Financial Markets

Special Report

Highlights Uncovered Interest Rate Parity still works for currencies. However, it needs to be based on a combination of short- and long-term real rates. Currencies are also affected by global risk appetite, as approximated by corporate spreads and commodity prices. For the next six months, the euro has additional downside, while the dollar's rebound could run further. The CAD also looks attractive. Feature In July 2016, in a Special Report titled, "In Search Of A Lost Timing Model," we introduced a set of intermediate-term models to complement our long-term fair value models for various currencies.1 These groups of models provide additional discipline - a sanity check if you will - to our regular analysis. Additionally, these models can help global equity investors manage their currency exposure, having increased the Sharpe ratio of global equity portfolios vis-à-vis other hedging strategies, and also for a host of base-currencies.2 In this report, we review the logic underpinning these intermediate-term models and provide commentary on their most recent readings for the G10 currencies vis-à-vis the USD. UIP, Revisited The Uncovered Interest Rate Parity (UIP) relationship is at the core of this modeling exercise. This theory suggests that an equilibrium exchange rate is the one that will make an investor indifferent between holding the bonds of Country A or Country B. This means that as interest rates rise in Country A relative to Country B, the currency of Country B will fall today in order to appreciate in the future. These higher expected returns are what will drive investors to hold the lower-yielding bonds of Country B. Chart 1Interest Rate Parity: ##br##Generally Helpful, But... There has long been debate as to whether investors should focus on short rates or long rates when looking at exchange rates through the prism of UIP. This debate has regained vigor in the past six months as the dollar has greatly lagged the levels implied by 2-year rate differentials (Chart 1). Research by the Federal Reserve and the IMF suggests incorporating longer-term rates to UIP models increase their accuracy.3 This informational advantage works whether policy rates are or aren't close to their lower bound.4 Incorporating long-term rates as an explanatory variable increases the performance of UIP models because exchange rate movements do not only reflect current interest rate conditions, but currency market investors also try to anticipate the path of interest rates over many periods. By definition, long-term bonds do just that, as they are based on the expected path of short rates over their maturity - as well as a term premium, which compensates for the uncertain nature of future interest rates. There is another reason why long-term rate differential changes improve the power of UIP models. Since UIP models are based on the concept of indifference of investors between assets in two countries, changes in the spreads between 10-year bonds in these two countries will create more volatility in the currency pair than changes in the spreads between 3-month rates. This is because an equivalent delta in the 10-year spread will have much greater impact on the relative prices of the bonds than on the short-term paper, courtesy of their much more elevated duration. To compensate for these greater changes in prices, the currency does have to overshoot its long-term PPP to a much greater extent to entice investors trading the long end of the curve. Bottom Line: The interest rate parity relationship still constitutes the bedrock of any shorter-term currency fair value model. However, to increase its accuracy, both long-term and short-term rates should be used. Real Rates Really Count Another perennial question regarding exchange rate determination is whether to use nominal or real rate differentials. At a theoretical level, real rates are what matter. Investors can look through the loss of purchasing power created by inflation. Therefore, exchange rates overshoot around real rate differentials, not nominal ones. On a practical level, there are additional reasons to believe that real rates should matter, especially when trying to explain currency moves beyond a few weeks. Indeed, various surveys and studies on models used by forecasters and traders show that FX professionals use purchasing power parity as well as productivity differential concepts when setting their forex forecasts.5 Indeed, as Chart 2 illustrates, real rate differentials have withstood the test of time as an explanatory variable for exchange rate dynamics, albeit with periods where rate differentials and the currency can deviate from one another. It is true that very often, nominal rate differentials can be used as a shorthand for real rate differentials, as both interest rate gaps tend to move together. However, regularly enough, they do not. In countries with very depressed inflation expectations (Japan immediately comes to mind), nominal and real rate differentials can in fact look very different (Chart 3). With the informational cost of incorporating market-based inflation expectations being very low, we find the shorthand unnecessary when building UIP-based models. Chart 2Real Rates Work Better Over The Long Run Chart 3Real And Nominal Rate Spreads Can Differ Finally, it is important to remark that in environments of high inflation, inflation differentials dominate any other factor when it comes to exchange rate determination. However, the currencies discussed in this report currently are not like Zimbabwe or Latin America in the early 1980s. Bottom Line: When considering an intermediate-term fair value model for exchange rates, investors should focus on real, not nominal, long-term rate differentials. Global Risk Aversion And Commodity Prices Chart 4The Dollar Benefits From Global Stresses Global risk appetite is also a key factor in trying to model exchange rates. Risk-aversion shocks tend to lead to an appreciation in the U.S. dollar, which benefits from its status as the global reserve currency.6 Literature has often focused on the use of the VIX as a gauge for global risk appetite. Our exercise shows stronger explanatory power with options-adjusted spreads on junk bonds (Chart 4). Commodity prices, too, play a key role. Historically, commodity prices have displayed a very strong negative correlation with the dollar.7 This correlation is obviously at its strongest for commodity-producing nations, as rising natural resource prices constitute a terms-of-trade shock for them. However, this relationship holds up for the euro as well, something already documented by the European Central Bank.8 The Models The models for each cross rate are built to reflect the insight gleaned above. Each cross is modeled on three variables, with the model computed on a weekly timeframe. Real rates differentials: We use the average of 2-year and 10-year real rates. The rates are deflated using inflation expectations. Global risk appetite, approximated by junk OAS. Commodity prices: We use the Bloomberg Continuous Commodity Index. For all countries, the variables are statistically highly significant and of the expected signs. These models help us understand in which direction the fundamentals are pushing the currency. We refer to these as Fundamental Intermediate-Term Models (FITM). We created a second set of models, based on the variables above, which also include a 52-week moving average for each cross. The real rates differentials, junk spreads and commodity prices remain statistically very significant and of the correct sign. They are therefore trend- and risk-appetite adjusted UIP-deviation models. These models are more useful as timing indicators on a three- to nine-month basis, as their error terms revert to zero much faster. We refer to these as Intermediate-Term Timing Models (ITTM). Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com The U.S. Dollar Chart 5Dollar Back In Line With Fundamentals Chart 6More Upside For Now To model the dollar index (DXY), we used two approaches. In the first one, we took all the deviation from fair value for the pairs constituting the index, based on their weights in the DXY. In the second approach, we ran the model specifically for the DXY, using the three variables described above. U.S. real rates were compared to an average of euro area, Japanese, Canadian, British, Swiss and Swedish real rates, weighted by their contribution to the DXY. We then averaged both approaches, which gave us very similar results to begin with. After a short period when it traded below its FITM, the dollar's recent strength has pushed the greenback back to its equilibrium, suggesting the easy gains are behind us. However, the rising risks in EM along with the continued widening in rate differentials between the U.S. and the rest of the world could put upward pressure on the dollar for a few more months (Chart 5). When the trend in the dollar is included, the greenback also trades in line with the ITTM (Chart 6). This confirms the idea that the dollar could experience some more upside for the remainder of 2018, as periods of undervaluation to the ITTM tend to be followed by overshoots. The return of inflation, along with the injection of large amounts of fiscal stimulus in the U.S., could be the narratives that push the greenback up by another 5%. Despite a positive outlook for 2018, we remain concerned about the dollar's longer-term performance. Not only is it still trading at a 16% premium on a PPP basis, European rates have room to increase substantially once euro area economic slack is fully absorbed. We are not there yet, but continued robust growth in the euro area will let the ECB increase rates more aggressively than the Fed beyond 2020. The Euro Chart 7The Euro Is Not A Bargain Anymore... Chart 8...And Has More Downside Before Year End The FITM for EUR/USD continues to point south, dragged down by widening interest rate differentials in favor of the greenback. However, unlike in early 2017, the euro is no longer trading at a big discount to its fair value (Chart 7). As a result, unlike last year, the euro is not able to avoid the downward gravitational pull of a falling FITM. More worrisome for the euro's performance over the coming six months, EUR/USD is still trading at a premium to its ITTM, which adjusts our FITM by taking account of the euro's trend (Chart 8). Currently, the fair value for EUR/USD stands at 1.15, but the euro tends to undershoot its equilibrium after large overshoots such as when EUR/USD traded around 1.25. Moreover, if China's economic slowdown deepens, commodity prices will suffer, which will drag down both the FITM and the ITTM for the euro. We are not yet willing buyers of the euro at current levels. While we espouse a bearish short-term view on the euro, we will be looking to purchase it once it moves to the 1.15-1.10 range. On longer-term metrics, EUR/USD still trades at a significant discount to its fair value. Moreover, long-term rates could rise in Europe relative to the U.S. once investors begin to lift their expectations for future euro area policy rates more aggressively. As such, we continue to closely monitor the slowdown in both euro area and global growth. Once we see signs of stabilization, the euro should again catch a durable bid. The Yen Chart 9A Dovish BoJ Is Pushing Down ##br##The Yen's Fundamentals Chart 10Tactically, The Yen Is At Risk, But Softening Global ##br##Growth Will Limit Its Downside This Year The FITM for the yen is falling fast, and as a result the JPY cannot rally anymore against the dollar (Chart 9). The ITTM provides a very similar message: the yen still trades at a premium to its short-term equilibrium, and is vulnerable to the dollar's strength (Chart 10). Softness in the yen has materialized despite growing stresses in emerging markets and budding signs of a slowdown in global growth - two normally yen-bullish developments - making it clear that the breakdown between USD/JPY and interest rate differentials could not withstand a period of generalized strength in the dollar. While the yen could weaken against the dollar, it is likely to rally further against the euro. Weakness in global growth is likely to limit the yen's downside to the equilibrium implied by its ITTM. Meanwhile, EUR/USD is likely to undershoot this same equilibrium. This contrast points to further weakness in EUR/JPY. The British Pound Chart 11The Pound Is ##br## At Equilibrium Chart 12GBP/USD May Be Dragged Lower By A Falling ##br## EUR/USD, But Cable Is Less At Risk Than The Euro GBP/USD is in a very different position than EUR/USD. While the pound's FITM points south, driven by interest rate differentials, cable trades below its equilibrium level (Chart 11). For the FITM to move up from this point onward, the U.K. economy needs to stabilize. We do think this will happen as British inflation slows, which will support household real incomes, and thus consumer spending. This message is also confirmed by the fact that unlike EUR/USD, GBP/USD does not trade at a premium to the ITTM, which incorporates the trend in the pair (Chart 12). While investors bid up the pound against the dollar as the greenback weakened in 2017 and early 2018, they are still embedding a risk premium in the GBP, a consequence of the murky political outlook that has shrouded the U.K. ever since the Brexit referendum. The models confirm our analysis of two weeks ago: that the pound could experience some downside against the dollar if the euro were to weaken, but that nonetheless cable will suffer less than EUR/USD.9 As a result, EUR/GBP is likely to experience downside as the correction in EUR/USD unfolds. On a longer-term basis, traditional valuation metrics such as PPP suggest that the GBP remains cheap. However, for this judgment to be true, much will depend on the evolution of the negotiations between the U.K. and the rest of the EU. A British exit from the common market will invalidate the message from PPP models, as the economic relationship between the U.K. and its largest trading partner will change drastically, implying that the models are specified over a sample that is not relevant anymore. However, it remains far from clear what form Brexit will ultimately take. The Canadian Dollar Chart 13NAFTA Risk Premia Evident Here... Chart 14...And Here Not only is the loonie trading well below the levels implied by the FITM, but augmented interest rate differential models for the CAD still point north, suggesting its fundamental drivers are currently very supportive (Chart 13). The ITTM for the Canadian dollar confirms this message; even after adjusting for its trend the CAD still trades at a discount to equilibrium (Chart 14). Both formulations of the models highlight that a risk premium has been embedded into the Canadian dollar, reflecting still-possible hazards and setbacks surrounding NAFTA negotiations. However, BCA expects a benign outcome for Canada in the coming weeks, which should help the loonie down the road. Not only does the absence of a major overhaul to NAFTA imply that trade flows between the U.S. and Canada will avoid a major shock, it also means that the Bank of Canada can resume tightening monetary policy. The biggest risk for the Canadian dollar versus the greenback is global growth. So long as global growth has not stabilized, the CAD will find it hard to rally durably against the USD. As a result, we prefer to buy the CAD versus other currencies, the EUR and AUD in particular. The Swiss Franc Chart 15No Evident Deviation From ##br## Fundamentals In The Franc Chart 16Rising EM Stresses And Better Value Will ##br##Help The Swiss Franc Versus The Euro The FITM for the Swissie continues to move upward (Chart 15). In fact, the franc currently trades at a discount to its ITTM. This suggests that downside for the Swiss franc versus the dollar is limited for the remainder of the year (Chart 16). Since the Swiss franc already trades at a discount to the USD, but the euro does not, logically, the EUR/CHF is currently very pricey. Hence, it will be difficult for the euro to rally further against the franc this year. Moreover, the slowdown in global growth and the trouble facing EM assets and currencies are likely to further contribute to the current deceleration in European economic data. As a result, both short-term valuation metrics and economic considerations argue for selling EUR/CHF on a six-month basis. Longer term, the Swiss franc's strength in recent years has contributed to a sharp deterioration in Swiss competitiveness. Since the Swiss economy is very flexible, this has mostly been translated into strong deflationary pressures in the alpine state. As a result, the Swiss National Bank will continue to fight off any appreciation in the franc, maintaining very easy monetary conditions. Thus, long-term investors should not short EUR/CHF, but instead, they should use any weakness in this cross this year to accumulate larger bets on the long side. The Australian Dollar Chart 17AUD Fundamentals At Risk Chart 18AUD Not Cheap Enough To Flash A Buy Signal The FITM for the Aussie is currently in a holding pattern (Chart 17). Meanwhile, AUD/USD trades at a marginal discount to the trend-augmented version of the model, the ITTM (Chart 18). Do not get lulled into a sense of comfort by these observations. First, AUD/USD never stops a move at the ITTM; it tends to overshoot its equilibrium. In fact, undershoots tends to culminate at an 8% discount to the short-term fair value. Additionally, the global economic environment suggests that both the AUD's FITM and ITTM could experience downside in the coming months. Slowing global activity and budding EM stress weigh on commodity prices - key components of the models. They also weigh on Australian interest rate differentials vis-à-vis the U.S. - especially as the Australian economy is replete with slack - keeping wage pressures, inflationary pressures, and consequently the Reserves Bank of Australia at bay. This picture is in sharp contrast to Canada. Canadian labor market conditions are tight and the BoC is likely to resume its hiking campaign once uncertainty around NAFTA dissipates. Since the CAD trades at a much larger discount to both its FITM and ITTM, the relative economic juncture supports being short AUD/CAD. The New Zealand Dollar Chart 19NZD Weaker Than ##br##Fundamentals Imply Chart 20NZD Is Cheap Enough To Warrant ##br## A Buy Versus The AUD As was the case with the Aussie, the FITM for the kiwi has stabilized (Chart 19). However, unlike with the AUD, the NZD trades at a meaningful discount to the ITTM (Chart 20). The NZD has greatly suffered in response to a deceleration in New Zealand economic data and to investors' worries about the Adern government - a coalition of the left-leaning Labour and populist New Zealand First parties. Investors are especially concerned over limitation to immigration on long-term growth, as well as risks to the Reserve Bank of New Zealand's independence. These concerns are real, and warrant taking a cautious stance on the NZD. New Zealand growth has greatly benefited from decades of a large immigration influx and from a staunchly independent central bank. Moreover, slowing global growth and trade as well as rising EM stresses are also likely to exert downward pressure on the NZD's short-term fair-value estimates. We have been taking advantage of the NZD's discount to its FITM and ITTM by selling the Aussie/kiwi cross. AUD/NZD trades at a premium to its relative ITTM. Moreover, the deceleration in global growth and the stress in EM are likely to exact a greater toll on metals than agricultural prices. This represents a greater negative terms-of-trade shock for Australia than New Zealand. Since Australia displays greater labor market slack than New Zealand, this disinflationary shock will bit the larger of the two economies harder. Therefore, interest rate differentials should move against the AUD, pushing the relative ITTM and FITM down. The Norwegian Krone Chart 21NOK Still A Value Play Among ##br## Commodity Currencies... Chart 22...But It Could Experience Further Downside ##br##Against The Dollar This Year The fundamental model for the Norwegian krone remains in an uptrend, established since the beginning of 2016 (Chart 21). This reflects rallying oil prices, the key determinant of Norwegian terms-of-trade and growth. However, the NOK still trades slightly above its ITTM, its fundamentals adjusted for the trend in the currency pair (Chart 22). Over the next six months, the Norwegian krone could experience further downside versus the USD. Corrections in this pair tends to end when it trades 4% below its ITTM. Additionally, the rise in EM volatility and the great sensitivity of the Norwegian krone to USD fluctuations adds an economic impetus to this risk. Moreover, EUR/USD normally exerts a gravitational pull on the NOK/USD. Since we expects the euro to weaken further, this should drag the krone along for a ride. However, we continue to see downside in EUR/NOK as short-term valuations are not attractive, and as oil is likely to outperform the broad commodity complex. In the longer term, we are positive on the NOK. It is cheap based on long-term models that take into account Norway's stunning net international position of 220% of GDP. Moreover, the high inflation registered between 2015 and 2016 is now over as the pass-through from the weak trade-weighted krone between 2014 and 2015 is gone. This means that the NOK's PPP fair value has stopped deteriorating. The Swedish Krona Chart 23The SEK Has Been Clobbered ##br##Beyond Fundamentals... Chart 24...And Is Becoming Attractive,##br## But Beware The Riskbank The Swedish krona's short-term valuations are attractive. As was the case with the krona, the SEK's FITM remains in an uptrend (Chart 23), and the SEK trades at a sizeable discount to its ITTM (Chart 24). Despite this benign picture, we are reluctant to bet on the SEK. To begin with, the SEK displays the greatest sensitivity to the dollar of all the G-10 currencies; our dollar-bullish stance for the rest of the year thus bodes poorly for the krona, pointing to greater undervaluation ahead. Additionally, despite an economy running 2% above potential GDP, the Riksbank still runs an extremely accommodative monetary policy. In fact, recent communications by the Swedish central bank demonstrate a high degree of comfort with the SEK's weakness. It seems as though Riksbank Governor Stefan Ingves wants to competitively devalue the krona. With global growth softening, the Riksbank is likely to encourage further SEK depreciation as the Swedish business cycle is tightly linked to EM growth. We were long NOK/SEK until two weeks ago, when our target level was hit. While we look to re-open this position, the NOK/SEK currently trades at a small premium to its relative ITTM, and thus the corrective episode could run a few more months. Meanwhile, the relative short-term valuation picture suggests that the recent bout of weakness in EUR/SEK could run a bit further. However, weakening global growth and the Riksbank's dovish proclivities suggest that visibility on this cross remains exceptionally low. 1 Please see Foreign Exchange Strategy / Global Investment Strategy Special Report titled, "Assessing Fair Value In FX Markets", dated February 26, 2018, available at fes.bcaresearch.com and gis.bcaresearch.com. 2 Please see Foreign Exchange Strategy / Global Asset Allocation Special Reports titled, "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors", dated September 29, 2017, and "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors (Part II)", dated October 13, 2017, available at fes.bcaresearch.com and gaa.bcaresearch.com. 3 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori, "U.S. Dollar Dynamics: How Important Are Policy Divergence And FX Risk Premiums?" IMF Working Paper No.16/125 (July 2016); and Michael T. Kiley, "Exchange Rates, Monetary Policy Statements, And Uncovered Interest Parity: Before And After The Zero Lower Bound", Finance and Economics Discussion Series 2013-17, Board of Governors of the Federal Reserve System (January 2013). 4 Michael T. Kiley (January 2013). 5 Please see Yin-Wong Cheung and Menzie David Chinn, "Currency Traders and Exchange Rate Dynamics: A Survey of the U.S. Market", CESifo Working Paper Series No. 251 (February 2000); and David Hauner, Jaewoo Lee, and Hajime Takizawa, "In which exchange rate models do forecasters trust?" IMF Working Paper No.11/116 (May 2010) for revealed preference approach based on published forecasts from Consensus Economics. 6 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori (July 2016) 7 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori (July 2016) 8 Francisco Maeso-Fernandez, Chiara Osbat, and Bernd Schnatz, "Determinants Of The Euro Real Effective Exchange Rate: A BEER/PEER Approach", Working Paper No.85, European Central Bank (November 2001). 9 Please see Foreign Exchange Strategy Special Report titled, "A Long, Strange Cycle", dated May 4, 2018, available at fes.bcaresearch.com. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights So long as EM corporate and sovereign bond yields continue to rise, EM share prices will remain in a downtrend. EM corporate earnings growth has peaked while EM corporate profitability remains structurally weak. We recommend re-establishing a short Brazilian bank stocks position, and to continue shorting the BRL versus the U.S. dollar. Put Malaysian stocks on an upgrade watch list as the elections outcome is a long-term positive. However, its financial markets will likely face meaningful headwinds in the months ahead. Stay short MYR versus the U.S. dollar. Feature Monitoring Market Signals Rising U.S. bond yields are wreaking havoc on EM risk assets. Not only are EM currencies plunging, but sovereign and corporate bond yields are also spiking. In fact, EM share prices always decline when EM corporate and sovereign bond yields rise (Chart I-1). There is less correlation between EM equity and U.S. bond yields. Chart I-1EM Share Prices Always Decline When EM Corporate Bond Yields Rise The basis: So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate bond yields decline and EM share prices rally. But when EM corporate (or sovereign) yields rise, irrespective of whether this is due to rising U.S. Treasury yields or widening EM credit spreads, EM equity prices come under considerable selling pressure. Lately, both EM credit spreads have been widening and U.S. bond yields have been mounting. That said, EM sovereign and corporate credit spreads still remain tight by historical standards, suggesting this asset class is still pricing in little risk. Hence, as EM currencies continue to sell off, EM credit spreads will widen further (Chart I-2). Meanwhile, U.S. government bond yields in our view have more upside: U.S. growth is robust (nominal GDP growth is 5%) and inflationary pressures are heightening. Long-term Treasury yields have risen much less than 2- and 5-year bond yields. Therefore, it is not surprising that a bit of catch-up is now underway. Rising U.S. bond yields will inevitably inflict more damage on EM risk assets. EM share prices are sitting on their 200-day moving average (Chart I-3, top panel). Relative to DM, EM share prices have decisively broken below their 200-day moving average (Chart I-3, bottom panel). Chart I-2Weaker EM Currencies = Wider Credit Spreads Chart I-3A Breakdown In The Making? In addition to widening EM corporate and sovereign bond yields, there are some other market-based indicators that investors should monitor: The ratio of total return (including carry) of commodities currencies relative to safe-haven currencies1 is hovering around 200-day moving average (Chart I-4). A breakdown in this ratio will herald that the rally in EM risk assets is over and a bear market is underway. Chinese offshore and onshore corporate spreads are widening (Chart I-5). This could be the canary in the proverbial coal mine predicting a nascent downturn in Chinese share prices and China-related plays globally. Chart I-4Watch This Market Indicator Chart I-5China' On- And Off-Shore Credit Spreads Finally, investor sentiment on EM equities remains bullish. For example, net long positions of asset managers and leveraged funds in EM stock index futures was still extremely elevated as of May 11th (Chart I-6). Bottom Line: We continue to recommend a bearish stance on EM risk assets in absolute terms and underweighting EM stocks, currencies and credit markets versus their DM counterparts. The list of our recommended fixed-income and currency positions is available on page 19. EM Corporate Profits And Profitability It appears that EM profit growth has topped out, regardless of whether we consider net profits (Chart I-7, top panel), EBITDA or cash earnings2 (Chart I-7, bottom panel). These data are for EM non-financial companies included in the MSCI EM overall equity index. The blue lines are from Datastream's World Scope database, and the dotted lines are from MSCI. Chart I-6Investors Remain Positive On EM Equities Chart I-7EM Corporate Earnings Have Topped Out The last data points for World Scope's net income and EBITDA are as of the end of March 2018, before EM currencies began to plunge. It seems that net income and EBITDA data from World Scope slightly leads the comparable series from MSCI at turning points. This is due to statistical data compilation processes these sources employ. We examine non-financials' corporate profits because EM financials/banks' earnings are often distorted by provisions and other adjustments.3 As a result, they are a poor timing tool for profit cycle turning points. Our negative viewpoint on EM equities is contingent on a significant slowdown, and probably an outright contraction in EM corporate profits in the next 12 months. We have several observations on the EM profit cycle: China's credit plus fiscal spending as well as broad money impulses nicely lead EM corporate profit cycles, and they presently point to an impending cyclical downturn (Chart I-8). As a top-line slowdown transpires, consistent with our expectations, EM profit margins will shrink. If this indeed occurs, EM non-financial profit margins will roll over at levels on par with previous bottoms (Chart I-9). This holds when using both net income and EBITDA. Chart I-8China's Credit Cycle And ##br##EM Non-Financial Profits Chart I-9EM Non-Financials: ##br##Profit Margins Are Still Low The same point is pertinent for return on assets (RoA) of listed EM non-financial companies. Chart I-10 portends two versions of RoA measures using net income and EBITDA. If RoA were to peak now in this cycle - which is our baseline scenario - it would roll over at levels on par with previous bottoms reached in 2002 and 2008. Chart I-10EM Non-Financials: Return On Assets Bottom Line: If our outlook for a considerable slowdown in EM revenue growth this year materializes, EM non-financials' profit margins and RoA will relapse at very low levels - the levels that prevailed at previous cycle lows. Hence, EM corporate profitability remains structurally weak, consistent with our view that there has been little corporate restructuring in recent years. Among EM bourses, we are overweighting Taiwan, Korea, Thailand, India, central Europe, Mexico and Chile. Our underweights are Brazil, Turkey, South Africa, Peru, Malaysia and Indonesia. Brazil: Reinstate Short Bank Stocks Position Brazilian markets have sold off sharply of late. The currency has been the main culprit of the selloff. As we have repeatedly argued in the past, the exchange rate holds the key in Brazil. The country's stocks and local bonds as well as sovereign and corporate credit do well when the currency is strong or stable, and sell off during periods of real depreciation. We expect more downside in the currency, which will lead to escalating selling pressure in equity, credit and probably fixed-income markets. We are therefore reiterating our negative stance on Brazilian financial markets: The pace of real economic activity might be rolling over (Chart I-11A). This is occurring at a time when levels of economic activity are still severely depressed, well below their 2012 peak (Chart I-11B). Chart I-11ABrazil: Signs Of Growth Rollover... Chart I-11B...At Low Levels Business confidence also remains weak amid uncertainty ahead of this fall's presidential elections, which will continue to inhibit hiring and investment. In the meantime, the export sector, which has led growth since 2015, is facing headwinds. Exports in terms of volumes as well as value (U.S. dollars) have decelerated considerably (Chart I-12). As China's growth slows and commodities prices dwindle in the second half of this year, Brazil exports will contract. Nominal GDP growth has relapsed to its 2015 lows - a period when the country's financial markets were rioting (Chart I-13, top panel). Even though economic activity in real terms has rebounded, inflation has plunged resulting in extremely weak nominal income growth. Chart I-12Brazil: Exports Are Slowing Chart I-13Brazil Suffers From Low Inflation The GDP deflator and core consumer price inflation have plummeted to 20-year lows (Chart I-13, bottom panel). As a result, interest rates deflated by inflation - i.e., real interest rates - remain extremely high. Fiscal policy is restrained by a rule that limits current year spending growth to last year's inflation rate. This year's fiscal expenditure growth is going to be 3% in nominal terms. Given that inflation is still very depressed, this means that fiscal spending growth will be extremely low next year too. Furthermore, the central bank is unlikely to cut interest rates amid the turmoil in the currency market. The central bank also typically shrinks the banking system's reserves - tightens liquidity - during periods of exchange rate depreciation, as illustrated in Chart I-14. Therefore, the combination of weak nominal growth and high real interest rates will slip Brazil into a debt deflation dynamic - where indebtedness rises as nominal income/revenue growth remains below borrowing costs (Chart I-15). Chart I-14Falling BRL = Tighter Liquidity Chart I-15Brazil: An Unsustainable Gap This is especially true for government debt in Brazil. We maintain that the nation's public debt dynamics will remain on an unsustainable trajectory as long as government revenue growth does not exceed the level of nominal interest rates. In turn what Brazil needs are much lower real interest rates and a weaker currency to boost nominal GDP/income growth. This would ultimately stabilize public and private debt dynamics and improve debtors' ability to service debt. However, a sizable exchange rate depreciation, which is all but required to boost nominal growth, will in the interim be bad for financial markets, especially foreign investors. Chart I-16Brazil: Markets Have Hit Critical Levels Finally, there are a number of technical patterns that suggest a major top has been reached in Brazilian financial markets, and that downside from current levels will likely be significant. In particular, Brazil share prices in U.S. dollar terms have failed to break above their multi-year moving average, which has served as both a support and resistance in the past (Chart I-16, top panel). Likewise the real's total return including carry versus the dollar has been unable to break above its previous high. This, combined with the head-and-shoulder pattern of BRL (Chart I-16, bottom panel), suggests the real might be entering a bear market. Bank stocks are a large part of the equity index, and they have lately been under severe selling pressure. We are reinstating our short position in Brazilian banks. We closed this position last week when we removed our short Brazilian banks / long Argentine banks equity recommendation due to the selloff in Argentine banks.4 The currency depreciation is forcing local interest rates to rise, which is causing liquidity to tighten in Brazil. High borrowing costs in real terms are inhibiting credit demand. In particular, banks' aggregate loans to companies and households in both nominal and real terms are still shrinking. Although consumer loans are rising, the contraction in corporate lending has more than offset the recovery in household credit. Further, Chart I-17 demonstrates that the relapse in nominal GDP growth (shown inverted in the chart) heralds a rise in the rate of change of non-performing loans (NPL) as well as their provisions. As provisions begin to rise, banks' earnings will take a hit. Chart I-18 illustrates that banks have been reducing NPL provisions to boost profits and a rate of change in provisions has been a decisive factor driving bank equity prices in recent years. Chart I-17Slower Nominal Growth = Higher Provisions & NPLs Chart I-18NPL Provisions And Bank Stocks Bottom Line: Re-establish a short bank stocks position, and continue to short the BRL versus the U.S. dollar and MXN. Remain underweight Brazilian stocks as well as sovereign and corporate credit within respective EM portfolios. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com Malaysia: Short-Term Challenges, Long-Term Opportunities Chart II-1Malaysia: Banks Have Been ##br##'Cooking Their Books' The election victory by the Malaysian opposition coalition, Pakatan Harapan, offers a major opportunity to reverse the significant deterioration in Malaysia's governance and, hence, poor productivity growth that has occurred under the former Prime Minister Najib Razak. The political change is therefore a bullish development for Malaysia in the long-run. As such, we are placing the Malaysian bourse on an upgrade watch list. Yet the performance of Malaysia's financial markets in the coming months will remain challenged by vulnerabilities emanating from the country's weak banking system and potential negative forces that will subdue its external sector. These factors will slow growth in the months ahead, hurt the ringgit and exert downward pressures on Malaysian share prices: The health of Malaysian commercial banks is questionable. Since the economic downturn started in 2014, banks have grossly underreported their non-performing loans (NPLs) (Chart II-1). Additionally, they have been lowering NPL provisions to artificially boost their earnings in the past year or so (Chart II-1, bottom panel). Hence, banks' reported earnings are inflated. The former government tolerated these actions to ensure "economic and financial stability". Yet this sense of false "stability" will reverse under the new government. The latter headed by incoming Prime Minister Mahathir Mohamad will likely attempt to change leadership of state institutions and SOEs and also clean the financial system in order to improve its transparency and soundness. We suspect as a part of this restructuring, the authorities and the central bank will begin exerting pressure on commercial banks to recognize and provision for NPLs. It is always new leadership within financial regulatory institutions or banks that opt to open the books and recognize NPLs. Higher provisioning will cause bank earnings to slump considerably, jeopardizing their share prices (Chart II-2). Malaysian banks account for 34% of the MSCI Malaysia index and 40% of its total earnings. Finally, bank stocks are not cheap with a price-to-book value ratio of 1.6 and a trailing P/E ratio at 15. On the external front, rising U.S. bond yields will cause the U.S. dollar to strengthen versus the ringgit, which will not bode well for Malaysian financial assets. Chart II-3 shows that spreads of Malaysian local government bond yields over U.S. Treasurys have reached new cyclical lows. As such, local yields offer little caution for foreign bond investors. Given that around 29% of domestic currency bonds are owned by foreigners, the ringgit depreciation will likely generate selling pressure in the local bond market. Chart II-2Malaysia: Bank Stocks Are At Risk Chart II-3Malaysia: Local Bond Yields ##br##Spreads Over U.S. Treasurys Further, the outlook for Malaysia's trade balance is negative due to potential cracks in the semiconductors industry and in commodities. Semiconductors account for 15% of Malaysia's exports while commodities account for around a quarter of its exports; with energy making up 14% exports and palm oil accounting for 8%. Malaysian exports of semiconductors are likely peaking. Chart II-4 shows that the average of Taiwan's and Korea's semiconductors shipment-to-inventory ratios is pointing to a deceleration in Malaysia's semiconductor exports. Taiwan and Korea are major semiconductor manufacturing hubs that ship some of their chips to Malaysia for testing and assembly. On this note, Chart II-5 shows that Taiwanese semiconductor exports to Malaysia are decelerating. This is confirming a forthcoming slump in Malaysia's semiconductor exports. And finally, various semiconductor prices are beginning to decline. Chart II-4Malaysia's Semiconductor Industry At Risk Chart II-5Malaysia's Semi Exports To Slow As for commodities, palm oil prices have been weak (Chart II-6). The industry is facing significant headwinds due to import restrictions from India and the EU. Besides, Malaysia is probably bound to lose palm oil market share to Indonesia. China and Indonesia signed an agreement last week with the former agreeing to purchase more of this commodity from Indonesia. Chart II-6Unusual Divergence Between ##br##Oil And Palm Oil Prices Meanwhile, as our colleagues from the Geopolitical Strategy service argued this week, the incoming Prime Minister Mahathir Mohamad plans to review some Chinese investments in Malaysia that were undertaken by his predecessor.5 Doing so could induce China to retaliate by limiting Malaysian palm oil imports and reducing imports of other Malaysian products as well. Around 13% of Malaysian exports are shipped to China. A final word on oil is warranted. The surge in oil prices is unambiguously bullish for this economy. However, it is important to realize that this price surge is driven by escalating geopolitical risks and mushrooming traders' net long positions in crude rather than global demand. The former might persist for some time as U.S.-Iran hostilities linger. Continued strength in the dollar, however, could trigger a considerable decline in oil prices as traders head for the exits. On the whole, Malaysia's current account balance will deteriorate which will weigh on the Malaysian currency and hurt U.S. dollar returns of Malaysian financial assets. Faced with currency depreciation, the Malaysian central bank is unlikely to defend the currency by hiking interest rates or selling its foreign exchange reserves (doing so would also tighten banking system liquidity). The Malaysian economy cannot bear much higher interest rates as private-sector debt-to-GDP stands at a whopping 134%. In the meantime, currency depreciation will inflict pain on debtors with foreign currency liabilities. Malaysian companies are amongst the largest foreign currency borrowers in the developing economies univers. In short, the ringgit will come under material selling pressure like many other EM currencies and this will hurt the economy. This will also weigh on the equity index - which is dominated by banks. Bottom Line: While we recommend investors to maintain an underweight position in Malaysian equities for now, we are placing this bourse on upgrade watch list given the positive election results. We are waiting for the following to occur before upgrading Malaysia's stock market: (1) Commodities prices to fall and the semiconductor cycle to slow and (2) Malaysian commercial banks to recognize more NPLs and increase provisioning for bad loans. Meanwhile, currency traders should stay short MYR versus the U.S. dollar and equity investors should remain short banks. Finally, for fixed-income traders we continue to recommend long Thai / short Malaysia local bonds. Credit portfolios should underweight this sovereign credit for now. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 This index is constructed using an equal-weighted index of six total return commodities currencies such as BRL, CLP, ZAR, AUD, NZD and CAD divided by the total returns of the safe-haven currencies: JPY and CHF. 2 Cash earnings are defined and calculated by MSCI as earnings per share including depreciation and amortization as reported by the company - i.e. depreciation and amortization expenses are added to earnings in order to calculate cash earnings. 3 For example, please refer to discussion on Brazilian and Malaysian banks on pages 7 and 13, respectively. 4 Please refer to Emerging Markets Strategy Weekly Report "EM: A Correction Or Bear Market?" dated May 10, 2018, link is available on page 20. 5 Pleas see Geopolitical Strategy Weekly Report "Are You Ready For "Maximum Pressure?" dated May 16, 2018, available on gps.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Stay tactically long the SEK. Our preferred expression is long SEK/GBP. Stay tactically short the NOK. Our preferred expression is long AUD/NOK. Take profits in the underweight to Poland... ...and open a tactical countertrend position: long Poland's Warsaw General Index, short Italy's MIB. A coalition of populists governing Italy might ruffle some feathers in Brussels, but the main risk appears to be contained. Both The League and 5 Star Movement have dropped calls for a referendum on Italy's membership of the monetary union. Feature Italy And The U.K. Compete For Political Risk The European political lens is once again focussed on Italy as the two anti-establishment parties - The League and 5 Star Movement - negotiate to form a government. A coalition of populists governing Italy might ruffle some feathers in Brussels, but the main risk appears to be contained. Both parties have dropped calls for a referendum on Italy's membership of the monetary union, and have instead turned their fire on the EU's fiscal rules, specifically the 3 per cent limit on budget deficits. Chart of the WeekThe SEK Is Due A Tactical Rebound The populist demand for some fiscal relaxation is actually smart economics. When the private sector is paying down debt - as it is in Italy - private sector demand shrinks. To prevent a recession, the government must step in to borrow and spend the paid-down debt. And what seems to be fiscal largesse does not lead to crowding out, inflation, or surging interest rates. This means that as long as Italian populists correctly push back on the EU's draconian fiscal rules rather than the monetary union per se, the market is right to regard Italian politics as a drama, rather than an existential risk to the euro (Chart I-2). Chart I-2The Market Remains Unconcerned ##br##About Euro Break-Up Risk Maybe the European political lens should be focussed instead on Britain. The Conservative party remains as bitterly divided as ever on its vision for the U.K.'s future trading and customs relationships with the EU and the rest of the world. Paralysed and frightened by this division, Theresa May is delaying the legislative passage of three crucial bills - the EU Withdrawal Bill, the Trade Bill, and the Customs Bill. When these bills eventually reach a vote in the House of Commons later this year, any one of them could result in a humiliating defeat for May - and, quite likely, resignations from the government. Meanwhile, as the government kicks the issue into the long grass, firms are holding fire on long-term spending commitments in the U.K. and rechannelling the investment to elsewhere in Europe. Buy SEKs, Avoid NOKs For all the recent swings in the euro versus the dollar and pound, the trade-weighted euro has remained a paragon of relative stability (Chart I-3). This is because the moves versus the dollar and pound have largely cancelled out (Chart I-4). Earlier this year, euro weakness versus the pound coincided with strength versus the dollar; more recently, euro weakness versus the dollar has coincided with strength versus the pound. Chart I-3The Trade-Weighted Euro Has ##br##Remained Relatively Stable... Chart I-4...Because Moves Versus The Dollar And The ##br##Pound Have Largely Cancelled Out Interestingly, the driver of the trade-weighted euro remains the same as it has been for the past fifteen years - it is simply the euro area's long bond yield shortfall versus the U.K. and U.S. (Chart I-5). With the ECB already at the realistic limit of ultra-loose policy, the path for policy rate expectations cannot go meaningfully lower. This means that the trade-weighted euro has some long-term support given that the BoE and/or the Fed have tightening expectations that could be priced out, while the ECB effectively doesn't. Chart I-5The Trade Weighted Euro Is A Function Of The Euro Area's ##br##Long Bond Yield Shortfall Versus The U.K. And U.S. Put another way, for the trade-weighted euro to drift significantly lower, relative surprises in the economic, financial and political news have to be significantly worse in the euro area than in both the U.K. and the U.S. We think this configuration is unlikely. Nevertheless, the more interesting tactical opportunities lie elsewhere: the Swedish krona and the Norwegian krone. Recent tweaks to monetary policy frameworks in Sweden and Norway are responsible, at least partly, for technically exaggerated moves in their currencies which are likely to reverse. In the case of Sweden, the inflation target is unchanged at 2 per cent but the Riksbank introduced a variation band of 1-3 per cent, because "monetary policy is not able to steer inflation in detail." Given that Sweden's inflation rate is now close to 2 per cent, the market interpreted this tweak as very dovish - because it permits the continuation of ultra-accommodative policy. The upshot was that the SEK sold off. But our tried and tested indicator of excessive groupthink suggests that the currency may have overreacted (Chart of the Week). Hence, the tactical opportunity is to stay long the SEK, and our preferred expression is long SEK/GBP. In the case of Norway, a Royal Decree on Monetary Policy lowered the Norges Bank inflation target from 2.5 to 2.0 per cent. This followed years of failure to achieve the higher target. The market interpreted this change as hawkish, as it created the scope for tighter - or at least, less loose - policy than was previously expected. The upshot was that the NOK rallied. But again, the market reaction shows evidence of a technical overreaction (Chart I-6). Hence, the tactical opportunity is to stay short the NOK, and our preferred expression is long AUD/NOK. Chart I-6Our Preferred Expression Of Short NOK Is Versus The AUD Financial Markets Are Not Complicated, But They Are Complex The words 'complicated' and 'complex' appear to be interchangeable, but their meanings are quite distinct. The distinction is important because financial markets are not complicated, but they are complex. Something that is complicated is the sum of a large number of separate parts or processes. For example, making a car is complicated. But predicting the performance of financial markets over the medium term - say, a year or longer - is uncomplicated. The philosophy of Investment Reductionism teaches us that investment strategy is not made up of many separate parts or processes. It reduces to just three things: Predicting the evolution of the global economy. Predicting central bank reaction functions. Predicting tail-events: political, economic and financial. For example, this week's lesson in Investment Reductionism is to illustrate that the medium term decision to allocate between emerging market equities and the Eurostoxx600 largely reduces to the prospects for global metal prices (Chart I-7). Chart I-7EM Versus Eurostoxx600 = Metal Prices By contrast, something that is complex is not the sum of its parts, because the parts interact in unpredictable ways. Complexity characterizes the behaviour of financial markets over the short term - say, up to around six months. Therefore, the best way to model the behaviour of any investment over the very short term is to think of it as a complex adaptive system. A complex adaptive system is a system with a large number of mutually interacting agents, which can learn from their interactions and thereby adapt their subsequent behaviour. Examples include traffic flows, crowds in stadiums, and of course financial markets. A crucial property of all such systems is they possess an endogenous tipping point of instability, at which the behaviour undergoes a 'phase-shift'. This is the essence of how we identify likely short-term trend reversals in any investment such as the SEK and the NOK. This week's final trade recommendation uses this idea once again. Poland's equity market has underperformed recently in line with the general underperformance of the emerging market basket - and our underweight in the Warsaw General Index versus the Eurostoxx600 is handsomely in profit. However, looking at the market as a complex adaptive system, the extent of Poland's underperformance is overdone (Chart I-8). Chart I-8The Extent Of Poland's Underperformance Is Overdone Hence we are taking profit on our underweight in Poland and putting on a short-term countertrend position: long Poland's Warsaw General Index, short Italy's MIB. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* As discussed in the main body of the report, this week's new trade recommendation is a pair-trade: long Poland's Warsaw General Index, short Italy's MIB. The profit target is 5% with a symmetrical stop loss. Our preferred expression of long SEK is versus the GBP which is already in profit since initiation. 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-9 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

