Financial Markets

Highlights Despite having the largest negative return of major markets during the global equity market correction, China's investable stock selloff appears to be normal after controlling for its risk characteristics. Taken together, the association between the global correction and volatility/valuation should be viewed as a sharp reduction in complacency in the market. Several factors make us cautious about China's outsized tech sector exposure in a world of reduced complacency. We recommend that investors retain cyclical exposure to investable Chinese stocks while neutralizing exposure to the tech sector. Feature Chart 1An Average Size, But Very Rapid, ##br##Global Selloff Global equities have sold off quite sharply since the end of January, having declined a total of 9% in US$ terms from their January 26 high to last Friday's close (Chart 1). BCA addressed the rout in a Special Report last week,1 and noted that strong economic growth and positive earnings surprises are likely to keep the global equity bull market intact, a view largely supported by this week's stock market behavior. Still, the report also highlighted that investors need to adjust to the fact that realized volatility is likely to sustainably rise, even if forward-looking volatility measures (such as the VIX in the U.S.) are currently too elevated. More generally, we equate the return of volatility with a reduction in complacency, and in this week's report we explore the implications of lower complacency for investors with an overweight allocation towards Chinese equities. Our judgement is that the complacency risk for China's ex-tech equity market is low, but that the same cannot be said for China's technology stocks. We conclude by recommending two trades that investors can employ to retain cyclical exposure to investable Chinese stocks, but with a neutralized exposure to the tech sector. Normal Underperformance For China Chart 2At First China Appears To Be Among ##br##The Worst Performers... At first blush, China's investable stock market fared quite poorly during the global stock market correction. Chart 2 lists 21 major country stock markets by the magnitude of their decline in US$ terms and highlights that China's selloff ranks at the very top of the list. But a simple comparison of stock market performance is misleading, as it fails to adjust for the different degrees of riskiness that are normally observed across global equity markets. For example, it is well known that emerging market equities have tended to be high beta relative to global stocks over the past decade, and we noted in a recent Special Report that Chinese investable stocks have become high beta even relative to emerging markets. In order to properly compare the performance of these markets during the global stock market selloff, we rely on the concept of "abnormal return" that is often employed in event study analysis. This approach involves calculating a counterfactual "normal" return for each market based on its rolling 1-year alpha and beta versus global stocks prior to the selloff, and then comparing it to the actual return. This difference, the "abnormal return" of each market, is shown in Chart 3, which highlights that China's performance during the selloff was perfectly normal after controlling for its risk characteristics. In fact, Chart 3 shows that many equity markets outperformed on a risk-adjusted basis, highlighting that the magnitude of the selloff in global stocks could actually have been worse. As for the underlying cause of the selloff, we showed in last week's Special Report that a crowded "short volatility" trade was undoubtedly a driving force: Chart 4 highlights that net long speculative positions on the VIX had fallen to a new low over the past six months, a circumstance that has now completely reversed. But Chart 5 shows that valuation also appears to have been a factor contributing to the selloff, by presenting the abnormal returns shown in Chart 3 as a function of the difference between the market's 12-month forward P/E and that of the global benchmark. While the fit is somewhat loose, the chart confirms that markets with higher (lower) forward P/E ratios were more likely to have negative (positive) abnormal returns over the two-week period. Chart 3...But Not After Adjusting##br## For Riskiness Chart 4The Low-Vol Trade Contributed ##br##To The Speed Of The Selloff... Taken together, the association between the selloff and volatility/valuation should be viewed as a sharp reduction in complacency in the market. While this does not necessarily bode poorly for global equities over the coming 6-12 months, there are some potential implications to explore for China's investable stock market. Chart 5...But Valuation Was Also A Factor Complacency Risk And Chinese Stocks The sharp reversal in global markets raises the question of whether Chinese equities are complacent about some looming risk. The obvious candidate for complacency risk in China would be focused on its economy, and the potential for a more substantial economic slowdown than is currently expected by market participants. However, we are unconvinced that Chinese ex-tech stocks are somehow neglecting the risks facing China's economy over the coming year. First, we have noted in previous reports that Chinese investable ex-tech stocks are extremely cheap versus global ex-tech stocks, highlighting that investors have priced in a degree of structural risk. Second, recent economic data releases from China do not suggest that the pace of the ongoing economic slowdown is accelerating, suggesting that there is no basis to expect a severe downturn over the coming year. But we acknowledge that the same cannot be said for China's tech sector. While Chinese tech stocks are not stretched on a technical basis (either versus the investable benchmark or versus global tech stocks), several observations make us cautious about China's outsized tech exposure in a world of reduced complacency: First, the growth rates of IBES 12-month trailing and forward earnings growth for global technology stocks are currently at the 80th and 85th percentiles, respectively (Chart 6). This suggests that a substantial amount of fundamental improvement has already been priced in to global tech stocks, raising the risk of earnings disappointment over the coming year. Given that China's tech sector weight (42%) is considerably above that of the global benchmark (18%), a global tech selloff would cause China's investable stock market to underperform even if Chinese tech performance is in line with that of the global tech sector. Second, relative to global technology stocks, the growth rates of China's 12-month trailing and forward earnings growth are also quite elevated, at the 80th and 70th percentiles, respectively (Chart 6 panel 2). This suggests that the tech earnings exuberance observed globally is even worse in China. Third, Chart 7 highlights that China's tech sector has been responsible for pushing our relative composite valuation indicator for China into overvalued territory over the past year. Relative to global ex-tech, China's ex-tech stocks are still significantly cheap; relative to global tech, China's tech stocks are significantly overvalued. Last, we have noted in past reports that China's tech sector appears to be a domestic consumer play, and thus unlikely to significantly underperform over the coming year. However, we also noted in last week's report on China's housing market that the optimism of the consumer sector may be somewhat unfounded if it is based on expectations of future gains in employment and/or income.2 While we do not expect a broad-based retracement in China's consumer sector, even a moderate decline in consumer confidence could spark a non-trivial selloff in Chinese tech stocks given the stretched fundamental picture highlighted above. Chart 6Tech Earnings Growth##br## Is Significantly Stretched Chart 7Tech Stocks Have Pushed China ##br##Into Overvalued Territory Investment Recommendations Given our observations about the complacency risk facing Chinese tech sector stocks, we are making the following changes to our investment recommendations: We are closing our overweight MSCI China Free versus the emerging markets benchmark trade for a 31% relative return. This has been a core trade for BCA's China Investment Strategy service and has provided investors with significant outperformance since its initiation in May 2012. We are opening two new trades as a replacement for the closed China / EM position: 1) long MSCI China investable ex-technology / short MSCI All Country World ex-technology, and 2) long MSCI China investable value / short All Country World value. These two new trades are a slight variation of a single theme, which is to retain cyclical exposure to investable Chinese stocks while neutralizing exposure to the tech sector. While style indexes such as value and growth normally do not have such a stark sector orientation, Chart 8 highlights that the relative performance of China value vs global value looks very similar to our internally-calculated ex-technology indexes for both markets. This is because MSCI's China growth index is almost entirely made up of tech sector stocks, meaning that a relative value play effectively mimics an ex-tech position. As a final point, we noted above that it is difficult to see how Chinese ex-tech equities are complacent about the ongoing slowdown in China's economy. Chart 9 supports this view by presenting a model for China's investable ex-tech 12-month trailing earnings in US$ terms, based on the Li Keqiang index. The model fit has been tight over the past decade, and is currently forecasting roughly 10% earnings growth over the coming year. This would clearly represent a significant deceleration from current levels, but it is still a decent earnings result that signals Chinese ex-tech stocks are attractive on a risk/reward basis given the sizeable valuation discount that is levied on China relative to global stocks. Chart 8China Ex-Tech And Value:##br## Similar Performance Vs Global Chart 9Positive Ex-Tech Earnings Growth Likely, ##br##Even With A Slowing Economy We remain alert to the possibility of a further, more pronounced slowdown in China's economy, but barring that Chinese ex-tech stocks appear to be a solid buy over the coming 6-12 months. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "The Return Of Vol", dated February 6, 2018, available at gis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Is China's Housing Market Stabilizing?", dated February 8, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights As the Fed proceeds with its policy tightening this year, higher real rates and a stronger USD will weigh on silver and platinum prices, and, to a lesser extent, palladium prices. Offsetting these downward pressures, silver, and to a lesser extent platinum, could take their lead from the gold market, and outperform on the back of increased equity volatility and understated geopolitical risks this year.1 Palladium, as always, will march to its own drummer, as this market's defining feature remains chronic physical deficits and depleted inventories, which will prevent prices from reacting too severely to tighter Fed policy this year. Energy: Overweight. Supply-demand fundamentals still are supportive of crude oil prices overall, and continued backwardation in forward curves. Our long Jul/18 WTI vs. short Dec/18 WTI calendar spread, which gains as backwardation becomes more pronounced, is up 47.4% since inception on November 2, 2017. Base Metals: Neutral. Base metals remain well supported by still-strong global growth, estimates of which were revised higher by the IMF in its most recent World Economic Outlook. Precious Metals: Neutral. Fed tightening this year will weigh on silver and platinum, less so palladium (see below). Our long gold portfolio hedge is up 7.9%. Ags/Softs: Underweight. The USDA revised down its forecast of U.S. corn ending stocks in the latest WASDE on the back of an upwards revision to U.S. corn exports. Feature The term "precious metals" is something of a misnomer: Gold, silver, and platinum-group metals (PGMs) - chiefly platinum and palladium - do not constitute a single asset class, and should not be treated as such (Chart of the Week). Nevertheless, as with most commodity markets we cover, the evolution of these markets is highly sensitive to U.S. financial variables, particularly as regards monetary policy. Palladium is something of an outlier: It behaves more like an industrial metal, while silver, and to a lesser extent platinum, are more sensitive to the fundamental drivers of gold prices - i.e., the evolution of the USD's broad trade-weighted index (USD TWIB), and real U.S. interest rates. Palladium's demand is dominated by its use in catalytic converters in gasoline-powered cars, whereas industrial applications form a more limited source of demand for platinum and silver (Chart 2). Chart of the WeekA Schism In Precious Metals Chart 2Industrial Uses Dominate Palladium Gold, silver, and, to a more limited extent platinum are cointegrated in the long run, meaning their prices follow their own random walks, even though they share a long-term trend. Palladium, on the other hand, is more responsive to the physical realities of the automobile market - chiefly, demand for gasoline-powered cars. In our econometric analysis of the behavior of PGMs and silver, we use the CRB Metals Index as a proxy for industrial activity. We find that while all three are sensitive to changes in the CRB Metals Index, palladium prices are significantly more responsive (i.e., elastic) to industrial activity than platinum and silver (Table 1). Table 1Palladium Behaves Like An Industrial Metal Furthermore, while gold prices impact both silver, and, to a lesser extent platinum, they are not significant when it comes to the palladium market. Bullish Fundamentals Tightened Palladium Market Palladium registered a 60% gain in 2017. Its forward curve has been backwardated since June (Chart 3). This backwardation - i.e., spot prices trade higher than deferred prices - is a symptom of a tight market. In fact, according to Thomson Reuters GFMS data, the palladium market has been in a chronic deficit since 2007, with the 2017 deficit the largest since 2000. The culprit in this case has been strong demand and stagnant supply. While supply has been growing ~ 1% year-over-year (yoy) over the past 5 years, demand growth has averaged 1.7% yoy over the same period. Palladium demand over this period has been driven by its growing use in automobile catalytic converters, most notably in China, where sales of gasoline-powered cars exceed those of diesel-powered cars, which typically use platinum in their catalytic converters (Chart 4). Chart 3Tight Fundamentals In##BR##The Palladium Market Chart 4Growing Demand For##BR##Autocatalysts Dominated In The Past... Growth in global demand for palladium-based autocatalysts averaged 4.8% yoy in the past 5 years. The use of palladium for autocatalysts now makes up more than 75% of global palladium demand, up from 56% 10 years ago. Chinese demand for palladium used in autocatalysts grew from 10% of global demand in 2007 to more than a quarter of global demand last year. Given autocatalysts' oversized contribution to demand growth, the palladium market is highly dependent on car sales. Our modelling highlights global car production as a significant explanatory variable when it comes to palladium prices. Most significant are the U.S. and Chinese markets, which are the largest