators continued in June. Forward earnings estimates continue to climb at an impressive pace. The U.S. net revisions ratio pulled back a little, but remains well above the zero line. Moreover, positive earnings surprises continue to trounce negative surprises. That said, the earnings upgrades are partly due to the Trump tax cuts, which are still being reflected in analysts' estimates. Second, some of our indicators are warning that there are clouds on the horizon. Our Monetary Indicator has fallen to levels that are low by historical standards, which is a negative sign for risk assets. This partly reflects the slowdown in growth in the monetary aggregates (see the Overview section). Our Equity Technical Indicator is threatening to dip below the zero line, which would be a clear 'sell' signal. Our Equity Valuation Indicator is flirting with our threshold of overvaluation, at +1 standard deviations. This is not bearish on its own, but valuation does provide information on the downside risks when the correction finally occurs. Our Willingness-to-Pay (WTP) indicator for the U.S. has rolled over, although this hasn't yet occurred for Japan and the Eurozone. 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. This indicator suggests that flows into the U.S. stock market are waning. Finally, our Revealed Preference Indicator (RPI) for stocks remained on a 'sell' signal in June. 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. The U.S. 10-year Treasury is slightly on the inexpensive side and our Composite Technical Indicator suggests that the bond has still not worked off oversold conditions. This suggests that the consolidation period has further to run, although we still expect yields to move higher over the remainder of the year. The dollar is expensive on a PPP basis, but is not yet overbought. The long-term outlook for the dollar is down, but it has more upside in the next 6-12 months. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Please note that we are also publishing a Special Report on Mexico. Highlights The selloff in EM financial markets has been induced by slowing global trade amid lingering poor EM fundamentals. The Federal Reserve's resolve to tighten is aggravating the situation but is not the main cause of the EM turmoil. Consequently, the necessary conditions for a reversal in ongoing EM turbulence are not the Fed turning dovish but rather a bottom in the global trade cycle and China's growth. The latter two are not on the horizon, and we therefore believe there is much more downside in EM risk assets and currencies. Feature In our trip to Asia last week, the majority of investors we met attributed the current emerging market (EM) selloff to Federal Reserve tightening and trade wars. While we are not suggesting that the Fed tightening or trade war rhetoric have not impacted EM risk assets, we do contend that these reasons are inadequate to explain the selloff. In our opinion, the EM selloff has as much been driven by a slowdown in global trade as by expectations of higher U.S. interest rates and other factors. Diagnosing the underlying bases of a market move correctly is instrumental in gauging its sustainability and an eventual reversal. If one believes that the EM selloff has been due to the Fed, it would require the Fed turning dovish for the selloff to halt and reverse. If, however, the EM carnage has been driven by slowing global trade, the necessary condition for a reversal would be a bottom in the global trade cycle. In such a case, a dovish turn by the Fed or a drop in U.S. bond yields in and of themselves are unlikely to be sufficient. While EM risk assets could rebound for a couple of weeks on lower interest rate expectations in the U.S., any rebound will prove to be short-lived, and EM will resume their downtrend. Assessing the dynamics of both financial markets and the business cycle has led us to conclude that the EM selloff has been not only due to Fed tightening and the U.S.-China trade confrontation, but even more so due to a slowdown in global trade. The latter has transpired even though U.S. economic growth remains very robust. Chart I-1 illustrates that EM currencies and sovereign spreads correlate well with global trade growth. Since the beginning of this year, global trade and EM manufacturing have been decelerating, despite ongoing strength in U.S. demand. This, in our opinion, has been the main reason for the selloff in EM risk assets. In fact, EM manufacturing PMI and EM non-financials' corporate profit growth have rolled over since early this year, explaining widening in EM credit spreads (Chart I-2). Chart I-1EM Cracks Have Opened As Global Trade##br## Has Begun Slowing Down Chart I-2Slowdown In EM Corporate Profits ##br##Explains Widening Of EM Credit Spreads In turn, Chart I-3 demonstrates that the correlation between EM corporate spreads and share prices on one hand and U.S. bond yields on the other is rather loose. Notably, U.S. bond yields are at the same level they were in early April when the EM-centred selloff began. Meanwhile, EM equity and credit markets have diverged from their U.S. peers since early April (Chart I-4). Chart I-3EM Risk Assets And U.S. Bond Yields: ##br##Loose Correlation Chart I-4The Recent Divergence##br## Between EM And U.S. In this context, an important question is as follows: Why are EM economies and financial markets more vulnerable to rising U.S. borrowing costs than the U.S. itself? In reality, the American economy, stock market and corporate credit should be more exposed to Fed tightening than EM economies and financial markets. Yet the U.S. economy, stocks and corporate credit market have so far weathered rising borrowing costs quite well. Most interest rate-sensitive segments such as mortgages for home purchases and the junk corporate credit market have remained resilient. Historically, the correlation between EM risk assets and the Fed funds rate has been mixed - albeit more positive than negative (Chart I-5). On this chart, we shaded the periods when EM stocks rallied despite rising Fed funds rate. Chart I-5EM Stocks And Fed Tightening Cycles The episodes when EMs crashed amid rising U.S. interest rates were the 1982 Latin America debt crisis and the 1994 Mexican Tequila crisis. Yet, it is vital to emphasize that these crises occurred because of poor EM fundamentals - elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits and pegged exchange rates. Chart I-6The 1997/98 EM Crises Pushed U.S. Bond Yields Lower Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-'98. These late 1990 EM crises occurred without much in the way of Fed tightening or rising U.S. bond yields (Chart I-6). In contrast, EM stocks, credit markets and currencies did well during a period of rising Fed funds rate in 1988-89, 1999-2000, and 2017 as illustrated in Chart I-5. Altogether, we conclude that rising U.S. interest rates in and of themselves are not a sufficient condition for EM to sell off. Only in combination with poor EM fundamentals and a weakening global business cycle are rising U.S. borrowing costs negative for EM financial markets. EM fundamentals have been and remain indigent since early this decade. The 2016-'17 rally in EM was due to improving global growth. Yet the global business cycle has rolled over since early this year. This, in combination with lingering weak fundamentals throughout EM and the Fed's tightening, has produced the current EM selloff. All in all, the ongoing selloff in EM risk assets has been mainly due to the slowdown in global trade/business cycle. When global trade expands, weak parts of the chain do well. Conversely, when global trade growth dwindles, these same weak links are the first to break. As we have argued repeatedly, EM fundamentals have remained destitute in spite of 2016-17 rally. Indeed as soon as global trade began decelerating, the weakest parts of the global chain cracked. Specifically, China's import volumes for many raw materials and commodities have decelerated significantly (Chart I-7A and Chart I-7B). Imports of consumer goods, machinery, and transport equipment remain strong (Chart 7A, bottom panel). We believe it is a matter of time before the ongoing slowdown in credit and capital spending brings about weaker imports of industrial goods and machinery. Chart I-7AChina: Imports Volumes Have Been Slowing Down Chart I-7BChina: Imports Volumes Have Been Slowing Down Even though consumer spending in China remains robust, it has had a limited impact on the global economy in general and the rest of EM in particular. Most consumer goods and services that Chinese households buy are produced and sold domestically by mainland companies. In short, China's impact on EM and the rest of the world are primarily via its imports of commodities/raw materials and industrial goods, which are very vulnerable. On-shore