Highlights Copper has been stuck in the $2.90-$3.30/lb trading range since late August, 2017. Offsetting supply- and demand-side effects are keeping us neutral: Concerns over restrictions on China's scrap imports and possible industrial action in Chile, along with continued worries over a slow-down in China will keep prices range-bound until we see a fundamental catalyst on one side of the market. Our updated balances model shows a physical surplus in 2018, followed by a deficit in 2019. Energy: Overweight. Rising crude oil prices and steepening backwardation in Brent and WTI, to a lesser extent, will be supportive of our energy-heavy S&P GSCI recommendation, as we expected. The position is up 17.1% since it was initiated on December 7, 2017. Base Metals: Neutral. Our updated balances model points to a physical surplus in the copper market by year end (see below). Precious Metals: Neutral. A stronger USD and higher real rates are pressuring precious metals lower. Our long gold and silver positions are down 1.8% and 0.8%, respectively, over the past week. Ags/Softs: Underweight. The USDA expects Brazil to surpass the U.S. as the world's largest soybean producer in the upcoming crop year, for the first time in history. Nevertheless - and despite U.S.-Sino trade tensions - the report also predicts record U.S. exports of the bean in the 2018/19 crop year. Feature Chart of the WeekStuck In A Trading Range Copper on the COMEX averaged $3.12/lb since the beginning of the year - slightly higher than our $3.10/lb expectation published in January (Chart of the Week).1 Fears of a slowdown in China -suggested by weaker readings of the Li Keqiang Index - as well as a stronger dollar have been headwinds to further upside. On the flip side, upcoming contract renegotiations at Escondida, China's ongoing environmental efforts, and global PMI readings above the 50 boom-bust line have kept bulls interested in the red metal. Our estimate of the refined copper balance is for a physical surplus this year (Chart 2). Strong demand from Asia, and to a lesser extent North America, will support a moderate pickup in consumption this year. This will be met by greater refined output - a ramp in primary refined output will more than offset the expected decline in secondary production (i.e. refined copper produced from the scrap metal). Upside risk to this outlook comes from supply-side disruptions at the ore mines - particularly in Chile - and at refined levels. The biggest downside risk remains China's growth trajectory: If policymakers are unable to manage the transition to sustainable, consumer- and services-led growth in the market that accounts for 50% of global demand, prices will fall. Longer term, our models point to a physical refined-copper deficit on the back of stronger consumption growth vis-à-vis output growth. The key to a breakout - up or down -lies in the evolution of financial and fundamental factors. On the financial side, the USD has been edging higher since mid-April. Absent an upward copper price catalyst, a continuation in the USD's path will prevent the metal from booking strong gains. On the fundamental side, we expect copper markets to be in surplus this year. However, downside risks from a greater-than-expected slowdown in China could easily tilt the balance. Ongoing Chinese tightening of scrap copper imports will resist sharp moves to the downside. Chart 2Updated Balances: Expect A Refined Copper Surplus This Year Any of these factors may emerge as a catalyst for a breakout or a breakdown in the copper market this year. Yet for now our model is pointing to a physical surplus and we are comfortable with our neutral outlook. We expect near term prices to trade in the $2.90 to $3.15/lb range. Nevertheless, the evolution of these known unknowns may tilt our balances to either side. A break lower would be reason to sell, while a break above the upper bound would support an outlook for higher prices. Geopolitical Risks On The Horizon Political tensions are spilling into the copper market, threatening supplies, and bringing with them the prospect of higher prices. This is not without reason: Supply-side shocks to mined output have historically been a source of upside risk to prices. Foremost among the potential shocks is labor action at the Escondida mine in Chile, the world's largest. June 4 is the deadline for contract renegotiations to begin. These talks will follow last year's contract renewal efforts, which led to a 44-day strike, a 63% y/y decline in the mine's copper output in 1Q17, and eventually, an 18-month contract extension. As the world's largest mine, Escondida accounts for 1.27mm MT out of the 22mm MT of world capacity, and contributes ~5% of global supply. Efforts to lock in an advance deal ended late last month to no avail.2 Nevertheless, Escondida's production in 1Q18 has been exceptional - more than triple the same period last year. Furthermore, copper was among the metals that caught a bid last month amid fears of further rounds of U.S. sanctions on Russian companies. Russian oligarch Vladimir Potanin has a 33% stake in Norilsk, one of the world's largest copper mines - accounting for 388k MT of output last year. While sanctions against Potanin have not been announced, he was named in the U.S. Section 241 Foreign Asset Control filing, suggesting that he may be targeted in future sanctions, putting Norilsk's future at risk, à la Rusal. While fears of U.S. sanctions on Russia appear to have eased, the risk of such action on global copper supply was a tailwind to the copper market last month. In addition to the upside from these potential supply-side shocks, ongoing environmental reform efforts in China remain a theme in metals markets globally. In the case of the red metal, restrictions on Chinese access to "foreign waste" will curtail scrap shipments going forward. World secondary refined production from scrap accounts for almost 20% of global refined copper. China produces more than half of the world's secondary refined copper. This means that China's secondary output makes up 10% of all world refined copper production (Chart 3). Chart 3China's Secondary Output Important To Refined Copper Supply... As such, scrap copper imports play an important role in China - they act as a buffer against high prices, rising when prices lift, and dwindling in times of low prices. Among the measures implemented to gain more control over scrap markets in China are the following: 1. For the period between May 4 and June 4, the Chinese customs inspection firm - China Certification and Inspection Group North America - announced it would suspend the issuance of export certificates for scrap material shipments, including scrap copper.3 The aim of the suspension is to inspect the waste material and ensure it complies with China's new environmental regulations. In general China imports 15% of its copper scrap from the U.S. - purchasing more than 500k MT of scrap copper from the U.S. last year (Chart 4). Since the U.S. is China's top supplier of scrap copper, this specific initiative and China's ongoing efforts for environmental reform could be consequential to secondary refined output. 2. This move comes in addition to ongoing restrictions on imported solid waste. Starting in 2019, Category 7 scrap copper imports - i.e., solid waste, which account for ~20% of all scrap - will be banned.4 Since the beginning of the year, import licenses were granted only to scrap end-users and, since March 1, hazardous impurity levels in scrap copper imports were limited to 1% by weight. A Metal Bulletin report late last month estimated import quotas for scrap copper were 84% lower so far this year.5 As such, Jiangxi Copper - the largest copper refinery in the world - estimates that these restrictions will culminate in a 500k MT decline in scrap copper imports this year. In fact, scrap copper imports have already been falling significantly, with Chinese purchases down 40% y/y in 1Q18. The near-term implication of these restrictions on China's scrap copper imports would be to raise imports of refined copper, or of ores and concentrates. Scrap copper displaced from these restrictions will likely be diverted to other countries where they will be refined and shipped to China for final consumption. While an eventual move by Chinese companies to Southeast Asian countries in a bid to set up processing facilities there would eliminate the long term price impact, there may be some upside to prices during the transition phase. As such, China's imports of copper ores and concentrates, and of the refined metal, have been strong. During the first four months of the year, imports of ores and concentrates were up almost 10% y/y, while inflows of the refined metal are 15% above last year's levels (Chart 5). Chart 4...But Scrap Imports Are Restrained Chart 5China's Copper Imports Still Going Strong As these policy measures have been known to the public for quite some time, we suspect they are already priced into markets, and do not foresee further upside risk arising from this source. Nevertheless, their impact will remain significant, given that limited ability to produce scrap copper, which will restrict supply, will keep the market resistant to significant downward price pressure. Moderate Consumption Growth This Year Our updated balances model does not include any significant changes to our demand outlook from our January estimate. This is consistent with our consumption estimates for other industrial commodities that share strong co-movement properties with copper demand. We expect lower global consumption and growth than what's being projected by the International Copper Study Group (ICSG) and the Australian Department of Industry, Innovation and Science in its Resources & Energy Quarterly report. While China will remain the world's major copper consumer, a slowdown in its economy remains the foremost demand-side concern for us this year. DM economies appear to be comfortably perched at an above trend level. Fiscal stimulus in the U.S. and solid growth figures from the rest of the world will help keep demand in DM economies supported (Table 1). Table 1Strong Global Growth Will Support##BR##Copper Consumption However, Chinese demand growth remains vulnerable to a slowdown. As we outlined in our March 29 Weekly Report, while there are fundamental reasons to be concerned about Chinese growth going forward, there are no signs of alarm just yet.6 Manufacturing PMIs have come down in recent months, but they remain above the 50 boom-bust mark. That said, it is worth pointing out that the most significant indicator of the Chinese economy we track - the Li Keqiang index -has also been slowing as of late. We continue to expect the government to be able to pull off the managed slowdown it has embarked on. However, we are alert for any sign the Chinese economy is sharply decelerating, as it would lead us to revise our consumption forecast. A Surplus...At Least This Year Our demand and supply expectations lead us to call for a surplus of refined copper this year. Further out, we expect consumption growth to outpace production next year. The upward adjustment in our balance to a surplus since January is a result of upside revisions to supply amid a stable consumption growth path (Chart 6). Copper inventories remain elevated (Chart 7). While current levels of inventories are not a predictor of future price movements, they do indicate there is sufficient cushion in the market to withstand near-term supply disruptions. Chart 6Solid Production Path Amid Stable Consumption;##BR##Surplus Will Emerge Chart 7Inventories Will Cushion##BR##Against Supply Shocks Of course, along with other commodity markets, copper prices remain vulnerable to USD movements. In fact, the red metal's performance over the past month is especially impressive given the relative strength in the USD as of late. BCA expects the USD will appreciate in the coming months. Absent fundamental changes - i.e. supply- or demand-side shocks - copper markets will likely be restrained from staging a break-out rally by a stronger USD going forward. Bottom Line: Fundamental and financial risks to the copper market are slightly skewed to the downside this year. We expect a physical surplus to emerge by year-end, given slightly higher output and slower demand growth as China slows. On the downside, prices are vulnerable to a stronger USD and muted demand growth in China. On the upside, they are supported by supply-side concerns, chiefly at the Escondida mine and due to restrictions on China's imports of scrap copper. Stay neutral the red metal. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see p.11 of BCA Research's Commodity & Energy Strategy Weekly Report titled "Stronger USD, Slower China Growth Threaten Copper," dated January 25, 2018, available at ces.bcaresearch.com. 2 Please see "Union at BHP's Escondida copper mine in Chile says no advance deal likely," dated April 24, 2018, available at reuters.com. 3 Please see "China to suspend checks on U.S. scrap metal shipments, halting imports," dated May 4, 2018, available at reuters.com. 4 Please see "China scrap metal firms face pressure from import curbs: official", dated April 26, 2018, available at reuters.com and BCA Research's Commodity & Energy Strategy Weekly Report titled "Copper Getting Out Ahead Of Fundamentals, Correction Likely," dated August 24, 2017, available at ces.bcaresearch.com. 5 Please see "FOCUS: China's copper scrap import quotas down 84% so far this year," dated April 23, 2018, available at metalbulletin.com. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "China's Managed Slowdown Will Dampen Base Metals Demand," dated March 29, 2018, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Insert table images here Trades Closed in Summary of Trades Closed in

Highlights Divergence between U.S. and global economic outcomes is bullish for the U.S. dollar and bad for EM assets; Maximum Pressure worked with North Korea, but it may not with Iran, putting upside pressure on oil; An election is the only way to resolve split over Brexit and the new anti-establishment coalition in Italy is not market positive; Historic election outcome in Malaysia and the prospect of a weakened Erdogan favors Malaysian over Turkish assets; Reinitiate long Russian vs EM equities in light of higher oil price and reopen French versus German industrials as reforms continue unimpeded in France. Feature "Speak softly and carry a big stick; you will go far." - Theodore Roosevelt, in a letter to Henry L. Sprague, January 26, 1900. May started with a geopolitical bang. On May 4, a high-profile U.S. trade delegation to Beijing returned home after two days of failed negotiations. Instead of bridging the gap between the two superpowers, the delegation doubled it.1 On May 8, President Trump put his Maximum Pressure doctrine - honed against Pyongyang - into action against Iran, announcing that the U.S. would withdraw from the Obama administration's Iran nuclear deal - also referred to as the Joint Comprehensive Plan of Action (JCPOA). These geopolitical headlines were good for the U.S. dollar, bad for Treasuries, and generally miserable for emerging market (EM) assets (Chart 1).2 We have expected these very market moves since the beginning of the year, recommending that clients go long the DXY on January 31 and go short EM equities vs. DM on March 6.3 Chart 1EM Breakdown? Chart 2U.S. Dollar Rallies When Global Trade Slows Geopolitical risks, however, are merely the accelerant of an ongoing process of global growth redistribution. A key theme for BCA's Geopolitical Strategy this year has been the divergent ramifications of populist stimulus in the U.S. and structural reforms in China. This political divergence in economic outcomes has reduced growth in the latter and accelerated it in the former, a bullish environment for the U.S. dollar (Chart 2).4 Data is starting to support this narrative: Chart 3Global Growth On A Knife Edge Chart 4German Data... The BCA OECD LEI has stalled, but the diffusion index shows a clear deterioration (Chart 3); German trade is showing signs of weakness, as is industrial production and IFO business confidence (Chart 4); Another bellwether of global trade, South Korea, is showing a rapid deterioration in exports (Chart 5); Global economic surprise index is now in negative territory (Chart 6). Chart 5...And South Korean, Foreshadows Risks Chart 6Unexpected Slowdown In Global Growth Meanwhile, on the U.S. side of the ledger, wage pressures are rising as the number of unemployed workers and job openings converge (Chart 7). Given the additional tailwinds of fiscal stimulus, which we see no real chance of being reversed either before or after the midterm election, the U.S. economy is likely to continue to surprise to the upside relative to the rest of the world, a bullish outcome for the U.S. dollar (Chart 8). In this environment of U.S. outperformance and global growth underperformance, EM assets are likely to suffer. Chart 7U.S. Labor Market Is Tightening Chart 8U.S. Outperformance Should Be Bullish USD Additionally, it does not help that geopolitical risks will weigh on confidence and will buoy demand for safe haven assets, such as the U.S. dollar. First, U.S.-China trade relations will continue to dominate the news flow this summer. President Trump's positive tweets on the smartphone giant ZTE aside, the U.S. and China have not reached a substantive agreement and upcoming deadlines on trade-related matters remain a risk (Table 1). Table 1Protectionism: Upcoming Dates To Watch Second, President Trump's application of Maximum Pressure on Iran will cause further volatility and upside pressure on the oil markets. The media was caught by surprise by the president's announcement that he is withdrawing the U.S. from the JCPOA, which is puzzling given that the May 12 expiration of the sanctions waiver was well-telegraphed (Chart 9). It is also surprising given that President Trump signaled his pivot towards an aggressive foreign policy by appointing John Bolton and Mike Pompeo - two adherents of a hawkish foreign policy - to replace more middle-of-the-road policymakers. It was these personnel changes, combined with the U.S. president's lack of constraints on foreign policy, that inspired us to include Iran as the premier geopolitical risk for 2018.5 Chart 9Iran: Nobody Was Paying Attention! Iran-U.S. Tensions: Maximum Pressure Is Real Last year, BCA's Geopolitical Strategy correctly forecast that President Trump's Maximum Pressure doctrine would work against North Korea. First, we noted that President Trump reestablished America's "credible threat," a crucial factor in any negotiation.6 Without credible threats, it is impossible to cajole one's rival into shifting away from the status quo. The trick with North Korea, for each administration that preceded President Trump, was that it was difficult to establish such a credible threat given Pyongyang's ability to retaliate through conventional artillery against South Korean population centers. President Trump swept this concern aside by appearing unconcerned with what were to befall South Korean civilians or the Korean-U.S. alliance. Second, we noted in a detailed military analysis that North Korean retaliation - apart from the aforementioned conventional capacity - was paltry.7 President Trump called Kim Jong-un's bluff about targeting Guam with ballistic missiles and kept up Maximum Pressure throughout a summer full of rhetorical bluster. As tensions rose, China blinked first, enforcing President Trump's demand for tighter sanctions. China did not want the U.S. to attack North Korea or to use the North Korean threat as a reason to build up its military assets in the region. The collapse of North Korean exports to China ultimately starved the regime of hard cash and, in conjunction with U.S. military and rhetorical pressure, forced Kim Jong-un to back off (Chart 10). In essence, President Trump's doctrine is a modification of President Theodore Roosevelt's maxim. Instead of "talking softly," President Trump recommends "tweeting aggressively".8 It is important to recount the North Korean experience for several reasons: Maximum Pressure worked with North Korea: It is an objective fact that President Trump was correct in using Maximum Pressure on North Korea. Our analysis last year carefully detailed why it would be a success. However, we also specifically outlined why it would work with North Korea. Particularly relevant was Pyongyang's inability to counter American economic pressure and rhetoric with material leverage. Kim Jong-un's only objective capability is to launch a massive artillery attack against civilians in Seoul. Given his preference not to engage in a full-out war against South Korea and the U.S., he balked and folded. Trump is tripling-down on what works: President Trump, as all presidents before him, is learning on the job. The North Korean experience has convinced him that his Maximum Pressure tactic works. In particular, it works because it forces third parties to enforce economic sanctions on the target nation. If China were to abandon its traditional ally North Korea and enforced painful sanctions, the logic goes, then Europeans would ditch Iran much faster. Iran is not North Korea: The danger with applying a Maximum Pressure tactic against Iran is that Tehran has multiple levers around the Middle East that it could deploy to counter U.S. pressure. President Obama did not sign the JCPOA merely because he was a dove.9 He did so because the deal resolved several regional security challenges and allowed the U.S. to pivot to Asia (Chart 11). Chart 10Maximum Pressure Worked On Pyongyang Chart 11Iran Nuclear Deal Had A Strategic Imperative To understand why Iran is not North Korea, and how the application of Maximum Pressure could induce greater uncertainty in this case, investors first have to comprehend why the U.S.-Iran nuclear deal was concluded in the first place. Maximum Pressure Applied To Iran The 2015 U.S.