Financial Markets

Highlights The big danger of higher bond yields is to the $380 trillion edifice of global risk-assets, rather than to the global economy per se. Buy a small portfolio of 30-year government bonds, given that higher bond yields are now hurting equities and 30-year yields are close to resistance levels. The ongoing drama of Italian politics is an irritation, rather than an existential risk to the euro area, as long as Italian populists correctly focus their fire on EU fiscal rules rather than the single currency. Nevertheless, we prefer France's CAC over Italy's MIB and Spain's IBEX, given the latter markets' outsize exposure to banks, a sector in which we remain underweight. Feature When travellers from the U.K. find themselves in Continental Europe or the U.S. they frequently make a potentially fatal error. Trying to cross a busy street, they look right instead of left... Your author has made this error several times and lived to tell the tale, but there is an important moral to the story. However carefully you look, you won't spot the oncoming truck if you are looking in the wrong direction! Chart of the WeekEquities And Bonds Are Both Offering A Paltry 2% Look At the Markets, Not The Economy The global long bond yield is up around 60bps from the lows of last September, and it would be natural to ask if this poses a danger to the economy. Credit sensitive economic sectors are understandably feeling a headwind, and global growth has indisputably decelerated (Chart I-2). Yet there is no sense of an oncoming truck. Chart I-2Credit Sensitive Sectors Are Feeling A Headwind But are we looking in the wrong direction? While higher bond yields do not yet threaten the global economy, the big danger is to the $380 trillion edifice of global risk-assets.1 In the space of a few weeks, the correlation between bond yields and equities has suddenly and viciously reversed. When the 10-year T-bond yield was below 2.65%, the correlation was a near perfect positive, r = +0.9 (Chart I-3) but above 2.85%, it has flipped to a near perfect negative, r = -0.8 (Chart I-4). Chart I-3Below A 2.65% T-Bond Yield, Equities And##br## Bond Yields Were Positively Correlated Chart I-4Above A 2.85% T-Bond Yield, Equities And ##br##Bond Yields Have Been Negatively Correlated In 2000, 2008 and 2011, the right direction to look was at the financial markets. Recall that it was instabilities in the financial markets - the bursting of the dot com bubble, the mispricing of U.S. subprime mortgages, and the widening of euro area sovereign credit spreads - that spilled over into economic downturns. In any case, for investment strategy, whether such financial instabilities do or do not spill over into the real economy is a secondary concern. The primary concern must always be to identify financial market vulnerabilities - and opportunities. Rich Valuations Are In A Precarious Equilibrium The single most important determinant of an investment's long term return is not the investment's cash flows per se, it is the price that you pay for the cash flows. This is the fundamental lesson of investment. An investment's cash flows might be growing strongly, but if you overpay for the cash flows - for example, in a bubble - you will end up with a negative return. Conversely, cash flows might be collapsing, but if you buy them at an overly depressed price, you will end up with a positive return. It turns out that the long term prospective return from most investments is well-defined. For government bonds, it is the yield to maturity;2 for equities and other risk-assets it is empirically well-defined by the starting valuation, which tends to be an excellent predictor of the prospective long term return (Chart I-5). Chart I-5World Equities Are Priced To Generate 2% A Year For the long term prospective return from bonds, the main determinant is central bank policy, and specifically the expected path for interest rates. For the long term prospective return from equities, the main determinant is the return that the market demands relative to that on offer from bonds. What establishes this relative return? The answer is relative riskiness, specifically the potential for short term losses versus short term gains, technically known as negative skew. Investors hate negative skew - the potential to experience larger short term losses than gains. Hence, investors demand relative returns that are commensurate with the investments' relative negative skews. This brings us to the crux of the matter. At low bond yields, bonds become much more risky: their returns take on negative skew. Intuitively, this is because the lower bound to interest rates forces a very unattractive asymmetry on bond returns: prices can fall a lot, but they can no longer rise a lot. At a bond yield of 2%, theoretical and empirical evidence shows that bonds and equities possess the same negative skew (Chart I-6 and Chart I-7). Chart I-6At A 2% Bond Yield, 10-Year Bonds Have##br## The Same Negative Skew As Equities... Chart I-7...So At A 2% Bond Yield, Equities ##br##Must Also Offer A 2% Return Right now, the negative skews on bonds and equities are roughly the same, so investors are accepting roughly the same long term return from global equities as they can get from global bonds - a paltry 2% (Chart of the Week). This justifies an equity valuation as rich as at the peak of the dot com bubble. The trouble is that the valuation justification for $380 trillion of global risk-assets would crumble if the bond yield were to rise meaningfully. But which bond yield? As asset-classes tend to move as global rather than regional assets, the yield that matters is the global long bond yield. Given the large spread in yields across major bonds, a global yield of 2% equates to around 3% in the U.S. and 1% in Europe. This may explain why these are the yield levels at which the correlation between bond yields and equities has suddenly and viciously reversed. This brings us to the investment opportunity: 30-year government bonds. In recent years, 30-year yields have failed to sustain breaks through upper bounds: 3.2% for T-bonds; 2.0% for U.K. gilts; 1.4% for German bunds; and 0.9% for JGBs. Indeed, looking at these yields since 2015 it is hard to discern a bear market in 30-year government bonds (Charts I-8- I-11). Chart I-8Resistance At 3.2% Chart I-9Resistance At 2.0% Chart I-10Resistance At 1.4% Chart I-11Resistance At 0.9% With higher bond yields now hurting equities, and 30-year yields close to resistance levels, it is a good time to buy a small portfolio of 30-year government bonds. What Unites Italy With Japan? Italy and Japan are the only two major economies in which private indebtedness is considerably less than public indebtedness (Chart I-12 and Chart I-13). In the case of Italy, the very low private indebtedness means that its total indebtedness - as a share of GDP - is actually less than that in the U.K., France, Spain and Sweden. Chart I-12Private Indebtedness Is Less Than ##br##Public Indebtedness In Italy... Chart I-13...And In ##br##Japan The other thing that unites Italy with Japan is that their banking systems were left undercapitalised and in a 'zombie' state for years. Which, to a large extent, explains why private indebtedness has been declining in both economies. When somebody in the private sector pays down debt, say €100, and the banking system does not reallocate that €100 to a new private sector borrower, aggregate demand will contract by €100. To prevent this demand recession, the government must step in to borrow and spend the €100. Moreover, because the private sector is deleveraging, what seems to be fiscal largesse does not lead to crowding out, inflation, or surging interest rates. Instead, government borrowing and spending turns out to be a very sensible economic policy. On this basis, Japan countered its aggressive private sector deleveraging with equally aggressive public sector leveraging and thereby kept its economy motoring along. By contrast, Italy had its hands tied by the EU fiscal compact - which mistakenly looks at public indebtedness in isolation rather than in combination with private indebtedness. Hence, the Italian government was prevented from recapitalizing its banking system, and the Italian economy stagnated for a decade (Chart I-14 and Chart I-15). Chart I-14The Italian Government Was Prevented ##br##From Recapitalising The Banks... Chart I-15...And The Italian Economy ##br##Stagnated For A Decade In this sense, the populist parties in Italy - The League and 5 Star Movement - have correctly identified that Italy's problem is not the euro per se, but the EU's fiscal dogma. Both parties have dropped calls for a referendum on Italy's membership of the euro area, but have doubled down on their intentions to ignore the EU's misguided fiscal rules, such as the 3 per cent limit on budget deficits. As long as Italian populists correctly focus their fire on EU rules rather than the single currency, investors should view the ongoing drama of Italian politics as an irritation, rather than an existential risk to the euro area. Nevertheless, for the time being, we prefer France's CAC over Italy's MIB and Spain's IBEX. This is less a function of politics, and more a function of the latter markets' outsize exposure to banks, a sector in which we remain underweight. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Global equities and high yield and EM debt is worth around $160 trillion and global real estate is worth $220 trillion. 2 Assuming no default risk and no reinvestment risk. Fractal Trading Model* This week, we note that SEK/EUR is at a key technical turning point, and due a countertrend rally. As we already have a long SEK/GBP position open, we are not doubling up with SEK/EUR. In other trades, we are pleased to report that long USD/Chilean peso hit its 2.7% profit target, and is now closed. This leaves us with four open positions. 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-16 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 At just under 3-in-10 odds, the probability Brent crude oil prices will exceed $80/bbl by year-end is now more than double what it was at the beginning of the year, following President Trump's announcement he would withdraw the U.S. from the 2015 Joint Comprehensive Plan of Action (JCPOA), and re-impose all economic sanctions against Iran (Chart of the Week). Chart of the WeekProbability Brent Exceeds $90/bbl Is Understated By Markets We believe these odds are too low. Indeed, we think the odds of Brent prices ending above $90/bbl this year are higher than the 1-in-8 chance being priced in the markets presently, even though this is up from just under 4% at the beginning of the year. We also expect sharper down moves going forward, as news flows become noisier. Speculators have loaded the boat on the long side, and they will be exquisitely sensitive to any unexpected softening in fundamentals - e.g., a supply increase or the whiff of lower demand - given their positioning (Chart 2). Chart 2Specs Have Loaded the Boat##BR##Getting Long Brent and WTI Exposure Our research indicates that spec positioning in the underlying futures can, under some circumstances, dominate the evolution of oil options' implied volatility, the markets' key gauge of risk and the essential component of option pricing. As new risk factors arising from Trump's decision emerge, we expect option implied volatility to increase, as the frequency of spec re-positioning increases. Energy: Overweight. We are getting 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 expectation. We also recommend getting long Aug/19 $75 Brent calls vs. short Aug/19 $80/bbl calls. We already are long Dec/18 $65/bbl Brent calls vs. short $70/bbl calls expiring at the end of Oct/18, which are up 74.2% since they were recommended in Feb/18. Rising vol favors long options positions. The new positions will put on at tonight's close. Base Metals: Neutral. Refined copper imports in China grew 47% y/y in March. For the first four months of 2018 they are up 15% y/y. Imports of copper ores and concentrates were up 9.7% y/y in the January - April period. Precious Metals: Neutral. We remain strategically long gold and tactically long spot silver. A stronger USD continues to weigh on both. Ags/Softs: Underweight. The USDA's weekly Crop Progress report indicates farmers in the U.S. are catching up in their spring planting, converging toward averages for this time of year. Nevertheless, the condition of winter wheat remains a concern. Feature The wild swings in crude oil prices following President Trump's decision not to waive nuclear-related sanctions against Iran - down ~ 2% after Trump's announcement Tuesday, then up more than 2.5% the following morning - resolved one of the more important "known unknowns" ahead of schedule - to wit, would the U.S. re-impose nuclear-related sanctions against Iran, or continue to waive them.1 Ahead of Trump's announcement this week, speculators clearly were building long positions in Brent and WTI, as seen in Chart 2. Among other things, stout fundamentals, which we have been highlighting, and a possible tightening of supply on the back of the re-imposition of U.S. sanctions were obvious catalysts for building the bullish positions. We find specs do not Granger-cause oil prices, and typically these traders are reacting to fundamental news.2 This is consistent with other research into this topic.3 In other words, we find specs essentially follow the fundamentals, they don't lead them, and, as a result, the level of oil prices largely is explained by supply, demand and inventories. Based on the Granger-causality tests and our fundamental modeling, we believe oil markets are, to a very large extent, efficient in the sense that prices reflect most publicly available information.4 This is not to say, however, that the role of speculation can be dismissed as trivial to price formation. Spec Positioning Matters For Implied Volatility In Oil Our most recent research, building on earlier work on speculation in oil markets, finds that the concentration of speculators on the long side or the short side of the market actually does play a significant role in how volatility evolves (Chart 3, bottom panel).5 Other factors are important to the evolution of volatility, as well - i.e., U.S. financial conditions, particularly the stress in the system as measured by the St. Louis Fed's Financial Stress Index; EM equity volatility; and y/y percent changes in WTI oil prices themselves (Chart 3). But spec positioning clearly dominates: In periods of rising or elevated volatility, it explains most of the change in WTI option implied volatilities (Chart 4). This can push volatility higher when it occurs. However, on the downside, this does not hold - Working's T Index is not material to the evolution of implied volatility when uncertainty about future oil prices is low or decreasing. Chart 3Key Variables##BR##Explaining Volatility Chart 4Spec Positioning Dominates##BR##Evolution of WTI Implied Volatility Working's T Index and implied volatility are independent of price direction - they are directionless, therefore they cannot be used to forecast prices.6 These variables tend to increase when the quality of information available to the market deteriorates - i.e., when it becomes more difficult to form expectations about future oil prices. This is, we believe, an attractive time for informed speculators to enter the market and use their information to make profits. We find two-way Granger-causality between WTI implied volatility and Working's T, when the annual change in excess speculation is one-standard deviation above or below its mean. This means the more specs are concentrated on one side of the market in the underlying futures - long or short - the more influence their positioning has on volatility, and that the higher volatility is the more specs are drawn to the market. Given that specs' beliefs are different, this means there is a rising number of long or short spec contracts relative not only to specs on the other side of the market, but also to long and short hedgers. Why Speculation Is Important Prices do not suddenly manifest themselves in markets fully aligned with fundamentals. They are made efficient by hedgers off-loading risk based on their marginal costs, and speculators uncovering information that is material to the level at which prices clear markets. The goal of speculation is to buy low and sell high. Hedging and speculation are both done in the presence of noise, or pseudo-information that has no real connection with where markets clear.7 Information is to noise as substance is to a void. Noise can look like information, as Black (1986) notes, and people can trade on it, but they will lose money and eventually go out of business. Information, on the other hand, is costly, as Grossman and Stiglitz (1980) point out. To incentivize someone (a speculator) to gather it and feed it into prices via the market clearing - i.e., buying and selling based on information - they have to be able to make a profit. Speculators supply the liquidity necessary for trading - and, most importantly, hedging - to occur. Successful speculators make profits. Therefore, the information on which they trade is more often germane to the market-clearing process than not. To be successful they have to be willing to buy when prices are low, expecting them to go higher, and to sell when prices are high, expecting them to go lower. As Paul Samuelson wryly observed, "Is there any other kind of price than 'speculative' price? Uncertainty pervades real life and future prices are never knowable with precision. An investor is a speculator who has been