markets for gasoline-powered cars. While vehicle sales in China were strong in 2016, they have slowed considerably and recorded yoy declines in the most recent November and December data (Chart 5). Slowing demand growth for cars in China likely comes on the back of the phasing out of tax cuts on small vehicles. This will limit the upside for palladium prices from China's industrial demand. Growth in car sales in the U.S. has been even more muted, contracting in 2017 for the first time since 2009. However, a more concerted adoption of gasoline-powered cars in Europe - largely in response to efforts by cities to reduce emissions of particulate matter from diesel engines, and the highly publicized emissions-testing scandals involving European carmakers - will, at least partially, mitigate the negative impact of slowing demand from the top two gasoline-powered markets. On the supply side, global mine supply has been relatively stagnant over the past 5 years, expanding an average 1.2% yoy during this period. Russia, South Africa and Canada account for almost 90% of total palladium mine supply. And while Russian and South African supplies have been relatively flat over the years, Canadian palladium has grown to account for ~11% of global supply in 2017, up from 4% in 2010. Global palladium supply has been supported by metal recovered from autocatalyst scrap, which has been averaging 4.8% yoy growth in supply over the past 5 years. In fact, the share of palladium recovered from autocatalyst scrap has almost doubled in the past 10 years, and now makes up almost 20% of total supply. Growth in this source of supply has come down significantly (Chart 6). However, we expect palladium's exorbitant price and elevated steel prices to incentivize an increase in the metal's recovery from scrap. Indeed, GFMS expects recycled palladium to pave record highs this year and to surpass 2 million ounces next year. Chart 5...But Beware Of Slowing Gasoline Car Sales Chart 6Palladium Needs Restocking Strong demand, combined with limited supply growth, has weighed on palladium inventories. Furthermore, ETF holdings of palladium have come down sharply while net speculative long positions have skyrocketed. Given that stocks are so low, we do not expect a severe fall in prices. Bottom Line: Palladium behaves like an industrial metal and is especially sensitive to changes in demand for automobiles. While the stars were aligned for palladium last year - a weak USD, low real interest rates, and bullish fundamentals - car sales in the U.S. and China have been slow recently. Even so, a physical deficit will prevent a crash in the palladium market this year. Platinum Trading At A Discount To Palladium In contrast with palladium's remarkable performance last year, platinum was up a mere 3.4% in 2017. In fact palladium, which usually trades at a discount to platinum, has been more expensive since October (Chart 7). This can be attributed to differences in fundamentals. Palladium's market conditions have been significantly tighter than platinum. Greater demand for the physical metal than supply put the market in deficit last year, which supported platinum prices. As with palladium, catalytic converters are a major demand source for platinum; however, they account for ~ 40% of platinum demand - considerably less than the roughly 80% share of palladium demand accounted for by catalytic converter demand. Europe is the largest market for diesel cars, and, while total vehicle sales in Europe have remained healthy, diesel-powered cars have been losing market share since the Volkswagen emissions-rigging scandal came to light in 2015 (Chart 8). This hit platinum use in autocatalysts particularly hard. In addition, weaker demand from its second use - jewelry - is keeping a lid on platinum prices (Chart 9). In fact, Chinese demand for the white metal, which accounts for more than 50% of global platinum jewelry demand, has been falling. Despite weakening demand, global balances remained in deficit on the back of muted supply. Chart 7Platinum Now Cheaper Than Palladium Chart 8EU Diesel Car Market Losing Momentum Chart 9Platinum Jewelry Losing Its Appeal Platinum's market balance could be at risk if carmakers start using more of it in catalytic converters, now that it trades at a discount to palladium. Platinum is a superior material for autocatalysts, but palladium has been traditionally favored on a cost basis. Platinum's lower price incentivizes carmakers to switch to this metal. According to Johnson Matthey, it will be two years before the impact of such substitution begins to affect the palladium market. Bottom Line: Subdued demand for platinum jewelry combined with the loss of market share for diesel-powered cars in Europe will keep a lid on the platinum market this year. However, platinum follows gold, and this could support prices if equity investors hedge market volatility and future corrections by purchasing the metal. Silver Follows Gold Silver, and, to a lesser extent, platinum are not as exposed to the industrial business cycle as palladium. These metals' prices instead move in line with gold (Chart 10). Our modeling reveals that a 1% increase in gold prices is associated with a 0.76 pp increase in silver prices. Thus gold's spillovers to the silver market are significant. Even so, there are periods when this relationship disconnects. This is because, although industrial uses do not account for as large a share of silver demand as they do for palladium, such fundamentals do account for a significant source of demand. Thus, in addition to the financial factors which drive gold, silver's industrial applications give it some exposure to economic activity. In fact, a 1% increase in the CRB Metals Index is associated with a 0.17pp increase in silver prices. This explains why, in some instances, silver's cointegration with gold weakens. As a practical matter, gold is a superior hedge against equity downfalls than silver (Chart 11). While gold month-on-month (mom) returns outperform S&P 500 mom returns almost 80% of the time in periods of decreasing equity returns, the ratio for silver comes in at a lower 67%. On the other hand, gold mom returns outperform S&P 500 returns less than 30% of the time during periods when equities are increasing, while silver outperforms the stock market almost 40% of the time. Chart 10Silver And Gold##BR##Move In Tandem Chart 11Gold Outperforms Amid Equity Downfalls,##BR##Not During Rising Stocks In addition, although both gold's and silver's correlations with the S&P 500 become large and negative when the S&P 500 decreases in yoy terms, this negative correlation in the case of gold is significantly larger than for silver (Chart 12). In fact, along with silver's relatively weaker negative correlation with the S&P 500 during periods of negative equity returns, silver also exhibits a relatively stronger positive correlation with equities during periods of positive returns. While silver is an effective hedge against geopolitical and economic crises, gold's hedging ability remains superior (Chart 13). Silver and gold post similar returns during geopolitical crises; however, gold returns are significantly higher during economic crisis. Chart 12Negative Correlations More##BR##Pronounced During Equity Downfalls Chart 13Gold Is A##BR##Superior Protection This supports the finding that silver's hedging ability is hampered by its use in industrial applications, which make it more responsive to the business cycle than gold. Bottom Line: Gold and silver prices are cointegrated. However, given silver's industrial applications, it is more sensitive to business activity. This explains the periods of divergence in the two precious metals, and limits silver's ability to hedge against economic crises and falling equities. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 For a discussion of the gold market fundamentals, please see Commodity & Energy Strategy Weekly Report titled "Gold Still Shines Despite Threat Of Higher Rates," dated February 1, 2018. Available at ces.bcaresearch.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 The trajectory of EM bank profits and share prices will be critical to sustain the EM equity rally. Rising U.S. bond yields will push up EM local bond yields. This, along with poor quality of banks' earnings, will likely halt EM banks' stock rally. We reiterate our strategic equity position: short EM banks / long U.S. banks. The same strategy can be replicated in credit markets. In China, bank loan data are no longer indicative of aggregate lending to all segments of the economy. Banks' total claims, total assets, and money aggregates have all slowed. The Korean won is making a major top. Short it against an equal-weighted basket of the U.S. dollar and yen. Feature Chart I-1Rising U.S. Bond Yields = Higher EM Local ##br##Bond Yields And Lower Bank Stocks The key financial market variables with respect to the outlook for emerging markets (EM) are commodities prices, the U.S. dollar and EM bank share prices. We have written extensively on the former two, and today we elaborate on the third pillar: the importance of banks/financial stocks to the EM aggregate equity index. First, surging U.S. Treasurys yields point to higher EM local currency bond yields (Chart I-1, top panel). In turn, EM banks' share performance inversely correlates with EM local bond yields (Chart I-1, bottom panel). Altogether, this heralds lower EM bank share prices. Second, financials make up 24.4% of the MSCI EM equity market cap, with banks accounting for 18% out of the 24.4%. Hence, financials/banks' price fluctuations are critical to the EM equity benchmark. Importantly, financials' earnings accounts for 33.6% of EM listed companies earnings. By contrast, technology accounts for 27.6% of the EM market cap, but only 23.3% of EM total earnings (Table I-1). As to the EM technology sector, it is heavily skewed toward four large companies: Tencent, Alibaba, Samsung and TSMC. The latter two have already shown considerable weakness, with Samsung breaking down below its 200-day moving average (Chart I-2). Analyses on the former two companies are beyond the realm of macro research. What's more, these stocks are extremely overbought and probably expensive. If the rest of EM goes down, these two stocks are not likely to preclude it from happening. Third, banks in China, Turkey, Indonesia, Malaysia and Brazil have been boosting their reported EPS by reducing their provisions outright or the pace of provisioning. Table I-1EM Equity Sectors: Earnings & Market Cap Weights Chart I-2Is EM Tech Hardware Breaking Down? For various reasons, we believe these reductions in provisions are unjustified. In China, Turkey and Malaysia, NPLs are too low to begin with: the more accurate measures of NPLs are probably much higher in these banking systems given the magnitude and duration of the preceding credit boom (Chart I-3 and Chart I-4). Chart I-3China: Banks' Provisions Are Inadequate Chart I-4Turkey And Malaysia: ##br##Falling Provisions Are Untenable In Brazil and Indonesia, the recent weakness in nominal GDP growth - shown inverted on the chart - does not justify the outright reduction in the level of net new NPL provisions (Chart I-5). In short, some EM banks have inflated their EPS in recent quarters by reducing provisioning for bad loans. This suggests that their EPS quality is poor, and their profit recovery is unsustainable. Bottom Line: EM bank share prices have reached their previous high but are unlikely to break above that level, in our opinion (Chart I-6). Chart I-5Brazil And Indonesia: Declining ##br##Provisions Are Unsustainable Chart I-6EM Bank Share Prices ##br##Are Facing Resistance We reiterate our strategic call of being short EM banks and long U.S. bank stocks. The relative share price performance of EM versus U.S. banks has been inversely correlated with U.S. bond yields (Chart I-7). Chart I-7Rising U.S. Bond Yields = ##br##EM Banks Underperformance If our view on higher U.S. bond yields materializes, odds are that EM bank share prices will relapse considerably versus U.S. banks. Traders should consider implementing this trade. Credit investors can replicate the same strategy in credit markets. Strategy Considerations Investor sentiment remains bullish on risk assets in general and emerging markets in particular. The buy-on-dips mentality is well entrenched. Amid such investor consensus, it is important to consider alternative scenarios. Presently, the relative performance of Swiss versus global non-financial stocks is sitting on its long-term moving average (Chart I-8). Odds of a rebound in the relative performance of Swiss non-financial stocks from such oversold levels are fairly high. As and when the latter begin outperforming their global peers, it might entail a negative outlook for global bourses in general and cyclical equity sectors in particular. The basis is that Swiss non-financial stocks are defensive in nature, as pharmaceuticals and consumer staples account for a large portion of the total market cap. Not surprisingly, the previous bottoms in Swiss non-financials' relative performance versus global non-financials coincided with major tops in global equity bull markets. For now, the risk-reward for global stocks is unattractive, and the outlook for EM relative performance is extremely poor. Notably, relative manufacturing PMI trends favor DM over EM stocks (Chart I-9). Chart I-8Swiss Stocks Are At Critical Juncture: ##br##What Does It Mean For Global Equities? Chart I-9EM Relative To DM: PMIs And Share Prices Besides, as we discussed at great length in our recent report,1 EM equity valuations are on par with DM when adjusted for sector weights and sub-sectors with outlier valuation ratios. Our stance remains that EM risk assets will face a perfect storm this year for two reasons: Strong U.S. growth will cause U.S. inflation to rise, and the selloff in U.S. bonds has further to run. Higher U.S. interest rates should support the U.S. dollar and weigh on EM risk assets that have benefited disproportionally from the search for yield; While China's growth has slowed only moderately, our forward-looking leading indicators continue to point to further deceleration. A combination of these two tectonic shifts will amount to a perfect storm for EM risk assets in 2018. We explore these two issues in greater detail below. U.S. Inflation, The Fed And The U.S. Dollar We have the following observations on current U.S. economic dynamics: Fiscal stimulus is arriving at a time when growth is already robust, and the labor market is tight. This will likely produce higher inflation. Inflation does not need to surge to make a difference in financial markets. It would be fair to say investors have become complacent and financial markets are still pricing in a goldilocks scenario. Therefore, even a moderate rise in core inflation readings along with some anecdotal evidence that companies are able to raise prices will lead to further re-pricing in U.S. interest rate expectations. Higher U.S. interest rates pose a risk to EM, which have benefited considerably from the search for yield. EM currencies, domestic bonds and credit markets have so far held up well, despite the considerable rise in U.S. bond yields (see Chart I-1 on page 1). Based on this, it is tempting to argue that EM will be immune to rising U.S. interest rate expectations. Nevertheless, we believe this EM resilience has occurred because fund flows to EM remain very robust. These flows are often backward looking. Odds are that 10-year U.S. Treasury yields will move well north