listed Chinese stocks are also signaling that a pronounced growth deceleration is underway. Even though the MSCI China investable equity indexes remain elevated, their onshore peers have plunged. Chart I-8A and 8B demonstrate that China's onshore listed stock prices - large cap, small cap and many sectors - have plunged to or below their early 2016 lows. Chart I-8AChinese Share Prices: Onshore And Offshore Markets Chart I-8BChinese Share Prices: Onshore And Offshore Markets Chart I-9New Cyclical Lows For EM Relative Performance This downbeat message from Chinese onshore equity prices along with the recent sharp depreciation of the RMB corroborate that the mainland growth slowdown is gaining speed, which in turn argues for a bearish outlook for EM financial markets. Bottom Line: Our diagnosis is that the selloff in EM financial markets has been induced by slowing global trade and China's growth deceleration amid lingering poor EM fundamentals. The Fed's resolve in tightening is aggravating the situation, but it is not the main cause behind the EM turmoil. Consequently, the necessary conditions for a reversal of the ongoing EM turbulence are not the Fed turning dovish but a bottom in the global trade cycle and Chinese growth. The latter two are not on the horizon, and we therefore posit there is much more downside in EM risk assets and currencies. EM relative equity performance versus DM has broken to new cycle lows for the small-cap and equal-weighted indexes (Chart I-9, top and middle panels). The market cap-weighted overall index will likely be heading to new lows for this cycle too (Chart I-9, bottom panel). Investors should stay short/underweight EM risk assets. Our recommended country allocation is presented below. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

NOTE: There will be a few minor scheduling changes to BCA's China Investment Strategy service in July. We will publishing next week's report and the report scheduled on July 25 one day late, on Thursday, July 5 and 26, respectively. There will also be no report on Wednesday, July 18 due to our regular summer break. Highlights In response to the sharp spike in the risk of a full-blown U.S./China trade war, many market participants have concluded that significant fiscal and/or monetary policy stimulus is forthcoming. But for now, a depreciation in the RMB is the only clear and significant policy response to the imposition of U.S. import tariffs that we can currently observe, and we would still classify it as just a remedial measure. While a falling RMB will improve the financial position of China's exporters, it also increases the risk that the U.S. will follow through with the worst of their threats. Despite two conceivable upside scenarios for the equity market, we recommend a neutral stance towards Chinese stocks within a global equity portfolio and currently view the risks as largely to the downside. We are closing our long China / short Taiwan trade for a considerable profit, and recommend that investors go long low-beta sectors within the MSCI China index. Feature Chart 1A Decisive Technical Breakdown In ##br##Ex-Tech Stocks Vs Global In a Special Alert last week, we recommended that investors downgrade Chinese ex-tech stocks versus their global peers to neutral from overweight,1 after having placed them on downgrade watch at the end of March.2 Our recommendation was made in response to the ongoing slowdown in China's industrial sector, a significant escalation in the imposition of import tariffs between the U.S. and China, and an unfavorable shift in the risk/reward balance of global risky asset prices.3 It was also timely, as Chinese ex-tech stock prices have now decisively broken below their 200-day moving average (Chart 1). Following our shift in stance, the question facing BCA's China team, as well as global investors, is straightforward: Now what? Stimulus Watch The answer to this question among many market participants is that fiscal and/or monetary policy stimulus is forthcoming. We have no doubt that China will announce some remedial or compensatory measures in response to protectionist action from the U.S. Indeed, recent statements from the Ministry of Finance (MOF) suggest that planned fiscal spending for the year will be accelerated/brought forward, and the PBOC has already made a targeted cut to the reserve requirement ratio and reduced the relending rate for small company loans. However, we have argued that the bar for a fresh round of material stimulus is higher today than it was in the past, and we continue to hold this view. Elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities can respond with the usual barrage of infrastructure spending and increased bank lending. The economy likely needs to feel more pain before policymakers come to its aid with enough magnitude to potentially spark another upswing in economic activity. Below we outline a few perspectives on the potential for stimulus, and how investors can gauge whether policymakers are deploying enough stimulus to materially impact China's economic outlook: Fiscal Stimulus The MOF's statement reflects the first fiscal policy action that China would likely take to combat any economic weakness, which is to speed up spending that has already been approved but was planned to occur later in the year. But from the perspective of whether a policy action is likely to materially boost economic activity, frontloading pre-approved spending would qualify, at best, as a remedial measure. In our view, tracking China's budgetary government finance data represents the best method for investors to determine whether policymakers are truly stimulating via the fiscal channel. While it is true that China's shadow budget deficit is much larger than the official data show (Chart 2), there is a crucial aspect of China's recent mini-cycle that is not well understood by many investors: almost all of the expansion of China's fiscal stance from 2014-16 was from on-budget rather than off-budget spending. Given that China has been trying to limit off-budget spending as part of its structural reform program, our sense is that this time won't be different if China decides that significant fiscal stimulus is required. This is good news for investors, given that on-budget spending is easier to observe in real-time, and Chart 3 presents two simple measures that we are using to monitor China's fiscal stance, alongside their year-over-year changes: on-budget expenditure and the on-budget balance, both as a % of GDP. Based on these measures there are no signs yet that the fiscal stance is easing (in fact, the opposite has occurred over the past year), but we will watching Chart 3 closely over the coming months for any indication of a change. Chart 2China's Shadow Budget Deficit Is Large... Chart 3...But If China Stimulates It Will Likely Be On-Budget Monetary Stimulus In our judgement, the recent cut to the reserve requirement ratio is not likely to be effective at stimulating the domestic economy. Investors should note that the initial reaction of many market participants to the April 17 reserve requirement ratio cut of 1% was that it represented a shift in the PBOC's policy stance towards easing, which ultimately proved to be a false narrative. Chart 4 shows China's 3-month interbank repo rate (China's de-facto policy rate which leads average lending rates), and highlights the timing of two specific events: March 28, when news broke that the PBOC would extend the deadline for the implementation of new regulatory standards for asset management products, and April 17, when the PBOC announced its targeted reserve requirement ratio cut. The chart makes it clear that the decline in the repo rate was in response to the deadline extension rather than the repo rate cut. This is entirely consistent with the findings of our February 22 Special Report,4 particularly the fact that 75% of the monetary tightening that has occurred since late-2016 has been regulatory in nature. We have previously argued that the dip in the repo rate in response to the deadline extension would probably be temporary,5 and Chart 4 shows that the rate has indeed increased over that past two months. In short, there is no evidence that the April 17 reserve ratio cut had any measurable effect on the stance of monetary policy in China. Given this, there are two key points for investors. The first is that small cuts to the reserve requirement ratio should be viewed, at best, as remedial measures that may help blunt the impact of shock to the export sector, but they are unlikely to alter the downward trajectory of the "old economy" (the portion of China's economy that is most relevant to global investors). The second is that if cuts to the reserve requirement ratio or any other monetary policy action stimulates the provision of credit