-Iran deal resolved a crucial security dilemma in the Middle East: what to do about Iran's growing power in the region. Ever since the U.S. toppling of Saddam Hussein's regime in 2003, the fulcrum of the region's disequilibrium has been the status of Iraq. Iraq is a natural geographic buffer between Iran and Saudi Arabia, the two regional rivals. Hussein, a Sunni, ruled Iraq - 65% of which is Shia - either as an overt client of the U.S. and Saudi Arabia (1980-1988), or as a free agent largely opposed to everyone in the region (from 1990s onwards). Both options were largely acceptable to Saudi Arabia, although the former was preferable. Iran quickly seized the initiative in Iraq following the U.S. overthrow of Hussein, which created a vast vacuum of power in the country. Elite members of the country's Revolutionary Guards (IRGC), the so-called Quds Force, infiltrated Iraq and supplied various Shia militias with weapons and training that fueled the anti-U.S. insurgency. An overt Iranian ally, Nouri al-Maliki, assumed power in 2006. Soon the anti-U.S. insurgency evolved into sectarian violence as the Sunni population revolted and various Sunni militias, supported by Saudi Arabia, rose up against Shia-dominated Baghdad. The U.S. troops stationed in Iraq quickly became either incapable of controlling the sectarian violence or direct targets of the violence themselves. This rebellion eventually mutated into the Islamic State, which spread from Iraq to Syria in 2012 and then back to Iraq two years later. The Obama administration quickly realized that a U.S. military presence in Iraq would have to be permanent if Iranian influence in the country was to be curbed in the long term. This position was untenable, however, given U.S. military casualties in Iraq, American public opinion about the war, and lack of clarity on U.S. long-term interests in Iraq in the first place. President Obama therefore simultaneously withdrew American troops from Iraq in 2011 and began pressuring Iran on its nuclear program between 2011 and 2015.10 In addition, the U.S. demanded that Iran curb its influence in Iraq, that its anti-American/Israel rhetoric cease, and that it help defend Iraq against the attacks by the Islamic State in 2014. Tehran obliged on all three fronts, joining forces with the U.S. Air Force and Special Forces in the defense of Baghdad in the fall 2014.11 In 2014, Iran acquiesced in seeing its ally al-Maliki replaced by the far less sectarian Haider al-Abadi. These moves helped ease tensions between the U.S. and Iran and led to the signing of the JCPOA in 2015. From Tehran's perspective, it has abided by all the demands made by Washington during the 2012-2015 negotiations, both those covered by the JCPOA overtly and those never explicitly put down on paper. Yes, Iran's influence in the Middle East has expanded well beyond Iraq and into Syria, where Iranian troops are overtly supporting President Bashar al-Assad. But from Iran's perspective, the U.S. abandoned Syria in 2012 - when President Obama failed to enforce his "red line" on chemical weapons use. In fact, without Iranian and Russian intervention, it is likely that the Islamic State would have gained a greater foothold in Syria. The point that its critics miss is that the 2015 nuclear deal always envisioned giving Iran a sphere of influence in the Middle East. Otherwise, Tehran would not have agreed to curb its nuclear program! To force Iran to negotiate, President Obama did threaten Tehran with military force. As we have detailed in the past, President Obama established a credible threat by outsourcing it to Israel in 2011. It was this threat of a unilateral Israeli attack, which Obama did little to limit or prevent, that ultimately forced Europeans to accept the hawkish American position and impose crippling economic sanctions against Iran in early 2012. As such, it is highly unlikely that a rerun of the same strategy by the U.S., this time with Trump in charge and with potentially less global cooperation on sanctions, will produce a different, or better, deal. The recent history is important to recount because the Trump administration is convinced that it can get a better deal from Iran than the Obama administration did. This may be true, but it will require considerable amounts of pressure on Iran to achieve it. At some point, we expect that this pressure will look very much like a preparation for war against Iran, either by U.S. allies Israel and Saudi Arabia, or by the U.S. itself. First, President Trump will have to create a credible threat of force, as President Obama and Israeli Prime Minister Benjamin Netanyahu did in 2011-2012. Second, President Trump will have to be willing to sanction companies in Europe and Asia for doing business with Iran in order to curb Iran's oil exports. According to National Security Advisor John Bolton, European companies will have by the end of 2018 to curb their activities with Iran or face sanctions. The one difference this time around is Iraqi politics. Elections held on May 13 appear to have resulted in a surge of support for anti-Iranian Shia candidates, starting with the ardently anti-American and anti-Iranian Shia Ayatollah Muqtada al-Sadr. Sadr is a Shia, but also an Iraqi nationalist who campaigned on an anti-Tehran, anti-poverty, anti-corruption line. If the election signals a clear shift in Baghdad against Iran, then Iran may have one less important lever to play against the U.S. and its allies. However, we are only cautiously optimistic about Iraq. Pro-Iranian Shia forces, while in a clear minority, still maintain the support of roughly half of Iraqi Shias. And al-Sadr may not be able to govern effectively, given that his track record thus far mainly consists of waging insurgent warfare (against Americans) and whipping up populist fervor (against Iran). Any move in Baghdad, with U.S. and Saudi backing, to limit Iranian-allied Shia groups from government could lead to renewed sectarian conflict. Therein lies the key difference between North Korea and Iran. Iran has military, intelligence, and operational capabilities that North Korea does not. This is precisely why the U.S. concluded the 2015 deal in the first place, so that Iran would curb those capabilities regionally and limit its operations to the Iranian "sphere of influence." In addition, Iran is constrained against reopening negotiations with the U.S. domestically by the ongoing political contest between the moderates - such as President Hassan Rouhani - and the hawks - represented by the military and intelligence nexus. Supreme Leader Khamenei sits somewhere in the middle, but will side with the hawks if it looks like Rouhani's promise of economic benefits from the détente with the West will fall short of reality. The combination of domestic pressure and capabilities therefore makes it likely that Iran retaliates against American pressure at some point. While such retaliation could be largely investment-irrelevant - say by supporting Hezbollah rocket attacks into Israel or ramping up military operations in Syria - it could also affect oil prices if it includes activities in and around the Persian Gulf. Bottom Line: We caution clients not to believe the narrative that "Trump is all talk." As the example in North Korea suggests, Trump's rhetoric drove China to enforce sanctions in order to avert war on the Korean Peninsula. We therefore expect the U.S. administration to continue to threaten European and Asian partners and allies with sanctions, causing an eventual drop in Iranian oil exports. In addition, we expect Iran to play hardball, using its various proxies in the region to remind the Trump administration why Obama signed the 2015 deal in the first place. Could Trump ultimately be right on Iran as he was on North Korea? Absolutely. It is simply naïve to assume that Iran will negotiate without Maximum Pressure, which by definition will be market-relevant. Impact On Energy Markets BCA Energy Sector Strategy believes that the re-imposition of sanctions could result in a loss of 300,000-500,000 b/d of production by early 2019.12 This would take 2019 production back down to 3.3-3.5 MMB/d instead of growing to nearly 4.0 MMb/d as our commodity strategists have modeled in their supply-demand forecasts. In total, Iranian sanctions could tighten up the outlook for 2019 oil markets by 400,000-600,000 b/d, reversing the production that Iran has brought online since 2016 (Chart 12). Is the global energy market able to withstand this type of loss of production? First, Chart 13 shows that the enormous oversupply of crude oil and oil products held in inventories has already been cut from 450 million barrels at its peak to less than 100 million barrels today. Surplus inventories are destined to shrink to nothing by the end of the year even without geopolitical risks. In short, there is no excess inventory cushion. Chart 12Current And Future Iran Production Is At Risk Chart 13Excess Petroleum Inventories Are All But Gone Second, spare capacity within the OPEC 2.0 alliance - Saudi Arabia and Russia - is controversial. Many clients believe that OPEC 2.0 could easily restore the 1.8 MMb/d of production that they agreed to hold off the market since early 2017. However, our commodity team has always considered the full number to be an illusion that consists of 1.2 MMb/d of voluntary cuts and around 500,000 b/d of natural production declines that were counted as "cuts" so that the cartel could project an image of greater collaboration than it actually has achieved (Chart 14). In fact, some of the lesser "contributors" to the OPEC cut pledged to lower 2017 production by ~400,000 b/d, but are facing 2018 production levels that are projected to be ~700,000 b/d below their 2016 reference levels, and 2019 production levels are estimated to decline by another 200,000 b/d (Chart 15). Chart 14Primary OPEC 2.0 Members Are ##br##Producing 1.0 MMb/d Below Pre-Cut Levels Chart 15Secondary OPEC 2.0 "Contributors"##br## Can't Even Reach Their Quotas Third, renewed Iran-U.S. tensions may only be the second-most investment-relevant geopolitical risk for oil markets. Our commodity team expects Venezuelan production to fall to 1.23 MMb/d by the end of 2018 and to 1 MMb/d by the end of 2019, but these production levels could turn out to be optimistic (Chart 16). Venezuelan production declined by 450,000 b/d over the course of 21 months (December 2015 to September 2017), followed by another 450,000 b/d plunge over the past six months (September 2017 to March 2018), as the country's failing economy goes through the death spiral of its 20-year socialist experiment. The oil production supply chain is now suffering from shortages of everything, including capital. It is difficult to predict what broken link in the supply chain is most likely to impact production next, when it will happen, and what the size of the production impact will be. The combination of President Trump's Maximum Pressure doctrine applied to Iran, continued deterioration in Venezuelan production, and the inability of OPEC 2.0 to surge production as fast as the market thinks is unambiguously bullish for oil prices. Oil markets are currently pricing in a just under 35% probability that oil prices will exceed $80/bbl by year-end (Chart 17).13 We believe these odds are too low and will take the other side of that bet. Indeed, we think that the odds of Brent prices ending above $90/bbl this year are much higher than the 16% chance being priced in the markets presently, even though this is up from just under 4% at the beginning of the year. Chart 16Venezuela Is A Bigger Risk Chart 17Market Continues To Underestimate High Oil Prices Bottom Line: Our colleague Bob Ryan, Chief Commodity & Energy Strategist, also expects higher volatility, as news flows become noisier. The recommendation by BCA's Commodity & Energy Strategy is to go long Feb/19 $80/bbl Brent calls expiring in Dec/18 vs. short Feb/19 $85/bbl calls, given our assessment that the odds of ending the year above $90/bbl are higher than the market's expectations. A key variable to watch in the ongoing saga will be President Trump's willingness to impose secondary sanctions against European and Asian companies doing business with Iran. We do not think that the White House is bluffing. The mounting probability of sanctions will create "stroke of pen" risk and raise compliance costs to doing business with Iran, leading to lower Iranian exports by the end of the year. Europe Update: Political Risks Returning Risks in Europe are rising on multiple fronts. First, we continue to believe that the domestic political situation in the U.K. regarding Brexit is untenable. Second, the coalition of populists in Italy - combining the anti-establishment Five Star Movement (M5S) and the Euroskeptic Lega - appears poised to become a reality. Brexit: Start Pricing In Prime Minister Corbyn Since our Brexit update in February, the pound has taken a wild ride, but our view has remained the same.14 PM May has an untenable negotiating position. The soft-Brexit majority in Westminster is growing confident while the hard-Brexit majority in her own Tory party is growing louder. We do not know who will win, but odds of an unclear outcome are growing. The first problem is the status of Northern Ireland. The 1998 Good Friday agreement, which ended decades of paramilitary conflict on the island, established an invisible border between the Republic of Ireland and Northern Ireland. Membership in the EU by both made the removal of a physical border a simple affair. But if the U.K. exits the bloc, and takes Northern Ireland with it, presumably a physical barrier would have to be reestablished, either in Ireland or between Northern Ireland and the rest of the U.K. The former would jeopardize the Good Friday agreement, the latter would jeopardize the U.K.'s integrity as a state. The EU, led on by Dublin's interests, has proposed that Northern Ireland maintain some elements of the EU acquis communautaire - the accumulated body of EU's laws and obligations - in order to facilitate the effectiveness of the 1998 Good Friday agreement. For many Tories in the U.K., particularly those who consider themselves "Unionists," the arrangement smacks of a Trojan Horse by the EU to slowly but surely untie the strings that bind the U.K. together. If Northern Ireland gets an exception, then pro-EU Scotland is sure to ask for one too. The second problem is that the Tories are divided on whether to remain part of the EU customs union. PM May is in favor of a "customs partnership" with the EU, which would see unified tariffs and duties on goods and services across the EU bloc and the U.K. However, her own cabinet voted against her on the issue, mainly because a customs union with the EU would eliminate the main supposed benefit of Brexit: negotiating free trade deals independent of the EU. It is unclear how PM May intends to resolve the multiple disagreements on these issues within her party. Thus far, her strategy was to simply put the eventual deal with the EU up for a vote in Westminster. She agreed to hold such a vote, but with the caveat that a vote against the deal would break off negotiations with the EU and lead to a total Brexit. The threat of such a hard Brexit would force soft Brexiters among the Tories to accept whatever compromise she got from Brussels. Unfortunately for May's tactic, the House of Lords voted on April 30 to amend the flagship EU Withdrawal Bill to empower Westminster to send the government back to the negotiating table in case of a rejection of the final deal with the EU. The amendment will be accepted if the House of Commons agrees to it, which it may, given that a number of soft Brexit Tories are receptive. A defeat of the final negotiated settlement could prolong negotiations with the EU. Brussels is on record stating that it would prolong the transition period and give the U.K. a different Brexit date, moving the current date of March 2019. However, it is unclear why May would continue negotiating at that point, given that her own parliament would send her back to Brussels, hat in hand. The fundamental problem for May is the same that has plagued the last three Tory Prime Ministers: the U.K. Conservative Party is intractably split with itself on Brexit. The only way to resolve the split may be for PM May to call an election and give herself a mandate to negotiate with the EU once she is politically recapitalized. This realization, that the probability of a new election is non-negligible, will likely weigh on the pound going forward. Investors would likely balk at the possibility that Jeremy Corbyn will become the prime minister, although polling data suggests that his surge in popularity is over (Chart 18). Local elections in early May also ended inconclusively for Labour's chances, with no big outpouring for left-leaning candidates. Even if Labour is forced to form a coalition with the Scottish National Party (SNP), it is unlikely that the left-leaning SNP would be much of a check on Corbyn's Labour. Chart 18Corbyn's Popularity Is In Decline Bottom Line: Theresa May will either have to call a new election between now and March of next year or she will use the threat of a new election to get hard-Brexit Tories in line. Either way, markets will have to reprice the probability of a Labour-led government between now and a resolution to the Brexit crisis. Italy: Start Pricing In A Populist Government Leaders of Italy's populist parties - M5S and Lega - have come to an agreement on a coalition that will put the two anti-establishment parties in charge of the EU's third-largest economy. Markets are taking the news in stride because M5S has taken a 180-degree turn on Euroskepticism. Although Lega remains overtly Euroskeptic, its leader Matteo Salvini has said that he does not want a chaotic exit from the currency bloc. Is the market right to ignore the risks? On one hand, it is a positive development that the anti-establishment forces take over the reins in Italy. Establishment parties have failed to reform the country, while time spent in government will de-radicalize both anti-establishment parties. Furthermore, the one item on the political agenda that both parties agree on is to radically curb illegal migration into Italy, a process that is already underway (Chart 19). On the other hand, the economic pact signed by both parties is completely and utterly incompatible with reality. It combines a flat tax and a guaranteed basic income with a lowering of the retirement age. This would blow a hole in Italy's budget, barring a miraculous positive impact on GDP growth. The market is likely ignoring the coalition's economic policies as it assumes they cannot be put into action. This is not because Rome is afraid to flout Brussels' rules, but because the bond market is not going to finance Italian expenditures. Long-dated Italian bonds are already cheap relative to the country's credit rating (Chart 20), evidence that the market is asking for a premium to finance Italian expenditures. This is despite the ongoing ECB bond buying efforts. Once the ECB ends the program later this year, or in early 2019, the pressure on Rome from the bond market will grow. Chart 19European Migration Crisis Is Over Chart 20Italian Bonds Still Require A Risk Premium We suspect that both M5S and Lega are aware of their constraints. After all, neither M5S leader Luigi Di Maio nor Lega's Salvini are going to take the prime minister spot. This is extraordinary! We cannot remember the last time a leader of the winning party refused to take the top political spot following an election. Both Di Maio and Salvini are trying to pass the buck for the failure of the coalition. In one way, this is market-positive, as it suggests that the anti-establishment coalition will do nothing of note during its mandate. But it also suggests that markets will have to deal with a new Italian election relatively quickly. As such, we would warn investors to steer clear of Italian assets. Their performance in 2017, and early 2018, suggests that the market has already priced in the most market-positive outcome. Yes, Italy will not leave the Euro Area. But no, there is no "Macron of Italy" to resolve its long-term growth problems. Bottom Line: The Italian government formation is not market-positive. Italian bonds are cheap for a reason. While it is unlikely that the populist coalition will have the room to maneuver its profligate coalition deal into action, the bond market may have to discipline Italian policymakers from time to time. In the long term, none of the structural problems that Italy faces - many of which we have identified in a number of reports - will be tackled by the incoming coalition.15 This will expose Italy to an eventual resurgence in Euroskepticism at the first sight of the next recession. Emerging Markets: Elections In Malaysia And Turkey Offer Divergent Outcomes As we pointed out at the beginning of this report, an environment of rising U.S. yields, a surging dollar, and moderating global growth is negative for emerging markets. In this context, politics is unlikely to make much of a difference. The recently announced early election in Turkey is a case in point. Markets briefly cheered the announced election (Chart 21), before investors realized that there is unlikely to be a consolidation of power behind President Erdogan (Chart 22). Even if Erdogan were to somehow massively outperform expectations and consolidate political capital, it is not clear why investors would cheer such an outcome given his track record, particularly on the economy, over the past decade. Chart 21Investors Briefly Cheered Ankara's Snap Election Chart 22Is Erdogan In Trouble? Malaysia, on the other hand, could be the one EM economy that defies the negative macro context due to political events. Our most bullish long-term scenario for Malaysia - a historic victory for the opposition Pakatan Harapan coalition - came to pass with the election on May 9 (Chart 23).16 Significantly, outgoing Prime Minister Najib Razak accepted the election results as the will of the people. He did not incite violence or refuse to cede power. Rather, he congratulated incoming Prime Minister Mahathir Mohamad and promised to help ensure a smooth transition. This marks the first transfer of power since Malaysian independence in 1957. It was democratic and peaceful, which establishes a hugely consequential and market-friendly precedent. How did the opposition pull off this historic upset? Ethnic-majority Malays swung to the opposition; Mahathir's "charismatic authority" had an outsized effect; Barisan Nasional "safety deposits" in Sabah and Sarawak failed; Voters rejected fundamentalist Islamism. What are the implications? Better Governance - Governance has been deteriorating, especially under Najib's rule, but now voters have demanded improvements that could include term-limits for prime ministers and legislative protections for officials investigating wrongdoing by top leaders (Chart 24). Economic Stimulus - Pakatan Harapan campaigned against some of the painful pro-market structural reforms that Najib put in place. They have promised to repeal the new Goods and Services Tax (GST) and reinstate fuel subsidies. They have also proposed raising the minimum wage and harmonizing it across the country. While these pledges will be watered down,17 they are positive for nominal growth in the short term but negative for fiscal sustainability in the long term. Chart 23Comfortable Majority For Pakatan Harapan Coalition Chart 24Voters Want Governance Improvements The one understated risk comes from China. Najib's weakness had led him to court China and rely increasingly on Chinese investment as an economic strategy. Mahathir and Pakatan Harapan will seek to revise all Chinese investment (including under the Belt and Road Initiative). This review is not necessarily to cancel projects but to haggle about prices and ensure that domestic labor is employed. Mahathir will also try to assert Malaysian rights in the South China Sea. None of this means that a crisis is impending, but China has increasingly used economic sanctions to punish and reward its neighbors according to whether their electoral outcomes are favorable to China,18 and we expect tensions to increase. Investment Conclusion On the one hand, in the short run, the picture for Malaysia is mixed. Pakatan Harapan will likely pursue some stimulative economic policies, but these come amidst fundamental macro weaknesses that we have highlighted in the past - and may even exacerbate them. On the other hand, a key external factor is working in the new government's favor: oil. With oil prices likely to move higher, the Malaysian ringgit is likely to benefit (Chart 25), helping Malaysian companies make payments on their large pile of dollar-denominated debt and improving household purchasing power, a key election grievance. Higher oil prices are also correlated with higher equity prices. Over the long run, we have a high-conviction view that this election is bullish for Malaysia. It sends a historic signal that the populace wants better governance. BCA's Emerging Markets Strategy has found that improvements in governance are crucial for long-term productivity, growth, and asset performance.19 Hence, BCA's Geopolitical Strategy recommends clients go long Malaysian equities relative to EM. Now is a good entry point despite short-term volatility (Chart 26). We also think that going long MYR/TRY will articulate both our bullish oil story as well as our divergent views on political risks in Malaysia and Turkey (Chart 27). Chart 25Oil Outlook Favors Malaysian Assets Chart 26Long Malaysian Equities Versus EM Chart 27Higher Oil Prices Favor MYR Than TRY We are re-initiating two trades this week. First, the recently stopped out long Russian / short EM equities recommendation. We still believe that the view is on strong fundamentals, at least in the tactical and cyclical sense.20 Russian President Vladimir Putin has won another mandate and appears to be focusing on domestic economy and the constraints to Russian geopolitical adventurism have grown. The Trump administration has apparently also grown wary of further sanctions against Russia. However, our initial timing was massively off, as tensions between Russia and West did not peak in early March as we thought. We are giving this high-risk, high-reward trade another go, particularly in light of our oil price outlook. Second, we booked 10.26% gains on our recommendation to go long French industrials versus their German counterparts. We are reopening this view again as structural reforms continue in France unimpeded. Meanwhile, risk of global trade wars and a global growth slowdown should impact the high-beta German industrials more than the French. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Senior Analyst jesse.kuri@bcaresearch.com 1 Washington's demand that China cut its annual trade surplus has grown from $100 billion, announced previously by President Trump, to at least $200 billion. 2 Please see BCA Emerging Markets Strategy Weekly Report, "EM: A Correction Or Bear Market?" dated May 10, 2018, available at ems.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "'America Is Roaring Back!' (But Why Is King Dollar Whispering?),"dated January 31, 2018, and Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat,'" dated April 7, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, and "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 8 Instead of a "big stick," President Trump would likely also recommend a "big nuclear button." 9 This is an important though obvious point. We find that many liberally-oriented clients are unwilling to give President Trump credit for correctly handling the North Korean negotiations. Similarly, conservative-oriented clients refuse to accept that President Obama's dealings with Iran had a strategic logic, even though they clearly did. President Obama would not have been able to conclude the JCPOA without the full support of U.S. intelligence and military establishment. 10 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 11 While there was no confirmed collaboration between Iranian ground forces in Iraq and the U.S. Air Force, we assume that it happened in 2014 in the defense of Baghdad. The U.S. A-10 Warthog was extensively used against Islamic State ground forces in that battle. The plane is most effective when it has communication from ground forces engaging enemy units. Given that Iranian troops and Iranian backed Shia militias did the majority of the fighting in the defense of Baghdad, we assume that there was tactical communication between U.S. and the Iranian military in 2014, a whole year before the U.S.-Iran nuclear détente was concluded. 12 Please see BCA Energy Sector Strategy Weekly Report, "Geopolitical Certainty: OPEC Production Risks Are Playing To Shale Producers' Advantage," dated May 9, 2018, available at nrg.bcaresearch.com. 13 Please see BCA Commodity & Energy Strategy Weekly Report, "Feedback Loop: Spec Positioning & Oil Price Volatility," dated May 10, 2018, available at ces.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "Bear Hunting And A Brexit Update," dated February 14, 2018, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, and "Europe's Divine Comedy Party II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "How To Play Malaysia's Elections (And Thailand's Lack Thereof)," dated March 21, 2018, available at gps.bcaresearch.com. 17 For instance, the proposed Sales and Services Tax (SST) is more like a rebranding of the GST than a true abolition. And while fuel subsidies will be reinstated - weighing on the fiscal deficit - they will have a quota and only certain vehicles will be eligible. It will not be a return to the old pricing regime where subsidies were unlimited and were for everyone. 18 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, available at gps.bcaresearch.com. 19 Please see BCA Emerging Markets Strategy Special Report, "Ranking EM Countries Based on Structural Variables," dated August 2, 2017, available at ems.bcaresearch.com. 20 Please see BCA Geopolitical Strategy Special Report, "Vladimir Putin, Act IV," dated March 7, 2018, available at gps.bcaresearch.com.

