Financial Markets

Special Report

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

Highlights We have downgraded our 12-month recommendation on global equities and credit from overweight to neutral. If macro developments evolve as expected, then we will shift to an outright bearish stance on risk assets later this year or early 2019 in anticipation of a global recession in 2020. BCA has identified ten periods since 1950 when U.S. equities moved sideways for at least five months in a narrow range; when the economy is at full employment, stocks are more likely to sell off after these sideways periods than if there is still some slack in the labor market. Feature The outlook for global risk assets will likely be more challenging in the coming months. With that in mind, we have downgraded our 12-month recommendation on global equities and credit from overweight to neutral. BCA still expects that the U.S. stock-to-bond ratio will grind higher in the next 12 months, as U.S. stocks move sideways and Treasury yields climb (Chart 1A and 1B). We recommend that investors put the proceeds from the sale of equity positions into cash. Chart 1AScenarios For Stock-To-Bond Ratio ##br##If 10-Year Treasury Hits 3.80% Chart 1BScenarios For Stock-To-Bond Ratio ##br##If 10-Year Treasury Hits 3.29% Within a fixed-income only portfolio, we are selling credit and putting the proceeds into Treasuries. We maintain our underweight duration stance given our view of the Fed and the 10-year Treasury. At 2.91%, the 10-year is still below BCA's view of fair value (3.29%). Moreover, BCA's position is that the Fed's gradual path of rate hikes is consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%, well above current levels.1 On the credit side, we note that late in the cycle the yield curve is moderately flat, between 0 and 50 bps. Work by our U.S. Bond Strategy team2 shows that periods when the curve is flat are consistent with much lower excess returns than when the slope is above 50 bps (Chart 2). Given the low potential reward, a neutral posture on credit makes the most sense. Investors will not give up too much by starting to downgrade early. Tomorrow's U.S. Bond Strategy report will provide more details on the corporates versus Treasuries allocation. Chart 2Corporate Bond Performance And The Yield Curve BCA has recommended overweight positions in U.S. risk assets since spring 2009 when equities became attractive from a risk/reward perspective. At that time, the U.S. economy was weak, the Fed was easing, equity valuations were depressed and forward earnings estimates were dismal (Chart 3). In contrast, the risk/reward for risk assets today is much less attractive. The economy is in the late stages of an expansion and is running beyond full employment. The central bank is raising rates. Moreover, equity valuations are elevated and forward earnings estimates are at their most optimistic in 20 years (Chart 3 again). This means that good news is already priced into the equity market. When the Shiller PE, a measure of the market's valuation, is between 30 and 40, 1-year returns are tepid at best (Chart 4). Chart 3Five-Year Bottom-Up EPS Growth Estimates Are Impossibly High Chart 4Expected Returns Given Starting Point Shiller P/E We are not trimming exposure to risk assets because we are more concerned about the economic outlook. BCA's view is that odds of a U.S. recession in the next 12 months remain low. Furthermore, the traditional recession signals that we track do not suggest a recession is nigh (Chart 5). For example, the 2/10 yield curve is still positive at 34 basis points (panel 2). Upward movement in long-dated breakevens will offset some of the upward pressure at the front-end from further Fed rate hikes, limiting the amount of curve flattening during the next few months. Once long-dated breakevens get back to a range between 2.3% and 2.5% then flattening could proceed more rapidly.3 Panel 3 shows that the LEI crosses below zero when a recession is imminent. The May LEI rose by 6% year-over-year. Initial claims for unemployment insurance in the week ending June 16 were 24K below their mid-December 2017 reading. Panel 4 shows that a 6-month increase in unemployment claims of between 75,000 and 100,000 is associated with a recession. The bottom line is that we are not concerned about a recession. Nonetheless, BCA's Equity Scorecard has dropped to 2, below the critical value of three that has been consistent in the past with positive equity returns (not shown). Table 1 updates our Exit Checklist of items that are important for the equity allocation call. Three of the nine are now giving a 'sell' signal and they suggest that prudence is necessary, despite the constructive economic outlook. Chart 5No Recession Signal Here Table 1Exit Checklist For Risk Assets Furthermore, several technical indicators that we monitor signal caution. The National Association of Active Investment Managers (NAAIM) says that active managers have increased equity risk since the start of the year (Chart 6). At 89%, the average equity exposure of institutional investors is close to the cycle high reached in March 2017, which was the highest since 2007, just before the S&P 500 peak in October 2007. Furthermore, BCA's Equity Speculation Index remains elevated. At slightly under 2, it is at a position where bear markets began in 2000 and 2007, and it is well above the level seen just before the 2015 bear market (Chart 7, panel 1). That said, not all technical indicators are flashing red. Chart 8 shows that BCA's Technical Indicator is not at an extreme (panel 1). Moreover, BCA's Equity Sentiment Composite Index is neutral (panel 2); panel 3 shows that the U.S. large cap equities remain in the middle of their 2009-2018 recovery channel, albeit in the top half of the channel. Note that the S&P 500 tested the top end of the channel (near 2850) in January 2018. Chart 6Active Managers Have Increased ##br##Equity Exposure This Year Chart 7Equity Speculation Is Elevated Chart 8Not All Technical Indicators Are Bearish The risk to our neutral stance on equities is that credit and equities will rally to fresh highs before the cycle is done. However, given our bias for capital preservation and views on the late stage of the business cycle, it is not advisable to reach for the last few drops of return. With equity valuations stretched, we would rather be early and judicious and miss out on the last few basis points of outperformance rather than be late and underperform as risk assets sell off. BCA's view is that the next recession will