via easier lending standards (rather than by reducing the cost of borrowing), their effect should result in a pickup in broad measures of credit growth rather than a reduction in interest rates. Chart 5 highlights that, for now, no such pickup has occurred; adjusted total social financing, which excludes equity issuance but includes municipal bonds, remains in a downtrend. This series, along with its impulse equivalent, are both included in the BCA Li Keqiang Leading Indicator which is at the core of our efforts to monitor the cyclical condition of China's business cycle. Chart 4No Evidence That April RRR Cut Eased Interest Rates Chart 5No Evidence That April RRR Cut Eased Lending Standards The Exchange Rate BCA's Geopolitical Strategy team has recently argued that China is likely to retaliate to a potential tariff imposition by weakening CNY/USD. This would have the effect of improving the competitiveness of exports priced in RMB, or would bolster the revenue of exporters selling goods priced in U.S. dollars (by way of receiving more RMB after converting the dollars received). Evidence has emerged over the past week to suggest that the PBOC is indeed allowing China's currency to depreciate against the U.S. dollar. Chart 6 shows the actual CNY/USD exchange rate alongside the value that would be predicted based on its relationship with the dollar over the year prior to its early-April peak. The chart suggests that the decline in CNY/USD appears to have, until very recently, reflected the strength in the U.S. dollar. However, the chart shows that CNY/USD has fallen over the past few days by magnitude in excess of what would be expected given movements in the U.S. dollar, implying that the very recent weakness is likely policy-driven. Chart 6The PBOC Is Letting CNY/USD Depreciate We agree that depreciating the currency versus the U.S. dollar will improve the financial condition of domestic exporters, but we would also caution investors against looking at a deep depreciation in CNY/USD in an encouraging light. We have noted in previous reports that such a development would be a clear sign of an outright, full-scale trade war between the U.S. and China, and in this context currency deprecation should still be classified as just a remedial measure (i.e. it is unlikely to lead to a renewed upswing in Chinese economic activity). Bottom Line: A depreciation in the RMB is the only clear and significant policy response to the imposition of U.S. import tariffs that we can currently observe, and we would still classify it as just a remedial measure. While a falling RMB will improve the financial position of China's exporters, it may also invite even further protectionist action from the U.S. Investment Recommendations Our recommendation to cut Chinese ex-tech stocks to neutral means that investors should be looking both for upside and downside risks when judging when to make their next allocation shift. For now, our discussion above underscores that we view the risks largely to the downside. The scenario that would cause us to further downgrade Chinese stocks to underweight within a global equity portfolio is not difficult to imagine: the worst outcome in the U.S. / China trade dispute materializes, the global economy slows meaningfully, and the inertia from the ongoing structural reform program causes Chinese policymakers to limit their stimulus to compensatory, remedial measures until a painful slowdown emerges in the domestic economy. We are not yet past the "point of no return" on the way to this outcome, but the events of the past two weeks have clearly moved us further along the path. Conversely, there are two scenarios that we can envision that could cause us to upgrade Chinese stocks back to overweight: Chart 7Keep Monitoring Floor Space Sold A protectionist exchange occurs between China and the U.S. but fails to devolve to the most damaging outcome. China's remedial measures are successful at easing the pain from tariffs on domestic producers, and the economic outlook stabilizes. In this scenario the most acute risk would be removed, but the gradual underlying downtrend in China's "old economy" would be intact. In this case we would be more comfortable upgrading Chinese stocks if there was an additional reflationary tailwind, such as a boost from fiscal spending or some reversal of the monetary tightening that has occurred since late-2016. But a significant, exogenous acceleration in economic activity from some other sector of China's economy would also fit the bill, and we have argued in past reports that housing appears to be the best candidate. Chart 7 highlights that residential sales volume may now be in a gradual uptrend, which could translate into stronger construction in the months ahead. The second scenario that would cause us to upgrade Chinese stocks is straightforward: Chinese policymakers determine that the risks to growth from an export shock are unacceptably large given the existing slowdown in the industrial sector, and decide to temporarily reverse course on the structural reform path by opting for "big bang" fiscal and/or monetary stimulus. A significant and highly investment-relevant mini-cycle upswing occurred in China the last time that the authorities strongly prioritized growth, and we will watching closely for real indications of a shift in attitude in this direction. For now our judgement is that policymakers have a higher pain threshold than in the past, suggesting that this is outcome is not yet probable. Related to our decision to downgrade Chinese ex-tech stocks to neutral within a global equity portfolio, we have three updates to our trade book: We are closing our long MSCI China / short MSCI Taiwan position and upgrading our Taiwanese cyclical stance to neutral: Despite being massively overweight technology stocks, Chart 8 highlights that Taiwan is a comparatively low-beta equity market versus China. Our trade has generated a 21% return since we initiated it in February 2017, and we believe it is time to book profits. Given Taiwan's small size it is actually possible that its economy and/or equity market will suffer disproportionately if the worst U.S. / China trade outcome materializes, which could cause us to revisit the trade. But for now our judgement is that a neutral position is warranted. We are sticking with our long China onshore corporate bond trade: We would certainly expect credit spreads on Chinese corporate bonds to flare in response to a deteriorating economic outlook, but we highlighted in our June 13 Weekly Report how high the bar is for investors to lose money on these bonds.6 In short, China's corporate bond market already offers a margin of safety given its high yield and a comparatively short duration, and we do not see recent developments on the trade front as a sufficiently compelling reason to exit the trade. We are initiating a new trade - within the MSCI China index, long low-beta sectors / short benchmark: Chart 9 presents the relative US$ stock price return of a portfolio of low-beta level 1 GICS sectors within the MSCI China index, relative to the index itself. Our methodology in calculating the portfolio is the same as that employed in the A-share factor analysis that we presented in our June 13 report; namely it is a value-weighted portfolio of sectors with below-median rolling 1-year market beta.7 The chart shows that the portfolio has outperformed over time, but sold off quite substantially last year as the high-flying tech sector boosted the performance of the overall index. The relative performance trend for low-beta has recently strengthened and crossed above its 200-day moving average, which we regard as a supportive technical signal to initiate the trade. Chart 8Taiwan's Equity Market Is Low Beta Vs China's Chart 9Go Long Low-Beta Sectors Vs The Broad Market Bottom Line: Despite two potential upside scenarios, we recommend a neutral stance towards Chinese stocks within a global equity portfolio and currently view the risks as largely to the downside. We are closing our long China / short Taiwan for a considerable profit, and recommend that investors go long low-beta sectors within the MSCI China index. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see China Investment Strategy Special Alert "Downgrade Chinese Stocks To Neutral", dated June 20, 2018, available at gis.bcaresearch.com. 2 Please see China Investment Strategy Special Report, "Chinese Stocks: Trade Frictions Make For A Tenuous Overweight," dated March 28, 2018, available at cis.bcaresearch.com. 3 Pease see Global Investment Strategy Special Report "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 19, 2018, available at gis.bcaresearch.com. 4 Pease see China Investment Strategy Special Report "Seven Questions About Chinese Monetary Policy", dated February 22, 2018, available at cis.bcaresearch.com. 5 Pease see China Investment Strategy Weekly Report "China: A Low-Conviction Overweight", dated May 2, 2018, available at cis.bcaresearch.com. 6 Pease see China Investment Strategy Weekly Report "A Shaky Ladder", dated June 13, 2018, available at cis.bcaresearch.com. 7 The current sector weights of the portfolio are: 26% telecom services, 24% industrials, 19% health care, 16% utilities, and 14% consumer staples. Cyclical Investment Stance Equity Sector Recommendations

