Global

Highlights The global economy is slowing. However, growth should stabilize at an above-trend pace over the next few months, as fiscal policy turns more stimulative and interest rates remain in accommodative territory. President Trump's macroeconomic policies are completely at odds with his trade agenda. Fortunately, Trump appears willing to cut a deal on trade, even if it is on terms that are not nearly as favorable to the U.S. as he might have touted. The recently renegotiated South Korea-U.S. Free Trade Agreement is a case in point. We remain cyclically overweight global equities, but acknowledge that valuations are stretched and the near-term market environment could remain challenging until leading economic indicators improve. Feature Global Equities: Near-Term Outlook Is Still Hazy We published a note on February 2nd entitled "Take Out Some Insurance" warning investors that the stock market had become highly vulnerable to a correction.1 The VIX spike began the next day. Although volatility has fallen and equities have rebounded so far in April, we are reluctant to sound the all-clear. The near-term signal from the beta version of our MacroQuant model has improved a bit but remains in bearish territory, as it has for over two months now (Chart 1). Chart 1MacroQuant Model Suggests Caution Is Warranted The model is highly sensitive to changes in growth. Starting early this year, it began to detect a weakening in a variety of leading economic indicators in the U.S. and, to an even greater degree, abroad. Most notably, global PMIs and the German IFO have dipped, Korean and Taiwanese exports have decelerated, Japanese machinery orders have fallen, and the Baltic Dry Index has swooned by 36% from its December high (Chart 2). The model also noted an increase in inflationary pressures, suggesting that monetary policy would likely end up moving in a less accommodative direction. The emergence of stagflationary concerns came at a time when bullish stock market sentiment stood at very elevated levels (Chart 3). Our empirical work has shown that equities perform worst when sentiment is deteriorating from bullish levels and perform best when sentiment is improving from bearish levels (Chart 4). Chart 2Growth Has Peaked Chart 3Stock Market Sentiment Was Very ##br##Bullish Earlier This Year Chart 4Swings In Sentiment And ##br##Stock Market Returns Waiting For The Economic Data To Stabilize The good news is that the drop in equity prices has caused sentiment to return to more normal levels. The bad news is that the activity data has continued to disappoint at the margin, as evidenced by the weakness in economic surprise indices and various "nowcasts" of real-time growth (Chart 5). Ultimately, we expect global growth to stabilize at an above-trend pace over the coming months, which should allow equities to grind higher. Monetary policy is still quite accommodative. The yield on the JP Morgan Global Bond Index has averaged 1.88% since the end of the Great Recession (Chart 6). We do not know where the "neutral" level of bond yields has been over this period. However, we do know that unemployment in the major economies has been falling, which suggests that monetary policy has been in expansionary territory. Despite the move away from quantitative easing by many central banks, the yield on the JP Morgan Global Bond Index is only 1.53% today. This implies a fortiori that bond yields today are well below restrictive levels. The conclusion is further strengthened if one assumes, as seems highly plausible, that the neutral bond yield has risen over the past few years, as deleveraging headwinds have abated and fiscal policy has turned more stimulative (Chart 7). Chart 5Unexpected Slowdown In Growth Chart 6Interest Rates Are Off Their Bottom, ##br##But Are Not Restrictive Chart 7Fiscal Policy Will Be Stimulative ##br##This Year And Next The Protectionism Bugbear Global growth has not been the only thing on investors' minds. The specter of a trade war has also loomed large. It is true that the standard early-19th century Ricardian model that first-year economics students learn predicts very small welfare losses from increased protectionism.2 The model, however, makes highly antiquated assumptions about how trade works. Trade today bears little resemblance to the world in which David Ricardo lived - the one where England exchanged cloth for Portuguese wine (the example Ricardo used to illustrate his famous principle of comparative advantage). Chart 8Trade In Intermediate Goods Dominates To an increasingly large extent, countries do not really trade with one another anymore. One can even go as far as to say that different companies do not really trade with each other in the way they once did. A growing share of international trade is between affiliates of the same companies. Trade these days is dominated by intermediate goods (Chart 8). The exchange of goods and services takes place within the context