Highlights Global Volatility Vs. Inflation: Global financial markets are staging a recovery after the February volatility shock, with the U.S. showing the most resiliency. With inflation still rising in the U.S., and with inflation differentials still favoring the U.S. versus other developed markets, there is still the greatest scope for higher bond yields in the U.S. Stay below-benchmark portfolio duration and underweight U.S. Treasuries. New Zealand: New Zealand government bonds have been a star outperformer over the past year, as inflation has eased and the RBNZ has kept rates steady. With the economy set to slow in response to weaker immigration inflows, and with inflation still languishing well below the central bank's target, expect continued outperformance of New Zealand debt versus developed market peers. Feature Chart of the WeekThe Comeback Kids After a lengthy period of convalescence following the February VIX spike, some calm has been restored to financial markets. Global equities are staging a recovery from the correction seen earlier this year, with major indices like the U.S. S&P 500 and the MSCI All-Country World Index breaking out above key technical levels last week (Chart of the Week). Volatility in developed economy credit has also died down a bit, although corporate bond spreads still remain above the lows of the year in most countries. The resiliency of risk assets is even more impressive when viewed against the continuing climb of oil prices, fueled further by President Trump's announcement last week that the U.S. was pulling out of the Iran nuclear deal. With the benchmark Brent oil price now within hailing distance of $80/bbl, developed market government bond yields remain under upward pressure through higher inflation expectations (bottom panel). Yet as been the case for the past several months, the greatest upward pressure on global bond yields has been seen in the U.S., where the benchmark 10-year Treasury yield is once again knocking on the door of the 3% level. Global growth has lost some momentum in the first few months of the year, but not by enough to cause any loosening of capacity pressures through rising unemployment rates. Until the latter occurs, central banks will remain focused on the slow-but-steady rise in inflation pressures. This will limit any material decline in government bond yields as markets must price in both higher inflation expectations and some degree of interest rate increases. Not every central bank will deliver on what is currently discounted in terms of rate hikes, however, which continues to create more attractive relative fixed income country allocation opportunities now than have been seen in the past few years. We continue to recommend an overall below-benchmark portfolio duration stance, favoring corporate credit over sovereign debt. Within dedicated government bond portfolios, we favor underweight exposures in the U.S., Canada and core Europe while overweighting Australia, the U.K. and Japan. Lower U.S. Volatility Does Not Necessarily Mean Greater Global Stability The surge in market volatility earlier in the year began in the U.S. following the "wage inflation scare" in early February. The idea that dormant U.S. wage inflation could finally have awakened shook markets out of their slumber, driving the VIX index sharply higher (with some nudging from volatility-linked ETFs and other leveraged vehicles). Yet other markets saw a surge in vol, like currencies and the MOVE index of U.S. Treasury option prices (Chart 2). The latter development underscores one of our key investment themes for 2018, which is that the low market volatility environment will end through higher bond volatility.1 Faster U.S. inflation was expected to be trigger for that pickup in U.S. bond volatility, which would lead to a more aggressive path of Fed rate hikes and more uncertainty about the U.S. growth outlook beyond 2018. We did not expect that inflation-driven surge in bond volatility until the latter half of this year, but what happened in early February showed how the investing backdrop can turn ugly once inflation makes a comeback. Looking ahead, the subdued readings from the Chicago Board Options Exchange VVIX index, which measures the implied volatility of VIX options, indicate that the VIX can continue to head lower in the coming weeks (top panel). Combined with some easing of pressures seen in funding markets through the wider LIBOR-OIS spread (bottom panel), the backdrop is in place for continued recovery in U.S. equity and credit markets. It's a different story in non-U.S. markets, however. Softening global growth in the first quarter of the year, combined with steady increases in U.S. interest rate hike expectations, has resulted in the U.S. dollar staging a recovery after the pounding it took in 2017 (Chart 3). That combination of higher U.S. bond yields, a stronger dollar and weaker growth is a classic toxic brew for Emerging Market (EM) assets, which have been underperforming under the weight of investor outflows. None of those factors looks set to reverse in the near term, and we continue to recommend underweight allocations to EM fixed income (especially corporate debt). Chart 2The VIX Storm Has Blown Over Chart 3Not All Risk Assets Have Been Stabilizing Within the major developed markets, the most important factor at the moment is diverging inflation trends rather than growth. While U.S. inflation continues to drift higher, inflation in the euro area and U.K. has lost momentum (Chart 4). Surprisingly, Japanese inflation has finally started to show a bit of life - even after a period of yen appreciation - but perhaps that is because domestic inflation is finally awakening with annual wage growth hitting a 15-year high of 2.1% in March (3rd panel). Core inflation remains well below the Bank of Japan's 2% target, however. Meanwhile, last week's release of the April U.S. CPI data showed that inflation was still moving higher despite the outcome being slightly worse than expected (Chart 5). Importantly, some large and important elements of the CPI, like Shelter costs (33% of the total CPI index) and core goods prices (20%), saw a pickup in year-over-year inflation in line with our models and leading indicators. Given that U.S. real GDP growth leads core CPI inflation by about five quarters (top panel), this suggests that all of our inflation indicators are pointing to additional increases in U.S. inflation in the next 3-6 months. Chart 4Diverging Trends In Global Inflation Chart 5U.S. Inflation Momentum Still Trending Higher With U.S. inflation heading higher and non-U.S. developed market inflation languishing, there is still much more upside risk for U.S. Treasury yields than for the other government bond markets, mostly via higher U.S. inflation expectations. Stay underweight the U.S. within global hedged bond portfolios and remain long U.S. inflation protection by favoring TIPS over nominal Treasuries. Bottom Line: Global financial markets are staging a recovery after the February volatility shock, with the U.S. showing the most resiliency. With inflation still rising in the U.S., and with inflation differentials still favoring the U.S. versus other developed markets, there is still the greatest scope for higher bond yields in the U.S. Stay below-benchmark portfolio duration and underweight U.S. Treasuries. New Zealand: Outperformance To Continue Under New RBNZ Leadership Chart 6Good Timing On Our Bullish NZ Call One of the more successful trade recommendations we have made over the past year was to go long New Zealand government bonds versus U.S. Treasuries and German government debt in May 2017.2 Our call was predicated on a simple premise. The Reserve Bank of New Zealand (RBNZ) would maintain a dovish policy bias far longer than markets were expecting because of subdued inflation, at a time when the Fed would be hiking interest rates and the markets would begin to discount an end to the ECB's asset purchase program. Since we initiated that recommendation one year ago, headline New Zealand CPI inflation has slowed from 1.9% to 1%, while the RBNZ has kept policy rates unchanged. The spread between 5-year New Zealand government debt and 5-year U.S. Treasuries has collapsed from +74bps to -56bps, while the 5-year New Zealand-Germany spread has tightened from 292bps to 234bps. The overall New Zealand government bond index has outperformed the Barclays Global Treasury index by 120bps, currency hedged into U.S. dollars (Chart 6). Looking ahead, it may prove difficult to repeat those numbers from current levels. Yet it is even more challenging to construct a bearish case for New Zealand debt - the economy still looks sluggish, inflation is languishing well below the RBNZ target, and there have been changes at the central bank that will likely keep a dovish bias to New Zealand monetary policy. A Big Shakeup At The RBNZ There are several major moves that have just taken place at the RBNZ that should ensure that the central bank will not be raising rates anytime soon. First, Adrian Orr took over as RBNZ Governor back in March, replacing Graeme Wheeler. Orr was the Chief Executive of the New Zealand government pension (superannuation) fund, but was also a former RBNZ Chief Economist and Deputy Governor. He has stated an intention to make the RBNZ a more open, communicative central bank than Wheeler, who shunned media interviews and limited the number of on-the-record speeches by RBNZ officials. This will make the central bank a more transparent entity and limit the ability of the central bank from doing unexpected policy moves, as it has done in the past. The transparency will increase next year when the RBNZ moves to a full policy committee approach, where interest rates will be decided by a vote rather than a decision solely made by the Governor. Second, the New Zealand government has altered the RBNZ's monetary policy mandate following a review after the victory by the Labour party in last year's election. The central bank must now not only target price stability, but also seek to "maximize sustainable employment" in the New Zealand economy, not unlike the dual mandates of the U.S. Federal Reserve or Reserve Bank of Australia. This marks a major shift for the RBNZ, which was the first central bank to introduce an official inflation target in 1989. This change fulfils the new Labour-led government's campaign promise to promote job creation, which also includes restricting immigration. New Zealand Finance Minister Grant Robertson did state last November that the government would only consider candidates for RBNZ Governor that would be "willing and ready to adopt the new processes" of its review of the RBNZ's policy mandate.3 Robertson also noted that the new framework might result in monetary policy staying more accommodative from time to time. This smacks of increased government pressure on the RBNZ to keep policy as loose as possible to boost economic growth. Governor Orr has already had to go on the defensive, publicly stated that the central bank had "always" been considering short-term swings in employment when making its interest rate decisions. At a minimum, the case for future interest rate increases would have to be very strong under the new policy framework, focused on inflation seriously threatening the upside of the RBNZ's 1-3% target band. Economy Looking Sluggish After last week's monetary policy meeting, where the central bank kept the Overnight Cash Rate at 1.75% and downgraded its growth projections, Orr noted that the markets had "finally seemed to listen" to the RBNZ's message that policy rates would be on hold for a long time. He pointed to the decline in the New Zealand dollar (NZD) to a six-month low following the meeting as a "good thing for a trading nation" like New Zealand.4 His blunt, yet cautious, tone fits with developments in the New Zealand economy of late. Growth slowed over the course of 2017, with real GDP expanding at a 2.9% year-over-year rate in the fourth quarter after averaging 3.5% growth since 2014. The two major drags on growth were consumer spending and residential investment, both of which decelerated from unsustainably high growth rates in the prior few years that were fueled by high rates of net immigration (Chart 7). In the May 2018 Monetary Policy Report (MPR) released last week, the RBNZ noted that it expects net immigration to fall for three reasons: a strengthening Australian labor market, tighter visa requirements and the departure of those with temporary visas.5 The RBNZ is projecting immigration levels will steadily decline over the next four years, returning to levels last seen in 2011 in 2020, which will cause consumer spending growth to slow from over 4% to 2% by the end of the projection period (middle panel). That will also act as a major drag on housing activity, with no significant growth in real residential investment expected until 2020 (bottom panel). This will come on top of other regulatory changes introduced in 2016 to cool an overheated housing market (limiting loan-to-value ratios on mortgage lending). The RBNZ now expects real GDP growth to slow to 2.8% in 2018, a pace below its estimate of potential GDP growth of 3.2%. Not only is consumer spending and housing expected to slow, but the business sector is also projected to remain sluggish. Business confidence and capacity utilization are both well off the 2017 peak, thanks mainly to the slump in the dairy sector, which remains a critical part of the New Zealand economy (Chart 8). The fall in dairy prices and milk production was reportedly caused by poor weather conditions and falling demand from China, but the declines may be bottoming out (bottom panel). Besides the agricultural sectors, manufacturing and service sectors are still in decent shape, with the PMIs for both still above 50 even after last year's declines (top panel). The softer China demand story is not just about dairy, however. Growth in overall export demand from China has slowed dramatically over the past year, from 50% year-on-year down to -4.3% in March (Chart 9, 2nd panel). Australian export demand has also decelerated, which is critical given that those two countries represent 40% of total New Zealand exports. The RBNZ export survey, which has been a reliable leading indicator for New Zealand export growth, shows that exports are likely to continue falling over the next 6-8 months (top panel). With the overall commodity price index have clearly slowed (bottom panel), it is likely that the terms of trade will remain a drag on New Zealand economic growth, and the NZD, through a deteriorating current account deficit (now -3% of GDP) in the coming months. Chart 7Immigration-Fueled Growth Set To Reverse In NZ Chart 8Dairy Still Matters For NZ Chart 9NZ Exports Getting Hit Where's The Inflation? Despite the recent cooling of growth, the New Zealand unemployment rate is well below the OECD's estimate of the full employment NAIRU. Unlike other developed market countries with low unemployment rates, however, New Zealand's labor force participation rate is currently close to an historical high near 71% (Chart 10). While a high participation rate should mean that New Zealand is truly at full employment, wage growth remains anemic even with booming levels of job vacancies (3rd panel). The growth in average hourly pay for overall workers is still below the rate of headline CPI inflation, although this will get a bump with a 4.8% minimum wage increase being adapted last month. Overall, New Zealand's headline CPI inflation reached the RBNZ's target rate only once in Q1 2017, after several years of staying below that 2% benchmark, then started to slow down again over the rest of last year (Chart 11). Currently, headline and core CPI inflation are only 1.1% and 0.9%, respectively. This is now at the lower bound of the RBNZ's 1-3% target band, justifying the central bank's dovish bias. Chart 10Low Unemployment With No Wage Growth Chart 11No Inflation Problems For The New RBNZ Governor Within the main components of the index, non-tradables (i.e. domestically based) inflation has maintained stable growth near 2%, but tradables (i.e. globally based) prices are in outright deflation. This remains the biggest source for the undershoot of the RBNZ's inflation target over the past year - shockingly, a period when oil prices surged higher and the trade-weighted NZD softened. Yet the low levels of inflation are not filtering though into household expectations, with survey data showing that inflation is expected to stay above 2% next year, and even rise to 3% over the next five years. Policy To Stay On Hold For A Lot Longer The RBNZ is not as optimistic as households on inflation, however. The central bank is projecting that the headline CPI index will only rise by 1.1% in 2018 and will not return to the 2% target until 2021. On the back of this, the RBNZ is also projecting that the Overnight Cash Rate will remain at 1.75% until the end of 2020. Chart 12NZ Bonds Will Continue To Outperform The market is still pricing in one 25bp rate hike over the next 12 months, according to our calculations from the Overnight Index Swaps market (Chart 12). We see no reason for the RBNZ to not be taken at its word about holding rates steady, especially given the new dovish elements of the RBNZ's revised mandate. With price and wage inflation still so surprisingly low, the RBNZ can go for its maximum employment mandate and maintain highly accommodative monetary conditions. This includes both low policy rates and keeping the currency as weak as possible. We would recommend leaning against the mild increase in New Zealand bond yields, and the modest flattening of the yield curve, currently priced into the forwards (3rd and 4th panels). That suggests maintaining an above-benchmark duration stance for dedicated New Zealand fixed income investors. It also means adapting a bullish stance on New Zealand government bonds from a relative perspective to other developed markets. We are maintaining our current recommended spread trades for 5-year New Zealand bonds versus 5-year U.S. Treasuries and 5-year German debt. We have maintained the U.S. trade on a currency-hedged basis, as we typically do with all our recommendations. For the New Zealand-Germany spread trade, however, we made a rare exception and entered that trade on an unhedged basis. This was because we had a strong view that the euro would depreciate against most major currencies last year, including the NZD. That did not occur last year as the euro surged higher, which meant that our New Zealand-Germany trade took losses as NZD/EUR declined. For now, we are keeping that trade on an unhedged basis given the depressed level of NZD/EUR, but we will keep a tight stop going forward in the event of a broader breakdown in the NZD. Bottom Line: New Zealand government bonds have been a star outperformer over the past year, as inflation has eased and the RBNZ has kept rates steady. With the economy set to slow in response to weaker immigration inflows, and with inflation still languishing well below the central bank's target, expect continued outperformance of New Zealand debt versus developed market peers. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2018 Key Views: BCA's Outlook & What It Means For Global Fixed Income Markets", dated December 5th 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Distant Early Warning", dated May 30 2017, available at gfis.bcaresearch.com. 3 https://www.reuters.com/article/us-newzealand-economy-finmin/new-zealand-finance-minister-says-new-rbnz-governor-must-take-on-dual-mandate-idUSKBN1DG0EY?il=0 4 https://www.reuters.com/article/us-newzealand-economy-rbnz-orr/rbnz-governor-says-markets-finally-getting-the-hint-on-low-rates-idUSKBN1IC0LS 5 https://www.rbnz.govt.nz/monetary-policy/monetary-policy-statement/mps-may-2018 Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Highlights Butterfly Trades: Duration-neutral butterfly trades are the best way to gain pure exposure to changes in the slope of the yield curve while remaining insulated from parallel shocks. Yield Curve Models: In this report we present models for each different butterfly spread combination across the entire Treasury curve. The models allow us to pinpoint the most attractively valued parts of the yield curve at any given point in time. We also demonstrate how trading rules based on our valuation models have delivered excellent investment results. Current Curve Valuation: Our models show that the most attractively valued butterfly spread at the moment is a position long the 7-year bullet and short the 1/20 barbell. We recommend closing our current position long the 5-year bullet and short the 2/10 barbell, and shifting into the 7-year over 1/20. Feature Last summer we published a Special Report that explained why duration-neutral butterfly trades are the best way to gain exposure to changes in the slope of the yield curve.1 That report focused on the 2/5/10 butterfly spread, which is defined as the spread between the 5-year Treasury note and a barbell consisting of the 2-year and 10-year notes. For this method to work the 2-year and 10-year notes must be weighted so that the dollar duration (DV01) of the 2/10 barbell matches the DV01 of the 5-year bullet.2 Chart 1Butterfly Strategy Valuation The report demonstrated how, when using the above weighting scheme, a long position in the 5-year bullet versus a short position in the 2/10 barbell allows investors to profit from a steepening of the 2/10 Treasury slope while remaining insulated from small parallel yield curve shocks. Similarly, we showed that investors who want to gain exposure to 2/10 curve flattening should go long the 2/10 barbell and short the 5-year bullet. The report also presented a fair value model for the 2/5/10 butterfly spread based on the 2/10 slope. The model allows us to incorporate initial valuation into our yield curve trading framework. For example, while the 5-year bullet will tend to outperform the 2/10 barbell when the 2/10 slope is steepening, it will require very little 2/10 steepening for it to outperform when the 5-year appears cheap on our model. More 2/10 steepening is required when the 5-year is initially expensive. In this follow-up Special Report we extend the above modeling framework to all different segments of the yield curve. The results of our analysis, shown in Chart 1, allow us to quickly scan the entire Treasury curve and identify which butterfly combinations are most attractively valued. We can then consider the message from our valuation models alongside our macro view of how the slope of the yield curve will evolve. These two factors together will suggest appropriate butterfly trades to implement. This Special Report proceeds in three sections. The first section provides a quick re-cap of the theory of butterfly trades with a focus on the importance of valuing butterfly spreads relative to the slope. The second section explains the process we followed to extend our 2/5/10 butterfly model to the rest of the yield curve. The final