NOTE: We will not be publishing a report next week. The next Global Fixed Income Strategy Weekly Report will be published on Tuesday, July 10th. Highlights Global Corporates: The clash between monetary policy and the markets that we have been expecting to unfold in 2018 is upon us. Downgrade global spread product exposure to neutral (3 of 5) from overweight, and raise government bond exposure to neutral. Maintain a below-benchmark portfolio duration, however, as global bond yields have not yet peaked for this cycle. Country Allocation: Move to neutral on U.S. investment grade and high-yield corporates, while staying underweight (2 of 5) on euro area corporates. Downgrade emerging market hard currency sovereign and corporate debt to maximum underweight (1 of 5) - the combination of a rising dollar, Fed tightening and slower Chinese growth will remain a huge problem for emerging market assets. Feature Chart Of The Week3 Big Reasons To Downgrade Spread Product Last week, BCA as a firm moved to a less positive stance on global equities and credit, downgrading both to neutral from overweight on a cyclical (6-12 month) horizon.1 Dating back to our 2018 Outlook published at the end of last December, we had anticipated that we would be shifting to a less aggressive asset allocation sometime around mid-year.2 The expected trigger would be a move by central banks to a more restrictive policy stance that would start to impact future growth expectations. That time has come, and we are now recommending moving to a less bullish stance on global credit. Many of the tailwinds that supported the stellar performance of risk assets in 2017 - most importantly, coordinated global growth, accommodative monetary policies and a weakening U.S. dollar - have transformed into headwinds over the course of 2018 and are unlikely to reverse before risk assets suffer a setback (Chart of the week). At a minimum, there is now enough uncertainty, at a time when many asset classes are richly priced, to make the risk/reward balance for being long growth-sensitive assets like equities and corporate debt less attractive. This week, we are downgrading our recommended stance on global spread product to neutral (3 out of 5) from overweight, while upgrading our recommended allocation for government bonds to neutral from underweight. This represents an unwind of a long-standing recommendation that dates back to January 31st, 2017 when we strategically downgraded U.S. Treasury exposure and upgraded U.S. corporate debt.3 We are closing that recommendation at a relative total return gain of 2.3% for U.S. investment grade and 6.7% for U.S. high-yield over Treasuries (Chart 2). Chart 2Closing A Successful Overweight Stance ##br##On U.S. Corporates We still believe that global bond yields will remain under upward pressure from both higher inflation and a less favorable supply/demand balance for fixed income (more issuance, less central bank buying). The fact that bond yields will NOT be able to fall much to reinvigorate softening global growth - because of rising inflation at a time of diminished economic slack - is a critical reason why we are turning more cautious on global credit. Thus, we are maintaining our recommended below-benchmark overall portfolio duration stance, even as we upgrade our government bond allocation to neutral. We recommend placing the proceeds of a reduction of global corporate debt exposure into shorter-maturity government bonds, which we are doing in our model bond portfolio (see page 15). At the country level, we are downgrading U.S. corporate bonds, both investment grade and high-yield, to neutral from overweight. We still are of the view that U.S. corporates are better positioned to outperform non-U.S. credit, however, even in a more challenging environment for credit returns. Thus we are keeping our recommended underweight allocations to euro area corporate debt (2 out of 5 for both investment grade and high-yield). We see a much nastier backdrop brewing for emerging markets (EM), however - a stronger dollar, higher U.S. interest rates, slowing Chinese growth, diminished global capital flows - so we are downgrading both EM hard currency sovereign and corporate debt to maximum underweight (1 out of 5). In terms of other spread product categories, we are maintaining our neutral allocation to U.S. mortgage-backed securities, while downgrading U.K. and Canadian corporate debt to underweight. For those that can invest in U.S. muni debt, we are upgrading that sector to overweight (4 out of 5). The Reasons To Cut Corporate Credit Exposure Now Global credit has not performed well in the first half of 2018, with only U.S. high-yield corporates providing a positive return year-to-date among the major markets: U.S. investment grade: -3.6% total return, -1.7% excess return over duration-matched Treasuries U.S. high-yield: +0.7% total return, +1.5% excess return Euro area investment grade: -0.3% total return, -1.1% excess return Euro area high-yield: -0.5% total return, -1.0% excess return EM USD-denominated sovereign debt: -5.5% total return, -3.6% excess return EM USD-denominated corporate debt: -2.9% total return, -1.7% excess return Chart 3The Start Of Something Big? While there have been plenty of geopolitical tensions for markets to fret over this year (U.S. trade policy, North Korea), the biggest reason for the underperformance of credit is due to the most typical of reasons - tightening global monetary policy. One way to measure the stance of monetary policy is to look at the slope of government bond yield curves. According to the Bloomberg Barclays government bond index data, the "global yield curve" - the spread between the Global Treasury index yield for the 7-10 year and 1-3 year maturity buckets - is now a mere 6bps (Chart 3). That is the flattest the global curve has been since the first quarter of 2007. That is a potentially ominous sign given that the Global Financial Crisis began brewing around the same time. The global yield curve became deeply inverted in the late 1990s, as well, which preceeded the 1998 EM crisis and, later, the global telecom bust. Fundamentally, we see four main reasons to downgrade global credit now: 1. Global growth is slowing and becoming less synchronized The first half of 2018 has seen a deceleration of global economic activity from the robust pace of 2017. This has been a broad-based cooling of activity so far, with cyclical indicators like manufacturing PMIs still well above the 50 level that suggests expanding growth in all major economies. Yet there are signs that the pullback in growth may persist throughout 2018 and into 2019. The OECD's global leading economic indicator (LEI) is rolling over and our LEI diffusion index - a leading indicator of the LEI - suggests additional weakness should be expected. This is significant for credit markets, as returns on corporate bonds are highly correlated to the swings in the global LEI (Chart 4). This is true even in the U.S., which is bucking the slowing global growth trend and where confidence is booming and domestic leading indicators are accelerating (Chart 5). Chart 4Corporate Bonds Follow The Global LEI Chart 5Upside Risks For U.S. Growth That easing of non-U.S. growth is likely rooted in the slowdown underway in China. Policymakers there have been tightening monetary conditions and acting to reign in excessive debt growth. This has resulted in a slowing of overall economic growth after the stimulus-fueled boom in 2016 that helped kick-start global growth last year through robust Chinese imports and consumption of industrial commodities. Given the sheer size of Chinese demand, the global economy will look very different when Chinese imports are growing at a 30% pace rather than the current pace below 10%. Our most reliable forward-looking indicators for Chinese growth, like our Li Keqiang leading indicator, are calling for additional cooling of Chinese economic activity in the latter half of 2018 (Chart 6). This reinforces the signal given by our global LEI diffusion index, with both indicating that additional struggles in the performance of global credit markets should be expected (based off the relationship shown in Chart 4). One additional point: the ongoing trade tensions between the Trump administration and all of the major U.S. trading partners represents an additional potential downside risk to global growth. The story is still quite fluid, as it always is with this president, but the uncertainty created by the trade frictions is definitely a negative for risk assets, at a minimum. 