of a massive global supply chain, where such phrases as "outsourcing," "vertical integration" and "just-in-time inventory management" have entered the popular vernacular. This arrangement has many advantages, but it also harbors numerous fragilities. A small fire at a factory in Japan that manufactured 60 percent of the epoxy resin used in chip casings led to a major spike in RAM prices in 1993. Flooding in Thailand in 2011 wreaked havoc on the global auto industry.3 The global supply chain is highly vulnerable to even small shocks. Now imagine an across-the-board trade war. Equities represent a claim on the existing capital stock, not the capital stock that might emerge after a trade war has been fought. A trade war would result in a lot of stranded capital. It is not surprising that investors are worried. Trump's Dubious Trade Doctrine The psychology of a trade war today is not that dissimilar to that of an actual war among the great powers. It would be immensely damaging if it were to happen, but because everyone knows it would be so damaging, it is less likely to occur. How then should one interpret President Trump's tweet that "Trade wars are good, and easy to win?" One possibility is that he is bluffing. The U.S. exported only $131 billion in goods to China last year, which is less than the $150 billion in Chinese imports that Trump has already targeted for tariffs. China simply cannot win a tit-for-tat trade war with the United States. Unfortunately, there is also a less charitable interpretation, as revealed by the second part of Trump's tweet, where he said, "When we are down $100 billion with a certain country and they get cute, don't trade anymore - we win big. It's easy!" Trump seems to equate countries with companies: Exports are revenues and imports are costs. If a country is exporting less than it is importing, it must be losing money. This is deeply flawed reasoning. I run a trade deficit with the place where I eat lunch, but I don't go around complaining that they are ripping me off. One would think that Trump - whose businesses routinely spent more than they earned, accumulating debt in the process - would understand this. But apparently not. As we discussed two weeks ago, the U.S. runs a trade deficit mainly because its deep and open financial markets, along with a relatively high neutral rate of interest, make it an attractive destination for foreign capital.4 If a country runs a capital account surplus with the rest of the world - meaning that it sells more assets to foreigners than it buys from foreigners - it will necessarily run a current account deficit. Trump's Macro Policy Colliding With His Trade Policy In this respect, President Trump's macroeconomic policies are completely at odds with his trade agenda. By definition, the current account balance is the difference between what a country saves and what it invests. The U.S. fiscal position is set to deteriorate over the coming years, even if the unemployment rate continues to fall - an unprecedented occurrence (Chart 9). A bigger budget deficit will drain national savings. Chart 9The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Meanwhile, an overheated economy will cause capital spending to rise as firms run out of low-cost workers. If Trump succeeds in boosting infrastructure spending, aggregate U.S. investment will rise even more. The current account deficit is highly likely to widen in this environment. A Temporary Reprieve? Chart 10Trump's Protectionist Agenda Is A ##br##Popular One Among Republican Voters The prospect of a wider trade deficit means that Trump's protectionist wrath will not go quietly into the night. It may, however, go into remission for a little while. Trump's approval rating has managed to rise over the past few months because his protectionist agenda is popular with a large segment of the population (Chart 10). However, if the problems on Wall Street begin to show up on Main Street - as is likely to happen if stocks resume their decline - Trump will change his tune. This is especially true if a trade war threatens to hurt U.S. agricultural interests. Rural areas have been a key source of support for Trump's populist rhetoric. Trump has shown a willingness to cut a deal on trade even if the negotiated outcome falls well short of his bluster. Consider the agreement between the U.S. and Korea in late March to amend their existing trade pact. Trump had called the South Korea-U.S. Free Trade Agreement an "unacceptable, horrible deal" and a "job killer." After the agreement was renegotiated, the President described it as a "wonderful deal with a wonderful ally." What did Trump get that was so wonderful? The Koreans agreed to double the ceiling on the number of U.S. automobiles that can be exported to Korea without having to meet the country's tough environmental standards to 50,000. The problem is that the U.S. only shipped 11,000 autos to Korea last year, so the original quota was