of 3%. Such a considerable rise in yields will weigh on EM risk assets. It is essential to realize that the positioning in EM stocks, local bonds and credit is more elevated today than it was before the 2015 downturn. Finally, Chart I-10 illustrates that U.S. banks' excess reserves at the Federal Reserve have started to drop. In recent years the periods of reserve declines have coincided with a strong U.S. dollar, yet the latest drop in banks' excess reserves has not yet produced a meaningful rally in the greenback (the dollar is shown inverted in Chart I-10). The Fed's ongoing tapering efforts and the U.S. Treasury's replenishment of its account at the Fed are bound to produce further reductions in banks' excess reserves. Based on the latter's correlation with the exchange rate, this should support the greenback. Notably, the U.S. dollar is fairly valued, according to our most favored valuation measure: the unit labor cost-based real effective exchange rate (Chart I-11). This takes into account both wages and productivity, and hence gauges competitiveness much better than real effective exchange rate measures that rely on consumer and producer prices. Chart I-10Shrinking U.S. Banks Excess ##br##Reserves = Stronger U.S. Dollar Chart I-11The U.S. Dollar Is Not Expensive Finally, tax cuts are supply side reforms, and they are typically bullish for the currency. Bottom Line: A combination of stronger growth, rising interest rate expectations, neutral valuations and oversold conditions should help the U.S. dollar to rebound. The rally in the U.S. exchange rate versus EM currencies will be pronounced if China's growth slows, as we expect it to. Making Sense Of Chinese Data China's slowdown has so far been moderate. However, in any economy a downturn almost always begins with a moderation in growth. That, however, is not sufficient reason to conclude that the growth slump will be benign or short-lived. Judgement on the duration and magnitude of a slowdown should be based on the existence of major macro imbalances, or lack thereof. Given that China has enormous money, credit and property market excesses/imbalances and policy has been tightening, we believe that growth disappointments will be non-trivial and more substantive than the market consensus currently expects. The following corroborate the case for a deepening growth slump ahead: The annual change in the manufacturing new orders-to-inventory ratio from the National Bureau of Statistics points to a relapse in Caixin's manufacturing PMI as well as steel, iron ore and coal prices (Chart I-12). This indicator also heralds a decline in analysts' EPS net revisions for all Chinese stocks (Chart I-13). Chart I-12China: An Impending Slowdown Chart I-13China: EPS Net Revisions Have Peaked While some economic data like imports for January were strong, it is important to realize that this January had a few more working days compared with January 2017 due to the Chinese New Year falling in February this year. Although the same seasonal adjustment should be applied to money and credit data, there are other critical dimensions specific to the credit data that investors should be aware of. Banks' loans to companies and households - widely watched by the investment community - was very strong in January relative to the previous month. However, loan and most of other data in China should be seasonally adjusted. The annual growth rate in RMB bank loans is still very robust at 13.2% (Chart I-14, top panel). However, the growth rates of banks' total assets, total claims and broad money have all dropped close to 10% or below (Chart I-14). The disparity between bank loans on the one hand and their claims and assets on the other is due to the following: In China's banking statistics, banks' loans to non-bank financial institutions - such as financial trusts, investment corporations, insurance, financial leasing companies and auto-financing companies, and loan companies - are not included in banks' loan data. Hence, bank loan data do not reveal the banks' full impact on the economy. By extending credit to non-bank financial institutions, banks have expanded their balance sheets without exceeding their loan quotas. In short, banks have funded shadow banking and by extension the real economy and speculative investment schemes but have done so via non-bank financial institutions. In addition, banks have also bought a lot of corporate and local government bonds that are not considered loans. Overall, bank loans have been understating the degree of the banking system's credit expansion. In the past year, regulators have been forcing banks to reduce their lending to non-bank financial institutions. With this channel of balance sheet expansion restricted (Chart I-15, top panel), banks are probably resorting to more traditional loans to expand their balance sheets and earn income. Chart I-14China: Bank Loans, ##br##Assets And Total Claims Chart I-15China: Bank Lending To Shadow ##br##Banking Is Being Curtailed In short, one needs to look at banks' aggregate claims on all entities - companies, households, non-bank financial institutions and governments - to assess whether their lending to the economy is slowing or accelerating. Chart I-16China: Structure Of Bank Assets Consistent with the ongoing regulatory clampdown, banks' claims on non-bank financial institutions - so called shadow banking - have plummeted in the past 12 months after expanding 50-70% annually for several years in a row (Chart I-15, top panel). The bottom three panels of Chart I-15 indicate that the annual growth rates of banks' claims on companies, household and the government have either already decelerated or are slowing now. Their respective shares in banks' total assets are displayed in Chart I-16. While banks' RMB loans remain the largest category of assets, the importance of other claims has risen. Bottom Line: Several leading indicators continue pointing to an impending slowdown in the mainland's economy. Bank loan data is no longer indicative of total bank assets expansion/aggregate lending to all segments in the economy. Broader measures - such as banks' total claims, assets and money aggregates - have decelerated considerably. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Korea: A Major Top In The Won The Korean won is vulnerable on several fronts: Its real effective exchange rate based on unit labor costs is well above its historical mean (Chart II-1, top panel). Importantly, based on this same measure, the won is very expensive versus the Japanese yen (Chart II-1, bottom panel). The manufacturing cycle has already weakened in Korea (Chart II-2). Chart II-1The Won Is Expensive Chart II-2Korea's Manufacturing Is Weakening Japanese exports in U.S. dollar terms are starting to outperform Korean ones (Chart II-3), suggesting that Korean exporters might be losing market share to their Japanese rivals. Furthermore, manufacturing inventories are rising sharply in Korea but not in Japan (Chart II-4). Relative manufacturing inventory trends also favor the yen versus the won (Chart II-4, bottom panel). Chart II-3Relative Exports: Korea Versus Japan Chart II-4Manufacturing Inventories: Korea And Japan The won's appreciation has depressed Korea's export prices in local-currency terms. In Japan, on the other hand, local-currency export prices are holding better. Interestingly, the relative export price trend in U.S. dollars points to the won's depreciation versus the yen (Chart II-5). Korean non-financial stocks have broken below their 200-day moving average, which corroborates that corporate profitability is deteriorating (Chart II-6). Korean equities have been among the world's worst-performing bourses year-to-date. Chart II-5Export Prices: Korea And Japan Chart II-6Korean Non-Financial Stocks Are Cracking In addition, the correction in Korean stocks commenced before the recent plunge in the S&P 500. This highlights that the relapse in Korean share prices was not only due to the contagion from the U.S. equity selloff. Finally, the technical profile of the won points to a major top. Chart II-7 shows that the won is facing multi-year technical resistance versus the U.S. dollar. Chart II-7KRW/USD Exchange Rate: ##br##A Long-Term Technical Profile Investment Conclusions We have been short the Korean won versus the Thai baht since October 19, 2016 and this trade has produced a 7.3% gain. We recommend closing this trade and shorting the won versus an equally-weighted basket of the U.S. dollar and yen. The rationale to short the KRW versus this basket is to hedge against a possible near-term U.S. dollar selloff if China is forced to revalue the RMB further, as we discussed in February 7, 2018 report.2 In regards to equities, we are closing our long KOSPI / short Nikkei trade with a 1% loss since April 26, 2017. Within the EM universe, we continue recommending a neutral allocation to Korean stocks excluding technology. Despite their recent underperformance, EM-dedicated managers should continue overweighting Korean tech stocks. The reasoning behind this is that the potential currency depreciation will help their corporate profitability as tech shipments are not exposed to Chinese capital spending. The latter will be the epicenter of negative growth surprises in our opinion. Finally, Korean local bond yields will soon top out as the deflationary pressures from a stronger currency become more evident in the economy. Korean bonds will outperform U.S. Treasurys on a currency-hedged basis. 1 Please refer to Emerging Markets Strategy Special Report, titled "EM Equity Valuations (Part I)," dated January 24, 2018, the link is available on page 19. 2 Please refer to Emerging Markets Strategy Weekly Report, titled "A Regime Shift?," dated February 7, 2018, the link is available on page 19. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The best recession indicators are not flashing red, but volatility is rising as the end of the cycle approaches; U.S. fiscal policy is surprising to the upside, as we expected; The next recession will usher in an inflationary political paradigm shift, with wealth transferred from Baby Boomers to Millennials; Expect a new U.K. election ahead of March 2019, but do not expect a second referendum unless popular opinion swings decisively against Brexit; Stay short U.S. 10-year Treasuries versus German bunds; short Fed Funds Dec 2018 futures; and initiate a short GBP/USD trade. Feature February has been tough for global markets, with the S&P 500 falling by 5.9% since the beginning of the month. Several clients have pointed out that the market may be sniffing out a recession and that the "buy the dip" strategy is therefore no longer applicable. It is true that markets and recessions go together (Chart 1), but it is not clear from the data that the equity market alone predicts recessions correctly. Chart 1Bear Markets & Recessions: Unclear Which One Leads The Other BCA's House View is that a recession is likely at the end of 2019.1 This view is in no small part based on our political analysis.2 President Trump ran on a populist electoral platform and populist policymakers globally have a successful track record of delivering higher nominal GDP growth than their non-populist counterparts (Chart 2). We assume that the Powell Fed will respond to such higher growth and inflation prospects no differently from the Yellen Fed and that it will restrict monetary policy to an extent that will usher in a mild recession by the end of next year. Chart 2Populists Deliver (Nominal) GDP Growth Of course, predicting recessions is extraordinarily difficult. Being six months early or late would still be an achievement, but the implications for the equity market would likely be considerably different. If our "late 2019" call is actually an "early 2019" recession, then equity markets may indeed be at or near their cyclical peaks. A "buy on dips" strategy may work for the next quarter or so, but superior returns over the course of the year may be achieved with a bearish strategy. To help guide clients through the uncertainty, our colleague Doug Peta, chief strategist of BCA's Global ETF Strategy, has recently updated BCA's methodology for identifying the inflection points that usher in a recession.3 In our 70-year history as an investment research house, we have picked up two definitive truths: valuation and technical indicators cannot call a recession. So what can? We encourage clients to pick up a copy of Doug's analysis.4 The report highlights the three BCA Research recession indicators: the orientation of the yield curve, the year-over-year change in the leading economic indicator (LEI),5 and the monetary policy backdrop. Charts 3, 4, and 5 show how successful the three indicators are in calling recessions. In our 50-year sample period, the yield curve has successfully called all seven recessions with just one false positive. However, it tends to be overly eager, preceding the onset of a recession by an average of nearly twelve months. When we combine the yield curve indicator with the LEI, the false positives go away. Chart 3The Yield Curve Has Called Seven Of The Last Eight Recessions... Chart 4... And So Has The Leading Economic Indicator To confirm the recession signal and make it more robust, we also consider the monetary policy backdrop. Over the nearly 60 years for which BCA's equilibrium fed funds rate model has calculated an estimate of the equilibrium policy rate, every recession has occurred when the fed funds rate exceeded our estimate of equilibrium. In other words, recessions only occur when monetary policy settings are restrictive. Today, none of the indicators are even close to pointing to a recession, with the LEI at a cyclical peak. However, the yield curve and monetary policy are directionally moving towards the end of the cycle. Taken together, they suggest that the only controversy about our late 2019 recession call is that it is so early. So why the market volatility? Because wage growth in the U.S. has begun to pick up in earnest (Chart 6), revealing that BCA's concerns about inflation may at last be coming true. Investors, after more than a year of rationalizing weak inflation by means of dubious concepts (Amazon, AI, robots, etc.), may be reassessing their forecasts in real time, causing market turbulence. Chart 5Tight Policy Is A Necessary,##br## If Not Sufficient, Recession Ingredient Chart 6Wages Picking##br## Up In Earnest There is of course a political explanation as well. Our colleague Peter Berezin correctly called the end of the 35-year bond bull market on July 5, 2016.6 The timing of the call - mere days after the U.K. EU membership referendum - was not a coincidence. As Peter mused at the time, "the post-Brexit shock running through policy circles leads to a further easing in fiscal and monetary policy." He was not speaking about the U.K. alone, but in global terms. Indeed, the populists have begun to deliver. Ever since President Trump's election, we have cautioned clients not to doubt the White House's populist credentials.7 After a surge in bond bearishness immediately following the election, investors lost faith in the populist narrative due to the failure of Congress to pass any significant legislation, as if Congress has ever been a nimble institution under previous presidents. But investors are beginning to realize that their collective political analysis was extremely wrong. Not only have profligate tax cuts been passed, as we controversially expected throughout 2017, but Congress is now on the brink of a monumental two-year appropriations bill that will add