successful; a speculator is merely an investor who last lost his money."8 Known Unknowns Will Keep Vol Elevated Chart 5BCA's Oil Price Forecast Unchanged,##BR##Following Trump's Iran Announcement In the wake of Trump's announcement, the fundamental and geopolitical landscape has been re-cast, creating additional "known unknowns", particularly re how the U.S. will implement the renewed sanctions and the timing of these moves. Among the new known unknowns, which can only be resolved with the passage of time, are: The precise timing and extent of the re-imposed sanctions on the part of the U.S., which will evolve over the next 90 to 180 days. Demand-side implications of higher prices, particularly in EM economies where policymakers used the low prices following OPEC's 2014 - 16 market-share war to eliminate fuel subsidies, which prevented high prices from being experienced by their citizens. The supply-side implications of higher prices on U.S. shale production - does production and investment, including pipeline take-away capacity, take another leg higher? The Kingdom of Saudi Arabia's (KSA) ability to raise output, given the Kingdom said it would be raising output in the event Iranian volumes are lost to export markets. The fate of the Saudi Aramco IPO, and how the re-imposition of sanctions by the U.S. on Iran affects the royal family's decision on whether to float 5% of the company publicly. Will production in distressed states in- and outside of OPEC be negatively affected by increasing geopolitical risk?9 Among the "known unknowns," Iran's next moves rank high, as do responses to such moves by the U.S. and its allies. The U.S. and its Gulf allies clearly view Iran as a threat and, with the re-imposition of sanctions against Iran, are confronting it. Iran has a similar view vis-à-vis the U.S. and its Gulf allies. Left to be determined: Does Iran increase its level of direct action against KSA, upping the ante, so to speak, in its ongoing proxy wars with the Kingdom? Is Gulf production threatened? Are U.S. - European relations threatened by Trump's action? Thus far, European leaders have indicated they remain committed to the sanctions deal Trump walked away from. What would it take for OPEC 2.0 to restore actual production cuts we estimate at 1.1 to 1.2mm b/d to the market? What would it take to trigger a release of the U.S. Strategic Petroleum Reserve (SPR), estimated at just under 664-million-barrel, which could be released to the market at a rate of 500k to 1mm b/d? These known unknowns are not causing us to change our price forecast for this year - $74/bbl for Brent and $70/bbl for WTI, based on our fundamental modeling (Chart 5). However, we do think price risk is to the upside in both markets, given the elevated geopolitical tensions in the market. We continue to expect more frequent prices excursions to and through $80/bbl for the balance of the year, particularly for Brent. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 We lay out some of these "known unknowns" in BCA Research's Commodity & Energy Strategy Weekly Report "Tighter Balances Make Oil Price Excursions To $80/bbl Likely," published April 19, 2018. In addition to the Iran issues, which have been resolved, Venezuela looms large. Oil production declined by 900k b/d between December 2015 and March 2018, with half of that occurring in the past six months. We are carrying Venezuela's current production at ~ 1.5mm b/d, although other estimates have it lower. With the country moving closer to collapsing as a functioning state, the risk to its oil output and exports is high. 2 Granger-causality refers to an econometric test developed by Clive Granger, the 2003 Nobel laureate in economics. It determines whether past values of one variable can be said to predict, or cause, the present value of another variable. 3 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Specs Back Up The Truck For Oil," published April 26, 2018, available at ces.bcaresearch.com. See also the International Energy Agency's "Oil: Medium-Term Market Report 2012;" and "The Role of Speculation in Oil Markets: What Have We Learned So Far?" by Bassam Fattouh, Lutz Kilian and Lavan Mahadeva, published by The Oxford Institute For Energy Studies. Also, see "Speculation, Fundamentals, and The Price of Crude Oil," by Kenneth B. Medlock III, published by the James A. Baker III Institute for Public Policy at Rice University, August 2013. 4 This is the semi-strong form of market efficiency. For a discussion of how markets impound information in prices, please see Eugene Fama's Noble lecture, "Two Pillars of Asset Pricing," which was reprinted in the June 2014 issue of The American Economic Review (p. 1467). 5 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Specs Back Up The Truck For Oil," published April 26, 2018, in which we introduce Holbrook Working's "T Index," a measure of speculative concentration in futures and options markets. It is available at ces.bcaresearch.com. Briefly, Working's T Index shows how much speculative positioning exceeds the net demand for hedging from commercial participants in the market. Excessive speculation - spec positioning in excess of hedging demand by commercial interests - could be read into index values above 1.0. However, the U.S. CFTC notes values of Working's T at or below 1.15 do not provide sufficient liquidity to support hedging, even though "there is an excess of speculation, technically speaking." Formally, Working's T Index looks like this: 6 Please see Irwin, S. H. and D. R. Sanders (2010), "The Impact of Index and Swap Funds on Commodity Futures Markets: Preliminary Results", OECD Food, Agriculture and Fisheries Working Papers, No. 27. 7 Please see Black, Fischer (1986), "Noise," in the Journal of Finance, 41:3; and Grossman, Sanford J., and Stiglitz, Joseph E. (1980), "On the Impossibility of Informationally Efficient Markets," in the June issue of the American Economic Review. 8 Please see Samuelson, Paul A. (1973), "Mathematics Of Speculative Price," in the January 1973 SIAM Review, 15:1. 9 Please see "Geopolitical Certainty: OPEC Production Risks Are Playing To Shale Producers' Advantage," published by BCA's Energy Sector Strategy on May 9, 2018, which discusses these production risks in depth. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights Chart 1Interest Rate Expectations Last week the Federal Reserve made some necessary tweaks to the language in its statement. Namely, with the year-over-year core PCE deflator now up to 1.88%, the Fed was forced to upgrade its assessment of inflation and note that it has "moved close" to the 2 percent target. To assuage concern that such a change might lead to a quicker pace of rate hikes, the statement also emphasized that the inflation target is "symmetric" and noted that its policy of "gradual increases in the federal funds rate" will continue. While the recent increase in inflation is not sufficient to nudge the Fed away from "gradualism", the more important observation is that yields are still not high enough to discount the Fed's gradual approach (Chart 1). The Fed has tightened policy once per quarter since December 2016, tapering asset purchases in place of a rate hike in September 2017. It should be obvious that, absent an economic shock, one rate hike per quarter is the Fed's definition of "gradual". And yet, the market is still priced for barely more than two hikes for the balance of 2018, and not even two rate hikes for all of 2019! Maintain a below-benchmark duration stance until the market comes to grips with the Fed's gradualism. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 4 basis points in April, bringing year-to-date excess returns up to -77 bps. The Corporate index option-adjusted spread tightened somewhat in the first half of April, but widened anew during the past couple of weeks and recently made a new high for the year. Despite this sell-off, valuation remains expensive for investment grade corporates. The 12-month breakeven spread for an A-rated bond has only been tighter 27% of the time since 1989 (Chart 2). The same measure for a Baa-rated bond has only been tighter 28% of the time. We are preparing to cyclically scale back our corporate bond exposure, and will start the process once TIPS breakeven inflation rates reach our target range, signaling that monetary conditions are sufficiently restrictive. Our target range is 2.3% to 2.5% for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. Those rates currently sit at 2.16% and 2.23%, respectively. In a recent report we noted that corporate bond excess returns fall sharply once the 2/10 Treasury yield curve flattens to below 50 bps, though they typically remain positive until the curve actually inverts.1 The 2/10 Treasury slope currently sits at 45 bps. That same report also notes that while the outlook for corporate revenue growth is strong, rising employee compensation costs will likely soon put a dent in profit margins and cause gross leverage to resume its uptrend (panel 4). This will apply further widening pressure to spreads later in the year. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 121 basis points in April, bringing year-to-date excess returns up to 102 bps. The average index option-adjusted spread tightened 16 bps on the month, and currently sits at 343 bps. The 12-month trailing speculative grade default rate moved higher for the second consecutive month, hitting 3.92% in March. Moody's baseline forecast still calls for it to fall to 1.7% by March of next year. Based on Moody's default rate projection and our estimate of the recovery rate, we forecast High-Yield default losses of 0.85% for the next 12 months. This translates to a 12-month excess return of 257 bps for the High-Yield index versus Treasuries, assuming an unchanged junk spread (Chart 3). One hundred basis points of spread widening would lead to an excess return of -140 bps during this time horizon, and 100 bps of spread tightening would lead to an excess return of +654 bps. However, such a large spread tightening is almost certainly over-optimistic. As inflation continues to rise and the Fed applies the brakes, a floor will likely remain under the VIX index of implied equity volatility and this will prevent junk spreads from recovering their cyclical lows (top panel). This would be consistent with behavior typically seen late in the cycle, once the 2/10 Treasury slope flattens to below 50 bps.2 MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 18 basis points in April, bringing year-to-date excess returns up to -22 bps. The conventional 30-year zero-volatility MBS spread tightened 4 bps on the month, split between a 1 bp tightening of the option-adjusted spread (OAS) and a 3 bps decline in the compensation for prepayment risk (option cost). While mortgages are no longer excessively cheap compared to corporate credit (Chart 4), we still see limited potential for spread widening during the next 6-12 months. Rising interest rates should serve to limit mortgage refinancing, and muted refis are closely linked to tight MBS spreads (bottom panel). We also view extension risk as relatively limited for conventional 30-year MBS. Using a model of excess MBS returns that we introduced in February, we estimate that despite the 25 bps increase in duration-matched Treasury yields that occurred in April, extension risk trimmed only 2 bps off monthly excess returns.3 Our excess return Bond Map also shows that conventional 30-year MBS require far fewer days of average spread tightening to earn 100 bps of excess return than most other Aaa-rated structured products (Non-Agency Aaa-rated CMBS being the exception), although they are also more likely to deliver losses. But given the benign refinancing back-drop, we remain reasonably positive on the sector.4 Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 9 basis points in April, dragging year-to-date excess returns down to -7 bps. Sovereign debt underperformed the Treasury benchmark by 37 bps on the month, while Foreign Agencies underperformed by 15 bps and Domestic Agencies underperformed by 14 bps. Local Authorities delivered 14 bps of outperformance and Supranationals bested duration-equivalent Treasuries by 5 bps. Dollar strength hurt the performance of Sovereign debt last month, and relative valuation continues to show that Sovereigns are expensive relative to similarly-rated U.S. corporate bonds (Chart 5). We remain underweight USD-denominated Sovereign debt. Conversely, Foreign Agencies and Local Authorities continue to offer very attractive spreads, especially considering the duration and spread volatility characteristics of those sectors. Our excess return Bond Map shows that both sectors offer a superior risk/reward trade-off than the Barclays Aggregate and almost all of its components.5 The large presence of state-owned energy companies in the Foreign Agency sector means it should also benefit from higher oil prices in the coming months. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 65 basis points in April, bringing year-to-date excess returns up to 94 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio declined 2% in April as fund inflows returned to the sector (Chart 6). Persistently low visible supply is also contributing to the strong technical environment for yield ratios. The tax-adjusted yield for a 10-year municipal bond is now about 46 bps below the yield offered by an equivalent-duration corporate bond. As we have shown in prior research, investors typically get an opportunity to shift out of corporates and into munis at a positive spread differential before the end of the cycle.6 We will await this more attractive entry point before aggressively shifting our allocation in favor of munis. In a recent report we noted that state and local governments are still working to repair their budgets.7 More states enacted tax increases than decreases in fiscal year 2018 and the projected nominal budget increase across all states is a paltry 2.3%. Fortunately, our Municipal Health Monitor indicates that the hard work is paying off, and suggests that ratings upgrades should continue to outpace downgrades for the time being (bottom panel). Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve rose considerably in April, steepening a touch out to the 5-year maturity point and flattening thereafter. The 2/10 Treasury slope flattened 1 basis point in April, and currently sits at 45 bps. The 5/30 slope flattened 9 bps on the month and currently sits at 34 bps. The trade-off between the pace of Fed rate hikes on the one hand, and the re-anchoring of long-dated TIPS breakeven inflation rates on the other will dictate the slope of the yield curve during the next six months. With the 10-year TIPS breakeven inflation rate at 2.16%, it remains slightly below the range of 2.3% to 2.5% that is consistent with well-anchored inflation expectations. It will be difficult for the yield curve to flatten aggressively until that target is met. After that, curve flattening becomes much more likely. We continue to recommend a position in the 5-year bullet versus the duration-matched 2/10 barbell, primarily due to extremely attractive starting valuation. Our model suggests that the 2/5/10 butterfly spread is priced for 17 bps of 2/10 curve flattening during the next six months (Chart 7). With long-maturity TIPS breakevens still below target, we think that is too high a bar. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 93 basis points in April, bringing year-to-date excess returns up to 161 bps. The 10-year TIPS breakeven inflation rate rose 12 bps on the month and currently sits at 2.16%. The 5-year/5-year forward TIPS breakeven inflation rate increased 6 bps and currently sits at 2.23%. As we explained in a recent report, we view the first stage of the bond bear market as being driven by the re-anchoring of inflation expectations.8 We will consider inflation expectations well anchored when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are in a range between 2.3% and 2.5%, where they were the last time that inflation was well anchored around the Fed's target. If the recent trend in inflation continues, then this re-anchoring will occur relatively soon. The annualized 6-month rate of change in the trimmed mean PCE deflator has already returned to the Fed's target, and the annual rate of change jumped from 1.71% to 1.77% in March (Chart 8). Pipeline measures of inflation pressure also continue to strengthen. Our Pipeline Inflation Indicator is in a strong uptrend and the prices paid component of the ISM manufacturing survey is closing in on 80, a level last seen in 2011 (panel 4). ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 13 basis points in April, bringing year-to-date excess returns up to -6 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 4 bps on the month and now stands at 40 bps, 7 bps above its pre-crisis low. Our recently introduced excess return Bond Map shows that both Aaa-rated credit card and Aaa-rated auto loan ABS exhibit lower risk and less potential for gains than the Barclays Aggregate index.9 It also confirms that credit card ABS are somewhat more attractive than auto loan ABS, offering approximately the same potential for excess return with less risk. Compared to other fixed income sectors, Aaa-rated ABS offer greater potential return and higher risk than Agency CMBS, Domestic Agencies and Supranationals. But the ABS sector also has a less attractive risk/reward profile than the Foreign Agency, Local Authority and Investment grade corporate sectors. Fundamentally, while consumer delinquencies remain low, they are heading higher alongside a rising household debt service coverage ratio (Chart 9). The persistent (though mild) deterioration in credit quality causes us to maintain a neutral allocation to the sector, despite reasonably attractive valuations. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 60 basis points in April, bringing year-to-date excess returns up to 71 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 4 bps on the month and currently sits at 69 bps, close to one standard deviation below its pre-crisis mean. Our excess return Bond Map shows that Aaa-rated non-Agency CMBS offer greater potential reward, but also greater risk, than the majority of other high-rated spread products. The exception is conventional 30-year Agency MBS, which offer a less attractive risk/reward trade-off.10 That being said, the fundamental picture for commercial real estate is less appealing than on the residential side. CMBS spreads continue to diverge from commercial property prices (Chart 10). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 26 basis points in April, bringing year-to-date excess returns up to 12 bps. The index option-adjusted spread was flat on the month and currently sits at 47 bps. According to our Bond Map, Agency CMBS offer greater potential excess return and less risk than both the Supranational and Domestic Agency sectors. We continue to view the Agency CMBS space as an attractive low-risk spread sector. Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.70%. The drop in the model's fair value stems from a decline in the global PMI to 53.5 from a recent peak of 54.5. While global growth has undoubtedly lost momentum in recent months, we also suspect that our 2-factor model is finally breaking down. The 2-factor model does not contain a variable to capture the degree of resource utilization in the economy. Logically, as slack dissipates in the economy and inflationary pressures mount, then the same level of global growth should be associated with a higher Treasury yield, all else equal. This means that at some point, as we approach the end of the cycle, the model will break down and consistently produce fair value readings that are too low. We suspect that we may be reaching this point. When we augment our model with an additional variable to measure the degree of resource utilization, in this case the employment-to-population ratio, we find that the new model projects a fair value of 3.28% for the 10-year Treasury yield (Chart 11). This 3-factor model would not have worked as well as our 2-factor model during the zero-lower bound period, as can be seen by looking at how rolling regression betas from each of the three variables moved sharply following the recession (bottom three panels). However, as we move further away from the zero-lower bound we expect the regression coefficients to return to pre-crisis levels, meaning that it will be important to monitor both trends in global growth and the amount of resource slack in the economy. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com 4 For details on the Bond Map please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Profiting From A Higher LIBOR", dated March 20, 2018, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "As Good As It Gets For Corporate Debt", dated April 24, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights BCA's call is that the robust labor market will boost wages and incomes, and insulate the consumer from rising energy costs and interest rates. Residential investment will add to GDP growth this year and support housing-related investments. Q1 results for S&P 500 earnings and revenues are exceeding raised expectations amid increase in tariff talk. Feature Last Friday's employment report shows a strong U.S. labor market with moderate wage pressures. The Fed can continue with a leisurely pace of rate hikes, which do not disrupt risk assets. The U.S. economy added 164,000 of net new jobs in April. Taking into account the 30,000 upward revision to the prior months, the increase in payrolls was in line with the consensus forecast of 195,000. With the 3-month moving average at 208,000 the pace of jobs growth is running comfortably above the trend growth in the labor force. This is reflected in the unemployment rate dropping from 4.1% to a new cyclical low of 3.9%. The jobless rate is nearing the 3.8% low seen during the height of the tech bubble in 2000. Even though the pace of jobs growth is strong and the unemployment rate is probing new lows, wage gains remain moderate. Average hourly earnings increased by just 0.1% m/m in April. Moreover, last month's gain was revised down to 0.2% m/m from an initially reported 0.3% m/m. As a consequence, the annual rate of wage inflation has slowed slightly to 2.6% from a recent high of 2.8% in January. The underlying trend in wage inflation is higher, but it is fairly shallow (Chart 1). The April employment report is "Goldilocks" for U.S. equities. The labor market is strong and the economy is growing about 3%. With modest wage and inflation pressures, there is no need for the Fed to turn more aggressive to cool a rapidly overheating economy. The modest trajectory of Fed rate hikes alongside modest income gains and stout consumer balance sheets will insulate the largest segment of the economy from higher interest payments and rising gasoline costs. Residential construction will also benefit from a gradual central bank, and housing-related assets are poised to outperform. Corporate profits can also continue to grow while the Fed maintains a gradual pace of rate hikes. The Q1 earnings and revenue reports for S&P 500 firms are outstanding. BCA's call is that the robust labor market will boost wages and incomes, and insulate the consumer from rising energy costs and interest rates. As we stated in our report on April 2,1 conditions that crushed the consumer ahead of the 2007-2008 recession are not in place and will not be for some time. Chart 2 shows that at 41.8%, household purchases of essentials as a percentage of disposable income are near all-time lows and have dropped by more than 1% since early 2013. In contrast, spending on necessities rose by a record 3% in the five years ending 2008. This matches levels reached at the end of the 1980s when interest rates, inflation and oil prices all soared. Wrenching consumer-driven economic downturns ensued after both episodes. Chart 1Another Goldilocks##BR##Jobs Report For U.S. Risk Assets Chart 2Consumer Is Not Stressed##BR##Despite Higher Energy Costs While investors remain concerned that rising rates and higher energy costs could derail the consumer and slow the economy, we take a different view. Energy represents 3.8% of consumers' spending on essentials while interest costs account for 15.9%. BCA expects that the Fed will continue to raise rates gradually in the next 12 months, in lockstep with the market's stance. However, we anticipate that the Fed will be more aggressive from mid-2019 through mid-2020 as inflation moves beyond the Fed's 2% target. BCA's U.S. Bond Strategy service notes that if we assume that the equilibrium fed funds rate is approximately 3%, then the cyclical peak for the 10-year Treasury yield will occur between 3.35% and 3.52%,2 roughly 35 to 50 bps higher than current levels. In previous research, we stated that a modest rise in rates would not be a burden on consumers.3 BCA's Commodity & Energy Strategy team forecasts that West Texas Intermediate oil prices will average $70/bbl. in 2018 and $64/bbl. in 2019. However, it also notes that tight balances in global oil make it likely those numbers will make excursions to $80/bbl.4 If production in Venezuela deteriorates more than expected or the supply in Iran or Libya is compromised, then oil could move beyond $80/bbl and, depending on the supply disruptions, to $90/bbl. Chart 3 shows that the consumer can easily withstand a rise in oil prices to $90/bbl. BCA's assumption is that natural gas and electricity prices will remain at current readings. Chart 3U.S. Consumer Is Well Insulated From Rising Energy Costs Bottom Line: Tighter labor markets and rising incomes will overcome rising interest rates and higher oil prices, and allow consumers to contribute to above-trend GDP growth. We see gradual upturns ahead for both oil prices and interest rates, but nothing so significant to trigger the collapse of consumer spending. Housing and housing-related assets will also flourish in the next year. Housing-Related Assets: An Update Residential investment will add to GDP growth this year and support housing-related investments. Chart 4 shows that housing in this cycle lagged previous slow-burn recoveries5 by a wide margin. Inventories of new and existing homes are near all-time lows, and the homeownership rate has turned higher alongside incomes and household formation (Chart 5). BCA's view is that escalating mortgage rates are not an impediment to housing construction. Nonetheless, housing did not contribute to economic growth in Q1 2018, but it did add 0.46% to real GDP in Q4 2017 as construction activity surged following last summer's hurricanes in Florida and Texas. Chart 4Residential Investment's Share##BR##Of GDP Has Lagged Prior Long Cycles Chart 5Solid Housing##BR##Fundamentals In Place Chart 6 estimates the remaining pent-up demand for housing, based on the deviation from its 1990-2007 trend in the ratio of the number of households to the total population. A closing of the gap implies an extra 1.35 million housing units. The equilibrium number of housing starts that cover underlying population growth, plus the units lost to scrappage, is estimated at about 1.4 million annually. If the household formation 'catch up' fully occurs in the next two years, which would add another 675,000 units per year, then total demand could be close to 2 million in each of the next two years. This compares with March's housing starts of 1.3 million. Clearly, this is an aggressive forecast, and we doubt starts will advance at this pace in the next few years, but it does suggest that housing construction is likely to perk up. Chart 6A Catch-Up Housing Construction##BR##Will Occur If This Gap Closes The above analysis suggests that residential investment will contribute to GDP growth this year and next. There are favorable implications for housing-related financial assets. We originally examined the implications of a rebound in residential construction activity in 2012.6 Our approach was to test the historical excess return performance of several financial assets as a function of key housing market variables. We concluded that housing-related financial assets were set to outperform their respective benchmarks in a bullish housing scenario in the following year (and beyond). Our original analysis is updated in this report, with a few modifications. First, we examine the relationship between key housing market variables and excess returns of housing-related assets since the onset of the U.S. economic expansion in June 2009, given the structural change in the housing market that occurred following the Great Recession. Secondly, our analysis is based on a more focused set of housing market indicators, given the relatively poor predictive power of new home sales and the months' supply of houses for sale following the crisis period on housing-related asset returns. Table 1 presents the list of housing-related assets that we examined,7 along with the key housing market variables used to forecast excess returns (and whether they were significant predictors in the post-crisis era). The table highlights that most of the variables contain useful information, with the exception of the two noted above, sales of new homes and inventories of unsold homes. The right-most column presents the share of excess returns explained by a composite model of the factors noted as significant for each asset that varies from a low of 14% to a high of 22%. Table 1Important Predictors Of Housing-Related Asset Excess Returns* (June 2009-December 2017) Charts 7 and 8 present a set of relatively conservative assumptions for the key housing market variables shown in Table 1, based on a rise in housing starts only modestly above the scrappage rate referred to in the previous section. We assume that house price appreciation and housing affordability are moderate due to further rate hikes from the Fed and mounting inflation. We also suppose that the homebuilders' confidence index stays flat, refi applications remain low linked to the uptrend in mortgage rates, and purchase applications rise in conjunction with housing starts. Chart 7A Set Of Conservative Assumptions... Chart 8...For Key Housing Market Variables Finally, Table 2 illustrates the predicted excess returns of housing-related assets in the coming 12 months, along with the annualized excess returns in 2017 and, for reference, in the entire sample period. It is important to note that excess returns of corporate bonds are presented relative to duration-matched government bonds, not a speculative- or investment-grade corporate bond aggregate. Table 2Excess Returns Of Housing-Related Assets* (%) Investors can draw several important conclusions from our analysis: All but one of the housing-related assets are expected to outperform their respective benchmarks in the next year, even given our conservative assumptions about the pace of gains in the housing market. Our model predicts outperformance for the three corporate bond assets (shown in Tables 1 and 2) relative to their respective corporate bond benchmarks, albeit only marginally in the case of investment-grade banks. Moreover, the model projects modest outperformance for agency MBS. With the exception of S&P 500 banks, the model's predicted excess returns are lower in the coming year than they have been on an annualized basis since the onset of the recovery. This highlights that housing-related assets have moved ahead at least some of the expected normalization in the housing market over the next few years. However, a full rise to our equilibrium estimate of 2 million starts during the next two years could potentially lead to an even larger outperformance than the model forecasts. Moreover, Charts 9A and 9B suggest that valuation will not be an impediment to the outperformance of housing-related assets. Chart 9AValuation Won't Be An Impediment... Chart 9B...For Housing Related Assets Bottom Line: Investors should look to housing-related assets as a source of potential outperformance in 6-12 months. The historical relationship between key housing market variables and the excess returns of these assets implies the latter is set to outperform, even given conservative assumptions about the housing factors. Stunning Results More than 80% of S&P 500 companies have reported Q1 results, and EPS and sales growth are well ahead of consensus expectations at the start of April. Moreover, the counter-trend rally in margins remains in place. We previewed the Q1 2018 S&P 500 earnings season earlier this year.8 82% of companies have released results so far, with 79% beating consensus EPS projections, which is well above the long-term average of 69%. Moreover, 76% have posted Q1 revenues that topped expectations, exceeding the long-term average of 56%. The surprise factor for year-over-year numbers in Q1 stands at a robust 7% for EPS and 1.5% for sales. The earnings surprise reading is well above the long-term average of 5%, while the sales surprise figure is right at the long-term average. Both the earnings and sales surprise figures are even more impressive given that analysts' views of Q1 results increased between the start of Q1 2018 and the actual Q1 reporting season. Analysts' estimates typically move lower as a quarter unfolds, in effect lowering the bar for results. Table 3S&P 500: Q1 2018 Results* We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning in mid-2018. Even so, the results to date suggest that Q1 will be another quarter of margin expansion. Average earnings growth (Q1 2018 versus Q1 2017) is a stunning 26% with revenue growth at 8%. However, on a four-quarter basis, U.S. margins fell slightly in the fourth quarter. Still, they remain high on the back of decent corporate pricing power. Strength in earnings and revenues is broadly based (Table 3). Earnings per share rose in Q1 2018 versus Q1 2017 in all 11 sectors. EPS results are particularly stout in energy (84%), technology (35%), financials (30%), materials (30%) and industrials (25%). The technology, materials, real estate and industrial sectors likewise all experienced substantial sales gains (16%, 13%, 14% and 11% respectively). Excluding energy, S&P 500 profits in Q1 2018 versus Q1 2017 are still vigorous at 24%. BCA's U.S. Equity Strategy service introduced profit models for all 11 S&P 500 sectors in January.9 Optimistic managements have raised the bar significantly for 2018 results in the past few months (Chart 10). On October 1, 2017, before the GOP introduced the tax bill, the bottom-up estimate for the S&P 500's 2018 EPS growth stood at 11%. The assessment grew to 20% at the start of the earnings reporting season in early April. As of May 4, 2018, the figure climbed slightly to 22%. Moreover, the upward revisions are widespread. Calendar year 2018 EPS growth rate estimates in 10 of 11 sectors are higher today than at the start of October 2017. Chart 10High Bar For 2018... But Focus Will Quickly Turn To 2019 While the ebullience is linked to the tax bill, other factors such as solid global growth, a steeper yield curve and higher energy prices are also responsible. The tax bill lowered the corporate tax rate for 2018 and the repatriation holiday provides firms with excess cash. However, U.S. trade policy is a concern in several industries. Chart 11 shows that through April 27, 45 companies cited tariffs in their Q1 earnings calls, a jump from 5 in the Q4 2017 reporting season. The Fed's business and banking contacts mentioned either tariffs or trade policy 44 times in the latest Beige Book (April 18); there were only 3 mentions in the March edition.10 Analysts expect EPS growth to slow significantly in 2019 (9%) from the anticipated 2018 clip, which matches BCA's stance (Chart 12). However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in early 2020. Chart 11Plenty Of Tariff Talk##BR##In Q1 Earnings Calls Chart 12Strong S&P 500 EPS Growth Ahead,##BR##Will Start To Slow Soon Bottom Line: EPS growth is expected to peak at over 20% later this year (4-quarter moving total basis using S&P 500 data) and subsequently decelerate because of a modest margin squeeze as U.S. wage growth picks up (Chart 11). A slowdown in global growth will also crimp profit growth later this year. Incorporating the fiscal stimulus lifted the EPS growth profile relative to our previous forecast. Nonetheless, BCA believes that the earnings backdrop will remain a tailwind for the equity market. The Tax Cut and Job Act raised expectations for 2018 in most sectors and so far, corporate managements have exceeded the lofty projections. However, it may be more difficult to maintain in the second half of 2018. Stay overweight stocks versus bonds. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Has Global Growth Peaked?", published April 2, 2018. Available at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Bond Strategy Weekly Report "A Signal From Gold?", published May 1, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA Research's The Bank Credit Analyst Monthly Report from February 2017. Available at bca.bcaresearch.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Tighter Balances Make Oil Price Excursions To $80/bbl Likely", published April 19, 2018. Available at ces.bcaresearch.com. 5 Please see BCA Research's The Bank Credit Analyst Monthly Report from March 2017. Available at bca.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report," U-3 Or U-6?," published February 13, 2012. Available at usis.bcaresearch.com. 7 Note that we have excluded fixed- and floating-rate home equity loan ABS from our list of housing-related assets because of a lack of data, as well as investment-grade REITs because of a very low degree of return predictability from key indicators of the housing market. 8 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Has Global Growth Peaked?", published April 2, 2018. Available at usis.bcaresearch.com. 9 Please see BCA Research's U.S. Equity Strategy Special Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models," published January 16, 2018. Available at uses.bcaresearch.com. 10 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Short Term Caution Warranted", published April 23, 2018. Available at usis.bcaresearch.com.

Highlights The U.S. labor market is now at full employment and the plethora of fiscal stimulus coming down the pike could cause the economy to overheat. If the recent rebound in the U.S. dollar reverses, this will only add to aggregate demand by boosting net exports. There are two main scenarios in which the U.S. can avoid overheating while the value of the greenback resumes its decline: 1) The Fed tightens monetary policy by enough to slow growth but other central banks tighten monetary policy even more; 2) the U.S. is hit by an adverse demand shock that forces the Fed to back away from further rate hikes. Neither scenario can be easily discounted, but both seem unlikely. The first scenario assumes that the neutral real rate of interest is fairly high outside the U.S., when most of the evidence says otherwise. The second scenario ignores the fact that adverse demand shocks, even if they originate from the U.S., tend to become global fairly quickly. Weaker global growth is usually bullish for the dollar. This suggests that the dollar rally has legs. EUR/USD is on track to hit 1.15 over the coming months, but a plunge below that level is possible given that the dollar is one of the most momentum-driven currencies out there. For now, investors should favor DM over EM equities and oil over metals. Feature Running Hot More than a decade after the Great Recession began, the U.S. labor market is back to full employment (Chart 1). The headline unemployment rate stands at 4.1%, below the Fed's estimate of NAIRU. Broader measures of labor slack, such as the U-6 rate, the number of workers outside the labor force wanting a job, and the share of the unemployed who have quit their jobs, are also back to pre-recession levels. Most business surveys show that companies are struggling to fill vacant positions (Chart 2). Wage growth is picking up, especially among low-skilled workers, whose compensation tends to be more closely tied to labor slack than their better-skilled counterparts (Table 1). Chart 1U.S. Is Back To Full Employment Chart 2Survey Data Point To Higher Wage Growth Ahead Table 1Wage Growth Is Accelerating Despite its recent rebound, the broad trade-weighted dollar is still down nearly 7% since its December 2016 high. According to the New York Fed's macro model, a sustained decline in the dollar of that magnitude would be expected to boost the level of GDP by about 0.5%. This would be equivalent to a permanent 50 basis-point cut in interest rates in terms of its effect on aggregate demand.1 Not that long ago, market participants and numerous pundits expected the dollar to continue its slide. Net short dollar positions reached their highest level in nearly six years in mid-April, before moving lower over the past two weeks (Chart 3). "Short dollar" registered as the second-most crowded trade in the monthly BofA Merrill Lynch survey of fund managers that was conducted between April 6 and 12, behind only "long FAANG-BAT stocks."2 Chart 3Short Dollar Is A Crowded Trade The Fed's Dilemma This raises an obvious question. If the consensus view that so many market investors subscribed to only a few weeks ago turns out to be correct and the dollar does give up its recent gains, how is the Fed supposed to tighten financial conditions by enough to keep the economy from overheating? One response is the Fed could raise rates by enough to slow growth. If the dollar falls while this is happening, so be it. The Fed can always hike rates more quickly in order to ensure that the contractionary effect of higher interest rates more than offsets the stimulative effect of a weaker dollar. The problem with this answer is that the dollar is only likely to weaken if other central banks are tightening monetary policy as much or more than the Fed. Chart 4 shows that the dollar has generally moved in line with interest rate differentials between the U.S. and its trading partners. Chart 4Historically, The Dollar Has Moved In Line With Interest Rate Differentials There is little scope for rate expectations to narrow at the short end of the yield curve if U.S. growth remains above trend for the remainder of the year, as we expect will be the case. This is simply because most other major central banks are in no hurry to raise rates. The ECB has effectively pledged not to raise rates until at least the middle of next year. The U.K. remains mired in a post-Brexit slump. The BoJ is nowhere close to meeting its 2% inflation target (20-year CPI swaps are still trading at 0.6%). There is some room for rate expectations to converge further along the yield curve. However, for that to happen, investors must come to believe that the gap in the neutral rate of interest between the U.S. and its trading partners will shrink. It is far from obvious that they will do so. The Neutral Rate Is Higher In The U.S. Than The Euro Area Consider a comparison between the U.S. and the euro area. A reasonable proxy for the market's view of the neutral rate is the expected overnight rate ten years ahead, which can be calculated using eurodollar and euribor futures. The spread currently stands at about 100 basis points in favor of the U.S., down from 150 basis points at the start of 2017. Taking into account the fact that market-based inflation expectations are somewhat lower in the euro area, the spread in real terms is close to 50 basis points. That is not a lot, considering all the reasons to suppose that the neutral rate is higher in the U.S.: U.S. fiscal policy is a lot more stimulative. The IMF expects the U.S. fiscal impulse, which measures the change in the structural budget deficit, to reach 0.8% of GDP in 2018 and 0.9% in 2019. The fiscal impulse in the euro area and most other economies is likely to be much smaller (Chart 5). While the U.S. fiscal impulse will fall back to zero in 2020-21 barring a fresh wave of tax cuts or spending increases, the difference in the structural fiscal balance between the U.S. and the euro area will still widen to a record high of 6% of GDP by then (Chart 6). It is this difference that determines the gap in neutral rates.3 The U.S. will feel decreasing private-sector deleveraging headwinds in the years ahead. Euro area private-sector debt, measured as a share of GDP, is above U.S. levels and still close to all-time highs. In contrast, U.S. private-sector debt is down by 18% of GDP from its 2008 peak (Chart 7). The demographic divide between the U.S. and the euro area will widen. A rising labor participation rate allowed the euro area's labor force to grow at virtually the same pace as the U.S. between 2000 and 2015 (Chart 8). However, now that the euro area participation rate is above the U.S., the scope for further structural gains in participation in the euro area are limited. Over the past two years, labor force growth in the euro area has fallen behind the United States. If this trend continues and labor force growth in the two regions converges to the underlying rate of growth in the working-age population, it could reduce euro area GDP growth by over 0.5 percentage points relative to U.S. growth. Slower GDP growth typically implies a lower neutral rate. Chart 5U.S. Fiscal Policy##br## Is More Stimulative Chart 6U.S. And Euro Area: Gap In Fiscal##br## Balances Will Hit Record Highs Chart 7Deleveraging Headwinds Will Be##br## Stronger In The Euro Area Than The U.S. Chart 8Slowing Euro Area Labor Force ##br##Participation Will Weigh On Growth When Things Go Sour If other major central banks find themselves hard-pressed to raise rates anywhere close to U.S. levels, how about the opposite case: The one where an adverse shock forces the Fed to cut rates towards overseas levels? Since interest rates in many other economies remain at rock-bottom levels, there is little scope for their central banks to cut rates even if they wanted to. In contrast, the Fed is no longer constrained by the zero bound, which gives it greater leeway to ease monetary policy. While such a scenario cannot be easily ruled out, it is mitigated by the fact that frothy asset markets in the U.S. have not produced large imbalances in the real economy. This stands in sharp contrast to the last two recessions. The Great Recession was exacerbated by a massive overhang of empty homes. The 2001 recession was aggravated by a huge overhang of capital equipment left in the wake of the dotcom bust. The surging dollar and increased Chinese competition also laid waste to a large part of the U.S. manufacturing base, necessitating a period of painful adjustment. Today, both the housing and manufacturing sectors are in reasonably good shape. This suggests that rates can rise further before growth stalls out. And even if the U.S. economy begins to flounder, it is not clear that this would lead to a weaker dollar. Remember that the U.S. mortgage market was the focal point of the Global Financial Crisis, and yet the dollar still strengthened by over 20% between July 2008 and March 2009. A recent IMF study concluded that changes in U.S. financial conditions have an outsized effect on growth outside the United States.4 Weaker global growth is generally good for the dollar (Chart 9). The old adage "When America sneezes, the rest of the world catches a cold" still rings true. If higher U.S. rates lead to a stronger dollar, this could put pressure on emerging markets. Similar to what transpired in the mid-to-late 1990s, a feedback loop could arise where rising EM stress causes the dollar to strengthen, leading to even more EM stress: A vicious circle for emerging markets, but a virtuous one for the greenback. Chart 10 shows that EM equities are almost perfectly inversely correlated with U.S. financial conditions. Chart 9Decelerating Global Growth Tends ##br## To Be Bullish For The Dollar Chart 10Tightening U.S. Financial Conditions Will Not Bode Well For EM Stocks Investment Conclusions The dollar is bouncing back. This week's FOMC statement caused the greenback to briefly sell off before it rallied back. We do not think the Fed's decision to include the word "symmetric" in describing its inflation target was as important as some observers believe. The Fed has stressed that it has a symmetric target for many years. If anything, the inclusion of the word could mean that the Fed now realizes that it is behind the curve in normalizing monetary policy and thus wants to prepare the market for the inevitable inflation overshoot. That could mean more rate hikes down the road, not fewer. As such, we expect the dollar to continue strengthening. Our Foreign Exchange Strategy team's intermediate-term timing model sees EUR/USD hitting 1.15 in the next three-to-six months (Chart 11). A plunge below this level is possible given that the dollar is one of the most momentum-driven currencies out there (Chart 12). Chart 11Euro Is Poised To Weaken Chart 12The Dollar Is A Momentum-Driven Currency Sterling should also edge lower against the dollar over the next few quarters. Our global fixed-income strategists remain bullish on gilts, reflecting their view that the market has been too hawkish about how many hikes the BoE can deliver over the next year. Over a longer-term horizon, the pound has upside against both the U.S. dollar and most other currencies. If a new Brexit referendum were held today, the "remain" side would probably win (Chart 13). Rules are made to be broken. It is the will of the people, rather than legal mumbo-jumbo, that ultimately matters. In the end, the U.K. will stay in the EU. The Japanese yen faces cyclical downside risks as global bond yields move higher, leaving JGBs in the dust. However, similar to sterling, the longer-term prospects for the yen are brighter. The currency is cheap and should benefit from Japan's large current account surplus and its status as a massive holder of overseas assets (Chart 14). Chart 13Bremorse Sets In Chart 14The Yen's Long-Term Outlook Is Bullish Emerging market currencies rallied between early 2016 and the beginning of this year, but have faltered lately (Chart 15). BCA's EM and geopolitical strategists expect the Chinese government to expedite structural reforms and take steps to slow credit growth and cool the bubbly housing market. We do not anticipate that this will lead to a proverbial hard landing, but it could put renewed pressure on commodity prices over the next few months. Metals are much more exposed to a China slowdown than oil (Chart 16). Correspondingly, we favor "oily" currencies such as the Canadian dollar over "metallic" currencies such as the Australian dollar. Chart 15EM Currencies Have Been ##br##Wobbling Of Late Chart 16Base Metals Are More Sensitive ##br##To Slower Chinese Growth As for risk assets in general, our model still points to near-term downside risks to global equities (Chart 17). However, we expect these risks to fade as global growth stabilizes at an above-trend pace. That should set the stage for a rally in developed market stocks into year-end. Chart 17MacroQuant* Model: Still Pointing To Moderate Downside Risks For Stocks Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Specifically, the New York Fed model says that a 10% depreciation in the dollar would be expected to raise the level of real GDP by 0.5% in the first year and by a further 0.2% in the second year, for a cumulative increase of 0.7%. A 7% decline in the dollar would thus translate into a 0.7*7 = 0.49% increase in GDP. Using former Fed chair Janet Yellen’s preferred specification of the Taylor rule equation, which assigns a coefficient of one on the output gap, a permanent 0.49% of GDP increase in net exports would have the same effect on aggregate demand as a permanent 49 basis-point decline in the fed funds rate. Assuming a constant term premium, this would also be equivalent to a 49 basis-point decline in long-term Treasury yields. 2 FAANG stands for Facebook, Apple, Amazon, Netflix, and Google. BAT stands for Baidu, Alibaba, and Tencent. 3 Conceptually, changes in the budget deficit drive changes in aggregate demand, whereas the level of the budget deficit drives the level of aggregate demand. One can see this simply by noting that aggregate demand is equal to C+I+G+X-M. A one-off increase in G temporarily lifts the growth rate in demand, but permanently increases the level of demand. The neutral rate is determined by the level of demand and not the change in demand because the neutral rate, by definition, is the interest rate that equalizes the level of aggregate demand with aggregate supply. 4 Please see “Getting The Policy Mix Right,” IMF Global Financial Stability Report, (Chapter 3), (April 2017). Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The greenback normally weakens when the U.S. business cycle matures; 2018 may prove an exception to this rule. Rising U.S. inflation could clash with deteriorating global growth, bringing the monetary divergence narrative back in vogue. This would help the dollar. EM assets are especially at risk from a rising dollar. Tightening EM financial conditions would ensue, creating additional support for the dollar. The yen is caught between bearish and bullish crosscurrents. Continue to favor short EUR/JPY and short AUD/JPY over bets on USD/JPY. Set a stop sell on EUR/GBP at 0.895, with a target at 0.8300 and a stop loss at 0.917. Feature Late in the business cycle, U.S. growth begins to slow relative to the rest of the world, and normally the U.S. dollar weakens in the process. The general trajectory of the dollar this business cycle is likely to end up following this historical pattern, and last year's decline for the greenback was fully in line with past experience. However, 2018 could be an odd year, where the dollar manages to rally thanks to a combination of softening global growth and rising inflationary pressures in the U.S., which forces the Federal Reserve to be less sensitive to the trajectory of global economic conditions than it has been since the recession ended in 2009. Normally, The USD Sags Late Cycle We have already showed that EUR/USD tends to rally once the U.S. business cycle matures enough that the Fed pushes interest rates closer to their neutral level. Essentially, because the eurozone business cycle tends to lag that of the U.S., the European Central Bank also lags the Fed, which also implies that European policy rates remain accommodative longer than those in the U.S. Paradoxically, this means that late in the cycle, European growth can outperform that of the U.S., and markets can price in more upcoming interest rate increases in Europe than in the U.S., lifting the euro in the process (Chart I-1). Chart I-1The Euro Rallies Late In The Business Cycle Not too surprisingly, these dynamics can be recreated for the entire dollar index. As Chart I-2 illustrates, when we move into the later innings of the business cycle, global growth begins to outperform U.S. growth, and in the process, the DXY weakens. There has been an exception to these dynamics - the late 1990s - when the dollar managed to rally despite the lateness of the U.S. business cycle. Back then, the dollar was in a bubble, and the strong sensitivity of the dollar to momentum (Chart I-3) helped foment self-fulfilling dollar strength.1 Moreover, EM growth was generally weak. This begs the question, could 2018 evoke the late 1990s? Chart I-2What Works For The Euro Mirrors What Works For The Dollar Chart I-3Momentum Winners: USD And JPY Crosses Bottom Line: Normally, the U.S. dollar tends to weaken in the later innings of the U.S. business cycle, as non-U.S. growth overtakes U.S. growth. However, in 1999 and in 2000, the dollar managed to rally despite the U.S. business cycle moving toward its last hurrah. Not A Normal Cycle This cycle has been anything but normal. Growth in the entire G-10 has been rather tepid. While it is true that potential growth, or the supply side of the economy, is lower than it once was, courtesy of anemic productivity growth and an ageing population, demand growth has also suffered thanks to a protracted period of deleveraging. But the U.S. has been quicker than most other major economies in dealing with the ills that ailed her, executing a quicker private sector deleveraging than the rest of the G-10 (Chart I-4). As a result, today the U.S. output and unemployment gaps are more closed than is the case in the rest of the G-10. As Chart I-5 illustrates, aggregate U.S. capacity utilization - which incorporates both industrial capacity utilization and labor market conditions - is at its highest level since 2006. With growth staying above trend, the inevitable is finally materializing and inflation is picking up. Chart I-4The U.S. Delevered, It Is Now Reaping The Benefits Chart I-5The Fed Is Now Less Sensitive To Foreign Shocks As Chart I-5 illustrates, aggregate U.S. capacity utilization - which incorporates both industrial capacity utilization and labor market conditions - is at its highest level since 2006. With growth staying above trend, the inevitable is finally materializing and inflation is picking up. Core PCE is now at 1.9%, and thus the 2% target is finally within reach. Just as importantly, 10-year and 5-year/5-year forward inflation breakevens have rebounded to 2.17% and 2.24% respectively, close to the 2.3% to 2.5% range - consistent with the Fed achieving its inflation target (Chart I-6). This implies that inflation expectations are getting re-anchored at comfortable levels for the Fed. As the threat of deflation and deflationary expectation passes, the Fed is escaping the fate of the Bank of Japan in the late 1990s. It also means that the Fed is now less likely to respond as vigorously to a deflationary shock emanating from outside the U.S. than was the case in 2016, when the U.S. economy still had plentiful slack, and realized and expected inflation was wobblier. The rest of the DM economies have not deleveraged, have more slack, and are more opened to global trade than the U.S. This exposure to the global economic cycle was a blessing in 2017, when global trade and global industrial activity were accelerating. But this is not the case anymore. As Chart I-7 illustrates, the Global Zew Economic Expectations survey is exhibiting negative momentum, which historically has preceded periods of deceleration in the momentum of global PMIs as well. Chart I-6Stage 1 Almost Complete The Fed Finally Enjoys ##br##Compliant Inflationary Conditions Chart I-7Downdraft In##br## Global Growth While this phenomenon is a global one, Asia stands at its epicenter. China's industrial activity is slowing sharply, as both the Li-Keqiang index2 and its leading index, developed by Jonathan LaBerge who runs BCA's China Investment Strategy service, are falling (Chart I-8, top panel). China is not alone: Korean exports and manufacturing production are now contracting on an annual basis; Singapore too is suffering from a clearly visible malaise (Chart I-8, middle and bottom panels). Advanced economies are also catching the Asian cold. Australia and Sweden, two small open economies, have seen key leading economic gauges slow (Chart I-9, top panel). Even Canadian export volumes have rolled over (Chart I-9, middle panel). Finally, the more closed European economy is showing worrying signs, with exports slowing sharply and PMIs rolling over. As we highlighted two weeks ago, even the European locomotive - Germany - is being affected, with domestic manufacturing orders now contracting on an annual basis.3 Chart I-8Asia Is The Source Of The Malaise Chart I-9The Cold Might Be Spreading This dichotomy between U.S. inflation and weakening global activity is resurrecting a theme that was all the rage in 2015 and 2016: monetary divergences. Fed officials sound as hawkish as ever and will likely push up the fed funds rate five times over the next 18 months even if global growth softens a bit. However, the ECB, the Riksbank, the Bank of England, the Reserve Bank of Australia, the Bank of Canada and even the BoJ are all backpedaling on their removal of monetary accommodation. They worry that growth is not yet robust enough, or that capacity utilization is not as high as may seem. The theme of monetary divergence will therefore likely be the result of non-U.S. central banks softening their rhetoric, not the Fed tightening hers. The end result is likely to cause a period of strength in the U.S. dollar, one that may have already begun. In fact, that strength is likely to have further to go for the following five reasons: First, as we showed in Chart I-3, the dollar is a momentum currency, and as Chart I-10 illustrates, the dollar's momentum is improving after having formed a positive divergence with prices. Chart I-10USD Momentum Is Picking Up Second, speculators and levered investors currently hold near-record amounts of long bets on various currencies, implying they are massively short the dollar (Chart I-11). This raises the probability of a short squeeze if the dollar's autocorrelation of returns stays in place. Chart I-11 Third, the dollar is prodigiously cheap relative to interest rate differentials (Chart I-12). While divergences from interest rate parity are common in the FX market, they never last forever. Thus, if monetary divergences become once again a dominant narrative among FX market participants, a move toward UIP equilibria will grow more likely. Fourth, rising Libor-OIS spreads have been pointing to a growing shortage of dollars in the offshore market. The decline in excess reserves in the U.S. banking system corroborates the view that liquidity is slowing drying up. Historically, these occurrences point to a strong dollar (Chart I-13). Chart I-12A Return To Interest-Rate##br## Parity? Chart I-13Falling Excess Bank Reserves Equals Strong Greenback Liquidity Factors Point To A Dollar Rebound Fifth, a strong dollar tightens EM financial conditions (Chart I-14). This could deepen the malaise already visible in Asia that seems to be slowly spreading to the global economy. This last point is essential, as it lies at the crux of the reason why the USD is the epitome of "momentum currencies." Essentially, this reflects the importance of the dollar as a source of funding for emerging market governments and businesses. The amount of EM dollar debt has been rising. In fact, excluding China, dollar-denominated debt today represents 16% of EM GDP, 65% of EM exports and 75% of EM reserves - the highest levels since the turn of the millennium (Chart I-15). Practically, this means that the price of EM currencies versus the USD is a key component to the cost of capital in EM. Chart I-14The Dollar Is The Enemy ##br##Of EM Financial Conditions Chart I-15EM Have A Lot ##br##Of Dollar Debt Additionally, EM local currency debt instruments are exhibiting their highest duration since we have data, making them more vulnerable to higher global interest rates (Chart I-16). Hence, the capital losses resulting from a given move higher in interest rates have grown, sharpening the risk that EM bond markets could experience a violent liquidation event. Moreover according to the IIF, the average sovereign rating of EM debt is at its lowest level since 2009. Normally, the allocation of global institutional investors into EM debt is positively correlated with the quality of EM issuers, but today this allocation has risen to more than 12%, the highest share in over five years. This suggests that DM investors are overly exposed to EM risk, creating another source of potential selling of EM assets. Ultimately, these risk factors can create a powerful feedback loop that support the sensitivity of the dollar to momentum. A strong U.S. dollar hurts EM assets, which prompts overexposed global investors to sell EM currencies further. This can be seen in the negative correlation of the broad trade-weighted dollar and high-yield EM bond prices (Chart I-17, top panel). Additionally, because rising EM bond yields as well as falling EM equities and currencies tighten EM financial conditions, this hurts EM growth. However, the U.S. economy is not as sensitive to EM growth as the rest of the world is.4 As a result, weakness in EM assets also translates into dollar strength against the majors (Chart I-17, middle panel). Additionally, commodity currencies tend to suffer more in this environment than European ones, as shown by the rallies in EUR/AUD concurrent with EM bond price weakness (Chart I-17, bottom panel). These risky dynamics in EM markets therefore are a key reason why we expect the U.S. dollar to be able to rally, bucking the normal weakness associated with the late stages of a U.S. business cycle expansion. Specifically, EUR/USD is set to suffer this year as the euro's technical picture has deteriorated significantly (Chart I-18), and, as we argued two weeks ago, the euro area still has plenty of slack. Chart I-16Heightened EM Duration Risk Chart I-17EM Risks Help The Greenback Chart I-18EUR/USD Technicals Are Flimsy Bottom Line: For the remainder of 2018, the dollar is likely to buck the weakness it normally experiences in the late innings of a .S. business cycle expansion. The U.S. is significantly ahead of the rest of the world when it comes to inflation, giving more room for the Fed to hike rates. This difference is now put in sharper focus than last year as the global economy is weakening, which could prompt a period of dovish rhetoric in the rest of the world that will not be matched by an equivalent backtracking in the U.S. Moreover, while positioning and technical considerations also favor a dollar rebound, the vulnerability of EM assets increases this risk by creating an additional drag on foreign growth. What To Do With The Yen? The yen currently sits at a tricky spot. Historically, the yen tends to depreciate against the USD when we are at the tail end of a U.S. business cycle expansion (Chart I-19). Toward the end of the business cycle, U.S. bond yields experience some upside - upside that is not mimicked by Japanese interest rates. The resultant widening in interest rate differentials favors the dollar. Chart I-19The Yen Doesn't Enjoy Late Cycle Dynamics On the other hand, a period of weakness in EM assets, even if prompted by a dollar rebound, could help the yen. The yen is a crucial funding currency in global carry trades, and a reversal of these carry trades will spur some large yen buying. Moreover, Japan has a net international investment position of US$3.1 trillion. This means that Japanese investors, who are heavily exposed to EM assets, are likely to repatriate some funds back home. So what to do? We have to listen to economic conditions in Japan. So far, despite an unemployment rate at 25-year lows and a job-opening-to-applicant ratio at a 44-year highs, Japan has not been able to generate much inflationary pressures. In fact, while the national CPI data has remained robust, the Tokyo CPI, which provides one additional month of data, has begun to roll over (Chart I-20). The Japanese current account is deteriorating sharply. This mostly reflects the downshift in EM economic activity as 44% of Japanese exports are destined to those markets. Interestingly, in response to the deterioration in export growth, import growth is also decelerating sharply, pointing toward a domestic impact from the foreign weakness (Chart I-21). It is looking increasingly clear that overall economic momentum in Japan is slowing. Both the shipment-to-inventory ratio as well as the Cabinet Office leading diffusion index are exhibiting sharp drops - signs that normally foretell a slowdown in industrial production and therefore a deterioration in capacity utilization, which still stands well below pre-2008 levels (Chart I-22). Chart I-20Weakening Japanese Inflation Chart I-21The Asian Malaise Is Hitting Japan Chart I-22Japanese Outlook Deteriorating In response to these developments, BoJ Governor Haruhiko Kuroda has been sounding more dovish. Moreover, after its latest policy meeting, the BoJ is acknowledging that it will take more time than anticipated for inflation to move toward its 2% target. In this environment, the yen has begun to weaken against the USD, especially as the greenback has been strong across the board. Moreover, USD/JPY was already trading at a discount to interest rate differentials. The downshift in Japanese economic data as well as the shift in tone by the BoJ are catalyzing the closure of this gap. Practically talking, USD/JPY is currently a very dangerous cross to play, as it is caught between various cross currents: a broad-based dollar rebound and a BoJ responding to a slowing economy can help USD/JPY; however, rising EM risks could boost it. On balance, we now expect the bullish USD forces to prevail on the yen, but we are not strongly committed to this view. Instead, have long maintained that the higher probability vehicle to play the yen is to short EUR/JPY.5 We remain committed to this strategy for the yen. Based on interest rate differentials, the price of commodities and global risk aversion, the euro can decline further against the yen, as previous overshoots are followed with significant undershoots (Chart 23, left panels). Moreover, speculators remains too long the euro versus the yen (Chart I-23, right panels). Additionally, EUR/JPY remains expensive on a long-term basis, trading 13% above its PPP-implied fair value. Finally, in contrast to Japan's large positive net international investment position, Europe's stands at -4.5% of GDP. Japanese investors have proportionally more funds held abroad than European investors do, and therefore more scope to repatriate funds in the event of rising EM asset volatility. We have also highlighted that selling AUD/JPY, while a more volatile bet than being short EUR/JPY, is another attractive way to play the risk to EM markets. Not only is AUD/JPY still very overvalued (Chart I-24), but Australia remains highly exposed to EM growth. This remains an attractive bet, despite a good selloff so far this year. Chart I-23AShort EUR/JPY Is A Cleaner Story (I) Chart I-23BShort EUR/JPY Is A Cleaner Story (II) Chart I-24AUD/JPY Is At Risk Bottom Line: The yen tends to depreciate against the USD in the later innings of a U.S. business cycle expansion, a response to rising U.S. bond yields. However, the yen also benefits when EM asset prices fall, a growing risk at the current economic juncture. Moreover, Japanese economic data are deteriorating and the BoJ is shifting toward a more dovish slant. The balance of these forces suggests that the yen rally against the dollar is done for now. However, the yen has further scope to rise against the