nowhere close to binding. The Koreans also agreed to reduce steel exports to the U.S. to about 70% of the average level of the past three years in exchange for a permanent exemption from Trump's 25% steel tariff. That may sound like a major concession, but keep in mind that only 12% of Korea's steel exports go to the United States. Korea also re-exports steel from other countries. These re-exports can be curtailed without causing major damage to Korea's steel industry. The shares of Korea's largest publicly-listed steel companies jumped by 1.7% on the first trading day after news of the deal broke, eclipsing the 0.8% rise in the KOSPI index. Investment Conclusions The global economy is going through a soft patch and this could weigh on stocks in the near term. However, if trade frictions fade into the background and global growth stabilizes over the coming months, as we expect will be the case, global equities should rally to fresh cycle highs. Granted, we are in the late stages of the business-cycle expansion. U.S. interest rates are likely to move into restrictive territory in the second half of 2019. Given the usual lags between changes in monetary policy and the real economy, this would place the next recession in 2020. By then, barring any fresh stimulus, the U.S. fiscal impulse will have dropped below zero. It is the change in the fiscal impulse that matters for growth. If growth has already slowed to a trend-like pace by late 2019 due to a shortage of workers, the economy could easily stall out in 2020. Given the still-dominant role played by U.S. financial markets, a recession in the U.S. would quickly be transmitted to the rest of the world. Stocks will peak before the next recession starts, but if history is any guide, this will only happen six months or so before the economic downturn begins (Table 1). This suggests that the equity bull market still has another 12-to-18 months of life left. The extent to which investors may wish to participate in any blow-off rally this year is a matter of personal preference. As was the case in the late 1990s, long-term expected returns have fallen to fairly low levels. A comparison between the Shiller P/E ratio and subsequent 10-year returns over the past century suggests that the S&P 500 will deliver a total nominal annualized return of only 4% during the next decade (Chart 11). A composite valuation measure incorporating both the trailing and forward P/E ratio, price-to-book, price-to-cash flow, price-to-sales, market cap-to-GDP, dividend yield, and Tobin's Q shows only modestly higher expected returns for stock markets outside the U.S. (Appendix A). Table 1Cyclically, It Is Too Soon To Get Out... Chart 11...But Long-Term Investors, Take Note As such, while we recommend overweighting global equities over a 12-month horizon, we would not fault long-term investors for taking some money off the table now. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Take Out Some Insurance," dated February 2, 2018. 2 Roughly speaking, the Ricardian model predicts that the welfare loss from protectionism will be one-half times the average percentage-point increase in tariffs times the change in the import-to-GDP ratio. Imports are about 15% of U.S. GDP. Consider a 10 percent across-the-board increase in tariffs. Assuming a price elasticity of import demand of 4, this would reduce trade by 1-0.96^10=0.33 (i.e., 33%), which would take the import-to-GDP ratio down from 15% to 10%. As such, the welfare loss would be 0.5*0.1*(15%-10%)=0.25%, or just one quarter of one percent of GDP. 3 James Coates, "Real Chip Shortage Or Just A Panic, Crunch Is Likely To Boost Pc Prices," Chicago Tribune, dated August 6, 1993. "Thailand Floods Disrupt Production And Supply Chains," BBC.com, dated October 13, 2011; Ploy Ten Kate, and Chang-Ran Kim, "Thai Floods batter Global Electronics, Auto Supply Chains," Reuters.com, dated October 28, 2011. 4 Please see Global Investment Strategy Weekly Report, "U.S.-China Trade Spat: Is R-Star To Blame?" dated April 6, 2018. APPENDIX A Chart 1Long-Term Real Return Prospects Are Slightly Better Outside The U.S. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Oil markets could get even tighter, depending on fundamental "known unknowns." Chart of the WeekEM Import Volumes Continue Expanding,##BR##Reflecting Rising Incomes And Oil Demand The largest of these unknowns are the evolution of Iranian and Venezuelan oil output. With the May 12 deadline for U.S. President Donald Trump to waive trade sanctions against Iran fast approaching, and Venezuela's output in free fall, supply could contract dramatically. On the demand side, our short-term trade model is signaling EM imports continue to grow, which indicates continued income growth (Chart of the Week). EM growth drives oil demand growth. DM growth also will support commodity demand this year and next. The likelihood oil prices push toward - or exceed - $80/bbl this year is high. An