nearly 1% of GDP worth of fiscal thrust in 2018 higher than what the IMF expected for the U.S. (Chart 7). In addition, Congress has set in motion the process to re-authorize the use of "earmarks" - i.e. legislative tags that direct funding to special interests in representatives' home districts (Chart 8).8 Chart 72018 Fiscal Thrust Was Unexpected Chart 8Here Comes Pork! By our back-of-the-envelope accounting, Congress is about to authorize just shy of $400bn in extra spending over the next two years.9 If earmarks are allowed back into the legislative process, we could see up to another $50bn in spending. An infrastructure deal, which now also looks likely given that the Democrats have realized that their "resistance"/ "outrage" strategy does not work against the Trump White House, could add significantly to that total. We are already positioned for these political developments through two fixed-income recommendations. We are short U.S. 10-year Treasuries vs. German Bunds, a recommendation that has returned 27.7 bps since September 2017. In addition, we are short the Fed Funds December 2018 futures, a recommendation that has returned 43.17 bps since the same initiation date. In addition, we went long the U.S. dollar index (DXY) on January 31, right before the stock market correction and precisely when the greenback appeared to bottom. Should investors prepare for runaway inflation this cycle? Is it time to load up on gold? We do not think so. The fiscal impulse from the two-year budget deal will become negative in 2020. The capex incentives from the tax cut plan are also front-loaded. The paradigm-shifting impact on inflation will require a policy paradigm shift. And we expect such a shift only after the next recession. To put it bluntly, U.S. voters elected a TV game show host due to angst at a time when unemployment stood at 4.6% (the rate on November 2016). Who will they elect with unemployment rising to 6% in the aftermath of the next recession, or God forbid if that next recession is worse than we think it will be? Policymakers are unlikely to sit around and wait for an answer to that question. Extraordinary measures will be taken to prevent the median voter from lashing out against the system when the next recession hits. Inflation, which is a redistributive mechanism, will be employed to transfer wealth from savers (mainly well-to-do retirees) to consumers (their children). In large part, this will be a generational wealth transfer between Baby Boomers (or at least those with some savings) and their Millennial children. Given that Millennials have become the largest voting bloc in the U.S. as of the 2016 election, this will be a populist policy with firm backing in the electorate. The next recession will therefore usher in the inflationary era of the next decade, regardless of how painful the actual recession is. In the meantime, we recommend that clients with a 9-to-12 month horizon continue to "buy on dips," given that a recession is not on the horizon. However, with the U.S. 10-year yield approaching 3%, China moderately slowing down (with considerable risk to the downside), and the U.S. dollar slide arrested, we think that the outperformance of EM equities is over. Brexit: We Can't Work It Out10 The EU agreed on January 29 to its negotiation guidelines for the temporary transition period after the U.K. officially leaves the bloc in March 2019.11 The British press predictably balked at the conditions - the term "vassal state" has been liberally bandied about - which in our view included absolutely nothing out of the expected. The EU conditions for the transition period are not the fundamental problem. Rather, the problem is that the "Vote Leave" campaign was never honest with its promises. Boris Johnson, the most prominent supporter of Brexit ahead of the vote and now the foreign minister in Prime Minister Theresa May's cabinet, famously quipped after the referendum that "there will continue to be free trade and access to the single market."12 The problem with that promise, however, was that it was predicated on using London's "superior negotiating position" vis-à-vis the EU in order to force the Europeans to redefine what membership in the Common Market means. As we pointed out in our net assessment ahead of the Brexit referendum, the problem with exiting the EU but remaining in the Common Market is that the issue of sovereignty is not resolved (Diagram 1).13 As such, Johnson and other Brexit supporters argued that they could change the relationship by forcing the EU to change how the Common Market works. Diagram 1Common Market Membership Is Illogical Except for one problem: the U.K.'s negotiating position is not, never was, nor ever will be, superior. Anyone with a rudimentary understanding of how trade works can understand this. For example, the U.K. is a significant market for Germany, at 6% of German exports (right in line with the 6% of total EU exports that go to the U.K.). However, the EU is a far greater destination for British exports, with 47% of all exports going to the bloc.14 As we expected, the EU has surprised the conventional wisdom by remaining united in the face of negotiations. And as we also predicted, the Tories are now completely divided.15 PM May will attempt to hammer out an internal deal on how to approach the transition deal. But her political capital is so drained by the disastrous early election results that there is practically no way that she can produce a set of negotiating guidelines that will not be pilloried in the press. As such, we expect a new election to take place in the U.K. ahead of March 2019, perhaps sooner. We do not see how May's negotiating position will satisfy all wings of the Conservative Party. In addition, we see no scenario by which the ultimate exit deal with the EU gets enough votes in Westminster. Investors betting on that election replacing a second Brexit referendum would be wrong. A Jeremy Corbyn-led, Labour government will only turn against Brexit once the polls definitively turn against it. This has not yet happened, as the gap between supporters and opponents of Brexit in the polls, while widening in favor of opponents, remains within a margin of error (Chart 9). As such, Corbyn would scrap the Tory-led negotiations with the EU and ask Brussels for even more time - and thus more market uncertainty! - in order to produce a Labour-led Brexit deal.16 In order for the probability of Brexit to definitively decline, the polls have to show that "Bregret" or "Bremorse" is setting in. Without a move in the polls, U.K. politicians will continue to pursue Brexit, no matter how flawed their tactics may be. Policymakers are ultimately not the price makers but the price takers. On the issue of Brexit, the U.K. median voter is only slightly miffed regarding the outcome. Current polls suggest that Labour could win the next election, albeit needing to rule with a coalition (Chart 10). This would prolong the uncertainty facing the economy. Not only is Corbyn the most left-leaning politician in a major European economy since François Mitterand, but also his coalition would likely include the Scottish National Party and potentially the Liberal Democrats. Keeping all their priorities aligned could be even more difficult than the balancing act PM May is performing between soft-Brexiters, hard-Brexiters, and the Democratic Unionist Party. Chart 9Bremorse: Rising, But Not Definitive Chart 10Anti-Brexit Forces On The Rise Meanwhile, on the economic front, the situation is not much better. Our colleague Rob Robis, BCA's chief bond strategist, recently penned a critical assessment of the U.K. economy.17 As Rob pointed out, the OECD leading economic indicator is decelerating steadily and pointing to a real GDP growth rate below 2% in 2018 (Chart 11). The biggest factors that will weigh on growth will be a sluggish consumer and softer capex. Household consumer growth has been slowing since early 2017, driven by diminishing consumer confidence (Chart 12, top panel). High realized inflation, which has sapped the purchasing power of U.K. workers who have not seen matching increases in wages, is weighing on confidence (third panel). Consumers were able to maintain a decent pace of spending during a period of stagnant real income growth by drawing on savings, but that looks to be tapped out now with the saving rate down to a 19-year low of 5.5% (bottom panel). Chart 11U.K. Growth Set To Slow Chart 12The U.K. Consumer Looks Tapped Out Making matters worse, U.K. consumers are not seeing much of a wealth effect from the housing market. The January 2018 readings of the year-over-year growth rate of U.K. house prices from the Halifax and Nationwide indexes came in at 1.9% and 3.1% respectively (Chart 13). In addition, the net balance of national house price expectations from the Royal Institution of Chartered Surveyors (RICS) has steadily declined since mid-2016 and now sits just above zero (i.e. equal number of respondents expecting higher prices and falling prices). The same indicator for London was a staggering -47% in January 2018. Apparently, foreigners are no longer interested in a Brexit discount. Our global bond team goes on to point out that political uncertainty is also weighing on U.K. business investment spending. Capital expenditure growth slowed to 4.3% year-over-year in nominal terms in Q3 2017 and is even lower in real terms (Chart 14). Chart 13No Wealth Effect ##br## From Housing Chart 14Brexit Gloom Trumps ##br##Export Boom For U.K. Companies Putting all of this together, neither our global bond team nor our foreign exchange team expect the Bank of England to raise interest rates, despite the market pricing in 36 bps of rate hikes over the next twelve months. As Chart 15 illustrates, inflation across a broad swath of components is likely to slow sharply in the coming months as the trade-weighted pound has stopped depreciating. Thus, the pass-through from a lower exchange rate is beginning to dissipate.18 In the long-term, we understand why investors are itching to bet on Brexit never happening. But to get from here to there, the market will have to riot. And that means more downside to U.K. assets. Chart 15U.K. Inflation:##br## Less Pass-Through From The Pound Chart 16GBP:##br## Stuck In A Rut Bottom Line: BCA's FX strategist, Mathieu Savary, has pointed out that the trade-weighted pound is testing the upper bound of its post-Brexit trading range (Chart 16). As our FX and bond teams show in their respective research, the economics currently at play make it unlikely that the pound will be able to punch above the ceiling of this range. Our political assessment adds to this view. In fact, we expect that the coming political uncertainty, including an early election prior to March 2019, is likely to take the pound back to the floor of its trading range. As such, we are recommending that clients short cable, GBP/USD. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," June 16, 2017, available at gis.bcaresearch.com. 2 Please see BCA Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, and "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017, available at bcaresearch.com. 3 Please see BCA Special Report, "Timing The Next Equity Bear Market," dated January 24, 2014, and "Timing Equity Bear Markets," dated April 6, 2011, available at bcaresearch.com. 4 Please see BCA Global ETF Strategy Special Report, "A Guide To Spotting And Weathering Bear Markets," dated August 16, 2017, available at etf.bcaresearch.com. 5 The ten components of leading economic index for the U.S. include: 1. Average weekly hours, manufacturing; 2. Average weekly initial claims for unemployment insurance; 3. Manufacturers' new orders, consumer goods and materials; 4. ISM® Index of New Orders; 5. Manufacturers' new orders, nondefense capital goods excluding aircraft orders; 6. Building permits, new private housing units; 7. Stock prices, 500 common stocks; 8. Leading Credit Index TM; 9. Interest rate spread, 10-year Treasury bonds less federal funds; and 10. Index of consumer expectations. Source: The Conference Board. 6 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications," dated November 9, 2016, and "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 9 We are referring to the Senate deal struck last week to authorize additional military spending ($80bn in FY2018 and $85bn in FY2019) and discretionary spending ($63bn in FY2018 and $68bn in FY2019), as well as to provide disaster relief in the amount of $45bn for both fiscal years. 10 Life is very short, and there's no time ... For fussing and fighting, my friend ... 11 Please see European Council, "Brexit: Council (Article 50) adopts negotiating directives on the transition period," dated January 29, 2018, available at consilium.europa.eu. 12 Please see "UK will retain access to the EU single market: Brexit leader Johnson," Reuters, dated June 26, 2016, available at uk.reuters.com. 13 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 14 This is not a coincidence. The whole point of the EU is that it is the world's richest consumer market. As such, it has massive negotiating leverage with all trade partners. As a side note, this throws into doubt the logic that the U.K. can get better trade deals by leaving the bloc. The first test of that premise will be its negotiations with the EU itself. 15 Please see BCA Special Report, "Break Glass To Brexit: A Fact Sheet," dated June 17, 2016, available at bca.bcaresearch.com. 16 Investors should remember that Westminster voted decisively 319 to 23 to reject the Liberal Democrats' amendment seeking a referendum on the final Brexit agreement. Only nine Labour MPs voted in favor of the amendment after Jeremy Corbyn instructed his party to abstain. 17 Please see BCA Global Fixed Income Strategy Weekly Report, "A Melt-Up In Equities AND Bond Yields?" dated January 23, 2018, available at gfis.bcaresearch.com. 18 Please see BCA Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com.

The 10% tactical pullback that we had been flagging in recent publications with the tech sector correctly sniffing it out has materialized, and our strategy is to start "buying the dip" as we do not foresee a recession in the coming 9-12 months. While an undershoot cannot be ruled out, given the emotional nature of recent market action, a number of indicators we track suggest that it would be a mistake to get extremely bearish at the current juncture: First, the recent market swoon along with rising EPS estimates have knocked down valuations, pushing them to a 16 handle on a 12-month forward P/E basis, which is also the 4-year average (see chart below). Second, credit spreads have been surprisingly quiet. Bond spreads across the risk spectrum are extremely sensitive to risk-off phases and one would have expected a sharp widening in spreads during the recent turmoil. Third, the U.S. dollar has remained muted despite recent stock market jitters. A soft greenback is purely redistributive and represents a boost to global growth. Fourth, short equity market positions are pinned near all-time highs, representing latent dry powder. Finally, the VIX went vertical, surging beyond the 50 level. Both the jump in the VIX and the swift reversal of 175K net short to roughly 85K net long speculative VIX futures positions signal that capitulation was likely hit. In other words, all these indicators suggest that the bulk of the selling may have already occurred, and an absorption/consolidation phase will likely take place in the next few weeks. Please see yesterday's Weekly Report for additional details.