be sparked by the Fed overtightening in 2019 and 2020 when it finds itself behind the curve on inflation. Moreover, because inflation is at the Fed's 2% target and the economy is beyond full employment, the price at which the Fed's "policy put" gets exercised is much lower than earlier in the cycle. The implication is that the Fed will be reluctant to deviate from its tightening path even in the face of more turmoil in the EM space or in Europe. This supports our guarded view on equities and our decision to move into cash instead of Treasuries. Geopolitical risk is another reason to be cautious. Chart 9 shows that globalization, a tailwind for risk assets, is stalling. Moreover, there is an increased threat of a breakup in the Eurozone, led by political uncertainty in Italy (Chart 10). In addition, tensions with Iran are mounting. Nonetheless, our Geopolitical Strategy service notes that the U.S.'s relationship with China is the primary source of geopolitical peril (Chart 11).4 Although we are not adjusting our view on the dollar,5 a stronger greenback would bolster our case for caution on risk assets. A higher dollar would hurt the profits of U.S. multinationals and could lead to instability in the emerging markets, raising the odds of a policy misstep. Chart 9Globalization Has Reached Its Zenith Chart 10Risk Of Eurozone Breakup Is Rising Chart 11BCA's Geopolitical Power Index Illustrates A Multipolar World Equity volatility will accelerate through year end, as is often the case late in equity bull markets. Bottom Line: If macro developments evolve as expected, then we will shift to an outright bearish stance on risk assets later this year or early 2019 in anticipation of a global recession in 2020. Absent a recession, we would move to underweight stocks if a wider trade war develops. We would consider temporarily shifting our 12-month recommendation back to overweight if global equities sell off by more than 15% in the next few months, especially if our economic indicators remain constructive and the Fed either cuts rates or signals that it is on hold. Treading Water BCA has identified ten periods since 1950 when U.S. equities moved sideways for at least five months in a narrow range (See Appendix Charts 1 and 2).6 We excluded bear markets and recessions from our analysis because our view is that neither condition will occur in the next 12 months. Table 2 shows that these sideways episodes lasted an average of eight months. At the end of six of the ten intervals, U.S. large cap equities rallied (1986, 1988, 1992, 1997-1998, 2004, and 2015); after two phases, stocks recovered briefly and then sold off (1951-52 and 1972). At the conclusion of the 1991 episode, stocks rallied and then resumed moving sideways. Stocks sold off after the eight-month sideways phase in 1976. Table 2What Happens After Stocks Move Sideways? Four (1951-52, 1972, 1988, 1997-98) of the ten sideways periods occurred after the U.S. economy reached full employment. The 10 year Treasury yield increased as stocks moved sideways in 1972 and in 1988, but fell in the 1997-98 episode. The S&P 500 PE ratio increased in two sideways phases (1972 and 1997-98) and contracted in 1988. S&P 500 EPS growth accelerated in 1972, 1988 and 1997-98 phases. The S&P 500 rallied after the sideways episodes in 1988 and 1997-98, but sold off after the 1951-52 and 1972 sideways phases that occurred after the economy hit full employment (Chart 12). Chart 12S&P 500 Valuations, EPS Growth, Margins And The 10-Year Treasury Yield When Stocks Move Sideways As the S&P 500 moved sideways when the economy was not yet at full employment (1976, 1986, 1991, 1992, 2004 and 2015), 10-year Treasury yields fell four times (1976, 1986, 1991 and 1992) and rose in two (2004 and 2015). The forward PE ratio for the S&P 500 expanded in 1986 and 1992, but contracted in 1991, 2004 and 2015. EPS growth during sideways episodes for stocks when the economy was not yet at full employment is mixed. EPS growth accelerated in 1976, 1992 and 2004, but slowed in 1986, 1991 and 2015 as oil prices fell. U.S. large cap equities rallied after four of the sideways periods when the economy was not yet at full employment (1986, 1992, 2004 and 2015) but sold off after the 1976 sideways move (Chart 12 again). We intend to further examine the macro backdrop during sideways periods for U.S. equities in future Weekly Reports. Bottom Line: BCA expects bond yields to rise in the next 12 months and S&P 500 profit growth will peak. Stocks are more likely to move higher after a period of sideways price action if the economy is not at full employment. Rising PE ratios as stocks move sideways most often lead to equity rallies after the sideways phases end. With valuations already elevated, PEs are unlikely to expand much further in this cycle. Moreover, the U.S. economy reached full employment in early 2017, making it less likely that the Fed will hit the pause button on its rate hike regime. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's U.S. Bond Strategy Weekly Report, "Bond Bear Still In Tact," published June 5, 2018. Available at usbs.bcaresearch.com. 2 Please see BCA's U.S. Bond Strategy Weekly Report, "As Good as It Gets For Corporate Debt," published April 24, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA's U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty," published June 19, 2018. Available at usbs.bcaresearch.com. 4 Please see BCA's Geopolitical Strategy "Are You Sick of Winning Yet," published June 20, 2018. Available at gps.bcaresearch.com. 5 Please see BCA Research's Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," published June 20, 2018. Available at gis.bcaresearch.com. 6 There are well-established periods for bull and bear markets for U.S. equities, however not for "sideways" episodes for stocks. We have defined "sideways" as a period of range-bound equity price movements that have lasted for at least five months outside of recessions and bear markets. Readers may have other definitions of "sideways". APPENDIX CHARTS Chart 1Sideways Epsisodes For Stocks 1950-1980... Chart 2..And 1980-2018

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

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

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

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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

Special Report

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

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 ##br##Push 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