extension of OPEC 2.0's production cuts into next year all but assures such excursions in 2019.1 Our forecast for 2018 remains at $74 and $70/bbl for Brent and WTI; we are leaving our 2019 forecasts at $67 and $64/bbl, respectively, but anticipate raising them as OPEC 2.0 forward guidance evolves. Energy: Overweight. Oil trade recommendations closed in 1Q18 were up an average 82%. The trades were initiated between Sep/17 and Jan/18. Base Metals: Neutral. LME aluminum's backwardation extends to end-2021, reflecting tighter physical markets. This supports our long S&P GSCI call, which is up 11.4% since Dec 7/17, when we recommended it. Precious Metals: Neutral. We are getting tactically long spot silver at tonight's close. Back-to-back physical deficits in 2016 and 2017, global income growth, and near-record speculative short positioning in COMEX silver - 79.8k futures contracts - are bullish. Ags/Softs: Underweight. Importers of U.S. sorghum into China now are required to post a 179% deposit with Chinese customs, according to Xinhuanet. The state-run news agency reported Ministry of Commerce findings of a surge in U.S. imports - from 317k MT in 2013 to 4.80mm MT in 2017 - which drove down local prices 31%, and "hurt local industries." Feature Our updated balances modeling indicates oil markets remain tight, and will continue to tighten this year, given our fundamental assumptions for supply and demand (Chart 2). We now estimate slightly lower crude oil production this year - 99.73mm b/d vs. our March estimate of 100.20mm b/d - with OPEC output at 32.12mm b/d, vs. 32.50mm b/d last month (Table 1). This is offset by non-OPEC supply growth, which continues to be led by rising U.S. shale-oil output (Chart 3). We expect production in the "Big 4" basins - Bakken, Permian, Eagle Ford and Niobrara - to average just over 6.44mm b/d this year, up 1.21mm b/d y/y, and 7.78mm b/d next year, up just over 1.34mm b/d. Chart 2Oil Markets Will Tighten Further Chart 3Lower OPEC Production Offset By U.S. Shales Table 1BCA Global Oil Supply - Demand Balances (mm b/d) We are leaving our consumption growth estimate for this year unchanged at 1.70mm b/d, bringing demand to 100.32mm b/d in 2018 on average, and raising our expectation for 2019 to 1.70mm b/d growth, which will take it to 102.00mm b/d on average (Chart 4). Global inventories will continue to drain on the back of these bullish fundamentals, falling somewhat more than we expected last month (Chart 5). We would note the trajectory of inventory growth likely will be altered once we have definitive 2019 production guidance from OPEC 2.0 - i.e., we expect some production cuts to be maintained next year, keeping inventories closer to end-2018 levels. These fundamentals leave our price forecasts unchanged at $74 and $70/bbl for Brent and WTI this year, and $67 and $64/bbl, respectively, next year (Chart 6). Again, we caution clients we fully expect to raise our 2019 forecast as OPEC 2.0 forward guidance evolves. Ministers of the coalition met this month in New Delhi and Riyadh, presumably to discuss institutionalizing their confederation.2 Chart 4Oil Demand##BR##Remains Stout Chart 5Bullish Fundamentals##BR##Drain Inventories Chart 6Price Forecast Unchanged,##BR##But Upside Risks Are Rising Once Again With "Known Unknowns"3 Supply-Side "Known Unknowns" A critical juncture in the evolution of the oil markets is fast approaching: The May 12 deadline for U.S. President Donald Trump to waive trade sanctions against Iran, and a determination on whether the U.S. will impose sanctions directly against Venezuela's oil industry. We have no advance knowledge of what the administration will do, but the signaling from the Trump White House has us inclined to believe the Iran sanctions will not be waived this time around. Action against Venezuela also is difficult to predict, but, of late, markets are sourcing alternative crude streams against a growing likelihood such sanctions will be imposed.4 Approaching the deadline for waiving Iranian sanctions, we have Iranian crude production at ~ 3.85mm b/d in 2H18, and a little over 3.90mm b/d next year. Prior to sanctions being lifted in January 2016, Iran was producing 2.80mm b/d. It is difficult to determine what will happen if sanctions are not waived by the U.S. - critically, whether U.S. allies will support such a move - so it is difficult to determine how deeply Iranian production and exports will be affected, if at all. S&P Global's Platts service noted a former Obama administration official estimated as much as 500k b/d of Iranian exports could be lost to the market, should the sanctions be restored. Other estimates range as high as 1mm b/d.5 We are carrying Venezuelan crude production at 1.52mm b/d for March, and have it declining to just over 1.40mm b/d by December. Last year, production averaged just over 1.90mm b/d. The government of Nicolas Maduro has run the economy and the state oil company, PDVSA, into the