2. Global inflation pressures are rising, most notably in the U.S. Even with the latest dip in non-U.S. growth, the global economy is still operating with the least amount of spare capacity since the mid-2000s boom. The U.S. unemployment rate is down to 3.8%, the lowest level in eighteen years. 75% of OECD countries now have unemployment rates below the OECD's estimate of the full-employment NAIRU, with capacity utilization rates also rising. The pricing backdrop is as healthy as it has been since 2011, according to the measure of world export prices from the Netherlands-based Bureau for Economic Policy Analysis which is now growing at a 10% annual rate (Chart 7). Chart 6Downside Risks For Chinese Growth Chart 7A More Inflationary Global Backdrop, Especially In The U.S. The previous two times export prices grew that rapidly in 2008 and 2011 - two very challenging years for financial markets - global CPI inflation rates expanded rapidly, especially in the U.S. Headline CPI inflation ended up reaching peaks of 6% and 4%, respectively, during those prior two episodes. Non-U.S. inflation rates also accelerated, but not to the same degree as in the U.S. A similar dynamic is playing out in 2018, with U.S. inflation rates accelerating (both headline and core), at a faster pace than in the other major developed economies. With the U.S. labor market growing tighter each month, and with U.S. growth likely to continue expanding at an above-potential pace for the next few quarters, it is unlikely that the current upturn in U.S. inflation will slow on its own. This will ensure that the Fed will continue on its planned monetary tightening path that will soon take U.S. monetary conditions into restrictive territory - eventually weighing on U.S. growth expectations and raising concerns over future downgrade and default risks, and returns, in U.S. corporate bond markets. 3. Growth and monetary policy divergences will continue to boost the value of the U.S. dollar The divergences between growth, inflation and monetary policy in the U.S. and the rest of the world are now helping raise the value of the U.S. dollar, which had declined nearly 10% on peak-to-trough basis in 2017. The dollar has been rising in 2018, which has been weighing on EM currencies and financial markets as is typically the case during periods of dollar strength. EM economies have been rapidly accumulating dollar-denominated debt in recent years, leaving EM borrowers as highly exposed to the swings in the dollar and interest rates as they have been since the late 1990s. The current backdrop is setting itself up for a repeat of the 2015/16 period when pro-U.S. growth divergences caused the dollar to soar and triggered major selloffs in EM financial assets that spilled over into U.S. and developed market equities and credit (Chart 8). Right now, the moves have been far more modest than seen in the 2015/16 period. Since the start of 2018, the U.S. trade-weighted dollar is up 4% and EM equities are down -6% (in U.S. dollar terms), while U.S. investment grade credit spreads have risen 37bps from the February lows. This is far less than the moves seen in 2015/16, where the dollar rose 16%, EM equities sold off -34% and U.S. credit spreads widened nearly 100bps. Those moves were enough to cause the Fed to delay its rate hike plans after the initial post-QE rate hike in December 2015, triggering a significant decline in U.S. bond yields (bottom panel) and the dollar that eventually stabilized global financial markets. With the U.S. economy in a much healthier position today than two years ago, and with U.S. core inflation running close to the Fed's 2% target, it will take much larger market moves than have been seen of late before the Fed would consider taking a pause on its current 25bps-per-quarter pace of rate hikes. The mechanism for that to happen will be a stronger dollar and any associated impact on U.S. financial markets. However, it must be a very large move (as it was in 2015/16) to have enough of a negative impact on the U.S. economy, U.S. corporate profits or U.S. inflation for financial markets, and the Fed, to take notice. In Chart 9, we show the U.S. trade-weighted dollar with three different scenarios for the change in the currency to the end of 2018: flat, up 5% and up 10%. We show the dollar in level terms in the top panel, while showing the year-over-year growth rate of the dollar (on an inverted scale) in the bottom three panels. In those last three panels, we also show the potential areas where a strong dollar would impact the U.S. economy the most: net exports, corporate profit growth from earnings earned outside the U.S. (using top-down profit data) and headline inflation. Chart 82015/16 Revisited? Not Yet Chart 9A Much Stronger USD Is Needed To Impact U.S. Growth & Inflation The charts show that a 10% rise in the dollar by year-end would likely take enough of a bite out of U.S. growth and inflation for U.S. equity and credit markets to sell off and for the Fed to take a pause on its rate hike plans. A more modest 5% rise in the dollar will have a more muted impact, especially with stronger underlying U.S. growth and inflation pressures than was the case in 2015/16. That latter scenario of a more moderate rise in the dollar would be our most likely scenario - one that would prove to be challenging for U.S. credit market performance. The dollar increase would be enough to keep EM financial markets on the defensive, but would not be large enough to get Fed rate hikes out of the way and allow for a big decline in Treasury yields that would help support risk assets. A slowly rising dollar is another reason to reduce credit exposure in fixed income portfolios. 4. Central bank liquidity provision through asset purchases is slowing rapidly One of our major themes for 2018 has been that the removal of the extraordinary liquidity expansion by central banks would weigh on asset returns. This would occur through the Fed allowing maturing bonds accumulated during its QE program to begin running off its balance sheet, and through a slower pace of bond buying in the case of the European Central Bank (ECB) and the Bank of Japan (BoJ). Already, the increase in developed market bond yields, and the lowering of returns in global equities and credit, have largely followed the path laid out by our indicator of central bank liquidity provision - the annual growth in the balance sheets of the Fed, ECB, BoJ and Bank of England (Chart 10). Our central bank liquidity indicator suggests that there is still more upside for global government bond yields as central banks become less directly active in bond markets. At the same time, the diminished liquidity growth means there is less investor money to be forced out of risk-free government bonds into risky assets like corporate credit, which should help erode credit market returns on the margin. This will occur through reduced inflows into credit that are just chasing yield, and a return to more fundamental drivers of credit market valuation like growth, inflation, leverage and downgrade/default risks - all of which are now on the rise in the U.S. Bottom Line: The clash between monetary policy and the markets that we have been expecting to unfold in 2018 is upon us. Tightening monetary policies, rising bond yields, slowing global growth, widening growth divergences, increasing U.S. inflation pressures, a strengthening U.S. dollar, emerging market instability, diminished central bank liquidity, reduced global capital flows, global trade tensions - all are now creating a backdrop that is more challenging for risk assets. Downgrade global spread product exposure to neutral (3 of 5) from overweight, and raise government bond exposure to neutral. Maintain a below-benchmark portfolio duration, however, as global bond yields have not yet peaked for this cycle. Asset Allocation Decisions To Be Made So in terms of our fixed income asset allocation recommendations, but in our strategic tables on page 16 and our model bond portfolio on page 15, we are making the following changes: Downgrade U.S. Investment Grade & High-Yield Corporates To Neutral (3 out of 5) The bulk of our primary indicators for U.S. credit are at levels that are consistent with a neutral allocation (Chart 11). Our top-down Corporate Health Monitor is right at the line dividing the deteriorating health and improving health regimes (although this is only because of a cyclical improvement in some of the underlying indicators). U.S. monetary policy is close to neutral, as measured by the real fed funds rate versus the Fed's r-star estimate. The