Highlights Spread Product: TIPS breakeven inflation rates are holding firm despite the correction in equity markets. Remain overweight spread product versus Treasuries for now, but be prepared to reduce exposure once long-maturity TIPS breakevens reach our target range of 2.4% to 2.5%. Volatility: While implied interest rate volatility could increase further in the near-term, its upside will be limited by a flattening yield curve in the second half of this year. Municipal Bonds: After-tax muni yields are near the high-end of their historical ranges relative to investment grade corporate bonds. MBS: The option-adjusted spread offered by a conventional 30-year Agency MBS is tight relative to its own history, but appears quite attractive relative to an investment grade corporate bond. Feature Chart 1Corporate Spreads Are Stoic The stock market is down and volatility is up dramatically. At least so far the pass through to credit spreads has been relatively mild (Chart 1), but this does not make us more optimistic. Rather, our sense is that last week's market action is yet another sign that we are approaching the end of the credit cycle. Same Loop, Different Day Last week's equity sell off is best viewed through the lens of the Fed Policy Loop that we introduced in 2015 (Chart 2).1 The Fed Policy Loop is a framework for understanding the interplay between monetary policy and risk assets. Its recent dynamics can be summarized as follows: The perception of easy Fed policy fuels the outperformance of risk assets, and seven months of falling inflation between last January and August kept that perception in place for all of 2017. The end result is that financial conditions eased dramatically - stock prices soared and credit spreads tightened. But easing financial conditions also sow the seeds of their own destruction. Easier financial conditions eventually beget stronger growth and stronger growth eventually begets higher inflation (Chart 3). Last week the market finally caught a whiff of inflation and started to price-in a more hawkish Fed reaction function. Chart 2The Fed Policy Loop Chart 3Financial Conditions Lead Growth And Growth Leads Inflation On a positive note, the Loop framework also tells us that the Fed will eventually ease policy in response to tighter financial conditions and this will allow the risk-on rally to resume. While this is undoubtedly true, the Fed's breaking point is also a lot higher when inflationary pressures are more pronounced. This is why we have repeatedly stressed that our cyclical call on spread product hinges on the path of long-dated TIPS breakeven inflation rates.2 Chart 4No Correction Here Last year, when the 10-year TIPS breakeven inflation rate was down around 1.6% - well below the 2.4% to 2.5% range that is consistent with inflation anchored around the Fed's target - the market understood that the Fed's tolerance for tighter financial conditions was quite low. This made it very difficult for risk assets to sell off meaningfully. But now, with the 10-year TIPS breakeven rate at 2.05% and the 5-year/5-year forward breakeven rate at 2.27%, the Fed can clearly tolerate more market pain. The bad news from a cyclical perspective is that, despite the equity correction, the market's assessment of inflationary pressure in the economy has barely budged. Long-maturity TIPS breakeven inflation rates are holding firm, as are the prices of crude oil and other commodities - prices that tend to correlate with TIPS breakeven rates (Chart 4).3 In other words, last week's correction didn't give our overweight spread product position any further room to run. While it may take a few more sessions, our sense is that the market and the Fed will hash out a new equilibrium in the near-term and that the true bear market in risk assets won't occur until inflationary pressures are even more pronounced. We continue to look for a range of 2.4% to 2.5% on long-maturity TIPS breakeven inflation rates before we scale back our cyclical overweight exposure to spread product. The inflation data take on extra significance between now and then, as each incoming report will help confirm or deny the message priced into TIPS breakevens. Every weak inflation print buys the credit cycle more time, every strong print hastens its demise. Next up: tomorrow morning's CPI. Don't Fear Rising Rate Vol The return of volatility was the other big story last week. The VIX index of implied equity volatility was as low as 9 in early January, but stood at 33 as of last Friday's market close. With rising inflation starting to weaken the "Fed put" in risk assets we think it is unlikely that equity volatility will return to its previous cycle lows.4 But what about the volatility in rates markets? The MOVE index of implied interest rate volatility also jumped last week, and its path going forward is of critical importance for Treasury yields. Chart 5 shows that the Kim & Wright estimate of the term premium embedded in the 10-year Treasury yield is highly correlated with the MOVE index, while the expectations component implied by that term premium is the mirror image of the fed funds rate. It follows that a surge in rate volatility would lead to much higher Treasury yields, particularly if the Fed continues to hike. However, it would be quite unusual for the MOVE index to increase significantly while the Fed is lifting rates. To see this we can simply observe the tight correlation between the MOVE index and the slope of the yield curve (Chart 6). The crucial question then becomes: Does the slope of the yield curve drive volatility or does volatility drive the slope of the curve? Chart 5Volatility And The Term Premium Chart 6Volatility And The Yield Curve Like most things in economics, the answer is a little bit of both. Chart 7Forecasters In Agreement It is relatively straightforward to see why higher rate volatility might lead to a steeper yield curve. To the extent that the slope of the yield curve reflects a term premium to compensate investors for the extra price risk in a long-dated bond, then investors should demand greater compensation to bear that extra risk when rate volatility is elevated. But that analysis ignores the other reason why the yield curve might be steep. Namely, the yield curve might be steep because the market expects the Fed to hike rates substantially. It would seem logical to expect that investors would be more uncertain about a forecast that calls for many rate hikes than they would be about a forecast that calls for only a few rate hikes. It therefore follows that an environment where the market expects a large change in the fed funds would also be an environment of elevated rate volatility. The two-way causation between rate volatility and the slope of the yield curve is reinforced by the fact that both trends also correlate with forecaster uncertainty about the macro environment. Chart 7 shows that the dispersion of individual forecasts for the 3-month T-bill rate and GDP growth correlate with both the MOVE volatility index and the slope of the yield curve. At the moment, disagreement amongst professional forecasters remains low relative to history. All in all, our sense is that once long-maturity TIPS breakeven inflation rates reach our target fair value range of 2.4% to 2.5% they are unlikely to move much higher. Fed hawkishness will ramp up considerably and the yield curve will be much more likely to flatten. This means that while implied interest rate volatility could increase further in the near-term, its upside will be limited by a flattening yield curve in the second half of this year. We are not overly concerned about a huge spike in rate volatility leading to a blow-out in bonds. Two Attractive Ways To De-Risk As stated in the first section of this report, the higher that TIPS breakeven inflation rates rise the closer we get to calling the end of the credit cycle. If current trends continue, then it is likely we will begin to de-risk the spread product side of our recommended portfolio in the not-too-distant future. With that in mind, we have identified two lower risk spread sectors that are starting to look attractive. 1) Municipal Bonds Like all spread sectors, at first blush municipal bonds appear quite expensive relative to Treasuries. Chart 8 shows Aaa-rated municipal bond yields, adjusted for the top marginal tax rate, relative to equivalent-maturity Treasury yields. The message is quite clear. Municipal bonds offer far less excess compensation relative to Treasuries than has been typical in the past. However, the valuation picture changes completely when we consider municipal bonds versus investment grade corporates. Chart 9 once again shows Aaa-rated municipal bond yields, adjusted for the top marginal tax rate, but this time relative to equivalent-duration corporate bonds. We do not attempt to match credit quality in Chart 9, so Aaa-rated municipal bonds are being compared to the corporate bond index which has an average credit rating of A3/Baa1. Chart 8Munis Expensive Versus Treasuries Chart 9Munis Cheap Versus Corporates Chart 9 shows that after-tax muni yields are near the high-end of their historical ranges relative to investment grade corporate bonds. In fact, a 10-year Aaa-rated municipal bond currently offers only 13 bps less yield than an equivalent duration A3/Baa1-rated corporate bond. In addition, whenever the after-tax yield on a 10-year Aaa-rated municipal bond has exceeded the yield on a 10-year corporate bond in the past, it has been a fairly good signal that investment grade corporates are too expensive and due for a correction. Not only did municipal bonds look more attractive than corporates before the crisis in 2007, but also before corporates sold off in 2011 and 2014 (Chart 9, bottom panel). Agency MBS Chart 10An Opportunity In MBS? As with munis, the option-adjusted spread (OAS) offered by a conventional 30-year Agency MBS is tight relative to its own history, but appears quite attractive relative to investment grade corporate bonds (Chart 10). Further, in a rising rate environment the risk of a large increase in mortgage refinancings is low and this should keep MBS spreads well contained. The biggest potential risk for MBS spreads is that a large spike in Treasury yields causes MBS duration to extend, and sparks a spread widening. In our report from two weeks ago we introduced a model for excess MBS returns in an attempt to quantify what sort of increase in Treasury yields would be necessary to make duration extension a meaningful risk for MBS.5 We modeled monthly excess returns for conventional 30-year MBS relative to duration-matched Treasuries using the following equation: Formula The monthly change in Treasury yields enters the equation with a positive sign because it proxies for refinancing risk. Higher yields lead to lower refis, and lower refis lead to MBS outperformance. The squared change in yields enters the equation with a negative sign because it proxies for extension risk. If yields rise too much during the month, then MBS duration will extend and the sector will underperform. Chart 11Refi Risk Is Low From that equation we calculated that, holding the change in OAS flat, it would take a monthly increase in yields of at least 72 bps to lead to negative monthly excess returns. However, in January this appeared not to work very well. The duration-matched Treasury yield in our equation increased only 38 bps in January and the OAS was virtually flat, but MBS still managed to underperform Treasuries by 16 bps on the month. Upon further investigation, the reason our model failed in January is that mortgage refinancings actually increased on the month even though Treasury yields rose (Chart 11). This behavior is unusual and we would not expect it to persist going forward. However, we also made one modification to our model that we expect will lead to more accurate results on a real-time basis. Specifically, we removed the intercept term from the prior model and replaced it with a 1-month lag of the average index OAS. The rationale is that since the intercept term is in the equation to capture the carry return in an MBS trade, we should use a more accurate measure of MBS carry rather than relying on the regression to calculate the historical carry. Our new equation is as follows: Formula Chart 12 Interestingly, using our new equation we find that the monthly increase in Treasury yields required to spark MBS underperformance is now a function of the current average OAS of the MBS index. This would seem to make sense. If the carry buffer is higher, then it should take a greater duration extension for capital losses to overcome the carry and lead to negative excess returns. The relationship between the required monthly increase in yields and the index OAS is illustrated in Chart 12. At the current average index OAS of 31 bps, our equation suggests that a monthly increase in Treasury yields of 58 bps or higher is required for extension risk to become meaningful. Bottom Line: Both municipal bonds and Agency MBS are starting to look attractive relative to investment grade corporate bonds. We stand ready to upgrade these sectors at the expense of investment grade corporate bonds when the time comes to de-risk our spread product portfolio. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Caught In A Loop", dated September 29, 2015, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com 3 For further details on the correlation between TIPS breakevens and commodity prices please see U.S. Bond Strategy Weekly Report, "It's Still All About Inflation", dated January 16, 2018, available at usbs.bcaresearch.com 4 Please see BCA Research Special Report, "The Return Of Vol", dated February 6, 2018, available at bca.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "The Most Important Chart In Finance", dated January 30, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy Relentless selling in utilities stocks is overdone and we are compelled to lift exposure to neutral. Operating metrics have turned the corner for the better, but a still challenging macro backdrop suggests that it is too soon to boost to an overweight stance. A rising interest rate backdrop, the sinking Cyclical Macro Indicator and near collapse in our sales growth model along with high chances of a profit margin squeeze, suggest that telecom services stocks are a sell. Recent Changes S&P Utilities - Upgrade to neutral for a gain of 15%. S&P Telecom Services - Downgrade to underweight, and add to high-conviction underweight list today. S&P Utilities - Removed from high-conviction underweight list last week for a gain of 18%.1 S&P Semiconductor Equipment - Removed from high-conviction underweight list last week for a gain of 20%.2 S&P Homebuilding - Removed from high-conviction underweight list last week for a gain of 10%.3 Feature Chart 1Time To Start 'Buying The Dip' Panic selling persisted last week, and equities struggled for direction, as the battle between liquidity withdrawal and stellar profit growth rages on. As we wrote in a recent report, the market will test the new Fed Chairman's resolve and this must have been an unnerving first week for Powell at the helm of the Fed.4 The 10% tactical pullback that we had been flagging in recent publications with the tech sector correctly sniffing it out has materialized, and our strategy is to start "buying the dip" as we do not foresee recession in the coming 9-12 months. While an undershoot cannot be ruled out given the emotional nature of recent market action, a number of indicators we track suggest that it would be a mistake to get extremely bearish at the current juncture. First and foremost, empirical evidence suggests that investors with a cyclical 9-12 month investment horizon should start to buy this correction (Chart 1). We analyzed SPX data back to the early-1960s and identified daily falls of 4% or more. There have been 16 such occurrences. In our sample we excluded the 1982 and 2015 incidents that rounded up to 4%, but were a hair below that level. For 1987 we included only one datapoint for the Black Monday crash and omitted occurrences very close to that date. Similarly, in the autumn of 2008 we only used the first large daily decline in our study and excluded other sizable downdrafts that were clustered around Lehman's collapse. We decided to exclude such clustered datapoints as they would skew our results to the upside. This analysis clearly demonstrates that it pays to "buy the dip" (top panel, Chart 1), and on average the SPX rises roughly 14% in the ensuing 12 months following the steep daily pullback (bottom panel, Chart 1). Interestingly, within a few weeks of the mini-crash empirical evidence suggests that markets typically retest those beaten-down levels and tend to hold above them. The implication is that investors have some time to deploy cash and/or reposition portfolios in order to take advantage of the recent pullback. Second, credit spreads have been surprisingly quiet. Bond spreads across the risk spectrum are extremely sensitive to risk off phases and one would have expected a sharp widening in spreads during the recent turmoil (fourth panel, Chart 2A). Chart 2ANo Systemic Risk Evident Chart 2BLatent Buying Power Third, the U.S. dollar has remained muted despite recent stock market jitters. A soft greenback is purely redistributive and represents a boost to global growth (third panel, Chart 2A). Fourth, short equity market positions are pinned near all-time highs representing latent dry powder (Chart 2B). Fifth, the VIX has gone vertical surging beyond the 50 level. Both the jump in the VIX and the explosion in trading volumes signal that capitulation was likely hit (second panel, Chart 2A). Finally, the recent market swoon along with rising EPS estimates have knocked down valuations pushing them to a 16 handle on a 12-month forward P/E basis (bottom panel, Chart 2A). In other words, all these indicators suggest that the bulk of the selling may have already occurred, and an absorption/consolidation phase will likely take place in the next few weeks. In fact, the recent let-up of soft data and simultaneous perkiness of hard data also corroborates that a lateral move is in the cards for the broad market (Chart 3). Chart 3Consolidation Phase Ahead We are willing to ride out the volatility and selectively look for opportunities to put cash to work, given our view that the longevity of the business cycle remains intact. Our core strategy remains to stay heavily focused on financials and industrials that benefit from our two key 2018 themes: higher interest rates and synchronized global capex upcycle. The energy sector also provides excellent value and a positive cyclical earnings outlook, based on BCA's upbeat crude oil view and rising odds of a virtuous capex upcycle. Meanwhile, health care remains our core defensive sector underweight. This sector still has to contend with political backlash against its multi-decade resilient selling price backdrop. With regard to the niche fixed income proxies, we are making a small tweak this week lifting the bombed-out utilities sector to neutral from underweight and locking in gains of 15% since inception. We are also downgrading defensive telecom stocks from neutral to underweight. Enough Is Enough In Bombed-Out Utilities In mid-summer we downgraded utilities to a below benchmark allocation, and subsequently on November 27th we were compelled to add it to our 2018 high-conviction underweight list, doubling down on our bearishness toward this fixed income proxy sector. These moves have paid handsome dividends and added alpha to our portfolio. Last week we crystalized gains by obeying our trailing stop that got triggered on our high-conviction list, registering 18% gains for the utilities underweight call. And, today we recommend an upgrade to a neutral stance to the niche S&P utilities sector, booking 15% gains since the July 24th inception, as indiscriminate selling has gone way too far in our opinion. Chart 4 shows that relative utilities performance has hit rock-bottom, plumbing all-time lows. In fact, the relative share price ratio has been so downbeat that if history at least rhymes a