EUR and the AUD. Two Charts On EUR/GBP Since we are anticipating EUR/USD to fall further toward 1.15, this also begs questions for the pound. Historically, a weak EUR/USD is accompanied by a depreciating EUR/GBP (Chart I-25). Essentially, the pound acts as a low-beta euro against the USD, and therefore when EUR/USD weakens, GBP/USD weakens less, resulting in a falling EUR/GBP. This time around, British economic developments further confirm this assessment. The spread between the British CBI retail sales survey actual and expected component has collapsed, pointing to a depreciating EUR/GBP (Chart I-26). Essentially, the brunt of the negative impact of Brexit on the British economy is currently being felt, which is affecting investor sentiment on the pound relative to the euro. Why could consumption, which represents nearly 70% of the U.K. economy, rebound from current poor readings? Once inflation weakens - a direct consequence of the previous rebound in cable - real incomes of British households will recover from their currently depressed levels, boosting consumption in the process. Chart I-25Where EUR/USD Goes,##br## EUR/GBP Follows Chart I-26Economic Conditions Also Point ##br##To A Weakening EUR/GBP Finally, today only 42% of the British electorate is pleased with having voted for Brexit, the lowest share of the population since that fateful June 2016 night. Moreover, this week, the House of Lords voted that Westminster can adjust the final deal with the EU before turning it into law. This implies that the probability of a soft Brexit, or even no Brexit at all, is increasing. However, the challenge to Theresa May's post-Brexit customs plan by MP Rees-Mogg, is creating yet another short-term hurdle that makes the path toward this outcome rather torturous. Additionally, it also raises the probability of a Corbyn-led government if the current one collapses. As a result, while the economic developments continue to favor being short EUR/GBP, the political environment is still filled with landmines, creating ample volatility in the pound crosses. We will use any rebound to EUR/GBP 0.895 to sell this pair. Bottom Line: If the euro weakens further, GBP/USD is likely to follow and depreciate as well. However, the pound will likely rally against the euro. Historically, GBP/USD behaves as a low-beta version of EUR/USD. Moreover, the maximum post-Brexit economic pain is potentially being felt right now, implying a less cloudy economic outlook for the U.K. Additionally, the probability of a soft Brexit or no Brexit at all is growing even if partial volatility remains. Set a stop sell on EUR/GBP at 0.895, with a target at 0.8300 and a stop loss at 0.917. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 2 The Li-Keqiang index is based on railway cargo volume, electricity consumption, and loan growth. 3 Please see Foreign Exchange Strategy Weekly Report, titled "The ECB's Dilemma", dated April 20, 2018, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, titled "Yen: QQE Is Dead! Long Live YYC!", dated January 12, 2018, and Foreign Exchange Strategy Weekly Report, titled "The Yen's Mighty Rise Continues... For Now", dated February 16, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was marginally positive this week. As headline PCE climbed to the targeted 2% level, the underlying core PCE also edged up to 1.9%, highlighting growing inflationary forces. However, countering these positive releases were disappointing PMIs and a slowing ISM, as well as pending home sales, which contracted on a 4.4% annual basis. Regardless, the Fed acknowledged the strength of the U.S. economy. The FOMC referred to the inflation target as "symmetric", signaling that for now, inflation above target will not be used as an excuse to lift rates faster than currently forecasted in the dots. Nevertheless, the much-awaited breakout in the dollar materialized two weeks ago. As global growth wains, key central banks such as the ECB, BoJ, and BoE are likely to retreat to a more dovish tilt, as growth forecasts are revised down. This should give the greenback a substantial boost this year. Report Links: Is King Dollar Facing Regicide? - April 27, 2018 U.S. Twin Deficits: Is The Dollar Doomed? - April 13, 2018 More Than Just Trade Wars - April 6, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was weak: M3 and M1 money supply growth both weakened to 3.7% and 7.6%; Annual GDP growth slowed down to 2.5%, as expected; Both the headline and core measures of inflation disappointed, coming in at 1.2% and 0.7%, respectively. The euro broke down below a crucial upward-slopping trendline, which was defining the euro's rally last year. Additionally, EUR/USD has also broken the 200-day moving average technical barrier, highlighting the impact on the euro of weakening global growth and faltering European data. This decline in activity, along with the presence of hidden-labor market slack have been picked up by President Mario Draghi and other key ECB officials. Therefore, weakness in the euro is likely to continue for now. Report Links: More Than Just Trade Wars - April 6, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Nikkei manufacturing PMI surprised to the upside, coming in at 53.8. However, Tokyo inflation ex-fresh food underperformed expectations, coming in at 0.6%. Moreover, consumer confidence also surprised negatively, coming in at 43.6. Finally, housing starts yearly growth underperformed expectations, coming in at -8.3%. The Bank of Japan decided to keep its key policy rate at -0.1% last Friday. Overall, the BoJ sounded slightly more dovish, acknowledging that it might take more time for inflation to move to their 2% target. Taking this into account, it might be dangerous to short USD/JPY as the BoJ could adjust policy to depreciate the currency. However investors could short EUR/JPY to take advantage of increased risk aversion. Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been negative: Gross domestic product yearly growth underperformed expectations, coming in at 1.2%. Moreover, manufacturing PMI also surprised to the downside, coming in at 53.9. Additionally, both consumer credit and mortgage approvals underperformed expectations, coming in at 0.254 billion pounds, and 62.014 thousand approvals respectively. The pound has depreciated by nearly 5.5% in the past 2 weeks. Poor inflation and economic data as well as generalized dollar strength. Overall, we continue to be bearish on the pound, as the uncertainty surrounding Brexit will continue to scare away international capital. Moreover, the strength of the pound last year should weigh significantly on inflation, limiting the ability of the BoE to raise rates significantly. Report Links: Do Not Get Flat-Footed By Politics - March 30, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was generally good: Building permits picked up, growing at a 14.5% annual rate, and a 2.6% monthly rate, beating expectations; The trade balance outperformed expectations comfortably, coming in at AUD 1.527 million; However, the AIG Performance of Manufacturing Index went down to 58.3 from 63.1; The AUD capitulated as a result of the growing global growth weakness, trading at just above 0.75. The RBA is reluctant to hike rates as Governor Lowe sited both stress in the money market and stretched household-debt levels as key reasons for his reluctance to hike. In other news, growing tension between Australia and its largest investor, China, are emerging in response to rumors that Chinese agents have been lobbying Australian officials in order to influence Australian politics. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: The unemployment rate surprised positively, coming in at 4.4%. Moreover, employment quarter-on-quarter growth outperformed expectations, coming in at 0.6%. However, the Labour cost index yearly growth surprised to the downside, coming in at 1.9%. Finally, the participation rate also surprised negatively, coming in at 70.8%. NZD/USD has depreciated by nearly 5%. Overall we continue to be negative on the kiwi, given that an environment of risk aversion will hurt high carry currencies like the New Zealand dollar. Moreover, a slowdown in global growth should also start to hurt the kiwi economy, given that this economy is very levered to China and emerging markets. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data was mixed: Raw material price index increased by 2.1% in March, more than the expected 0.6%; GDP grew at a 0.4% monthly rate, beating expectations of 0.3%; However, the Markit manufacturing PMI disappointed slightly at 55.5. The CAD only suffered lightly despite the greenback's rally. Governor Poloz argued that the expensive Canadian housing market and the elevated household debt load have made the economy more sensitive to higher interest rates than in the past. He also pointed out that interest rates "will naturally move higher" to the neutral rate level, ultimately giving mixed signals. Despite these mixed comments by Poloz, the CAD managed to rise against most currencies expect the USD. Report Links: More Than Just Trade Wars - April 6, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Real retail sales yearly growth underperformed expectations, coming in at -1.8%. Moreover, the KOF leading indicator also surprised negatively, coming in at 105.3 However, the SVME Purchasing Manager's Index came in at 63.9. EUR/CHF has been flat these last 2 weeks. Overall, we continue to bullish on this cross on a cyclical basis, given that the SNB will keep intervening in currency markets, as the economy is still too weak, and inflationary pressures are still to tepid for Switzerland to sustain a strong franc. However, EUR/CHF could see some downside tactically in an environment of rising risk aversion. Report Links: The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Registered unemployment surprised positively, coming in at 2.4%. Moreover, the Norges Bank credit indicator also outperformed expectations, coming in at 6.3%. USD/NOK has risen by more than 4% these past 2 weeks. This has occurred even though oil has been flat during this same time period. Overall we are positive on USD/NOK, as this cross is more influenced by relative rate differentials between the U.S. and Norway than it is by oil prices. However, the krone could outperform other commodity currencies, as oil should outperform base metals, as the latter is more sensitive to the Chinese industrial cycle than the latter. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The krona's collapse seem never ending. While the krona never responds well to an environment where global growth is weakening and where asset prices are becoming more volatile, Riksbank governor Stefan Ingves is not backing away from his dovish bias. In fact, the Swedish central bank is perfectly pleased with the krona's dismal performance. Thus, the Riksbank is creating a stealth devaluation of its currency, one that is falling under President Donald Trump's radar. Swedish core inflation currently stands at 1.5%, but it is set to increase. The Riksbank's resource utilization gauge is trending up and the Swedish housing bubble is supporting domestic consumption. As a result, the Swedish output gap is well above zero, and wage and inflationary pressures are growing. The Riksbank will ultimately be forced to hike rates much faster than it currently forecasts. Thus, we would anticipate than when the global soft patch passes, the SEK could begin to rally with great alacrity. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The global 6-month credit impulse is now indisputably in a mini-downswing phase. Stick with underweights in the classically cyclical sectors: banks, basic materials and industrials. The strategy has worked well since the start of the year, and it is too early to exit. For bonds, the implication is that yields can move only slightly higher before stronger headwinds to risk-assets and/or the economy provide a tradeable reversal in yields. The trade-weighted euro has some support given that the BoE and/or the Fed have tightening expectations that can be priced out, while the ECB doesn't. We have a slight preference for the FTSE100 and S&P500 over the Eurostoxx50. Feature Entering the fifth month of the year, one puzzle for investors is the conflicting messages coming from banks and bonds. While banks' relative performance is close to its 2018 low, bond yields are not far from their year-to-date high (Chart of the Week). Chart of the WeekBanks Or Bonds: Which One Is Right? This poses a puzzle because the performances of banks and bond yields are usually joined at the hip. The underperformance of the economically sensitive banks would suggest that global growth is decelerating, whereas the performance of bond yields would suggest that global activity is holding up well. Which one is right? The Global 6-Month Credit Impulse Is Indisputably In A Mini-Downswing Looking at the other classically cyclical sectors, the mystery seems to deepen. Industrials and basic materials are also in very clear downtrends this year, which corroborates the message from the banks. But the oil and gas sector is close to a year high, which corroborates the message from bond yields (Charts I-2-I-4). Chart I-2Industrials Have Underperformed... Chart I-3...And Basic Materials Have Underperformed Chart I-4...But Oil And Gas Has Outperformed... The conflicting messages from banks, basic materials and industrials on one side and bond yields and oil and gas equities on the other side reflect the disconnect between non-oil commodity prices which have drifted lower this year and oil prices which have moved sharply higher (Chart I-5). This disconnect, resulting from differing supply dynamics in the different commodity markets, points us to a likely solution to our puzzle. Chart I-5...Because Oil Has Disconnected ##br##From Other Commodities The classically cyclical sectors are taking their cue from global growth and industrial activity, which does appear to be losing momentum. The global 6-month credit impulse is now indisputably in a mini-downswing phase. In contrast, bond yields are taking their cue from the oil price, given its major impact on headline inflation, inflation expectations, and thereby on central bank reaction functions. Based on previous mini-cycles, we can confidently say that mini-downswing phases last at least six to eight months and that the usual release valve is a decline in bond yields. In this regard, the apparent disconnect between decelerating activity and un-budging bond yields risks extending this mini-downswing phase. Therefore, for the next few months, it is appropriate to stick with underweights in the classically cyclical sectors: banks, basic materials and industrials. The strategy has worked well since we initiated it at the start of the year, and it is too early to exit. This sector strategy necessarily impacts regional allocation as explained in the next section. For bonds, the implication is that yields can move only slightly higher before stronger headwinds to risk-assets and/or the economy provide a natural cap and a tradeable reversal in yields. Even More Investment Reductionism Imagine a world in which all the global commodity firms decided to get their stock market listings in London; all the global financials decided to list on euro area bourses; all the major tech companies listed in New York; and all the industrials listed in Tokyo. Clearly, each major stock market would just be a play on its underlying global sector and nothing more. Our imagined world is an exaggeration, but it does illustrate an important truth. A quarter of the market capitalisation of each major stock market is in one dominant sector, and this gives each equity index its defining fingerprint: for the FTSE100 it is commodity firms; for the Eurostoxx50 it is financials; for the S&P500 it is technology; and for the Nikkei225 it is industrials (Table I-1). Table I-1Each Major Stock Market Has A Defining Fingerprint There is another important factor to consider: the currency. A global oil company like BP receives its revenue and incurs its costs in multiple major currencies, such as euros and dollars. In this sense, BP's global business is currency neutral. But BP's stock price is quoted in pounds. This means that if the pound strengthens, the company's multi-currency profits will decline relative to the stock price and weigh it down. Conversely, if the pound weakens, it will lift the BP stock price. So the currency is the channel through which the domestic economy can impact its stock market, albeit it is an inverse relationship: a strong currency hinders the stock market; a weak currency helps it. The upshot is that the defining fingerprints for the major indexes turn out to be: FTSE100: global commodity shares expressed in pounds. Eurostoxx50: global banks expressed in euros. S&P500: global technology expressed in dollars. Nikkei225: global industrials expressed in yen. And that's pretty much all you need to know for regional equity allocation! The charts in this report should leave you in no doubt. True to our Investment Reductionism philosophy, the relative performance of the regional equity indexes just reduces to their defining fingerprints: FTSE100 versus S&P500 reduces to global commodity companies in pounds versus global tech companies in dollars, Eurostoxx50 versus Nikkei225 reduces to global banks in euros versus global industrials in yen. And so on (Charts I-6-I-11). Chart I-6FTSE 100 Vs. S&P 500 = Global Commodity##br## Equities In Pounds Vs. Global Tech In Dollars Chart I-7FTSE 100 Vs. Nikkei 225 = Global Commodity ##br##Equities In Pounds Vs. Global Industrials In Yen Chart I-8FTSE 100 Vs. Euro Stoxx 50 = Global Commodity##br## Equities In Pounds Vs. Global Banks In Euros Chart I-9Euro Stoxx 50 Vs. S&P 500 = Global Banks In ##br##Euros Vs. Global Tech In Dollars Chart I-10Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In##br## Euros Vs. Global Industrials In Yen Chart I-11S&P 500 Vs. Nikkei 225 = Global Tech In ##br##Dollars Vs. Global Industrials In Yen The Right Way To Invest In The 21st Century One important implication of Investment Reductionism is that the head-to-head comparison of stock market valuations is a meaningless and potentially dangerous exercise. Two sectors with vastly different structural growth prospects - say, banks and technology - must necessarily trade on vastly different valuations. So the sector with the lower valuation is not necessarily the better-valued sector. By extension, the stock market with the lower valuation because of its sector fingerprint is not necessarily the better-valued stock market. Another implication is that simple 'value' indexes may not actually offer better value! In reality, they comprise a collection of sectors on the lowest head-to-head valuations which, to repeat, does not necessarily make them better-valued. Some people suggest comparing a valuation with its own history, and assessing how many 'standard deviations' it is above or below its norm. The problem is that the whole concept of standard deviation assumes 'stationarity' - meaning, no step changes in a sector's valuation through time. Unfortunately, sector valuations are 'non-stationary': they undergo major step changes when they enter a vastly different economic climate. For example, the structural outlook for bank profits undergoes a step change when a credit boom ends. Therefore, comparing a bank valuation after a credit boom with the valuation during the credit boom is like comparing an apple with an orange. Pulling together these complexities of sector effects, currency effects, and step changes in sector valuations, we offer some strong advice on how to sequence the investment process: 1. Make your asset class decision at a global level. This is because asset classes tend to move as global entities, not regional entities. And also because at a global level, asset class valuation comparisons are less distorted by sector and currency effects. 