U.S. Treasury curve is very flat, although it is not yet inverted as typically precedes the end of a credit cycle. Finally, bank lending standards are only modestly in "net easing" territory according to the Fed's senior loan officer survey. Chart 10Fading Impact Of Global QE On Bond Markets Chart 11Downgrade U.S. IG & HY Corporates To Neutral With all these indicators hovering around neutral levels, a neutral allocation to U.S. corporates seems justified. Additionally, we recommend cutting across all credit tiers for both investment grade and high-yield, rather than focusing on cutting a specific tier more than another. Our preferred valuation metric - the 12-month breakeven spread relative to its history - is near the bottom quartile for all credit tiers (Charts 12 & 13) without one looking particularly more expensive than the others. Chart 12Not Much Of A Spread Cushion In U.S. Investment Grade ... Chart 13... Or U.S. High-Yield Keep Euro Area Investment Grade & High-Yield At Underweight (2 out of 5) We have maintained this strategic view based on the convergence between our top-down Corporate Health Monitors for both the U.S. and euro area. Right now, the cyclical improvement in U.S. financial metrics has come at the same time as a cyclical deterioration of euro area metrics from very healthy levels (Chart 14). The spread between the two Monitors has proven to be a good directional indicator for the relative performance between U.S. and euro area credit. That spread continues to point to additional expected outperformance by U.S. corporates, even in an overall more challenging environment for global credit markets. Throw in increased Italian political turmoil, softer euro area growth and the upcoming ECB tapering of its asset purchases - which will include corporate debt that the ECB has been buying steadily for the past three years - and the case for underweighting euro area corporates, especially versus U.S. equivalents, is a strong one. Downgrade EM Hard Currency Sovereign & Corporate Debt To Maximum Underweight (1 out of 5) We have been favoring U.S. investment grade credit over EM credit the past several months. The growth divergence between the U.S. and EM has been widening, while EM market valuations had gotten very rich. Now, EM spread widening is starting to correct that mis-valuation, although is still early in the process. The spread differential between U.S and EM credit is a good leading indicator of the relative returns between the two asset classes (Chart 15), thus last year's EM outperformance is leading to this year's underperformance. Chart 14Stay Underweight Euro Area Corporates Chart 15Move To Maximum Underweight EM Credit We wish to maintain the same "two notch" gap between our recommended level of U.S. and EM credit exposure, so by downgrading U.S. corporates to neutral (3 of 5), we must downgrade EM corporates to maximum underweight (1 of 5). All of the above changes will be reflected in our model bond portfolio on page 15. One final point - we should lay out the case for out next move from here. If the Fed tightening cycle goes as we envision it will, with U.S. growth staying strong and inflation expectations rising back to levels consistent with the Fed's inflation target, then we expect the next move will be to downgrade U.S. corporates to underweight. However, if there is enough of a market setback to cause the Fed to delay its rate hike cycle, as was the case in 2016, then we may consider moving back to overweight U.S. corporates on a tactical basis. We suspect, however, that the moves today are the beginning of the end game for the current credit cycle - the negatives for corporates are now outweighing the positives, and that gap is likely to get wider in the coming months. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 19th 2018, available at gis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "2018 Key Views: BCA's Outlook & What It Means For Global Fixed Income Markets", dated December 5th 2017, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "The Global Growth Upturn Has Legs: Reduce Duration, Upgrade Credit Exposure", dated January 31st 2017, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

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 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 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... 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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... Chart 4...A Slightly Longer Lead Time Since 2010 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 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 ... Chart 7... And When Markets Are Backwardated 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 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

Special Report

Highlights China's crude oil inventories - both strategic and commercial - have skyrocketed in recent years. This has entirely offset the decline in OECD commercial crude oil inventories. China's crude oil import growth is likely to average mid-single digit territory over the coming 18-24 months with risks of falling toward zero for several months. This is in sharp contrast to the average double-digit growth rate that prevailed during 2015-2017. Chinese crude oil inventories will rise much more slowly and a period of modest de-stocking in commercial crude inventories in China cannot be ruled out. Chinese crude oil final consumption growth is tempering alongside slowing growth in almost all major petroleum products demand. Both transportation and industrial consumption growth of petroleum products is showing considerable weakness. The investment implication is that Chinese oil demand and especially imports of crude oil will likely be much less supportive of oil prices in the coming two years than they have been in recent years.1 Feature The common narrative in the global investment community of late attributes the oil price rally since 2016 to the decline in OECD crude oil inventories. Yet, the OECD countries do not include China and many other developing nations. This report looks to shed light on China's impact on the oil market with respect to demand, output and inventories. The most revealing part of our assessment is that China's crude oil inventories have skyrocketed in recent years, which in turn have offset the decline in OECD commercial crude oil inventories. The top panel of Chart I-1 illustrates that when China's crude oil inventories are added to the OECD measure, the aggregate of global crude inventories is currently still near a record high. Chinese crude oil inventories have surged from 470 million barrels in 2014 to more than 1 billion barrels presently (Chart I-1, bottom panel). In brief, China has been importing much more oil than it has been consuming since the middle of 2014, when crude prices began to collapse (Chart I-2). In other words, the massive inventory accumulation has been a major force behind the double-digit growth in China's crude imports. Chart I-1Be Aware Of High Chinese Crude Oil Inventories Chart I-2China: Importing More Oil Than Consuming The key question for investors is: Will China maintain strong crude oil imports growth going forward? Having examined China's demand, output, and inventory dynamics, we conclude that the recent deceleration in Chinese crude oil import growth (to 5-6%) has been driven by legitimate fundamentals. Crude import growth is likely to average mid-single digit territory over the coming 18-24 months with risks of falling toward zero for several months. This is in sharp contrast to the average double-digit growth rate that prevailed during 2015-2017 (Chart I-3).2 Chart I-3Chinese Oil Imports Growth: ##br##No More Double Digits This suggests that China will be much less supportive of global oil prices in the coming year or two than it has been in recent years, a fact that may also weigh more generally on global investor sentiment towards China. A Clearer Picture Of Global Oil Inventories In Chart I-1, our calculation showed a massive buildup of China's crude oil inventories over the past three years, reaching a record high of 1,030 million barrels as of May 2018. Below we answer four questions about China's inventories: Why are China's oil inventories significant for investors? How did we calculate a timely monthly oil inventory estimate for China? How can investors judge the validity of our approach? What is the outlook for strategic and commercial inventory accumulation over the coming year? Why are China's oil inventories significant for investors? The following suggest that without China's oil inventory build-up, oil prices would not have rallied as much as they have over the past two years. In other words, China has been a major force pushing oil prices higher: Mainly due to the significant inventory buildup, the