ground. Inflation came in at 454% in 1Q18, leaving prices up 8,900% in the year ended in March, according to Reuters.6 Presently, oil workers are fleeing PDVSA in a "stampede," according to Reuters, leaving the company woefully short of experienced personnel.7 The company lacks the wherewithal to pay for basic additives (diluents) to make its crude oil marketable. It is possible some of the company's creditors in Russia or China will step in to take over operations, but so far nothing has been announced. Demand-Side "Known Unknowns" Our demand estimates are premised on continued global growth this year and next, consistent with the IMF's latest global economic assessment.8 The Fund expects global GDP growth of 3.9% this year and next, which we incorporate into our modeling. Aside from the usual litany of long-term economic ills plaguing DM and EM economies - high debt levels, aging populations, falling labor-force participation rates, low productivity growth, and the need for diversification among commodity-exporting EM economies - trade tensions have become a more prominent risk. The Fund notes increasing trade tensions - set off by the U.S. imposition of tariffs on aluminum and steel imports - have the potential to "undermine confidence and derail global growth prematurely." These tensions have been stoked by tit-for-tat tariff announcements by the U.S. and China over the past month or so. Our own research supports this concern, which we believe is particularly acute for EM economies, where income growth, trade and commodity demand are inextricably entwined. Continued EM trade growth is essential for commodity demand growth, particularly for oil: A 1% increase in EM import volumes has translated into roughly a 1% increase in Brent and WTI prices since 2000. These variables all are linked: EM economic growth correlates with higher incomes, higher commodity demand and higher import volumes.9 EM growth accounts for slightly more than three-quarters of the overall oil-demand growth we expect this year and next - ~ 1.30mm b/d of the 1.70mm b/d of growth we are forecasting. While the odds of a full-blown trade war remain low, in our estimation, we could begin to see the erosion of confidence and the potential for growth to be derailed affecting investment, trade volumes and EM growth generally, which would be bearish for oil demand growth. That said, we share the view articulated by our colleagues in BCA's Global Investment Strategy last week: "Just as investors were overly complacent about protectionism a few months ago, they have become overly alarmist now." "Both the U.S. and China have a strong incentive to reach a mutually-satisfying agreement over trade. President Trump has been able to shrug off the decline in equities because his approval rating has actually risen during the selloff ... . However, if the problems on Wall Street begin to show up on Main Street - as is likely to happen if stocks continue to fall - Trump will change his tune."10 A Note On Permian Basis Differentials WTI - Midland differentials recently weakened considerably, as take away capacity out of the basin became strained (Chart 7). Weakness in the Light Houston Sweet differentials, which measure the spread between the producing and consuming markets for WTI produced in the Permian, traded as wide as -$9.00/bbl. This market has experienced similar such widening of the basis, which can be seen in the WTI-Midland vs. WTI - Cushing differentials, which widened considerably when Permian production increased (Chart 8).11 These basis blowouts typically incentivize additional pipeline capacity. Indeed, earlier this year, some 2.4mm b/d of new takeaway capacity had been proposed by pipeline operators.12 Once this capacity is online, we expect to see WTI exports from the Gulf increasing. Chart 7Growing Pains In The Permian:##BR##Takeaway Capacity Constraints Chart 8Permian Crude Oil Production##BR##Exceeded Takeaway In The Past Bottom Line: We are maintaining our $74 and $70/bbl prices forecasts for Brent and WTI in 2018, and expect to revise our 2019 forecasts of $67 and $64/bbl, respectively, once we get definitive forward guidance from OPEC 2.0. We continue to monitor supply-side risk - chiefly re Venezuela and Iran - and trade-war threats to the demand side, for any information that could cause us to substantially revise our forecasts. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 OPEC 2.0 is the name we coined for the OPEC/non-OPEC producer coalition lead by the Kingdom of Saudi Arabia (KSA) and Russia. Member states pledged to remove 1.80mm b/d of production from the market, of which some 1.2mm b/d is believed to be actual production cuts, while the remainder is comprised of involuntary losses from Venezuela and other producers unable to offset decline curve losses. 2 Please see S&P Platts OPEC Guide of April 16, 2018, entitled "OPEC MAR CRUDE OIL PRODUCTION TUMBLES TO 32.14 MIL B/D, DOWN 250,000 B/D FROM FEB: PLATTS SURVEY," which reports on the OPEC 2.0 ministerial meetings this month in New Delhi and Riyadh. 