2. Make your sector decisions. Given that the companies that dominate European (and all major) indexes are multinationals, the sector decision should be based on the direction of the global economy. 3. Make your currency decisions. 4. You do not need to make any more major decisions! The main regional equity allocation, country allocation and value/growth allocation just drop out from the sector and currency decision. With the global 6-month credit impulse now indisputably in a mini-downswing phase (Chart I-12), the classically cyclical sectors are likely to continue underperforming for the next few months; the rise in bond yields faces resistance; and the euro - at least on a trade-weighted basis - has some support given that the BoE and/or the Fed have tightening expectations that can be priced out, while the ECB doesn't. Chart I-12The Global 6-Month Credit Impulse Is Indisputably In A Mini-Downswing Finally, in terms of regional equity allocation, Investment Reductionism implies a slight preference for the FTSE100 and S&P500 over the Eurostoxx50. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* In addition to the fundamental arguments in the main body of this report, fractal analysis finds that the outperformance of Oil and Gas relative to other commodity equities is technically extended. Hence, this week's trade recommendation is to underweight euro area Oil and Gas versus global Basic Materials. Set a profit target of 5%, with a symmetrical stop-loss. In other trades, we are pleased to report that long USD/ZAR hit its 6% profit target, and is now closed. This leaves us with five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-13 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations

Highlights Feature Chart of the WeekAg Vol Will Rise Over the coming three months markets will be zeroing in on spring planting in the U.S., looking for deviations from the USDA's March intentions report. This will occur against the cyclical backdrop of increased volatility, as markets attempt to price the real impact of Chinese tariffs (Chart of the Week). Putting aside fundamentals, U.S. financial conditions will be a headwind to ag prices this year. Longer term, despite the more favorable USD outlook, a slowdown in China, which accounts for ~ 20% of global food demand, could be bearish for ag prices. Highlights Energy: Overweight. U.S. crude oil output rose to a record 10.3mm b/d in February according to the U.S. EIA. U.S. crude production exceeded Saudi Arabia's in 1Q18; we expect it to exceed Russia's output of 11.2mm b/d by December, 2018. Base Metals: Neutral. Permanent waivers on steel and aluminum tariffs were granted to Australian, Argentine, and Brazilian imports by U.S. firms, while exemptions on imports from the EU, Canada and Mexico were extended to June 1. Precious Metals: Neutral. USD strength is weighing on gold and silver: Our long positions on both metals are down 3.0% and 6.2%, respectively, over the past two weeks. Ags/Softs: Underweight. Ag market volatility will increase, as markets assess U.S. spring planting progress against a backdrop of a possible trade war in ags between the U.S. and China (see below). Feature All Eyes On U.S. Planting Progress It is a busy time of year for U.S. farmers as spring planting is underway. Based on the USDA's annual Prospective Planting Report, released end-March, corn and soybean plantings will fall 2% y/y and 1% y/y, respectively. If realized, corn planted area in the 2018/19 crop year will be the lowest since 2015, and, for only the second time in the history of the series, will fall behind soybean acreage (Chart 2). The USDA's survey also indicates U.S. corn and soybeans will lose ground to wheat, where farmers intend to expand acreage by 3%. Even so, wheat planting intentions are the second lowest on record since the beginning of the series in 1919, surpassed only by last year's all-time low. Mother Nature is not co-operating either: unseasonably cold and wet weather is hindering planting this spring (Table 1). Planting of corn and spring wheat are significantly behind average for this time of the year. Similarly, heading of winter wheat - which accounts for ~ 70% of total wheat intentions - is also behind schedule. Furthermore, harsh winter weather reduced the condition of almost 40% of the crop to poor or very poor, with only 33% qualifying as good or excellent, compared to last year's assessment of 13% and 54%, respectively. Chart 2U.S. Soybean Acreage To Surpass Corn In 2018/19 Table 1U.S. Farmers Are Behind Schedule Weather-related delays are less of a risk for soybean plantings, which begin and end later in the summer. Progress is currently in line with historical averages, and, since farmers have an additional month of planting compared to corn and wheat, it is possible they will opt to switch their unplanted corn and wheat acreage to beans. This is a downside risk to the soybean market: When all is said and done, June soybean acreage may exceed targets indicated in the USDA's March intentions report. Although farmers' current lack of headway on the fields is cause for concern, it is still possible that farmers will be able to catch up, attaining their targeted acreage. A Backdrop Of Falling Inventories The termination of China's corn stockpiling scheme, which, prior to 2016 led to the rapid buildup of domestic inventories, was accompanied by policies designed to incentivize soybean plantings over corn. In the case of corn, these policies have paid off. By the end of the current crop year we expect the drawdown in Chinese inventories - along with U.S. stockpiles - to drag world corn reserves lower for the first time since 2010/11 (Chart 3).1 China's pro-soybean production policy is expected to yield a 1.1% expansion in the oilseed's planting area, leading to a 12.8% increase in output this crop year. Regardless, domestic inventories expressed in stocks-to-use (STU) terms are projected to fall (Chart 4). Similarly, world soybean reserves will contract on the back of a decline in Argentine output, which will lead to the largest - and one of only three on record - soybean deficits in the domestic market. In the case of wheat, although U.S. output is forecast to come down this year, weighing on domestic inventories, global markets remain well supplied (Chart 5). In fact, even though USDA's monthly revisions to U.S. production have been downward, forecasts of total use also were revised down. This means the net impact on the balance will be a wider-than-expected surplus. In the case of global markets, world wheat STU ratio will increase to levels last seen in 1986. Net, despite unfavorable weather weighing on the quality and quantity of U.S. wheat crops, there is no shortage of wheat in the world, unlike corn and soybeans. Chart 3Corn Deficit Eating##BR##Away At Stockpiles Chart 4China STU Falls Despite##BR##Pro-Soybean Policies Chart 5Global Wheat Markets Well Supplied##BR##Amid U.S. Supply Concerns Bottom Line: Given the slower-than-average planting progress this year, near term prices will likely reflect developments in the U.S., as farmers rush to get the crops in the ground. While winter wheat appears to be of poor quality this year, corn and spring wheat plantings are significantly behind schedule. This raises the risk that their acreages will be abandoned in favor of soybeans, which has a later planting window. All in all, if the June acreage report aligns with farmers' planting intentions, we expect to see an increase in wheat acreage at the expense of corn and soybean, which will provide some supply relief to domestic wheat markets. U.S. Farmers Less Competitive, Especially In Soybean Markets In theory, China's announced plans to levy duties on U.S. ag imports puts U.S. farmers - part of President Trump's base - at a disadvantage. But, reality may not be as bearish. The outcome hinges on whether the U.S. will be able to ramp up its exports to other markets amid declining imports from the top bean consumer. Given the impact of weather on soybean output in Argentina - where drought cut soybean output by 30% y/y - there will be a void in global supply. Since soybeans are fungible, we expect ex-China demand to remain supported on the back of limited global supply. This will provide an opportunity for the U.S. to export its surplus, at least in this crop year. To date, there appears to be some evidence of this. Domestic supply will be insufficient to cover Argentinian consumption this year (Chart 6). In an unusual move, USDA export sales data shows Argentina booked a 240k MT purchase of U.S. soybeans for delivery in the next marketing year. Argentina traditionally is a net exporter of soybeans. While we expect tariffs to reshuffle trade flows as China attempts to ensure supplies while avoiding U.S. soybeans, the net effect in terms of global demand for U.S. soybeans may not be as bearish as is feared. China simply does not have the domestic supply to satisfy its demands for beans. While opting for Brazilian or Argentinian beans may be way around importing U.S. supplies, this will open up other export opportunities for the U.S. variety, leading to a simple restructuring of trade flows.2 Recent declines in Chinese imports of U.S. soybeans amid growing imports from Brazil have been cited as evidence of a gloomy future for U.S. soybean farmers. However, this phenomenon is part of the Chinese import cycle: Brazilian soybeans flood Chinese markets in the second and third quarters, while American supplies flow in during the last and first quarters of any given year (Chart 7). Furthermore, U.S. soybean imports have been on the downtrend since the middle of last year. Thus, this observation alone does not signal a change in trend. Chart 6Weak Argentine Output##BR##Restrict Global Supplies Chart 7Chinese Preference For Brazilian Beans##BR##Typical For This Time Of Year In fact, the premium paid for Brazilian beans over those traded in Chicago spiked earlier last month. Although it has since come down slightly, it suggests Chinese consumers will have to bear the brunt of more expensive imports. Furthermore, this makes U.S. beans relatively cheaper - and more attractive - in the global market. All the same, higher costs may entice Chinese consumers to look at adjusting the feed formula by diversifying the source of feed. Although our baseline scenario is that these tariffs will remain in place, U.S. Treasury Secretary Steven Mnuchin and U.S. Trade Representative Robert E. Lightizer's trip to Beijing may be the opening salvo to less hostile trade developments. If this is the case, we would expect these trade-related risks to ease. Bottom Line: Tariffs on U.S. soybean imports to China are, in theory, bearish for U.S. markets. However, China's reliance on these beans, along with a tight market this year, makes the outlook less gloomy. Courses of action that may be pursued by China are (1) diversifying the source of the bean, (2) reducing demand for the bean by adjusting feed formula, and (3) continuing to raise domestic soybean acreage. Given the cyclical nature of China's soybean imports, we are entering a period of naturally low demand for U.S. soybeans. Thus, we will not likely see the real impact of current trade disputes until China's demand for American beans kicks in again in 4Q18. In the meantime, a global deficit will open up alternative opportunities for U.S. exports. U.S. And Foreign Financial Conditions Drive Long Run Outlook As weather and the on-going trade tensions between the U.S. and China evolve, the U.S. financial backdrop - particularly real interest rates and the broad USD trade-weighted index (TWIB) - will remain crucial to ag markets. In line with BCA Research's House View, we expect Fed rate hikes to exceed those of other central banks, providing support to a stronger USD over the next 12 months. This will weigh on ag prices.3 Chinese economic growth also could figure prominently, based on recent research from the CME Group, which operates the world's benchmark grain futures markets.4 The relationship between China's unofficial economic gauge - the Li Keqiang Index (LKI) - and ag prices appear to operate through the currency channel. A weaker Chinese economy - reflected in the LKI - suppresses industrial commodity demand, which ends up weighing on the currencies of major commodity exporters. This means the local costs of production for these exporters fall, which, with a 1- to 2-year lag, incentivizes crop plantings in these regions. The increased supply at the margin is bearish for ag prices, all else equal. Given the current environment of a slowing Chinese economy, this relationship is relevant to the longer-term outlook. The significance of the LKI in our grains models provides some evidence of this relationship (Chart 8). When applying the analysis to Brazilian and Russian ag markets, we find the LKI to be positively correlated with the Brazilian Real and the Russian Ruble. This, in turn, explains the inverse correlation we find between the LKI and future ag production in these two markets (Chart 9). A weaker domestic currency does appear to entice farmers to increase plantings of ag commodities, allowing them to take advantage of greater local currency profits from USD-denominated ag exports. Chart 8China Slowdown May Weigh Down On Ags... Chart 9...By Incentivizing Production Bottom Line: This preliminary analysis uncovers a supply side channel through which China may impact global ag supplies. It implies that a slowing Chinese economy may in effect spur greater global ag supplies, eventually weighing down on ag prices. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Senior Analyst HugoB@bcaresearch.com 1 Despite the increase in domestic supply amid greater offerings of state reserves, much of the state corn stocks are reportedly in poor condition, only suitable as a source for ethanol production - cited as the justification for upward revisions to corn consumption this year. As such, imports will likely remain indispensable. Overall it appears that China intends to raise its industrial consumption of corn in order to digest its stockpiles, with limited impact on prices. Late last year, China announced its target of nationwide use of bioethanol gasoline by 2020. It estimates that corn stockpiles are sufficient to meet near term demand for the grain used as the ingredient in E10, and hopes to achieve a physical corn market balance within five years. 2 Please see the Ags/Softs back section titled "Can China Retaliate With Agriculture," in BCA Research Commodity & Energy Strategy Weekly Report titled "Oil Price Forecast Steady, But Risks Expand," dated March 22, 2018, available at ces.bcaresearch.com. 3 For a more detailed discussion of the impact of U.S. financial variables on ag markets, please see BCA Research Commodity & Energy Strategy Weekly Report titled "Global Financial Conditions Will Drive Grain Prices In 2018," dated November 30, 2017, available at ces.bcaresearch.com. 4 Please see "Will A Sino-U.S. Trade War Impact Grain, Meat Markets?" dated March 28, 2018, available at cmegroup.