increase in Chinese oil imports has been bigger than the increase in global oil production in both 2016 and 2017, which are clearly different from previous years (Chart I-4, top panel). The 490 million-barrel increase in Chinese crude oil inventories over 2015-2017 alone mopped up 35% global oil production increase. While OECD commercial crude oil reserves have declined 275 million barrels from their July 2016 peak to May 2018, Chinese crude inventories have actually risen by 380 million barrels over the same period. As of May 2018, Chinese crude oil inventory levels had already risen to 36% of OECD total commercial crude oil inventories (Chart I-4, bottom panel). How did we calculate a timely monthly oil inventory estimate for China? Our Chinese crude oil inventory proxy was constructed based on the crude oil flow diagram shown in Chart I-5. Chart I-4China Has Been A Major Force For Oil Price Rally Chart I-5How We Derived Our Chinese Crude Oil Inventory Proxy? Total crude oil supply in China equals to the sum of crude oil net imports and domestic crude oil production. The crude oil available for demand is either for final consumption without any transformation, which in general only accounts for about 1-2% of total supply, or used in refineries to be transformed into petroleum products. The latter typically accounts for over 90% of total supply. The remaining unused crude oil is stored as either Strategic Petroleum Reserves (SPR) or Commercial Petroleum Reserves (CPR). Therefore, by deducting the crude oil consumed in the refining process from the total supply of crude oil, we derived the flow of inventory - the level of changes of inventory.3 By using the cumulative value of the flow inventory data, we were able to derive the stock of inventory. Here we assume the initial inventory in 2006 was zero. This assumption is reasonable as the first fill of the SPR was in 2007 and the stock of CPR was extremely low compared to current levels. Hence, any error in this calculation is reasonably minute. Chart I-2 on page 2 clearly shows that crude oil supply growth is much faster than the growth of domestic crude oil consumption, resulting in rising domestic crude oil inventories. In the meantime, Chart I-6 illustrates that most of the increase in China's crude oil imports have indeed been due to the massive build-up in domestic crude oil inventories - not growth in final demand. Chart I-6Significant Inventory Buildup Has Driven Up ##br##Chinese Crude Oil Imports Regarding the data, there is a technical question to clarify: Does the NBS data of crude oil consumed in the refining process cover all Chinese refineries? We believe so. The data always cover both state-owned refineries and large and medium non-state-owned refineries. The only question is whether the crude oil used in small refineries - which have capacity of 2 million tons per year or lower - are accounted for in the NBS data on the amount crude oil refined. According to NBS, the data is collected from refineries with annual main business income of RMB20 million and above. In China, all refineries have much higher revenue than RMB20 million. Even for a small refinery with capacity of 2 million tons per year, its annual main business income is considerably above this threshold. For example, at the end of 2013, there were 49 local refining enterprises in Shandong province, with total main business income of RMB 336 billion. This means on average one refining company in Shandong can generate about RMB 7 billion - significantly higher than the RMB20 million threshold. Investors should note that Shandong province has the most local refineries and owns the largest local refining capacity in China among all provinces. Since 2015 the government has also implemented supply reforms in the oil refinery sector, having shut down or upgraded outdated refining facilities with capacity of 2 million tons per year or lower. Therefore, the amount of crude oil used in the small refineries that is not captured by NBS statistics, if any, is insignificant. In addition, increasingly stringent environmental policies, intensifying domestic competition and rising requirements for higher-quality petroleum products have all forced many small refineries out of business. In brief, our level of conviction in our crude oil inventory estimate for China is high. How can investors judge the validity of our approach? Official Chinese oil inventory data does exist: the NBS publishes a yearly series of annual changes in domestic crude oil inventories. But the significance of our inventory estimate is that it is available with far greater frequency and timeliness than the official data, and a simple comparison of our proxy with the official data for crude oil inventories shows similar size and variations (Chart I-7). Hence, our inventory calculation provides investors with a timely monthly estimate of Chinese oil inventories that is consistent with official data. Chart I-7Validity Check: Our Inventory ##br##Proxy Vs. NBS Data What is the outlook for strategic and commercial inventory accumulation over the coming year? As of this past May, China had 290 million barrels of SPR and 740 million barrels of CPR. Looking forward, the pace of SPR accumulation will be significantly slower than the previous several years. Back in 2004, the government planned three phases of SPR construction. The first phase has long been completed, and was filled in before 2010. The completion of construction of the second phase of SPR was delayed from 2015 to last year. So far, the government has released little information about the third phase of SPR construction. Total capacity from the first two phases is 40 million tons: 12 million tons from the first phase and 28 million tons from the second phase. The NBS last December released Chinese crude oil SPR inventory data, which was at 37.73 million tons (277 million barrels) as of June 2017. We believe the second phase of the SPR was completed in the past 10 months, and that there is not much free SPR space left at the moment. The third phase has the same capacity (28 million tons, or about 200 million barrels) as the second phase. Given that in both first and second phases it has taken more than two years to select and construct the SPR sites, the fill of the third phase of the SPR will unlikely occur within the next two years. The CPR has been rising much faster than the SPR due to low oil prices and the government's policy of allowing local refineries to import crude oil starting in 2015. In the past three years, CPR accumulation accounted for about 80% of China's total crude oil inventory increase. This makes sense, as commercial crude oil users have much larger physical reserve space than the SPR. Also, both commercial users and the government would have taken advantage of previously low oil prices to import as much as they could during the past several years. This is in line with China's strategy of building commodities inventories when prices drop. Back in 2009-2010, when oil prices were low, China also significantly boosted its purchases of crude oil overseas to build up domestic crude oil inventories. As China will continue with its domestic refinery capacity expansion, we still expect further accumulation in the country's CPR, albeit at a much slower pace. That said, a brief period of modest de-stocking in commercial inventories of crude oil cannot be ruled out either. Current Chinese crude oil inventories (CPR and SPR combined) are no longer low (Chart I-8). They are equivalent to 123 days of crude oil net imports - much higher than the 90 days the IEA requires OECD countries to hold. Chart I-8Chinese Crude Oil Inventories: No Longer Low With Brent oil prices rising above $75 per barrel and elevated domestic crude oil inventories, both government and commercial users will likely slow their purchases of overseas oil for inventory accumulation. Tightening credit supply also will hinder companies' ability and willingness to finance more inventory accumulation. This might cause even a brief period of de-stocking in commercial inventories of crude oil. Bottom Line: After a massive buildup over the past three years, further inventory accumulation for both the SPR and CPR will slow considerably and in fact a period of modest de-stocking in commercial crude inventories in China cannot be ruled out. As a result, Chinese oil imports will converge to the pace of final demand growth. Tempering Final Oil Demand Growth In addition to our view that Chinese oil inventory accumulation will slow significantly and even could halt for several months, China's final oil demand growth is also trending lower (Chart I-9). As China's economic structure has been shifting from exports and investments to consumer spending, its energy intensity has declined. Petroleum products consumption within