section presents the results of two trading rules based on the read-out from our yield curve models. Butterfly Theory Revisited: The Importance Of Valuation In our report from last year we showed that, because both the bullet and barbell have the same DV01, a position long one and short the other is immune from small parallel yield curve shifts. However, because the longest maturity bond contributes more DV01 to the barbell than the short maturity bond, the barbell will underperform (outperform) the bullet when the curve steepens (flattens). This dynamic also means that the butterfly spread - defined as the bullet yield over the barbell yield - is positively correlated with the slope of the curve (Chart 2). The logic of this relationship depends on the fact that the yield curve tends to mean revert over time. A steep yield curve implies that it is more likely to flatten in the future. This means that when the curve is steep investors will demand greater compensation to enter trades that profit from further steepening. The bullet yield will therefore be bid up relative to the barbell. This is the relationship we exploit to create our yield curve models. Chart 2The Butterfly Spread And Slope Are Positively Correlated Trade Performance When The Butterfly Spread Is At Fair Value For example, let's consider the 2/5/10 butterfly spread once more. Our analysis shows that the butterfly spread is fairly valued when it is 0.14 times the slope of the 2/10 curve. The "first scenario" in Table 1 shows hypothetical returns to a position that is long the 5-year bullet and short the 2/10 barbell in four different yield curve scenarios. All four scenarios assume that the 2/5/10 butterfly spread is always fairly valued relative to the 2/10 slope (i.e. it is equal to 0.14 multiplied by the 2/10 slope). Table 1Hypothetical Butterfly Trade Performance Notice that the bullet outperforms the barbell in both scenarios where the 2/10 slope steepens and underperforms in both scenarios where the 2/10 slope flattens. It does not matter whether yields move higher or lower, only changes to the slope of the curve impact returns. Trade Performance When The Butterfly Spread Deviates From Fair Value Next, let's consider the "second scenario" shown in Table 1. Here we assume that the butterfly spread is initially different from its model-implied fair value and then reverts to fair value by the end of the investment horizon. Now, in the bear-steepening scenario the 5-year bullet actually underperforms the 2/10 barbell even though the yield curve steepens. This is because the 5-year bullet is initially expensive relative to the barbell. Notice that the 2/5/10 butterfly spread is initially only 4 bps. A fairly valued butterfly spread would have been 7 bps (0.14 * 50 bps). The point of this analysis is to demonstrate the importance of initial valuation. When the butterfly spread is initially below fair value, more curve steepening is necessary for the bullet to outperform the barbell. Similarly, the bottom half of Table 1 shows that when the butterfly spread is initially above fair value, more curve flattening is required for the barbell to outperform. Modeling The Entire Curve With that in mind, we decided to extend our simple modeling framework to every segment of the yield curve. Using par-coupon bond yields from the Federal Reserve we considered all possible butterfly combinations consisting of 1-year, 2-year, 3-year, 5-year, 7-year, 10-year, 20-year and 30-year Treasury securities. We then estimated models of each possible butterfly spread (bullet over barbell) versus the slope between the two maturities used in the barbell. Chart 3 shows that the effectiveness of these models varies considerably between the different butterfly combinations. Chart 31-Factor Model Adjusted R2 To understand why some butterfly combinations are more easily modeled than others we need to rely on an alternative theory for the positive correlation between the butterfly spread and the slope. This theory relates to the fact that implied interest rate volatility is also highly correlated with the slope of the yield curve (Chart 4). The reasoning is fairly straightforward. Investors demand more compensation to bear duration risk when the economic outlook is more uncertain and interest rate volatility is higher. Greater volatility therefore causes investors to bid up the term premium embedded in long-maturity Treasury securities, leading to a steeper curve. The strong relationship between implied volatility and the slope of the yield curve is important because another property of DV01-matched butterfly trades is that the barbell always has greater convexity than the bullet. Elevated convexity is a desirable property when interest rate volatility is high, meaning that the side of the trade with lower convexity (the bullet) will need to offer a higher yield to entice investors when rate volatility is elevated and the yield curve is steep. The key point is that while the barbell has greater convexity than the bullet in every butterfly combination, some butterfly combinations have a greater difference in convexity between the bullet and barbell than others. Chart 5 shows that those butterfly combinations with a larger convexity difference between the bullet and barbell are more sensitive to changes in the slope of the curve, and are thus easier to model using our framework. Chart 4The Yield Curve ##br##And Volatility Chart 5Models Work Better When The ##br## Convexity Mismatch Is Large Finally, because there are strong theoretical arguments for why the butterfly spread should be positively correlated with both the slope of the yield curve and interest rate volatility, we tried adding the MOVE index of implied rate volatility as a second independent variable in each of our yield curve models. We found that this second variable only materially improved the accuracy of the models for a handful of butterfly combinations: the 5/7/10, 5/7/30, 1/20/30, 2/20/30, 3/20/30, 5/20/30, 7/20/30 and 10/20/30. We will rely on two-factor models (using both the curve slope and the MOVE index) for those combinations, while using one-factor models (with the slope only) for the others. One advantage of using a model based only on the slope is that we can reverse the model to ask the question: What change in the slope is necessary in order for the butterfly spread to be considered "fairly valued" at its current level? By framing the valuation question in this context it is easier to link the message from our valuation models to our macro view on the yield curve. For example, our 2/5/10 butterfly spread model shows that the 5-year bullet is currently 6 bps cheap. Alternatively, we can also state that the 2/5/10 butterfly spread is priced for 32 bps of 2/10 flattening during the next six months (Chart 6).3 If we expect the 2/10 slope to flatten by more than what is discounted we should enter the barbell over the bullet. Conversely, if we think the slope will flatten by less than what is discounted we should favor the bullet. Chart 62/5/10 Butterfly Spread Fair Value Model Chart 7 shows the current valuation for every butterfly combination in this manner. Rather than showing whether the bullet is cheap/expensive relative to the barbell (as in shown in Chart 1), it shows what change in the slope between the two components of the barbell is currently being discounted by the butterfly spread. We omit the butterfly combinations that are modeled using both the slope and volatility from this exercise. Chart 7Discounted Slope Change During Next Six Months (BPs) Performance Tests We performed two tests to see whether our suite of yield curve models adds value to the investment process. Test #1 First, we considered each butterfly combination individually and tested the following trading rule: When the bullet is more than 0.5 standard deviations cheap on our model, we go long the bullet and short the barbell. When the barbell is more than 0.5 standard deviations cheap on our model, we go long the barbell and short the bullet. If nether the bullet nor the barbell is more than 0.5 standard deviations cheap we take no position. The trades are re-balanced daily and tested on a horizon from 1988 to the present. The results of this first test are shown in Chart 8. Here we see the annualized excess returns earned from each butterfly combination over the course of the testing horizon. In Chart 9 we also show the average number of times per year that the above trading rule would have recommended switching between the bullet, barbell and taking no position. Chart 10 shows the average annualized excess return divided by the average number of annual position changes. Chart 8Trading Rule Annualized Excess Returns Since April 1988 (BPs) Chart 9Average Number Of Trades Per Year Chart 10Excess Return Per Trade (BPs) While the test results are encouraging insofar as every combination delivers positive excess returns, we note that due to limits in the amount of historical data at our disposal, most of the back-test is performed in sample. Although our robustness checks suggest that the regression coefficients are fairly stable through time, so we expect the results to be replicable going forward. Chart 11Excess Returns Versus Model Fit We also observe that the performance is not equally distributed amongst the different curve models. In fact, we notice that the models with the best fit - and hence largest convexity mismatches between the bullet and barbell - deliver better results than models with worse fit (Chart 11). This is not very surprising, but it does reinforce that we should put more weight on the message from the valuation models with greater convexity mismatches than on those with smaller mismatches. Test #2 In practice, we would not recommend trying to implement every butterfly trade that appears cheap according to our models. Rather, the real power of our modeling framework is that we can choose the most attractive segment of the yield curve and implement that trade only - assuming it synchs up with our macro view of the yield curve. In our second performance test we did just that. Each month we chose the most attractively valued yield curve trade based on our models and implemented only that trade. Chart 12 shows that not only does that method deliver excellent excess returns over time, it also outperforms a benchmark where we take the average of all yield curve trades recommended by our models. Chart 12Test #2 Results At present, the most attractive butterfly trade according to our models is the 7-year bullet over the 1/20 barbell. This trade is directionally similar to our currently recommended position long the 5-year bullet over the 2/10 barbell, in that both will benefit from curve steepening (or less curve flattening than is currently priced). Given the more attractive value in the 7-year over 1/20 combination, we recommended investors shift their yield curve allocation away from the 2/5/10 butterfly to favor the 7-year bullet over the 1/20 barbell. Alex Wang, CFA, Senior Analyst alexw@bcaresearch.com Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 2 The dollar duration (DV01) is the dollar value of a basis point. It measures the dollar change in the price of a given bond assuming a one basis point change in yield. It is calculated as the bond's duration times its price, divided by 104. 3 We assume an investment horizon of 6 months, a length of time that approximates the average length of time it takes for the butterfly spread to revert to our model's fair value.

Highlights Portfolio Strategy Firming industry demand at a time when global energy capital spending budgets are renormalizing, along with rising crude oil prices, signal that high-beta energy services equities have more running room. Our confidence in additional significant bank relative price gains has decreased. There is budding evidence that the bank/yield curve correlation is getting re-established, as we had posited last autumn, and coupled with later cycle dynamics signal that the bank outperformance is getting long in the tooth. Recent Changes Crystalize gains of 6% in the S&P banks index and remove from the high-conviction overweight call list. Put the S&P banks index on downgrade alert. Prefer large caps to small caps (please refer to the May 10th Sector Insight). Table 1 Feature Equities staged a breakout attempt last week and the SPX reclaimed the 50-day moving average, with the energy sector leading the pack. However, the lateral move in place over the past quarter is not over yet as the market is still digesting the February 5th drawdown. Importantly, EPS euphoria cannot last forever and the inevitable profit growth deceleration post the calendar 2018 onetime tax reform fillip is weighing on the market. The 12-month forward EPS growth rate has come down to 15%, and as we move into the back half of 2018 it will continue to glide toward a still impressive 10% (or two times nominal GDP growth), which is where the calendar 2019 estimate currently stands (Chart 1). Following up from last week's 'Til Debt Do Us Part' Special Report, the overall market's (ex-financials and ex-real estate) 'Altman Z-score' is waving a mini yellow flag. Cyclical momentum in this indicator is giving way and the broad market's deteriorating creditworthiness is also, at the margin, anchoring profit growth (Chart 2). Chart 1Unsustainable EPS Euphoria Chart 2Watching Balance Sheets... Nevertheless, we remain constructive on the broad market from a cyclical 9-12 month horizon as the odds of recession are close to nil, and interpret recent market action as a sign of resiliency. The SPX refuses to give way to the bearish narrative plagued by geopolitical uncertainty/fears and slowing global growth. Chart 3 shows an extremely economically sensitive indicator, lumber, alongside the ISM manufacturing survey. Since 1969 when lumber futures first commenced trading, these two series have been tightly positively correlated. Recently, a rare and steep divergence is visible and our inclination is to expect all-time high lumber prices to arrest the ISM's fall in the coming months. True, lumber prices reflect a NAFTA-related premium and at the current juncture cannot be fully trusted that they are emitting an accurate economic signal. We, thus, resort to another - daily reported - global growth barometer, the Baltic Dry Index (BDI). The third panel of Chart 3 shows that a wide gap has opened between the ISM manufacturing index and the BDI. If our assessment is correct and this global growth soft patch is transitory, then the ISM will remain squarely clear of the 50 boom/bust line. Taken together, these two economically sensitive high frequency series comprise our Global Trade Indicator which is underscoring that global export growth will pick up in the back half of the year (bottom panel, Chart 3). Finally, on the domestic freight front,1 the composite freight index is also reaccelerating, signaling that domestic demand conditions are firing on all cylinders (fourth panel, Chart 3). Circling back to profit growth, long-term S&P 500 EPS growth expectations have vaulted to the highest level since the dotcom bubble (bottom panel, Chart 4). While in isolation, this measure signals we are in overshoot territory and such breakneck EPS growth is clearly unsustainable, the SPX PEG ratio tells a different story (we divide the 12-month forward price to earnings ratio by the long-term EPS growth rate to arrive at the current reading near 1 on the S&P 500 PEG ratio, Chart 4). Chart 3...But Economy Is Humming Chart 4Market Is Cheap According To PEG Ratio On this valuation measure the SPX appears cheap. Historically, every time the PEG ratio has sunk to one standard deviation below the mean, at least a reflex rebound ensued. Table 2 summarizes the five most recent iterations we included in the analysis since 1985. While we cannot rule out a steep undershoot, if history at least rhymes, the S&P should be higher in the subsequent 12 months (Chart 5). Chart 5SPX Cycle-On-Cycle Return Profile When The PEG Ratio Gets Depressed Table 2S&P 500 Yearly Returns* This week we are removing an early cyclical index from our high-conviction call list, locking in handsome profits, and updating a high-beta energy sub-index. Put Banks On Downgrade Watch Despite a blockbuster earnings season, banks have come under pressure recently. Worrisomely, they have not followed the 10-year Treasury yield higher and that is cause for concern. We first cautioned last October that banks would shatter their near one-to-one relationship with the 10-year UST yield and re-establish it with the yield curve likely in the back half of 2018 as the Fed would further lift the fed funds rate away from the zero lower bound.2 This positive correlation shift from interest rates to the yield curve slope is important as it will likely squeeze banks' net interest margins, a key profit driver (Chart 6). Charts 7 & 8 show that there is increasing empirical evidence that banks have already started making this transition away from the 10-year UST yield and toward the 10/2 yield curve, and we are thus compelled to book profits of 6% and remove this early cyclical index from the high-conviction overweight call list. The S&P banks index is now also on downgrade alert. Chart 6NIM Trouble? Chart 7Monitoring Shifting... Chart 8...Correlations What would cause us to change our yearlong cyclical constructive view and move to a benchmark allocation, is a lack of relative price outperformance in the next 10-year Treasury yield jump. Crudely put, if banks fail to best the market when the bond market further sells off roughly to 3.25%, as BCA's fixed income strategists expect, we will pull the trigger and downgrade to a neutral stance. Another reason we are likely to become more wary of bank relative performance in the coming quarters is the stage of the business cycle. Importantly, we wanted to test our hypothesis that in the late/later stages of the expansion early cyclicals, banks included, fare poorly. Therefore, at some point we should move away from our sanguine view on this index and not overstay our welcome as the current expansion has become the second longest on record according to the NBER designated recessions. In more detail, what we did to test this hypothesis was to document relative bank performance from when the ISM manufacturing peaked for the cycle until the recession commenced going back to the 1960s (Chart 9). Table 3 aggregates the results using monthly data. What is clear is that if the recession is a financial crisis related recession, then shy away from banks. But, in 4 out of the 7 last cycles dating back to the 1960s, banks outperformed the broad market in the later stages of the business cycle. Chart 9Banks Tend To Slump In Later Stages Of The Cycle Table 3Late Cycle Analysis Nevertheless, breaking down the results in two periods is instructive. One period recalibrates the bank relative returns from the ISM peak until the SPX peak, and the second one from the SPX peak until the recession commences (Table 3). Banks clearly underwhelm 4 out of the 7 iterations as the SPX crests, confirming our negative return hypothesis. Subsequently, as the SPX deflates when the economy heads into recession, relative bank performance significantly improves with the caveat that during financial crises, banks continue to bleed (in an upcoming Special Report we will be performing the same analysis on the GICS1 U.S. equity sectors, stay tuned). Two weeks ago we lifted our peak SPX target to 3200,3 and the implication is that banks' best days have likely passed, if history at least rhymes. Bottom Line: Stay overweight banks for now, but lock in gains of 6% and remove the S&P banks index from the high-conviction overweight call list, as our confidence is not as high as in late-November.4 Further, we are putting this key financials sub index on downgrade alert reflecting the negative implication from our later stages of the business cycle analysis. We are closely monitoring the yield curve slope and interest rate correlation with bank performance, and if banks refrain from participating in the next leg up in interest rates it will serve as a catalyst to prune exposure to neutral. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB. Energy Servicers: The Phoenix Is Rising Quarter-to-date the S&P energy services index is up 12% compared with the 2% rise in the broad market. Even year-to-date, oil servicing companies have bested the market by 600bps. The steep rebound in oil prices primarily lies behind such stellar outperformance, and BCA's Commodity & Energy Strategy still-upbeat crude oil view is a harbinger of even brighter days ahead for this high-beta energy sub sector (Chart 10). While we are exploring our capex upcycle theme via a high-conviction overweight in the broad S&P energy index, oil services companies are also a prime beneficiary of our synchronized global capital outlays upcycle theme. In fact, relative share price momentum does not yet fully reflect the rebound in industry investment (using national accounts) that remains in a V-shaped recovery since the Q1/2016 oil market trough (second panel, Chart 11). Importantly, OPEC 2.0 and $70/bbl oil prices have resulted in a semblance of normality in the E&P space (a key industry client) that has lifted spending budgets (bottom panel, Chart 11). The upshot is that energy services revenues will continue to expand (Chart 11). Energy related capital spending budgets are not only rising in the U.S. (primarily in shale oil), but also globally. The global rig count is breaking out, and declining OECD oil stocks suggest that drilling activity will remain robust (top and second panel, Chart 12). Chart 10Catch up Phase Chart 11Capex Upcycle... Chart 12...Beneficiary Taking the pulse of oil services industry slack is extremely important for profitability. Our global idle rig proxy is also making a breakout attempt following a massive two year plus retrenchment phase (top panel, Chart 13). Keep in mind that energy servicers have only recently exited deflation, that wreaked havoc in the sector's financial metrics. Now as a renormalization period is unfolding with higher underlying commodity prices breathing life into industry new order growth, even a modest pricing power rebound will go a long way in lifting depressed profits. In fact, new orders-to-inventories are in a reflex rebound. While such an exponential rise is unsustainable, firming oil services demand should continue to remove excess slack, a boon for industry selling prices and profits (middle and bottom panels, Chart 13). Sentiment toward this energy sub-index remains bombed out and there is widespread disbelief that this rebound is sustainable. Rather, the risk of a deflationary relapse has kept investors at bay pushing relative valuations deep into undervalued territory. Both our composite relative Valuation Indicator (VI) and relative price-to-book are hovering near all-time lows (bottom panel, Chart 12). Technicals are not as depressed as the VI reading, with the recent relative share price bounce lifting our relative Technical Indicator to the neutral zone (Chart 14). Chart 13Deflation Is Over Chart 14Unloved And Underowned In sum, there are more gains in store for the S&P energy services index. Firming industry demand at a time when global energy capital spending budgets are renormalizing, along with rising crude oil prices, signal that high-beta energy services equities have more running room. Bottom Line: Stay overweight the S&P energy service index. The ticker symbols for the stocks in this index are: BLBG: S5ENRE -NOV, SLB, FTI, BHGE, HAL, HP. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 The freight transportation services index consists of: For-hire trucking (parcel services are not included); Freight railroad services (including rail-based intermodal shipments such as containers on flat cars); Inland waterway traffic; Pipeline movements (including principally petroleum and petroleum products and natural gas); and Air freight. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Later Cycle Dynamics," dated October 23, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Lifting SPX Target," dated April 30, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Special Report