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Highlights Stay overweight Chinese ex-tech stocks for now, despite the recent spell of poor relative performance. Our downgrade watch for Q2 remains in effect, however, as the risks to this position are clearly to the downside. Recent data suggests that China's industrial sector continues to slow. We also see more downside risk from monetary policy and the pace of structural reform than the market, underscoring that our stance towards China is a low-conviction overweight. Taiwan's recent outperformance has largely been passive, in that it has been driven by the movement in stock prices outside of Taiwan. The factors boosting the relative performance of technology and bank stocks are unlikely to be sustained, suggesting that investors should remain underweight Taiwan within Greater China bourses. Feature Chart 1Ex-Tech Stocks Edging Closer##BR##To A Breakdown Vs Global Chinese ex-technology stock prices edged closer to a technical breakdown in April (Chart 1), as ongoing concerns about the impact of a trade war with the U.S. weighed further on investor sentiment. Consumer discretionary stocks have fared particularly poorly, as President Xi's pledge to open up the auto sector (which is negative for the market share of domestic firms) underscores that car producers are facing a losing scenario even if a further escalation in trade tension with the U.S. is avoided. Panel 2 of Chart 1 shows that recent decline has brought consumer discretionary stocks back to early-2017 levels relative to the broad market. The selloff in the consumer discretionary sector has significantly benefitted one of China Investment Strategy's open trades: long investable consumer staples / short investable consumer discretionary, initiated on November 16. The trade had already been outperforming prior to Xi's pledge in response to the original basis that we articulated (negative impact on autos from environmental reforms), but the news of a likely deterioration in market share has helped the trade earn a whopping 20% in less than 6 months. We recommend that investors stick with the call for now, until greater clarity emerges about the ultimate impact of trade negotiations with the U.S. But we have also recommended that investors place Chinese ex-tech stocks on downgrade watch for Q2 (while maintaining an overweight stance versus global equities), and that technical measures should be watched closely to determine whether a downgrade is indeed warranted. Within this framework, the recent deterioration in performance is worrying, raising the question of whether it is time for investors to reduce their exposure to ex-tech shares. Stay Overweight, For Now... Three factors point to "no" as the answer: Chart 2A Pro-Cyclical Allocation Is Consistent##BR##With A China Overweight Despite the weakness of Chinese stock prices over the past few weeks, they have not yet broken down technically: Chart 1 highlighted that their relative performance versus global stocks remains above its 200-day moving average. For now, this is consistent with a worsening in sentiment rather than full-fledged expectations of a sharp deterioration in equity fundamentals. Investors are clearly reacting to the negative potential effect of trade protectionism on ex-tech earnings, the ultimate impact of which remains subject to negotiation. We singled out consumer discretionary stocks as being likely to fare poorly under any realistic trade outcome, but the decline in Chinese relative performance since mid-April has occurred across all sectors, suggesting that a reversal may occur outside of the discretionary sector if a trade deal is struck with the U.S. Talks in China between high level U.S. and Chinese officials tomorrow and Friday are a hopeful sign that a relatively beneficial deal for both sides may be possible, suggesting that it is too early to cut exposure. Over a 1-year time horizon, BCA continues to recommend that investors remain overweight global equities within an overall balanced portfolio. We have highlighted in previous reports that the Chinese investable stock market is now a decidedly high-beta equity market versus the global benchmark (even in ex-tech terms),1 meaning that an overweight stance is justified barring a significantly negative alpha. Since Chart 2 illustrates that Chinese ex-tech stocks have in fact generated a modestly positive alpha over the past year, a pro-cyclical asset allocation stance continues to favor an above-benchmark weight to Chinese equities ex-technology. For now, our investment recommendations remain unchanged: investors should stay overweight Chinese stocks excluding the technology sector over the coming 6-12 months. But as highlighted below, the risks to China are clearly to the downside, which supports our decision to place Chinese stocks on downgrade watch for Q2. This watch remains in effect for the coming two months, a period during which we hope fuller clarity on the U.S./China trade dispute as well as the pace of decline in China's industrial sector will emerge. Bottom Line: Stay overweight Chinese ex-tech stocks for now, despite the recent spell of poor relative performance. Our downgrade watch for Q2 remains in effect, however, as the risks to this position are clearly to the downside. ...But The Risks Are To The Downside Table 1 updates our macro data monitor that we have published in a few previous reports. The monitor tracks the data series that we found to have the most reliable leading properties when predicting the Li Keqiang index (LKI),2 which we have defined as the most relevant proxy of China's business cycle. Table 1No Convincing Signs Of An##BR##Impending Upturn In China's Economy Chart 3Lower Inventories =##BR##A Rise In Housing Construction? The table now shows a March datapoint for all of the series that we track, and continues to argue that the trend in Chinese industrial activity is down. In particular, it appears to confirm that the elevated January/February levels in Bloomberg's calculation of the LKI were likely noise, and not a signal of an impending uptrend. The table highlights that none of the components of our leading indicator for the LKI are above their 12-month moving average, and 5 out of the 6 components fell in March. While the April update of the Caixin manufacturing PMI is being released as we go to press, the official manufacturing PMI also fell in April. On the housing front, floor space sold, one of the most important leading indicators for residential construction activity in China, has also decelerated over the past two months. In last week's joint Special Report with our Emerging Markets Strategy service, my colleague Ellen JingYuan He noted that steel prices are at risk not only because of a likely increase in supply, but from weaker demand due to a potential slowdown in the property market. BCA's China Investment Strategy service has actually taken a cautiously optimistic stance towards the housing market, and noted in an early-February report that there were a few signs of a pickup in activity.3 Chart 3 presents the most hopeful case, which is that the multi-year downtrend in residential construction relative to sales may be over given the significant reduction in housing inventories that has occurred over the past two years. Still, the level of inventories remains quite elevated by conventional standards, and it is difficult to see growth in residential construction sustainably rise if floor space sold remains weak, as it has been for the past two months. Given the recent evolution of the important macro data from China, our view is that the downside risk to the industrial sector should be clear to most investors. However, the potential for monetary policy easing and the extent of the tailwind for China from global growth remain two areas where we see more downside risk than some in the market. On the policy front, China's recent cut in the reserve requirement ratio (RRR) was greeted by some analysts as a sign of easing monetary policy, with others pointing to the recent decline in government bond yields as a clear sign that China's monetary policy is about to become less restrictive. However, we explained in a recent Special Report why the 3-month repo rate is currently the de-facto policy rate,4 and Chart 4 highlights that it appears to lead yields at the short-end. The recent tick down in the latter appears to be a delayed response to the sharp decline in the former, which preceded the RRR cut. Specifically, the repo rate slide was triggered by news reports in late-March that the deadline for new rules to be imposed on China's asset management industry would be extended, which is consistent with our argument that roughly 3/4ths of the tightening in monetary policy that has occurred since late-2016 has actually been regulatory/macro-prudential in nature. Given that the 3-month repo rate has since rebounded back to its post-2017 average following the announcement, we see no indication of any intension by the PBOC to ease monetary policy. Concerning trade, while the threat to China's export growth from U.S. protectionism is obvious, some investors have argued that global demand may be strong enough to overwhelm this negative effect and that it will buoy Chinese export growth (and, by extension, imports). This line of reasoning has a strong basis; Chart 5 shows that our BCA Global LEI is forecasting solid industrial production (IP) growth over the coming few months, and we have noted in past reports that there is a strong link between global IP and Chinese export growth. Chart 4No Convincing Signs Of Monetary Easing Chart 5Global Demand Likely To Remain Solid But Chart 6 presents a problem with this argument, which is that China's reform pain threshold is very likely positively correlated with global growth. In short, BCA has written extensively about how China has embarked on a multi-year reform effort that will likely weigh on growth in its early stages. We have made it clear that the pace of these reform efforts is likely to be responsive to the pace of economic growth (i.e. policymakers will set the pace to avoid a major growth slowdown), but the other side of this coin is that policymakers are likely to take advantage of a stronger export sector by increasing the pace of reforms. So while some investors view the external sector of China's economy as having some potential to counter weakness in the industrial sector if major protectionist action can be avoided, our sense is that ramped up reform efforts will offset and possibly overwhelm this positive factor, were it to occur. As a final point, in the context of Chart 6, material easing in either policy rates or the pace of reform efforts may occur over the coming 6-12 months, but it would likely be in response to a more serious slowdown in the economy than we are currently observing. As we noted in our April 18 Weekly Report,5 the possibility that Chinese authorities will need to stimulate the economy over the coming year is interesting because it raises the prospect of another economic mini-cycle in China, potentially leading to another meaningful acceleration. But the economic and financial market circumstances that would precede such an event are unlikely to be happy ones for investors, raising the risk of a serious selloff in China-related assets before policy eases sufficiently to return to an overweight stance. Chart 6If Demand For Chinese Exports Stays Strong,##BR##Reform Efforts Will Intensify Bottom Line: Recent data suggests that China's industrial sector continues to slow. We also see more downside risk than many investors from monetary policy and the pace of structural reform, underscoring that our stance towards China is a low-conviction overweight. An Update On Taiwanese Equities We last wrote about Taiwanese stocks in our December 14 Weekly Report,6 and argued that investors stick with our short MSCI Taiwan / long MSCI China trade and our underweight stance towards Taiwan vs Greater China bourses, despite extended technical conditions. Our recommendation was based on the argument that Taiwanese tech sector underperformance had been driven by material strength in the trade-weighted Taiwanese dollar (TWD), and that a lasting depreciation in the currency would be the most likely catalyst for a re-rating. Since our report in December, the relative performance of Taiwanese stocks has been volatile. After a period of underperformance versus Greater China stock prices, Taiwanese stocks then rose sharply in relative terms from late-February to early-April. The magnitude of the rise was sufficiently large to cause the relative price index to break above its 200-day moving average (Chart 7). However, Taiwanese relative performance has reversed course over the past month, retracing over half of the February to April surge. Chart 8 highlights that these confusing moves in Taiwanese stock prices versus Greater China have largely reflected passive outperformance in two sectors: tech sector outperformance versus China, and banking industry group outperformance versus global banks. On the tech front, Chinese tech stocks have been under pressure over the past month due to the tech-focused nature of U.S. import tariffs, and global investors appear to believe that Taiwanese tech stocks would not be as impacted by these tariffs as their Chinese peers. We disagree, as the export intensity of Taiwan's tech sector to China is quite high: exports to China account for 15% of Taiwan's GDP, and electronic components (i.e. semiconductors) account for nearly half of exports to China. This suggests that the tariff impact on Taiwan's tech sector will be sizeable even if it is indirect. Chart 7A Volatile Relative##BR##Performance Trend Chart 8Tech And Banks Have Driven Recent##BR##Developments In Relative Performance On the banking front, Chart 9 highlights that the outperformance of Taiwanese banks versus their global peers has occurred due to a failure of the former to selloff with the latter over the past few months. Global banks appear to be reacting to the recent flattening in the global yield curve caused by a rise at the short-end, whereas there is no sign of upcoming monetary policy tightening in Taiwan and Taiwanese banks have historically been low-beta versus their global peers (Chart 10). Chart 9Taiwanese Banks Have Passively##BR##Outperformed Global Banks Chart 10Continued Bank Outperformance Not##BR##Likely Barring A Decline In Global Equities We doubt that Taiwan's banks will continue to outperform global banks over the coming 6-12 months without a generalized selloff in global stock prices. As we noted earlier, BCA's house view is overweight global equities (and financials) over the cyclical horizon on the basis of still-strong global growth, stimulative U.S. fiscal policy, and the view that global monetary policy will not reach restrictive territory over the coming year. As such, we are inclined to lean against the recent outperformance of Taiwanese banks and, by extension, the trend in ex-tech relative performance. Bottom Line: Taiwan's recent outperformance has largely been passive, in that it has been driven by the movement in stock prices outside of Taiwan. The factors boosting the relative performance of technology and bank stocks are unlikely to be sustained, suggesting that investors should remain underweight within Greater China bourses. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Research's China Investment Strategy Special Report "China: No Longer A Low-Beta Market," published January 11, 2018. Available at cis.bcaresearch.com. 2 Please see BCA Research's China Investment Strategy Special Report "The Data Lab: Testing The Predictability Of China's Business Cycle," published November 30, 2017. Available at cis.bcaresearch.com. 3 Please see BCA Research's China Investment Strategy Weekly Report "Is China's Housing Market Stabilizing?," published February 8, 2018. Available at cis.bcaresearch.com. 4 Please see BCA Research's China Investment Strategy Special Report "Seven Questions About Chinese Monetary Policy," published February 22, 2018. Available at cis.bcaresearch.com. 5 Please see BCA Research's China Investment Strategy Weekly Report "The Question That Won't Go Away," published April 18, 2018. Available at cis.bcaresearch.com. 6 Please see BCA Research's China Investment Strategy Weekly Report "Taiwan: Awaiting A Re-Rating Catalyst," published December 14, 2017. Available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of April 30, 2018. There are no significant changes in the model's allocation this month, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD, %) As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 20 bps in April, largely driven by the Level 2 model which outperformed by 44 bps while the Level 1 model outperformed only by 2 bps. Since going live, the overall model outperformed the MSCI World by 156 bps, due to the 493 bps of outperformance from the Level 2 model which allocates funds among 11 non-U.S. countries. The Level 1 model (which allocates funds between U.S. and the non-U.S.) is on par with the MSCI world benchmark.Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Text below For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of April 30, 2018. For the third consecutive month, the model maintains a defensive positioning generating an alpha of 60 bps for the month of April. Following the end of trade threats (for now), the growth component of the model has stabilized. But, overall the model maintains the same weights from last month with an aggregate tilt of 1.3% towards defensive sectors. Energy remains the only cyclical sector with an overweight on the back of favorable valuations and improving momentum. Among defensive sectors, utilities maintains a large overweight of 5% on the back of better momentum. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," dated July 27, 2016, available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Aditya Kurian, Senior Analyst adityak@bcaresearch.com