temporary relief rebound is in sight. Such oversold levels in our composite technical indicator have marked previous troughs (bottom panel, Chart 5). Tack on a gap down in relative valuations right at the neutral zone, and the implication is that it does not pay to be bearish from current washed out relative share price levels. Chart 4Unloved... Chart 5...And Under-owned Utilities... On the operational front, nat gas prices are no longer reeling and should boost industry pricing power as they are the marginal price setter for utilities (top two panels, Chart 6). Electricity production is also staging a slingshot recovery. This demand increase should also underpin utilities selling prices. Resource utilization is on the rise, up roughly 700bps from the 2016 trough. Once again the removal of excess slack should at least put a floor under industry producer price inflation. Indeed, our utilities sector productivity proxy has caught on fire recently pushing four year highs as both industry output and employment restraint are aiding our gauge. The upshot is that sell side analyst pessimism has likely hit a trough (bottom panel, Chart 6). All of these positives signal that we should take a punt and boost exposure all the way to overweight, nevertheless a challenging macro backdrop keeps us on the sidelines for now. Chart 7 shows that utilities stocks are the mirror image of the global manufacturing PMI survey. In other words, relative share prices move inversely with the ebb and flow of global growth, showcasing their ultimate safe-haven status. Similarly, increasing capital outlays are negatively correlated with utilities stocks, and given our synchronized global growth and global capex themes, utilities have limited cyclical upside. Finally, this high dividend yielding sector also suffers when Treasury bond yields shoot higher, as competing risk free assets become more appealing. Higher interest rates is one of BCA's key 2018 themes, and any resumption of the 10-year Treasury selloff will continue to weigh on relative performance (bottom panel, Chart 7). Chart 6...Are Coming Back To Life... Chart 7...But Do Not Get Carried Away Netting it all out, relentless selling in utilities stocks is overdone and we are compelled to lift exposure to neutral. Operating metrics have turned the corner for the better, but a still challenging macro backdrop suggests that it is too soon to boost to an overweight stance. Bottom Line: Take profits of 15% and lift the S&P utilities sector to a benchmark allocation. Trim Telecom Services To Underweight We are filling the void from the upgrade in the S&P utilities sector by downgrading the S&P telecom services sector to underweight, and also adding it to the high-conviction underweight list. This defensive sector swap preserves our bearishness toward safe haven assets as both sectors have a similar weight in the SPX. Three main reasons are behind our dislike for this fixed income proxy sector: BCA's 2018 rising interest rate theme Both our Cyclical Macro Indicator (CMI) and our sales model send a distress signal A profit margin squeeze is looming The top panel of Chart 8 shows that high dividend yielding telecom services stocks and the 10-year yield are nearly perfectly inversely correlated. In fact, telecom services stocks are prime beneficiaries of disinflation/deflation and vice versa (bottom panel, Chart 8). BCA's bond market view remains that the 10-year yield will continue to rise on the back of rising inflation expectations, and this represents a bearish backdrop for the telecom services sector. Our CMI has melted and relative consumer outlays on telecom services have also taken a nosedive (top two panels, Chart 9), warning that revenue growth will be hard to come by for telecom carriers. In fact, while nearly all of the GICS1 sectors have come out of the top line growth lull of late-2015/early-2016, telecom services sales growth has relapsed. Worrisomely, our S&P telecom services revenue growth model remains deep in contractionary territory, waving a red flag (bottom panel, Chart 9). Still steeply deflating selling prices are a major headwind for the sector's top and bottom line growth prospects and coupled with a still expanding wage bill, suggest that a profit margin squeeze is looming (fourth panel Chart 10). Chart 8No Dial Tone Chart 9Models Say Shy Away Chart 10Looming Margin Squeeze The sell side analyst community does not share this dire earnings picture. Net earnings revisions have gone vertical likely on the back of the recent tax reform. However, increasing industry slack underscores that beyond any one time gains from a lower corporate tax rate, organic EPS growth will be anemic at best. In fact, telecom services weekly hours worked do an excellent job of forecasting the sector's net earnings revision ratio and the current message is grim for profits (bottom panel, Chart 10). Adding it up, a rising interest rate backdrop, the sinking CMI and near collapse in our sales growth model along with high chances of a profit margin squeeze, suggest that a fresh bear phase is likely in the S&P telecom services sector. Bottom Line: Downgrade the S&P telecom services sector to a below benchmark allocation. We are also adding it to our high-conviction underweight list. The ticker symbols for the stocks in this index are: T, VZ, CTL. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Insight, "Stocks Take An Escalator Up, And An Elevator Down," dated February 7, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Insight, "Housekeeping In Turbulent Times," dated February 9, 2018, available at uses.bcaresearch.com. 3 Ibid. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Will The Market Test Powell?" dated November 13, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Highlights The spike in volatility last week led to a sharp correction in equities. However, the bull market in equities is not over yet. The Fed's response to the selloff will be critical. Policymakers will closely monitor financial conditions. The most overvalued assets are at greatest risk during a selloff. Feature Financial markets did not give new Fed Chair Jay Powell a warm welcome last week. Volatility spiked, and risk assets fell sharply. Nonetheless, BCA's view is that strong economic growth and stout earnings growth will keep the bull market intact. The selloff is reminiscent of the 7% drop in the S&P 500 in May of 2006.1 Back in the spring of 2006, then Chairman Ben Bernanke had just taken the helm at the Federal Reserve. Global growth was strong, the U.S. dollar was selling off and global share prices were surging and overbought. From May through June 2006, markets sold off because of the then-prevailing narrative that Chairman Bernanke would be too dovish, allowing U.S. inflation to get out of hand. U.S. bond yields spiked, inflicting particular damage on EM assets. The February 2018 may not play out exactly like May 2006. That said, there are enough similarities to draw parallels. Global growth is robust and inflationary pressures are accumulating. Bond yields are rising, and the greenback is selling off. A new Fed Chairman just took over the reins, and there are growing odds that U.S. inflation will soon begin to rise, justifying more Fed rate hikes. The Fed's response to the tighter financial conditions will be crucial. The May 2006 selloff turned out to be just a correction in a bull market that lasted another 18 months. Still, investors today are also concerned about what to sell first as the end of the expansion draws closer. A Shake Up BCA strategists believe that the market turmoil since last week reflects a technical correction from overbought and over complacent levels, but the cyclical bull run is not yet over.2 Nonetheless, investors should note that the bull market is entering its late stages. The low inflation and low volatility era is ending as the U.S. economy begins to face late-cycle, supply-side constraints, especially in the labor market. Therefore, the equity advance will be associated with higher volatility than in the past few years. Chart 1 shows that the VIX soared by roughly four times more on February 5 than expected, based on the decline in equity prices. This suggests that the spike in volatility caused the stock market plunge, rather than the other way around. The relatively muted reaction in the past few days of other risk gauges, such as junk bonds, EM stocks, and gold prices, is consistent with this thesis. Chart 1Last Monday's VIX Spike Was Abnormally Large Importantly, the implosion of volatility funds is unlikely to reverberate across the global financial system in the same way as it did during the 2007-2009 financial crisis. The mortgage crisis a decade ago was so toxic that the losses were concentrated in the books of highly leveraged financial institutions. However, that does not appear to be the current case with volatility funds. The cyclical underpinnings for the bull market in equities is intact. The odds of a recession remain low (Chart 2). Corporate earnings continue to come in above expectations, aided by a wave of share buybacks linked to the U.S. Tax Cut and Jobs Act (Chart 3). Global economic growth remains upbeat as well. Chart 2Odds Of A Recession##BR##Remain Low Chart 3Buybacks, Surging Capex##BR##Raising The Bar For 2018 EPS Growth Chart 4U.S. Equities And Vol##BR##Climbed Through The 1990s This does not mean that everything will be smooth sailing. Last week's selloff marked an inflection point in the low-volatility world that has prevailed in the past few years. The VIX Humpty-Dumpty has been irrevocably broken. Volatility will stay elevated relative to what investors have come to anticipate. As the experience of the 1990s shows, stocks can still climb when volatility trends higher (Chart 4), but this is going to make for a more challenging investment environment. Bottom Line: Rising volatility does not mean the end of the bull market or the economic expansion. Bear markets outside of recessions are rare, and our view remains that the odds of a recession this year or next remain low. Moreover, the additional dose of fiscal stimulus passed by Congress late last week may extend the expansion into 2020. Stay overweight stocks versus bonds.3 The Policy Response The Fed's reaction to this new regime will be critical. The 7.2% drop in equities last week occurred on Jay Powell's first as Chairman of the Fed. Chart 5 shows that it is not unusual for the equity markets to be in turmoil in the early months of a new Fed Chair's tenure. BCA expects that Powell and his FOMC colleagues will adopt Janet Yellen's gradual approach to raising rates this year. Nonetheless, the January readings on average hourly earnings suggest that supply-side constraints are beginning to bite. The runway for low inflation and easy monetary policy may not be as long as some had hoped. Just like Yellen, Jay Powell will seek a consensus among his colleagues. The composition of the FOMC will probably shift in a more hawkish direction, but the evolution will be slow. In the meantime, the recommendations of career Fed staff will represent an important and often underappreciated source of continuity. Last week, several Fed speakers reinforced that the central bank will continue to monitor incoming economic and financial data, and react accordingly. The stock market rout has led to some tightening in financial conditions, but FCIs in the U.S. remain more expansionary than they were six months ago (Chart 6). As a result, U.S. economic growth is poised to accelerate even more in the first half of the year (Chart 7). This will push the unemployment rate further below NAIRU and ultimately force up wage and price inflation. Chart 5New Fed Chairs##BR##And The Equity Market Chart 6Decline In Equity Market##BR##Tightened Financial Conditions However, at 2.1% on February 8, the 10-year TIPS breakeven yield was still below the 2.4 to 2.5% range where markets need to worry about the Fed falling behind the curve (Chart 8). A shift above 2.4% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would signal that the FOMC will have to boost the pace of rate hikes and aggressively slow economic growth. We expect the Fed to tighten four times in 2018. We will likely take some money off the table if core inflation rises, even if it is still below 2%, when the TIPS breakeven reaches 2.4%. Chart 7Lagged Effect Of Easier##BR##Monetary Conditions Will Boost Growth Chart 8Breaking Down##BR##The Rise In Yields A sustained move above 3% on the nominal 10-year Treasury yield will require a more durable increase in inflation. Ultimately, we think core inflation will move4 above 2%, forcing the Fed to lift interest rates into restrictive territory. However, this probably will be a story for 2019 rather than 2018. Stocks tend to peak about six months before the start of a recession (Table 1). If the next recession occurs in late 2019, as we forecast, the equity bull market could last a while longer. The additional fiscal impulse from the spending bill passed by Congress last week may extend the expansion into early 2020. A modest overweight on global risk assets is warranted for now, but investors should consider reducing their risk exposure later this year. Table 1Too Soon To Get Out Bottom Line: The Fed and the market are now in agreement on rate hikes in 2018. BCA's U.S. Bond Strategists' stance is that the 2/10 curve will flatten from here, as the upside in long maturity yields will be limited once the TIPS breakeven inflation rates reach our target fair value range of 2.4-2.5%. Nonetheless, at that point, the nominal 10-year yield5 is likely to be between 3.0 and 3.25%. Stay underweight duration for now. Where Do We Go From Here? Clients have asked our view on the appropriate order in which to reduce risk assets. One way to approach the question is to compare valuation across asset classes. Presumably, the most over-valued ones are at greatest risk, and thus profits should be taken here first. It is difficult to compare valuation across asset classes. Should one use fitted values from models or simple deviations from moving averages? Over what time span? We include multiple measures because there is no widely accepted approach. More than one time period was used in some cases to capture regime changes. Table 2 provides our best approximation for nine asset classes. The approaches range from sophisticated methods6 developed over many years (i.e. our equity valuation indicators), to regression analysis on the fundamentals (i.e. oil), to simple deviations from a time trend (i.e. real raw industrial commodity prices and gold). Table 2Valuation Levels For Major Asset Classes We averaged the valuation readings where there were multiple estimates for a single asset class. The results are shown in Chart 9. Chart 9Valuation Levels For Major Asset Classes By far, U.S. equities stand out as the most expensive at 1.8 standard deviations above fair value. Gold, raw industrials and EM equities are next at one standard deviation overvalued. EM sovereign bond spreads follow at 0.7, tracked closely by U.S. Treasuries (real yield levels) and investment-grade corporate (IG) bonds (expressed as a spread). High-yield (HY) is only about 0.3 sigma expensive, based on default-adjusted spreads over the Treasury curve. That said, both IG and HY are very expensive in absolute terms based on the fact that government bonds are pricey. Oil is sitting very close to fair value, despite the rapid price run up in the past couple of months. This makes oil exposure doubly attractive because the fundamentals point to higher prices when the underlying asset is not expensive. Historical analysis around equity market zeniths provides an alternative approach to the sequencing question. Table 3 presents the number of days that various asset classes peaked before or after the past major five tops in the S&P 500. A negative number indicates that the asset class peaked before U.S. equities, and a positive number means that it peaked after. Table 3Asset Class Leads & Lags Vs. Peak In S&P 500 Unfortunately, there is no consistent pattern observed for EM equities, raw industrials, U.S. cyclical stocks, tech stocks or small-cap versus large-cap relative returns. Sometimes they reached their zenith before the S&P 500, and sometimes after. The EM sovereign bond excess return index peaked about 130 days in advance of the 1998 and 2007 U.S. equity market tops, although we only have three episodes to analyze due to data limitations. Oil is a mixed bag. A peak in the price of gold led the equity market in four out of five episodes, but the lead time was long and variable. The U.S. corporate bond market offers the most consistent lead/lag relationship. Both investment- and speculative-grade excess returns relative to government bonds peaked in advance of U.S. stocks in four of the five episodes. High-yield excess returns provided the most lead time, peaking on average 154 days in advance. Excess returns to high-yield were a better signal than total returns. This leading relationship is one reason why we plan to trim exposure to corporate bonds within our bond portfolio before we scale back on equities. Base metal prices will be hit particularly hard if the 2019 U.S. recession spills over as expected to the EM economies. We may downgrade base metals from neutral to underweight around the time that we downgrade equities, but much depends on the evolution of China's economy in the coming months. Oil is a different story. OPEC 2.0 will likely cut back on supply in the face of an economic downturn, which will help keep prices elevated.7 Therefore, we may not trim energy exposure this year. In terms of equities, our recommended portfolio is still overweight cyclicals for now. Our themes of a synchronized global capex boom, rising bond yield, and firm oil price means we will stay overweight in the industrials, energy and financial sectors. Utilities and homebuilders are underweight. Tech is part of the cyclical sector, but poor valuation keeps us underweight. Our U.S. Equity Strategists have already started a gradual shift away from cyclicals toward defensives. This transition will continue in the coming months as we reduce risk. We will also shift small caps to neutral on earnings disappointments and elevated debt levels.8 Bottom Line: The economic expansion is not over, but investors are already wondering what to sell first as the next peak in equities nears. Market participants should look to trim credit exposure before scaling back on equities, and BCAs' U.S. Equity Strategy service is already scaling back on cyclicals and reduced small caps to neutral from overweight last month. At under $60/ barrel WTI, oil is 5% below our Commodity & Energy Strategy's target of $63/bbl. Moreover, global inventories will continue to draw on the back of OPEC supply restraint as shale production growth alone will not satisfy stronger global demand driven by stronger global economic growth. If prices hit the low $70 range, supply restraint and demand growth will ebb, capping incremental upside. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA Research's U.S. Equity Strategy Insight "Buy The Dip," published February 8, 2018. Available at uses.bcaresearch.com. 2 Please see BCA Research's Global Investment Strategy Special Report "The Return Of Vol," published February 6, 2018. Available at gis.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report "Watching Five Risks," published January 24, 2018. Available at gps.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy PAS "Warning Signals," published February 6, 2018. Available at usbs.bcaresearch.com. 5 Please see BCA Research's U.S. Bond Strategy PAS "Warning Signals," published February 6, 2018. Available at usbs.bcaresearch.com. 6 Please see BCA Research's The Bank Credit Analyst Monthly Report, published January 25, 2018. Available at bca.bcaresearch.com. 7 Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Vs. The Fed," published February 8, 2018. Available at ces.bcaresearch.com. 8 Please see BCA Research's U.S. Equity Strategy Weekly Report "Too Good To Be True?," published January 22, 2018. Available at uses.bcaresearch.com.