3 "Known Unknowns" is a phrase popularized by Donald Rumsfeld, a former U.S. Secretary of Defence in the administration of George W. Bush, at a press conference. Please see the U.S. Department of Defence "News Transcript" of February 12, 2002, at http://archive.defense.gov/Transcripts/Transcript.aspx?TranscriptID=2636 4 Please see "A U.S. Ban On Crude Imports," published by vessel tracker KPLER April 13, 2018. 5 Please see "US foreign policy turn could take 1.4 million b/d off global oil market: analysts," published by S&P Global Platts March 20, 2018. 6 Please see "Venezuela inflation 454 percent in first quarter: National Assembly," published by reuters.com on April 11, 2018. 7 Please see "Under military rule, Venezuela oil workers quit in a stampede," published by uk.reuters.com on April 17, 2018. 8 Please see "Global Economy: Good News for Now but Trade tensions a Threat," published on the Fund's blog April 17, 2018. 9 Please see "Trade Tensions Cloud Oil Outlook," in the March 8, 2018, issue of BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 10 Please see "Is China Heading For A Minsky Moment?" in the April 13, 2018, issue of BCA Research's Global Investment Strategy. It is available at gis.bcaresearch.com. 11 LHS data is limited, as it only recently emerged as a benchmark for the Houston refining market. 12 Please see "Operators Race to Build Pipelines As Permian Nears Takeaway Capacity," in the March 2018 issue of Pipeline & Gas Journal. 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 U.S. Treasury Curve: The U.S. Treasury curve has flattened to new cyclical lows as the market has moved to fully price in the Fed's interest rate forecasts. Inflation expectations must rise further for those forecasts to be fully realized, however. Expect renewed U.S. curve steepening through higher inflation expectations and longer-term Treasury yields in the next 3-6 months. UST-Bund Spread Update: Stay in our recommended 10yr UST-Bund spread widening trade. as Treasury yield increases will not be matched in Bunds given slowing euro area economic momentum and a more balanced tone from the ECB. Global IG Corporate Sector Allocation: Our investment grade (IG) sector allocations, taken from our relative value models, have added positive performance since our last update in August. Feature The unpredictable, and at times unruly, behavior of financial markets over the first few months of 2018 has been exhausting for investors. A calm January was followed by the early February volatility spike and, more recently, huge intraday swings based on the ebb and flow of news on U.S. trade and foreign policy. Yet when looking at the year-to-date returns for various asset classes, the numbers do not seem unusually alarming given the amount of surrounding noise. Chart of the WeekA Long Road Back From The VIX Spike The S&P 500 index is only down -0.7%, while both equities in both the euro area and emerging markets (EM) equities are up +1.8% and +1.1%, respectively (using MSCI data in U.S. dollar terms). Credit markets are also delivering rather boring performance so far in 2018, from U.S. high-yield (+1.2% excess return over government debt) to euro area investment grade and EM hard currency corporates (both with an -0.1% excess return in U.S. dollar terms). Admittedly, these numbers look far less flattering considering the robust rally in risk assets in January. Yet the year-to-date returns simply do not line up with our impression of how investors' feel about how this year has gone so far. The perception is much gloomier than the actual outcome. Right now, markets are looking for guidance and direction and finding little of both. A big problem is that global bond yields, most notably in the U.S., have not fallen much from the highs for the year - even with global growth clearly losing some steam in the first quarter of 2018. The reason? Global inflation is in a mild cyclical upswing, a product of persistently tight labor markets and rising oil prices (Chart of the Week). The "leadership" in government bond markets has shifted away from accelerating global growth and an upward repricing of future central bank tightening, to rising inflation and unchanged monetary policy expectations. The notion of central bankers not being friendly to the markets remains our key theme for this year. We continue to expect that policymakers will not respond to the latest softer patch of economic data and will focus more on the reacceleration of inflation. This is especially true with risk assets stabilizing and volatility measures like the U.S. VIX index continuing to drift lower and, more importantly, the "volatility of volatility" (as measured by the VVIX index) now back to the levels that prevailed before the early February volatility spike (bottom panel). Although as BCA's strategists discussed at our View