Dear Client, This week, we are sending you a Special Report written by my colleague Juan Correa. This piece discusses value investing in the FX space, using purchasing power parity metrics in order to device profitable trading rules for investors. Contrarily to naive uses of PPP, the methods described by Juan provide profitable signals on long-term as well as short-term investment horizons. I trust you will find this report interesting and informative. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Feature "In our own day, many people have greatly increased their fortunes by carrying to Flanders and France ducats of two, four and ten....on each of which they make a big profit; and they bring merchandise from abroad which is worth little there and much here." - Martin Azpilicueta, Comentorio Resolutario de Usuras, 1556 Purchase Power Parity, or PPP, is perhaps the most basic concept for establishing the fair value of a currency. The theory dates back to 16th century Spain, where a group of theologians witnessed firsthand how a large influx of gold from the New World created a tremendous price imbalance between Spain and neighboring countries, providing traders with an opportunity to make a profit. From their observations, the main axiom of PPP was born: Once converted to a common currency, national price levels should be equal to one another. The theory is an offshoot of the Law of One Price, and simply states that if the above condition does not hold, there exists an arbitrage opportunity. Since its discovery, PPP has become a pillar of international economics, and has been the preferred measure to determine exchange rates for newly established countries. However, the usefulness of PPP to make investment decisions in currency markets remains doubtful. Specifically, academic literature has shown that the speed of convergence of currencies to their implied fair value is extremely slow1 (between 3 and 5 years2), making PPP a poor timing indicator. Moreover, academics have also struggled to find compelling evidence of long-run PPP convergence when including non-U.S. dollar crosses.3 This last point is crucial, as the data shows that many crosses do not revert back to their fair value, even If we consider multi-decade time horizons, and even if we take the average of the crosses for a particular currency to smooth out outliers (Chart I-1A and Chart I-1B). Chart I-1APPP: An Unreliable Fair Value Measure (I) Chart I-1BPPP: An Unreliable Fair Value Measure (I) A good example is EUR/CHF. This cross has been undervalued relative to its PPP value by at least 7% for more than three decades, suggesting there should have been immense upward pressure on this exchange rate. However over this same time frame, EUR/CHF has steadily depreciated by more than 36% (Chart I-2). Any investor using this absolute PPP undervaluation as a signal to buy this cross would have made a mistake, even with a very long time horizon. Chart I-2EUR/CHF: A Deceptive Bargain The PPP Puzzle: Theoretical Considerations Chart I-3The Penn Effect In Action Cases like the one above, where there is a consistent violation of the supposed non-arbitrage axiom, show how PPP can be a misleading indicator, even for long-term investors. While this valuation metric can be useful for some currencies, it cannot be applied in systematic fashion to make buying and selling decisions on the whole universe of investable G10 crosses. The unreliability of PPP is not a novel observation. Economists and investors alike have made numerous attempts to explain why PPP is not binding. Below we discuss the theoretical reasons as to why this is the case, and we review the performance of some of the common solutions used to solve these issues. The Balassa-Samuelson Hypothesis The Balassa-Samuelson Hypothesis originated from the empirical observation that countries with higher GDP per capita tend to have structurally higher prices (also known as "The Penn Effect") (Chart I-3). This hypothesis argues that this phenomenon occurs because richer countries, which are more productive, tend to have most of their competitive advantage concentrated in the tradable goods sector. In order for wages to equalize across sectors of the economy, non-tradable goods prices rise, making consumer price baskets, which are composed of both tradable and non-tradable goods, structurally higher in more productive countries.4 This theory would suggest that tradable prices should be uniform across countries. Therefore, an obvious solution to account for the Balassa-Samuelson effect would be to use tradable goods to estimate fair value. After all, a non-arbitrage condition can only hold in goods that can be traded. We use Bloomberg PPI-based PPP fair-value estimates to analyze whether assessing equilibria based on producer prices indices (which tend to be composed of highly tradable goods) provides a better fair-value estimate. Disappointingly, PPI-based PPP shows no material improvement in terms of acting as a reliable fair value measure over the PPP of the OECD that encompasses broader price baskets (Chart I-4A and Chart I-4B).5 Indeed, multiple currencies still display structural over- or under-valuations over multiple decades.6 Chart I-4ANo Significant Improvement ##br##In Valuation Using PPI (I) Chart I-4BNo Significant Improvement ##br##In Valuation Using PPI (II) The Border Effect Chart I-5The Border Effect In Action Why is it that highly tradable goods like those included in producer price indices can have such different prices in two countries over such a long period of time? A likely answer is transaction costs. Non-arbitrage conditions hold only if transaction costs are absent or minimal. In practice, this is rarely the case. Consider the results from the paper "The Border Effect: Some New Evidence."7 In this paper, Gopinath et al measure wholesale (pre-gross margin, pre-tax) costs of tradable goods from the same retail chain in both the U.S. and Canada. Overall, they find that while the difference between intra-country store costs is negligible, the median difference between Canadian and U.S. stores is nearly 18% (Chart I-5). This effect holds even when adjusting for distance as well as average income around the store. The results are particularly striking considering the U.S. and Canada share a common land border, speak the same language and have an extensive free-trade agreement. Accounting For Distortions: Stable Distribution Strategies Chart I-6Winners And Losers Of PPP Strategies Practitioners tend to have limited data on the degree of distortion affecting the PPP fair value of a currency. A strategy that sidesteps this issue is to buy (or sell) crosses that are undervalued (overvalued) relative to their historical distributions. Such a strategy recognizes that some currencies tend to be structurally overvalued and others tend to be structurally undervalued, for whatever the reason. However, these strategies assume that this overvaluation / undervaluation should be stationary through time.8 Therefore, if a currency is much more overvalued or undervalued than implied by its historical distribution, a selling or buying opportunity exists. We tested these kinds of "Stable Distribution" PPP strategies from the perspective of all G10 countries. Our methodology was the following: We estimated the average deviation of every currency cross from their OECD PPP measures over the first half of our sample (historical mean). We also estimated the standard deviation around this mean (sigma bands). We back tested the following strategy in the second half of our sample: Buy a currency when its disequilibrium to its OECD PPP estimate stands one standard deviation below its average PPP deviation. Hold this position until the currency's deviation from PPP returns to its historical mean. Sell a currency when its disequilibrium to its OECD PPP estimate stands one standard deviation above its average PPP deviation. Hold this position until the currency's deviation from PPP returns to its historical mean. Remain neutral otherwise. The Stable Distribution strategy provided positive returns in our sample of 37 out of the 45 crosses in the G10. However not all currencies performed equally. Crosses containing the British pound or the Swiss Franc did the best, while crosses containing the Japanese yen or Canadian dollar fared the worst (Chart I-6). Currencies where this strategy performed well exhibited a relatively stationary mean deviation from PPP, even if they were chronically overvalued like the Swiss franc (Chart I-7). This allowed the strategy to account for the distortion and provide an attractive return profile. Conversely, the strategy did rather poorly for yen-based investors (Chart I-8). This currency clearly experienced a paradigm shift in its structural valuation. Thus, the assumption that the past is a good predictor of the future failed to materialize, making for an unattractive return profile. Chart I-7CHF: Stable Valuation Chart I-8JPY: Paradigm Shift Please see Appendix C where the performance of the Stable Distribution strategy is presented for other currencies. A Few Words On Relative PPP A great number of PPP models are made using OLS regression on relative inflation rates (relative PPP). Although these kinds of models can be useful and tailored to account for other factors such as productivity or trade dynamics, they make the same assumption of stationarity in the distribution of the deviations of currencies from the Law of One Price as the strategy discussed above. Moreover, different composition in price baskets represent yet another drawback for OLS-based models. For a more detailed discussion on PPP measures, please see Appendix A. To see the performance of relative PPP models, please see Appendix D. Bottom Line: To account for distortions in valuations, investors can buy/sell currencies that are under/overvalued according to historical precedence by assuming the distribution will remain constant. While this strategy has performed well for currencies like the pound and the franc, the assumption of stationarity in valuation has failed to hold for the yen. Rethinking Theory: PPP Rank Is there any way where PPP valuations provide a reliable signal to investors, irrespective of the currency they are based on? We believe so. However, a slight rethink of PPP is required. While it is true there are many idiosyncratic reasons why the non-arbitrage condition of PPP cannot hold, this force should exert some pressure on currencies on average. In other words, when the sample of currencies under investigation is large, the sum of the distortions should tend to even out. We can express this by relaxing the axiom of PPP as follows: Once converted to a common currency, national price levels should, on average, converge. While this may seem like an insignificant change, this relaxed version of the PPP does one thing that absolute PPP does not: it focuses on buying overvalued currencies provided that at the same time more-overvalued currencies are also being sold, and selling undervalued currencies provided that concurrently more undervalued ones are being bought. We tested our relaxed-PPP axiom using the following strategy: Ranking all nine G10 currencies from cheapest to most expensive against our home currency, based on their percentage deviation from the OECD PPP estimate. Of these nine, buying the three most undervalued (or least overvalued) currencies against our home currency. Of these nine, selling the three most overvalued (or least undervalued) currencies against our home currency. Remaining neutral the middle three currencies. Rebalancing the portfolio every month (For clarity Table I-1 shows the steps taken by the strategy from the perspective of a EUR-based investor) Table 1 We call this strategy "PPP Rank." Chart I-9A and Chart I-9B show that the PPP Rank strategy manages to have an attractive return profile regardless of the home currency of the investor. Moreover, the performance of this strategy does not exhibit large drawdowns over our sample.9 Chart I-9APPP Rank: A Robust Value Strategy (I) Chart I-9BPPP Rank: A Robust Value Strategy (II) Another advantage of this strategy is that it does not make assumptions regarding the underlying distribution of a currency's mis-valuation. This makes the strategy's results robust throughout our sample. Nevertheless, its main disadvantage is that its success rests on a well-diversified exposure to all G10 currencies. Therefore, this strategy, like most factor-based methods, goes against investing in a few currency pairs, or having highly concentrated currency exposure. To be sure, the strategy does not claim to solve the PPP puzzle. Instead, we recognize that in practice finding the absolute fair value of a currency may not even be possible. However, this does not prevent investors from reliably generating positive returns by using diversification to implement value strategies in the FX market. Bottom Line: By investing in various currencies at once and ranking them according to their valuation, our PPP Rank strategy provides a way to profit from PPP valuations at an aggregate level in a way that is robust across currencies. Investment Implications What are PPP Rank and the Stable distribution strategies telling us now? Matrix 1 shows the recommendations from the PPP Rank strategy at the current juncture, for investors based in all the G10 countries. Currently, this value-based strategy tends to favor the GBP, the EUR and the JPY while being bearish on the NOK, the CHF and the AUD. These insights confirm our long-term bearish stance on the Swiss Franc10 and long-term bullish stance on the euro.11 As a reminder, this strategy works best with equal currency exposure. Please see Appendix B to see the performance of the strategy as a hedging tool. Matrix 1PPP Rank Recommendation Conversely, out of the top five crosses where the Stable Distribution PPP strategy worked best, no cross currently displays a one standard deviation over- or under-valuation that would signal a buying or selling opportunity (Please see Appendix C to see a ranking of the performance of the stable distribution strategy on all G10 crosses). As a concluding remark, investors must remember that PPP valuations make several assumptions than do not hold in practice, and existing methods to measure PPP equilibrium have numerous limitations. Therefore, caution should be taken when using PPP to make currency decisions. Juan Manuel Correa, Senior Analyst juanc@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Appendix A: Comparison Of Different PPP Measures Table II-1 Appendix B: PPP Rank And International Portfolio Hedging The majority of long-term players in the currency market are asset managers, who must decide whether or not and to what degree they should hedge their currency exposure arising from their positions in foreign markets. Given the long-term nature of PPP, we believe it best to analyze the performance of PPP Rank in the context of international portfolio hedging. Thus, we test whether our PPP Rank strategy adds value to the hedging process of international equity portfolio managers based in five different countries (the U.S, the euro area, Japan, the U.K. and Australia). Our methodology is the following: We hedge the totality of our currency exposure in the markets with the three most overvalued currencies according to PPP. We do not hedge our currency exposure in the markers with the three most undervalued currencies according to PPP. We hedge half of our currency exposure (least-regret hedging) for the middle three currencies. We apply the above strategy to an equally weighted G10 portfolio. Overall, we find that our ranking hedging strategy, applying our relaxed PPP axiom, tends to provide superior returns to all other hedging frameworks for portfolio managers in the U.S., Europe and the U.K. Meanwhile, returns for this strategy place second in Japan and Australia versus the alternatives over our sample (Chart II-1) Chart II-1PPP Rank Vs. Alternatives (I) More importantly, however, our hedging strategy outperforms traditional strategies from a risk-adjusted perspective, regardless of the home currency of the portfolio manager (Chart II-2).12 Another important consideration is the reliability and robustness of the strategy. To measure this, we compare the risk-adjusted returns of the PPP Rank strategy against the alternatives across four windows: 1999-2003, 2004-2008, 2009-2013 and 2014 to present. Chart II-3 shows that our PPP Rank strategy ranks best or second best throughout all windows, no matter where the investor is based. This stands in contrast to the alternatives, whose returns can vary wildly depending on the time frame analyzed. Chart II-2PPP Rank Vs. Alternatives (II) Chart II-3PPP Rank Vs. Alternatives (III) While the PPP Rank strategy is both effective and robust for equity hedging in our sample, it is worth noting that in practice it is not likely that equity investors have equal exposure to all G10 currencies. Therefore we also conducted a sensitivity analysis by using market weights (rebalanced monthly) for each G10 equity market, eliminating some of the currency exposure diversification which stands as the pillar of our strategy. Chart II-4A shows that when the portfolio currency exposure becomes more concentrated, the performance in terms of risk-adjusted returns suffers slightly for Australian and Japanese investors in our sample. However, as Chart II-4B shows, the robustness of the strategy is significantly reduced, with the performance of PPP Rank relative to the alternatives fluctuating more widely, depending on the time period analyzed. It is thus worth noting that the ranking strategy is most appropriate for investors who have diversified currency exposure to many currencies. Chart II-4ASensitivity Analysis Of PPP Rank ##br##Using Market Weights Chart II-4BSensitivity Analysis Of PPP Rank ##br##Using Market Weights Appendix C: Stable Distribution Strategies Chart III-1 - Chart III-8 and Table III-1 Chart III-1U.S. Dollar Chart III-2Euro Chart III-3British Pound Chart III-4Australian Dollar Chart III-5New Zealand Dollar Chart III-6Canadian Dollar Chart III-7Swedish Krona Chart III-8Norwegian Krone Table III-1G10 Crosses Ranked By Risk-Adjusted Returns In Stable Distribution Strategy Appendix D: Relative PPP We test Relative PPP strategies from the perspective of all G10 countries. Our methodology is the following: We regress the currency against relative PPI inflation. We estimate the regression coefficients for the first half of our sample. We also estimate the standard deviation around the fair value. We back test the following strategy in the second half of our sample: Buying a currency when it is undervalued by one standard deviation according to the regression model, and holding this position until the currency PPP deviation returns to its model implied fair value. Selling a currency when it is overvalued by one standard deviation according to the regression model, and holding this position until the currency PPP deviation returns to its model implied fair value. Remain neutral otherwise. Chart IV-1ARegression Based Relative PPP (I) Chart IV-1BRegression Based Relative PPP (I) 1 These results are also contentious. Most evidence of PPP holding in the long run is based on rejecting the null hypothesis of a unit root in the real exchange rate (in other words, the real exchange rate is stationary throughout time). However this is a necessary but not sufficient condition, as one would have to know that the level at which the real exchange rate is reverting to is in fact the PPP equilibrium. For more details please see Taylor, Alan M., and Mark P. Taylor. "The Purchase Power Parity Debate". Journal of Economic Perspectives, vol. 18, no.4, fall 2014, pp. 135-158. 2 Rogoff, Kenneth. "The Purchase Power Parity Puzzle". Journal of Economic Literature, vol. 34, no.2, June 1996, pp.647-668. 3 O'Connell, Paul G.J., The Overvaluation of PPP (April 1, 1996). Available at SSRN: https://ssrn.com/abstract=4125 4 While the Penn Effect is an empirical fact, the validity of the Balassa-Samuelson hypothesis as an explanation for it continues to be disputed. Please see Gubler, Mathias and Cristoph Sax (2016). The Balassa-Samuelson Effect Reversed: New Evidence from OECD Countries. SNB Working Papers and Choudhri, Ehsan U. and Lawrence L. Schembri (2009). Productivity, the Terms of Trade, and the Real Exchange Rate: The Balassa-Samuelson Hypothesis Revisited. Bank of Canada Working Papers 5 Although there is data from 1986 for this measure, Bloomberg uses a long-run averaging method of data from 1986 to 2000 to estimate equilibrium. Therefore we only look at the out-of-sample performance of this measure since 2000. 6 While PPI-based PPP fair value estimates are theoretically more appropriate in establishing fair value, the existing measures of PPI-based fair value have several drawbacks. For a comparison between different fair value measures please see Appendix A. 7 Gopinath, G., Gourinchas, P., Hsieh, C., & Li, N.L. (2009). Estimating the Border Effect: Some New Evidence. 8 This methodology fits most academic research supporting the existence of PPP (i.e. the real exchange rate is stationary.) 9 The success of this strategy suggest that PPP might hold loosely at a global level. 10 Please see Foreign Exchange Strategy Special Report, titled "The SNB Doesn't Want Switzerland To Become Japan," dated March 23, 2018, available at fes.bcaresearch.com 11 Please see Foreign Exchange Strategy Weekly Report, titled "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com 12 It is important to remember that investors based in two different currencies can have different hedged returns even when investing in the same portfolio. This is because it is impossible to perfectly hedge variable income assets such as equities. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The U.S. dollar still has meaningful upside versus the majority of currencies. We continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: TRY, ZAR, BRL, IDR, MYR and KRW. Fixed-income investors should continue to adopt a defensive allocation with respect EM local bonds. Asset allocators should underweight EM sovereign and corporate credit within a global credit portfolio. Argentine financial markets are rioting. We elaborate on our investment strategy below. Downgrade Indonesian stocks from neutral to underweight within an EM equity portfolio. Feature The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought. Rüdiger Dornbusch Emerging markets (EM) currencies have come under substantial selling pressure. Various indexes of EM currencies versus the U.S. dollar have broken below their 200-day moving averages (Chart I-1). EM sovereign spreads are widening, and local bonds yields are moving higher from very low levels. Chart I-1EM Currencies: A Breakdown? Our view is that we are witnessing the beginning of a major down leg in EM currencies and a major up leg in the U.S. dollar. This constitutes a negative environment for all EM risk assets. As the above quote from professor Rüdiger Dornbusch eloquently states, a meltdown in financial markets could take much longer to develop, but once it commences it is likely to play out much faster than investors expect. This does not mean we are certain that a full-blown EM crisis is bound to happen. Neither can we predict the speed of financial market moves. Nevertheless, based on our macro themes, we maintain that this down leg in EM currencies and EM risk assets will likely be large enough to qualify as a bear market rather than a correction. Consistently, we continue to recommend that investors adopt defensive strategies or play EM risk assets on the short side. This bear market in EM could be comparable to the EM selloff episodes of 2013 (Taper Tantrum) or 2015 (China's slowdown). In this report, we first discuss the outlook for the broad U.S. dollar, then examine the factors that typically drive EM currencies, and those that do not. The Dollar: A Major Bottom In Place The U.S. dollar has recently rebounded sharply, and we believe this marks the beginning of a major rally. The following factors will support the greenback in the months ahead: The U.S. dollar does well in periods of a slowdown in global trade (Chart I-2). The average manufacturing PMI index of export-oriented Asia economies such as Korea, Taiwan and Singapore points to a peak in global export volumes (Chart I-3). Further, China's Container Freight index signifies an impending deceleration in Asian export shipments (Chart I-4, top panel). Chart I-2U.S. Dollar Rallies When Global Trade Slows Chart I-3A Peak In Global Export Growth Chart I-4A Leading Indicator For Asian Exports ##br##And Asian Currencies Notably, this freight index - the price to ship containers - also correlates with emerging Asia currencies, and suggests that the latter stands to depreciate (Chart I-4, bottom panel). Chart I-5U.S. Dollar Liquidity And Exchange Rate The dollar should do particularly well if the epicenter of the global growth slowdown is centred in China - and if U.S. domestic demand remains robust due to fiscal stimulus, as we expect. Within advanced economies, the U.S. is the least vulnerable to a China and EM slowdown. Delta of relative growth will be shifting in favor of the U.S. versus the rest of the world. This will propel the dollar higher. Amid weakness in the world trade, growth will be priced at a premium. This will favor financial markets with stronger growth. The greenback will be the winner in the coming months. The U.S. twin deficits - the current account and budget deficits - would have acted as a drag on the dollar if global growth was robust/recovering. However, amid weakening global growth, the U.S. twin deficits are not a malignant phenomenon for the dollar; they will in fact support it as they instigate and reflect strong U.S. growth. As the Federal Reserve continues to reduce its balance sheet, the banking system's excess reserves will decline. Our U.S. dollar liquidity measure has petered out, which has historically been consistent with a bottom in the dollar; the latter is shown inverted on Chart I-5. As we have argued for some time, and to the contrary of widespread investor consensus, the U.S. dollar is not expensive. According to the real effective exchange rate based on unit labor costs, the greenback is fairly valued, as is the euro (Chart I-6). The yen is cheap but the Korean won is expensive (Chart I-6, bottom two panels). In our opinion, a real effective exchange rate based on unit labor costs is the most pertinent measure of exchange rate valuation. The basis is that it takes into account both wages and productivity. Labor costs are the largest cost component in many companies and unit labor costs are critical to competitiveness. Chart I-7 demonstrates that commodities-related currencies including those of Australia, New Zealand and Norway are on the expensive side, while the Canadian dollar is fairly valued. Chart I-6The U.S. Dollar Is Not Expensive Chart I-7Commodities Currencies Are Not Cheap There are no measures of real effective exchange rate based on unit labor costs for many EM currencies. If DM commodities currencies are not cheap, then it is fair to assume that EM commodities currencies are not cheap either. We are not suggesting that exchange rates of commodity producing EM nations are expensive, but we do believe their valuations are probably closer to neutral. When valuations are neutral, they are not a constraint for the underlying asset price. The latter can go either up or down. In short, the dollar is not expensive, and valuations will not deter its appreciation in the coming months. Finally, from the perspective of market technicals, the dollar's exchange rates versus many currencies appear to have encountered resistance at their long-term moving averages, as illustrated in Chart I-8A and Chart I-8B. Usually, when a market finds support (or resistance) at its long-term moving average, it often makes new highs (or lows). Chart I-8ATechnicals Are Positive For Dollar, ##br##Negative For EM Currencies Chart I-8BTechnicals Are Positive For Dollar, ##br##Negative For EM Currencies We are not certain if the broad trade-weighted U.S. dollar will make a new high. However, some EM currencies will drop close to or retest their early 2016 lows. Such potential downside is substantial enough to short the most vulnerable EM currencies. Bottom Line: The U.S. dollar has meaningful upside versus the majority of currencies. We continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: TRY, ZAR, BRL, IDR, MYR and KRW. What Really Drives EM Currencies A common narrative is that EM balance of payments and fiscal balances have already improved, making many EMs less vulnerable than they were during the 2013 Taper Tantrum. What's more, the interest rate differential between EM and the U.S. is still positive, heralding upward pressure on EM currencies. We do not subscribe to this analysis. First, current account balances do not always drive EM exchange rates. Chart I-9A and Chart I-9B illustrates that there is no meaningful positive correlation between EM currencies and both the level and changes in their current account balances. The same holds for the correlation between fiscal balances and exchange rates. Chart I-9ACurrent Account Balances ##br##And Currencies: No Correlation Chart I-9BCurrent Account Balances ##br##And Currencies: No Correlation Second, neither nominal nor real interest rate differentials over U.S. rates explain the trend in EM currencies, as shown in Chart I-10. Further, neither the level nor changes in interest rate differentials explain trends in EM exchange rates. On the contrary, it is the trend in EM currencies that drives local interest rates in EM. That is why getting the currencies right is of paramount importance to investors in various EM asset classes. So which factors do drive EM exchange rates? The key variables that define trends in EM currencies are U.S. bond yields, global trade cycles and commodities prices. The changes in U.S. bond yields and TIPS (inflation-adjusted) yields - not their difference with EM yields - have explained EM currency moves in recent years (Chart I-11). Chart I-10Interest Rate Differential Does Not ##br##Explain EM Exchange Rates Moves Chart I-11EM Currencies And U.S. Bond Yields Chart I-4 on page 3 demonstrates that China's Container Freight index leads regional exports and strongly correlates with emerging Asian currencies. Non-Asian EM currencies are mostly leveraged to commodities prices, as these countries (all nations in Latin America, Russia and South Africa) produce commodities. Not surprisingly, the EM exchange rate composed primarily of EM non-Asian currencies correlates well with commodities prices (Chart I-12). Finally, EM currencies are substantially more exposed to China than to DM economies. Chart I-13 shows that when Chinese imports are underperforming DM imports, EM currencies tend to depreciate. Chart I-12EM Currencies And Commodities Prices Chart I-13EM Currencies Are Exposed To China Not DM As such, what has caused EM currencies to riot in recent weeks? In short, it is the combination of the rise in U.S. bond yields and budding signs of slowdown in global trade. Chart I-14EM Currencies' Vol Is Still Low Commodities prices have so far been firm with oil prices skyrocketing. We expect the combination of China's slowdown and a stronger U.S. dollar to eventually suppress commodities prices in the months ahead. That will produce another down leg in EM currencies. Finally, the volatility measure for EM currencies is still very low, albeit rising (Chart I-14). This suggests that investors remain somewhat complacent on EM exchange rates. Bottom Line: Our negative view on EM currencies has been anchored on two pillars: the U.S. dollar rally driven by higher U.S. interest rate expectations and weaker Chinese growth/lower commodities prices. We are now witnessing the first down leg in EM currency bear market propelled by the first pillar. It is not over yet. The second down leg will come when China's growth slows and commodities prices relapse in the coming months. All in all, there is still material downside in EM exchange rates. EM Local Bond And Credit Markets EM local bond yields typically rise when EM currencies drop meaningfully (Chart I-15). Foreign investors hold a large share of EM local currency bonds (Table I-1). Chart I-15EM Local Bond Yields And EM Currencies Table I-1Foreign Ownership Of EM Local Bonds As EM currency depreciation erodes foreign investors' returns on EM local currency bonds, there could be a rush to exit their positions. Chart I-16 portrays that the total return on J.P. Morgan GBI EM local currency bonds in U.S. dollar terms has broken below its 200-day moving average. Fluctuations in total return on local bonds is primary driven by currency moves. If our negative EM currency view is correct, there will be more downside in this EM domestic bonds total return index. EM sovereign and corporate credit spreads often widen when EM currencies depreciate (Chart I-17). As EM currencies lose value, U.S. dollar debt becomes more expensive to service, and credit spreads should widen to reflect higher credit risks. Chart I-16EM Local Bonds Total ##br##Return Index In U.S. Dollars Chart I-17EM Credit Spreads And EM Currencies Finally, the ratios of U.S. dollar debt-to-exports and U.S. dollar debt-to-international reserves for EM ex-China are very elevated (Chart I-18). If these nations' exports stumble in the months ahead, the inflows of foreign currency will diminish, and credit spreads could widen to price this in. Chart I-18EM Ex-China: U.S. Dollar Debt ##br##Burden In Perspective To be sure, this does not mean there will be widespread defaults. Simply, credit spreads are too low and investor sentiment is too upbeat. As EM growth deteriorates, asset prices will have to re-price. Bottom Line: Asset allocators should continue to adopt a defensive allocation with respect EM local bonds. Asset allocators should underweight EM sovereign and corporate credit within a global credit portfolio. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Argentina Is Under Fire 10 May 2018 Argentine financial markets have been rioting, with the currency plunging by 11% versus the U.S. dollar since the beginning of April. What is the underlying cause of turbulence, and what should investors do? Argentina's macro vulnerability stems from the following factors: First, the country has very large twin deficits, and has relied on foreign portfolio flows to finance them (Chart II-1). Second, private credit growth has lately surged as households and companies have borrowed to buy imported consumer goods and capital goods (Chart II-2). This has created demand for U.S. dollars at a time when the greenback has begun to rebound and foreign investors' appetite for EM assets has diminished. Finally, progress on disinflation has been slow. Core inflation is still above 20% as sticky regulated prices have kept inflation high (Chart II-3). Chart II-1Argentina's Achilles Heal: Twin Deficits Chart II-2Argentina: Credit Growth Has To Be Reined In Chart II-3Argentina: Inflation Is Still A Problem Faced with a market riot, the Argentine central bank hiked its policy rate from 27.25% to 40% in the span of 8 days. Furthermore the government has requested a $30 billion IMF credit line. The aggressive rate hikes prove that the Argentine authorities, unlike many of their EM counterparts, have been adhering to orthodox macro policies. This makes Argentina stand out versus others in general, and Turkey in particular. Such orthodox macro policy responses leads us to maintain our long position in Argentine local bonds. The central bank has hiked interest rates well above both the inflation rate and nominal GDP growth (Chart II-4). Real interest rates are now at their highest level in the past 13 years (Chart II-5). We reckon that this policy tightening will likely be sufficient to stabilize macro dynamics, albeit at the cost of a growth downturn. Chart II-4Argentina: Are Interest ##br##Rates High Enough? Chart II-5Argentina: Highest Real Interest ##br##Rates In Over 13 Years! The drastic monetary tightening will crash credit growth and hence depress domestic demand and imports (Chart II-6). This will help narrow the trade deficit. The monetary squeeze with some fiscal tightening, shrinking real wages (deflated by headline consumer inflation) and a minimum wage nominal growth ceiling of 12.5% for 2018, will bring down inflation, albeit with a time lag (Chart II-7). The fixed-income market could look through the near-term spike in inflation due to the currency plunge. Chart II-6Argentina: High Borrowing Costs ##br##Will Crash Domestic Demand Chart II-7Argentina: Real Wage Growth Is Moderate Finally, the authorities have been gradually implementing their structural reform agenda. Crucially, recent tax and pension reforms were major wins for President Mauricio Macri's Cambiemos coalition, and should help ameliorate the country's fiscal balance. This stands in stark contrast to Brazil, which has so far failed to enact social security reforms despite a mushrooming public debt burden. High interest rates and a domestic demand squeeze are negative for corporate profits, including banks' earnings. However, they are positive for local bonds and ultimately for the currency. The diminishing current account deficit - due to contracting imports - and IMF financing will ultimately put a floor under the Argentine exchange rate. In turn, a cyclical growth downturn, moderating inflation, orthodox macro policies and high yields will entice investors into local currency bonds. Investment Recommendations Wait for the currency to depreciate another 5-10% versus the dollar in the next several weeks, and use that as an opportunity to double down on local currency bonds. While the peso could still depreciate by another 10% in the following 12 months, the extremely high coupon and potential for capital gains as yields ultimately decline will more than offset losses on the exchange rate. This makes the risk-reward of local bonds attractive. Maintain long Argentine sovereign credit and short Venezuelan and Brazilian sovereign credit positions. Orthodox macro policies, a continuation of structural reforms and an IMF credit line will likely cap upside in sovereign credit spreads versus Venezuela and Brazil, where public debt dynamics are worse. The difference between Argentine local currency bonds and U.S. dollar bonds is as follows: Local currency bond yields at 18% offer better value than sovereign credit spreads trading at 300 basis points over U.S. Treasurys. This is the reason why we are taking the risk of an unhedged position in domestic bonds, but remain reluctant to bet on the nation's sovereign U.S. dollar bonds in absolute terms. In addition, correlation among EM nations' sovereign spreads is much higher than correlation between their local bonds. We expect more turmoil in EM financial markets, but there is a chance that Argentine local bonds could decouple from the EM aggregates in the coming weeks or months. We are closing our long ARS/short BRL and long Argentine banks/short Brazilian banks trades. We had been expecting a riot in EM financial markets, but had not anticipated that Argentina would be affected more than Brazil. Finally, structurally we remain optimistic on Argentina's equity outperformance versus the frontier equity benchmark. Tactically (say the next 3 months), however, Argentine equities could underperform. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Indonesia: Facing Major Headwinds 10 May 2018 Indonesian stocks appear to be in freefall in absolute terms and relative to the EM benchmark (Chart III-1). Meanwhile, the currency has been selling off and local currency as well as sovereign (U.S. dollar) bonds spreads are widening versus U.S. Treasurys from low levels (Chart III-2). Chart III-1Indonesian Equities: Absolute ##br##And Relative Performance Chart III-2Indonesian Local Bonds ##br##And Sovereign Spreads These developments have been occurring due to vulnerabilities relating to Indonesia's balance of payments (BoP) dynamics. We believe Indonesia's BoP dynamics will deteriorate further and as such there is more downside for both the rupiah and its financial markets from here: Stronger U.S. growth and higher inflation prints will likely lead to higher interest rate expectations in the U.S. and lift the U.S. dollar further. This will likely lead to Indonesia's underperformance. Chart III-3 shows that Indonesia's relative equity performance versus the EM benchmark has been extremely sensitive to moves in U.S. Treasury yields. Hence, the cost of funding has been a critical variable for Indonesia. Indonesia is also a large commodities exporting nation and the latter account for around 30% of its exports. Specifically, coal, palm oil and copper make up about 9%, 8% and 2% of its exports, respectively. Coal exports are facing major headwinds. The Chinese government has moved to restrict coal imports in several Chinese ports in order to protect its domestic coal producers as we argued in our Special Report titled Revisiting China's De-Capacity Reforms.1 This development will be devastating for Indonesia's coal industry. Chart III-4 shows that the Adaro Energy's stock price - a large Indonesian coal mining company - is falling sharply. This stock price has already fallen by 40% in U.S. dollar terms since its peak on January 30. Chart III-3Indonesia Is Very Sensitive ##br##To U.S. Bond Yields Chart III-4Trouble In Indonesia's Coal Sector Further, palm oil prices have been weak while copper prices might be on edge of breaking down. Meanwhile, there are others negatives related to shipments of these commodities. Palm oil exports are at risk because India has imposed import duties on palm oil, while the European Parliament voted in favor of a ban on the use of palm oil in bio fuel by 2021. Offsetting these, however, China has just agreed to purchase more palm oil from Indonesia. In regard to copper, the ongoing dispute on environmental regulation between Freeport-McMoRan - a U.S. mining company that operates a large copper mine in Indonesia - and the Indonesian government, risks disrupting Freeport's copper production in Indonesia, hurting the country's export revenues. On the whole, export revenues are at risk of plummeting at a time when Indonesian imports are already too strong. This will worsen BoP dynamics further. Chart III-5 shows that a deteriorating trade balance in Indonesia is usually bearish for its equity market. It seems that the current account deficit will be widening when foreign funding is drying up. This requires either a major depreciation in the currency or much higher interest rates. As such, Bank Indonesia (BI) - Indonesia's central bank - might be forced to raise interest rates to cool down domestic demand and attract foreign funding to stabilize the rupiah. Even if the BI does not raise rates, it might opt to defend the rupiah by selling its international reserves. This would still bid up local interbank rates as defending the currency entails drawing down banking system liquidity, i.e., banks' reserves at the central bank. Chart III-6 shows that Indonesian interbank rates are starting to rise in response to falling international reserves. Chart III-5Indonesia: Swings In Trade ##br##Balance And Share Prices Chart III-6Indonesia: Currency Defense By Selling ##br##FX Reserves Leads To Higher Interbank Rates Higher rates will weaken domestic demand and are bearish for share prices. Importantly, foreign ownership of local bonds is still high at 39% and a weaker rupiah could cause selling by foreign investors, pushing yields even higher. Chart III-7Indonesia: Banks Profits Are At Risk Finally, a word on Indonesian banks is warranted. Financials account for 42% of Indonesia's MSCI market cap and 47% of its total earnings. Thus their performance is also very crucial for the outlook of the overall stock market. In our March 1st Weekly Report,2 we argued that Indonesian banks have been lowering their provisions to artificially boost earnings. This is not sustainable as these provisions are insufficient and will have to rise. As they ultimately rise, bank profits and share prices will hurt (Chart III-7). Bottom Line: We recommend investors to downgrade Indonesia's stocks from neutral to underweight within an EM equity portfolio. We also reiterate our short IDR / long USD trade and the short position in local bonds. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "Revisiting China's De-Capacity Reforms," dated April 26, 2018, the link available on page 23. 2 Please see Emerging Markets Strategy Weekly Report "EM Equity Valuations (Part II)," dated March 1, 2018, the link available on page 23. Equity Recommendations Fixed-Income, Credit And Currency Recommendations