industry (mining, manufacturing and electricity generation) posted the biggest decline on record in the past decade, while consumption in transport service and residential posted the largest gains (Chart I-10, top panel). In 2016, the transport service and residential sectors (car driving and cooking and heating) together accounted for 83% of the increase in Chinese total petroleum products consumption (Chart I-10, bottom panel). Chart I-9Slowing China's Oil Consumption Growth Chart I-10Drivers Of Chinese Oil Consumption Growth In terms of types of petroleum products, this economic shift has translated into higher growth in gasoline, kerosene and LPG consumption, and lower growth in diesel fuel and fuel oil consumption. Gasoline and kerosene are mainly consumed as fuel for passenger cars and airplanes, respectively. LPG is also widely used for residential heating and cooking fuel. By comparison, diesel fuel and fuel oil are more used in the industrial process, even though diesel is also a major fuel for commercial trucks and special vehicles. As a result, gasoline, kerosene and LPG have experienced a rising share of total Chinese petroleum consumption, while diesel and fuel oil and other products have drifted lower (Chart I-11). Looking forward, we still expect positive growth in Chinese petroleum products consumption, but expect it to fall from 4-5% to 3-4% over the next two years. Chinese car sales growth will remain weak at 1-2% in the coming years as rising car ownership, advanced public transportation and high frequency of traffic jams temper car sales growth (Chart I-12). Chart I-11Chinese Oil Products As Share Of Total ##br##Oil Consumption: Gains And Losses Chart I-12Weak Car Sales Growth Some government policies are discouraging residents from owning a car. For example, Beijing car buyers are required to obtain a license plate through a random draw before they can actually drive their car. The odds of obtaining a plate in Beijing as of this past February stood at an astonishingly low 1 in 1,907 - twice as low as the end of last year (1 in 800) and the lowest since the license plate lottery was introduced in January 2011. In Shanghai and Shenzhen, it costs more than $14,000 to get a new car license plate, and the success rate of bidding keeps declining. Meanwhile, the authorities' priority is to move to ecologically friendly vehicles. The government has been using sale tax discounts to promote sales of small-engine cars with engines up to 1.6L from 2008 to 2017. As a result, among existing cars and new car sales, passenger cars with capacity under 1.6L account for over 55% of total cars (Chart I-13). The government also encourages new energy vehicle (NEV) sales through direct cash subsidies, tax subsidies and easier access to a new car plate. With the government's support, we expect NEV sales growth to remain high (Chart I-14). NEV sales reached 770 thousand units last year, and accumulated sales will rise to 5 million units by 2020. Chart I-13Government Promotes ##br##Ecologically Friendly Vehicles Chart I-14Strong Growth of New Energy ##br##Vehicle Sales Will Continue In addition, the government is aiming to improve the average passenger car's fuel efficiency from 6.7L/100KM to 5L/100KM in 2020 and further to 4L/100KM in 2025. This means a 25% reduction in fuel consumption for driving 100KM over the next two years, and another 20% reduction from 2020 to 2025. Fuel efficiency improvement has been limited in the past several years as gas-guzzling SUVs have dominated sales. The government could increase its policy enforcement to facilitate the improvement in fuel efficiency over the next 12-18 months as we move closer to 2020. China has also started promoting ethanol consumption in transportation fuel to substitute gasoline to some extent. The industrial sector will continue to slow, which will lead to lower diesel and fuel oil demand. Bottom Line: Chinese organic oil demand growth is on a weakening path. Improving Chinese Crude Oil Production After accounting for inventory accumulation and underlying demand growth, production is the final aspect to consider when analyzing China's impact on the market for oil. The big contraction in Chinese crude oil production - a 6.9% drop in 2016 and a 4.1% decline last year - has contributed to 33% and 22% of Chinese net imports growth in 2016 and 2017, respectively (Chart I-15). Chart I-15Chinese Crude Oil Production ##br##Will Likely Improve Aging fields and oil prices below break-even production costs are the main culprits behind shrinking output. We expect Chinese crude oil output to recover over the next 12-18 months. As China has a crude oil production target of a minimum of 200 million tons in 2020, the country has to boost its output by 4.4% over the next two years. Odds are high that Chinese crude oil output may at least stop falling this year. Petro China has produced 1.38 million tons of crude oil in Xinjiang in the past two years and plans to raise its output from the region to 6 million tons, in accordance with the country's 13th five-year development plan (2016-2020). Rising oil prices may help recover some production losses. In 2016, some high-cost and low-efficiency production in the Shengli oilfield was shut down. In that year, the Xinjiang oilfield also cut 700 thousand tons of production. Oil majors such as PetroChina and CNOOC are ramping up their upstream exploration efforts. Bottom Line: Chinese crude oil output is likely to recover over the next 12-18 months. Investment Conclusions The major investment implication from the above analysis is that Chinese oil demand and imports will be much less supportive for global oil prices in the coming two years than they have been in recent years. Chart I-16Crude Oil: Still Near-Record ##br##High Speculative Positions From the perspective of BCA's China Investment Strategy service, this reality may weigh on global investor sentiment towards China given the prominence that many market participants place on China's commodity demand when judging its contribution to global economic activity. BCA's China team downgraded Chinese ex-tech stocks versus their global peers to neutral from overweight in yesterday's Special Alert,4 and our conclusions in this report support that recommendation. From the perspective of BCA's Emerging Markets Strategy service, the "China factor" has probably not been well discounted in the current price of oil, as both net speculative positions and open interest in crude oil recently rose to their highest levels since at least 2000 (Chart I-16). Hence, the Emerging Markets Strategy team believes the risk-reward for oil prices is poor. In comparison, a lot of positive news that has already occurred and is widely known by investors - i.e. OPEC production rationing, U.S. newly re-imposed sanctions on Iran and a further decline in Venezuelan crude oil output - has likely already been fully discounted in current oil prices. In addition, emerging market (EM) ex-China crude oil demand is facing strong headwinds, given that oil prices in many emerging countries in local currency terms have risen substantially and in some cases to new highs (Chart I-17A and Chart I-17B ). Besides, as many of these countries have removed fuel subsidies, local prices will continue to move in tandem with world oil prices. Chart I-17AOil Demand Growth In EM Ex-China: ##br##Facing Strong Headwinds Chart I-17BOil Demand Growth In EM Ex-China: ##br##Facing Strong Headwinds The combination of both high local currency oil prices and fuel subsidies removals entails that consumers in many developing countries are already feeling the pain from higher oil prices, and their demand will slow. EM ex-China accounts for 45.3% of global oil consumption. Hence, weakness in EM demand from EM ex-China will not be inconsequential for oil prices. Ellen JingYuan He, Associate Vice President Frontier Markets Strategy EllenJ@bcaresearch.com 1 This view differs from BCA's Commodities and Energy Strategy team's view on oil that is bullish. 2 Our research suggests that China's net exports of petroleum products will likely continue to rise strongly and require even more crude oil imports. However, the increase of Chinese crude oil imports for rising net petroleum products will not affect total global crude oil demand as its final oil products will just be consumed outside of China. Hence, it is about shifts in market share of refineries not oil final demand. 3 This is also adjusted for final consumption of crude oil without refining. This use of crude oil account for only 1-2% of total crude oil supply (output plus net imports). 4 Please see China Investment Strategy Special Alert "Downgrade Chinese Stocks To Neutral," dated June 20, 2018, available on cis.bcaresearch.com

Special Report

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