Highlights This week's global equities sell-off spilled into oil markets, taking Brent and WTI down 2.7% and 3.7% as of Tuesday's close, in line with the S&P 500 decline, which began Friday. In line with our House view, we do not believe this will, in and of itself, deter the Fed from raising overnight rates four times this year. Nor do we believe oil-price weakness earlier this week reflects a breakdown in fundamentals. Any demand-dampening effects coming from a stronger USD in the wake of Fed rate hikes will have a muted effect on oil prices, provided OPEC 2.0 can maintain production discipline, and, critically, keep the Brent and WTI forward curves backwardated.1 Likewise, any demand stimulation coming from a weaker USD in the wake of a more measured Fed policy - e.g., two or three hikes - also will be muted by backwardation. Energy: Overweight. Fundamentally, we cannot see anything that warrants a change in our average-price forecast of $67 and $63/bbl for Brent and WTI this year. Our long Jul/18 WTI vs. short Dec/18 WTI calendar spread, put on in expectation of continued backwardation in oil forward curves, is up 81.5% since Nov 2/17, when we recommended it. Base Metals: Neutral. Base metals also were caught up in the equities sell-off, with spot copper trading ~ $3.15 - $3.20/lb on the COMEX. As with oil, we do not see the equities sell-off as a harbinger of a bearish shift in base metals fundamentals. Precious Metals: Neutral. Gold returns were relatively flat amid the equities sell-off with only a 0.6% loss. Our long gold portfolio hedge is up 7.9% since it was recommended on May 4/17. Ags/Softs: Underweight. China opened an anti-dumping and anti-subsidy investigation into U.S. sorghum imports, which the country's foreign ministry insisted was not related to recent U.S. tariffs on solar panels and washing machines. China accounts for ~ 80% of U.S. sorghum exports. Feature The global equity sell-off spilled into oil markets, with Brent and WTI prompt futures down 2.7% and 3.7% over the past week when the equity slide began (Chart of The Week). The proximate cause of the equities down leg appears to be the stronger-than-expected U.S. wage growth reported last week, suggesting inflationary pressures continue to build in the U.S. This prompted speculation the Fed would be inclined to increase the number of rate hikes it executes this year - going from a consensus view of three hikes to four - and that financial conditions would tighten. The equities sell-off this prompted then led to speculation the Fed would dial back the number of rate hikes it executes this year. We believe the Fed will look through the recent equity-market volatility, and will lift rates four times this year, in line with BCA's once-out-of-consensus House view. Chart of the WeekOil Prices Caught Up In Equities Sell-Off Chart 2Fundamentals Support Backwardation As far as oil markets are concerned, as long as the Brent and WTI forward curves remain backwardated (Chart 2), any impact from U.S. monetary policy on oil prices - chiefly through currency effects - will be muted. Demand-dampening effects coming from a stronger USD in the wake of Fed rate hikes will be dissipated in backwardated markets. Likewise, any demand stimulation coming from a weaker USD in the wake of fewer rate hikes policy at the Fed - e.g., two or three hikes - will be muted by backwardation. Fundamentals Dominate Oil-Price Evolution Chart 3Strong Fundamentals##BR##Force Inventories Lower Fundamentals point to continued tightening of crude oil markets in 1H18, the period we have the greatest visibility on: OPEC 2.0's production cuts are pretty much locked in to end-June, when the producer coalition again will meet to assess market conditions, and global demand growth will remain robust. Even with U.S. shale-oil output increasing, OECD inventories will continue to draw during this period (Chart 3). OPEC 2.0's goal of reducing OECD inventories to five-year average levels likely will be met late in 1H18 or early in 2H18, based on our global balances model. While it is possible OPEC 2.0 will extend its production cuts to year-end 2018, we don't believe it is likely. Voluntary production cuts by Russia and Gulf OPEC nations, combined with decline-curve losses in non-Gulf OPEC producers have removed ~ 1.4mm b/d from the market since January 2017. The bulk of these cuts have been made by KSA and Russia, which account for close to 1.0mm b/d of OPEC 2.0 production cuts. Based on our fundamentally driven econometric model, extending OPEC 2.0's cuts to year-end would lift average prices in 2018 from our current expectation of $67/bbl for Brent and $63/bbl for WTI to $71 and $67/bbl, respectively. Counterintuitively, we believe maintaining prices at this level for the entire year is not the desired outcome of OPEC 2.0's production-cutting strategy. Higher price levels will incentivize larger-than-expected shale-oil production gains than we currently are forecasting - ~ 1.0mm b/d in 2018 and 1.2mm b/d in 2019. In addition, they would breathe life into marginal production around the world, particularly in provinces where break-evens and services costs have fallen - e.g., the North Sea, Barents Sea and offshore Brazil. OPEC 2.0's Long Game KSA's and Russia's oil ministers, the leaders of OPEC 2.0, have stated they would prefer to see their coalition endure beyond end-2018, when their production-cutting deal expires. Be that as it may, they have yet to publicly articulate an agreed strategy for OPEC 2.0, either in terms of a preferred price level or price band, or a strategy that builds on the gains they've made in backwardating oil forward curves. Chart 4Stakes Are High For OPEC 2.0##BR##If No Post-2018 Strategy Emerges Russian Energy Minister Alexander Novak recently suggested a preferred range for prices of $50 to $60/bbl for Brent, the international crude-oil benchmark. In the short term, KSA likely prefers a higher price - between $60 and $70/bbl for Brent - to support the IPO of Saudi Aramco, which probably will occur later this year. As we near the end of 1H18, OPEC 2.0's leaders will have to provide some indication they are converging on a common production-management strategy. They will, we believe, have to begin behaving more like a central bank - i.e., providing the market forward guidance - and less like a loose alliance of like-minded producers lurching between stop-gap measures to support prices. Importantly, when they do provide such guidance, they will have to follow through on publicly stated goals, or risk losing credibility with markets. The stakes are fairly high. If, as we've modeled in our unconstrained case, OPEC 2.0 returns ~ 1.1 - 1.2 mm b/d of actual production cuts (ex-decline-curve losses) to the market beginning in 2H18, and U.S. shale and other producers respond to 2018's higher prices with aggressive production growth that carries through 2019, Brent and WTI prices could be pushing toward $40/bbl by the end of 2019 (Chart 4). Also note that if prices start to moderate in H2 2018, 2019 shale production growth may ultimately be less than the 1.2 MMb/d we have forecast, softening the decline in prices during 2019. Longer term, we believe KSA and Russia are aligned with Russia's preference, if for no reason other than to keep U.S. shale-oil production from realizing the run-away growth sustained higher prices almost surely would provoke. Such growth would accelerate the development of U.S. crude oil export capacity - already hovering around ~ 2mm b/d - and the competition for market share in markets OPEC 2.0 members are keen to defend. Higher prices also would improve the competitive position of non-hydrocarbon-based transportation - e.g., electric vehicles and hybrids - which works against OPEC 2.0's long-term goals. Backwardation Matters For OPEC 2.0 Price levels always will be an important policy variable for OPEC 2.0. Equally important, we believe, will be having a strategy that maintains a backwardated forward curve in the Brent and WTI markets. This is because OPEC 2.0 member states sell oil at spot-price levels - the highest point of a backwardated forward curve - while shale-oil producers hedge their revenues over a 1- to 2-year interval. Other than allowing prices to collapse once again, this is the most viable way of constraining U.S. shale production growth longer term. The steeper the backwardation in the WTI forward curve, in particular, the lower the average price level of the hedges producers are able to lock in when they hedge forward revenues. This translates directly into lower output, since producers cannot afford to field as many rigs at lower prices over the life of the hedge as they would be able to field at higher prices. The extent to which OPEC 2.0 can keep forward curves backwardated will determine the extent to which the USD influences oil prices, as well. Our recently concluded research reveals backwardation can mitigate FX effects on oil prices induced by U.S. monetary policy. There is a long-term equilibrium between the level of the USD's broad trade-weighted index (TWIB) and crude oil prices (Chart 5). Indeed, the USD TWIB is one of the key variables we use in our demand, supply and price models. A weak dollar spurs consumption - USD/bbl prices ex-U.S. are cheaper in local-currency terms, especially for fast-growing emerging markets - while production costs ex-U.S. are higher, which limits output growth at the margin. A stronger dollar restrains consumption and encourages production ex-U.S., at the margin. However, this long-term equilibrium is asymmetric. The strength of the correlation between the level of the USD and crude oil prices is such that as oil inventories fall - and backwardation becomes more pronounced - the USD becomes less important to the evolution of oil prices.2 This can be seen in the month-on-month (m-o-m) rolling correlation between prompt WTI futures and the USD TWIB plotted against the spread between 1st nearby WTI futures and 12th nearby WTI futures (Chart 6). Chart 5Long-Term Inverse Correlation##BR##Between USD TWIB And Crude Prices Chart 6Backwardated Forward Curves##BR##Limit USD's Effect On Oil Prices With the exception of the Global Financial Crisis (GFC), the higher the backwardation in crude oil forward curves, the smaller the USD-WTI correlation becomes.3 This suggests that, if OPEC 2.0 can maintain the backwardation in WTI and Brent in 2018, the correlation between crude oil prices and the USD TWIB likely will not go back to the large negative correlation typical of previous cycles. In other words, sustained backwardation will weaken the inverse relationship between WTI prices and the USD TWIB vs. the long-term average in place since 2000, which is roughly when oil prices became random-walking variables. We also looked at year-on-year change in U.S. commercial inventories vs. the USD-WTI prices correlation (Chart 7). Our analysis indicates that when inventories are building, the correlation between USD and WTI prices becomes negative, and when they are falling the correlation goes to zero or positive. This supports our earlier observation that when crude inventories fall, the USD becomes less important to the evolution of WTI prices, particularly spot prices. One more point that we should note: the inverse relationship between the USD and oil prices is a two-way street. In addition to a weaker USD helping to support higher oil prices, higher oil prices have also tended to weaken the USD by inflating the U.S. trade deficit through more expensive petroleum imports. However, over the past decade, the U.S. has reduced its volumes of petroleum imports by roughly 75%, from 12-13 MMB/d in 2007 to only 3-4 MM b/d today (Chart 8). Therefore, this feedback loop of higher oil prices weakening the USD, and lower oil prices strengthening the USD, is greatly reduced. Chart 7Tighter Inventories Limit##BR##USD's Effect On Oil Prices Chart 8Lower Imports Of Petroleum Help##BR##Insulate USD From Oil Price Moves The USD's influence on the evolution of oil prices essentially is an exogenous variable out of OPEC 2.0's control. To the extent it can minimize these effects by backwardating oil forward curves, the coalition reduces the impact of an essentially exogenous USD risk from its production-management strategy. Bottom Line: The Fed likely will view the equity sell-off as a transitory event, and proceed with four overnight-rate hikes this year, in line with our House view. Any read-through from Fed policy decisions to the USD TWIB will be muted by continued backwardation in crude oil forward curves. To the extent OPEC 2.0 can maintain backwardated forward oil curves, it reduces the impact of an essentially exogenous USD risk from its production-management strategy. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Jargon recap: OPEC 2.0 is the moniker we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. Its historic production-cutting Agreement to remove 1.8mm b/d of production from the market - via a combination of outright cuts and decline-curve run-off - has largely held, despite wide-spread skepticism. "Backwardation" is a term of art in commodities describing a forward curve in which prompt-delivered crude oil trades at a higher price than crude delivered in the future - e.g., a year hence. This is a reflection of a tight market - i.e., refiners are willing to pay more for oil delivered tomorrow or next month than they are willing to pay for oil delivered next year. The opposite of a backwardated market is a "contango" market, another term of art. 2 Generally, falling commodity inventories put a premium on prompt-delivered supply. As inventories fall, there is less readily available supply in place to meet unexpected supply outages. Under such conditions, refiners will attempt to conserve inventory and bid for flowing supply more aggressively, either to replace consumption out of inventory or to keep inventories at safe levels so as to minimize stockout risks. Either way, prompt-delivered supply becomes more valuable than deferred supply. Backwardation reflects this dynamic by keeping prompt-delivered prices above prices for deferred delivery. Backwardation is the market's way of incentivizing storage holders to release inventory to the market. It also is the source of returns for long-only commodity index products. 3 The GFC of 2008 - 09 was a global liquidity event, in which correlations between most tradeable assets went to 1.0 as prices collapsed. 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 The end of the low volatility regime could mark a leadership change in global equities away from EM to DM. The near-term risk to our negative stance on EM risk assets is a scenario where Beijing allows RMB appreciation to head off major protectionist threats from the U.S. This could delay the U.S. dollar rally and support EM risk assets. The EM and commodities equity rallies might be facing formidable technical resistances. These equity segments have to break out these technical resistances decisively to confirm the sustainability of the bull market. Feature Global stocks have corrected, and volatility measures have surged. The low volatility regime appears to have come to a decisive end. Even though in the short run volatility measures could well decline after their steep surge of the past week, the cyclical outlook points to higher volatility relative to last year. Financial markets are likely to be re-priced to adjust to the end of this low-volatility period. This entails more stress, and an additional selloff in risk assets. Periods of low volatility historically sow the seeds of their own reversal. Investors tend to embrace high-risk strategies amid low volatility, and take on more leverage. As a result, market excesses and froth arise, increasing the market's vulnerability in the event of a reversal. The latest period of low volatility lasted for more than a year, and no doubt facilitated the build-up of froth and excesses in global financial markets. Chart I-1 illustrates that the aggregate volatility measure of various financial markets was at its lows of the past 12 years before surging in recent days. Chart I-1Rising Volatility Coincides With A U.S. Dollar Rally What does rising volatility mean for emerging market (EM) relative performance vis a vis developed markets (DM)? It is primarily contingent on the U.S. dollar. If the U.S. dollar rebounds along with the rise in volatility, as it has done in the past (Chart I-1), EM equities will commence underperforming DM bourses. If the U.S. dollar fails to rebound and drifts lower, EM stocks are likely to outperform DM equities. With respect to exchange rates, we believe one of the major driving forces for currencies is the relative growth trajectory. The latter can be approximated by relative equity market performance in local currency terms. Chart I-2 shows that U.S. share prices - of both large and small caps - have been outperforming their global counterparts in local currency terms. Persisting periods of outperformance of U.S. stocks versus their global peers eventually, albeit sometimes with a considerable time lag, instigates a stronger trade-weighted U.S. dollar. U.S. large-cap share prices are making new highs versus their global peers in local currency terms. This entails that the selloff in the broad trade-weighted dollar is at a very late stage. The dollar rebound is a missing trigger for EM relative equity outperformance to reverse. A Risk To Our View: The U.S. Dollar One risk to our negative stance on EM risk assets and our recommendation of underweighting EM versus DM is the continuation of the U.S. dollar selloff. The greenback has been trading very poorly despite jitters in global equity markets. The recent surge in the RMB versus the U.S. dollar may be indicative that the Chinese authorities are tolerating RMB appreciation to defuse a threat of major protectionist measures from the U.S. (Chart I-3). If the RMB continues to appreciate versus the greenback, Asian and other EM currencies will stay well supported, and EM outperformance will persist. Chart I-2U.S. Relative Equity Outperformance ##br##Warrants A Stronger Dollar Chart I-3Will Beijing Tolerate A Stronger RMB? We suspect that Chinese policymakers are reluctantly allowing the RMB to appreciate. Indeed, Chinese policymakers have been both vocal and public about their understanding of Japan's experience with deleveraging, and specifically the mistake made by Japanese policymakers of allowing the yen to appreciate in the early 1990s. As most know, deflationary forces stemming from the combined effects of deleveraging and currency appreciation set off a formidable deflationary adjustment in Japan in the 1990s. Given Japan's experience, our conjecture is that Chinese policymakers would rather opt for a stable-to-mildly weaker currency. This has been one of the cornerstones of our bullish bias on the U.S. dollar versus emerging Asian currencies. If China allows the RMB to appreciate further versus the U.S. dollar, a potential U.S. dollar rally versus EM currencies will be delayed. In turn, this will likely allow EM equity, currency and credit markets to outperform their DM peers. That said, a strong currency will add to the ongoing policy tightening in China. The cumulative impact of this policy tightening combined with currency appreciation will weigh on China's growth later this year. As such, our fundamental thesis on China-slowdown is still valid in the medium term. However, political interference in the currency markets could delay EM risk assets' response to it. Bottom Line: The near-term risk to our negative stance on EM risk assets is a scenario where Beijing allows further RMB appreciation to head off potentially major protectionist threats from the U.S. May 2006 Redux? The current riot in global stocks resembles the May 2006 correction to a certain extent. Back in the spring of 2006, then Federal Reserve Chairman Ben Bernanke had just taken the helm at the Fed. Global growth was strong, the U.S. dollar was selling off, and global share prices were surging and overbought. Chart I-4May 2006 And Now: EM Stocks, ##br##U.S. Bond Prices And U.S. Dollar In May-June 2006, markets sold off because of the then-prevailing narrative that Chairman Bernanke would be too dovish and would allow U.S. inflation to get out of hand. U.S. bond yields spiked, inflicting particular damage on EM. It seems that February 2018 may play out like May 2006. It will not be exactly the same, but there are enough similarities to draw parallels: Global growth is robust, inflationary pressures are accumulating. DM bond yields are rising and the greenback is selling off. The new Fed Chairman, Jerome Powell, just took over the reins at the Fed, and there are growing odds that U.S. inflation will soon begin to rise, justifying more Fed rate hikes. Chart I-4 illustrates the similarities between financial market dynamics in 2005-2006 and now. If we take 2006 as a guide, we can infer that the selloff is not yet over. In a matter of only five weeks EM share prices plunged by 25% in U.S. dollar terms, and the S&P 500 dropped by 7%. From a big-picture perspective, the May 2006 selloff was a sharp correction in a bull market that lasted for another year or so. Importantly, the 25% plunge in EM share prices that took place in 2006 occurred despite EM corporate profit growth expanding at a double-digit rate in 2006-'07. All that said, the 2006 selloff marked an important regime shift in the global economic landscape - the rate of U.S. growth peaked in the second quarter 2006, and began to decelerate. We believe that the current equity market riot will likely mark a bottom in U.S. inflation and the beginning of a slowdown in China. The U.S. Bond Market Selloff Is Not Over... Yet The selloff in the U.S./DM bond markets has not yet run its course: The U.S. inflation model - constructed by our colleagues in the Foreign Exchange Strategy service and based on U.S. capacity utilization and broad money supply - is pointing to higher inflation in the months ahead (Chart I-5). U.S. bond yields will likely move higher as forthcoming inflation prints validate our expectations for higher U.S. inflation. Fiscal stimulus amid robust growth and a tight labor market in the U.S. as well as record-high optimism among consumers and businesses have created fertile ground for rising inflation. The weak dollar of the past 12 months will also manifest in rising inflationary pressures. The U.S. bond term premium is still extremely low. Yet, budding uncertainty over inflation and the gradual end of QE programs in DM, will likely cause the U.S. bond term premium to rise from current depressed levels. Finally, simple DM bond markets technicals are still pointing to higher yields ahead (Chart I-6). Chart I-5U.S. Core Inflation Set To Rise Chart I-6U.S. Bond Yields: The Path ##br##Of Least Resistance Is Up Overall, the path of least resistance for DM bond yields is up. This will make EM local currency bond yields less attractive versus DM and especially versus U.S. Treasurys. Yield differentials between EM and the U.S. are already at a 10-year low (Chart I-7). Low risk premiums on EM local bonds and rising global financial market volatility suggest that flows to EM fixed income markets will slow over the course of this year. That said, near-term risks still remain due to the massive inflows that previously went into EM funds, and might not have been deployed yet. China's Tightening And Pending Slowdown It is not unusual for an equity market riot to begin with inflation and high-interest-rate fears and then culminate with a growth scare - with a rebound in between. 2018 may shape up to fit this pattern. Global equity markets seem to be immersed with inflation and policy tightening in the U.S. - and potentially in China. At some point, share prices could well stage a rebound but then relapse again as materially slower Chinese growth spills over to global trade.1 We have discussed our view on China and its spillover effect on EM in past reports, and will not reiterate our views and analysis here. We will only bring to clients' attention that manufacturing production volume in Asia has already been weakening for a couple of months (Chart I-8). Chart I-7EM Local Currency Bonds Over ##br##U.S. Treasurys: Yield Differential Chart I-8Asia's Manufacturing ##br##Production Growth Is Slowing Leadership changes in the equity markets occur amid selloffs. Hence, it is reasonable to expect a leadership shift within global equity market sectors and countries as well as currency markets. One major equity leadership shift could be that EM begins underperforming DM. A combination of rising U.S. inflation and bond yields and a slowdown in China are negative for EM financial markets, especially relative to DM ones. Reading Markets' Tea Leaves It remains to be seen how much further this selloff in global equities will last and whether this is the beginning of a major downtrend in EM risk assets. It is impossible to have perfect foresight. To help investors in their portfolio decisions, we combine our fundamental analysis with tools that assist us in forecasting business cycles as well as various chart patterns that may be indicative of the market's potential trajectory. The following charts illustrate that the EM and commodities equity rally may be facing formidable technical resistance. These equity markets have to break out decisively through these technical resistance lines to confirm the sustainability of the bull market. Global energy stocks have corrected after reaching their long-term moving average (Chart I-9, top panel). The latter served as a floor in the 2008 crash. It was a key technical level in the 2014-'15 bear market that did not hold up and was followed by a collapse in crude prices. Similarly, global steel stocks are exhibiting the same pattern (Chart I-9, bottom panel). Relative performance of emerging Asian share prices versus the global equity benchmark is also at a similar critical juncture (Chart I-10, top panel). Chart I-9Global Energy And Steel Stocks: ##br##A Technical Resistance Chart I-10Select EM Equity Markets ##br##Are Facing A Critical Test Finally, Brazilian share prices in U.S. dollar terms have also reached a crucial technical threshold (Chart I-10, bottom panel). Bottom Line: Share prices of a few equity sectors and markets that are imperative to the EM equity outlook are at important technical junctures. Failure to break above these technical resistance lines will corroborate our negative stance on EM/China growth and related financial markets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 We elaborated the relationship between China/EM and DM growth in November 29, 2017 Emerging Markets Strategy Weekly Report, the link is available on page 12. Equity Recommendations Fixed-Income, Credit And Currency Recommendations