Meeting yesterday, volatility can quickly return with a vengeance given softer global growth momentum, and with the geopolitical calendar heating up next month (the U.S. government must make its final decision on the China trade tariffs and investment restrictions).1 This led the group to downgrade our recommended global equity exposure and upgrade our global bond exposure on a tactical (0-3 months) basis, although our more medium-term cyclical allocations (6-12 months) were unchanged (overweight stocks versus bonds). From the point of view of global bond markets, we may now be in period of mild "stagflation" with softening growth and rising inflation. We remain of the view that the former is temporary and the latter is not. This backdrop will keep global bond yields under upward pressure for at least the next few months, with better expected performance of corporate debt over governments - albeit with the potential for higher volatility given more elevated geopolitical risks. What Next For The U.S. Treasury Curve? The Treasury curve flattened to a new cyclical low last week, with the spread between 2-year and 10-year bonds now sitting at 45bps. On the surface, this flattening seems consistent with a Fed that is maintaining a "cautiously hawkish" message and that its rate hike plans for 2018 are unchanged despite more volatile financial markets. Chart 2This UST Curve Flattening Is Different What makes this current episode different from other bouts of Treasury curve flattening over the past five years, however, is the starting point for the absolute of bond yields. According to our two-factor valuation model for the 10-year Treasury yield, yields are now just a touch above fair value, which is currently 2.78%. That yield valuation was at least +25bps before the previous flattening episodes between 2014 and 2017 (Chart 2). That distinction is critical in differentiating a bull flattener from a bear flattener. Simply put, longer-dated Treasuries are not yet cheap enough to suggest that investors should extend duration risk to benefit from any additional curve flattening from here. In fact, we see a greater risk that Treasury curve re-steepens a bit from here, as there is more room for longer-term inflation expectations to move higher than there is for the front-end of the curve to reprice an even more hawkish Fed. The recent softening of cyclical global economic data has been occurring while realized inflation rates have been slowly rising from depressed levels (Chart 3). Yet in the U.S., the slowing of growth seen in the first quarter of the year remains very modest compared to that seen in Europe or Japan, while core inflation rates (for both the CPI index and the PCE deflator) have accelerated back to 2%. The Atlanta Fed's GDPNow forecasting model is calling for Q1/2018 growth of 1.9%, while the New York Fed's Nowcast model is predicting Q1 growth of 2.8%. While both forecasts are a deceleration from the 3% rates seen in the previous three quarters in 2017, neither is below U.S. potential GDP growth, which the U.S. Congressional Budget Office now estimates to be 1.9%. Even in China, where the economy had been slowing as policymakers have aimed to tighten monetary policy and slow credit growth, cyclical indicators such as the Li Keqiang index (the preferred indicator of our China strategists) have shown a bit of a rebound of late. Right now, underlying U.S. growth and inflation momentum are still pointing towards the Fed delivering on its current projection of an additional 50bps of rate hikes in 2018, taking the funds rate to 2.25%, with even a chance of an additional hike if inflation continues to accelerate. This is essentially fully priced with a 2-year Treasury yield just under 2.4%, however, and the real funds rate is now at neutral according to measures like the Fed's r-star. Therefore, additional flattening pressures from the front end of the curve are unlikely unless the Fed is willing to signal a faster pace of rate hikes than currently laid out in its economic projections (the "dots"). At the same time, the 10-year TIPS inflation breakeven remains 25-35bps below the 2.4-2.5% range that would be consistent with the market expecting U.S. inflation to sustainably return to the Fed's 2% inflation target on the headline PCE deflator. Hence, a steeper Treasury curve is far more likely than a flatter Treasury curve from current levels. Where could this view go wrong? Perhaps the Trump administration's trade skirmishes with China could broaden into a full-on trade war that could cause deeper damage to U.S. equities, dampen growth expectations and drive longer-term yields lower. Coming at a time when there is a significant short position in the U.S. Treasury market, this could look similar to the prolonged bull-flattening seen in 2015-16. During that episode, duration exposure flipped from a big net short to very net long according to measures like the J.P. Morgan Duration Survey (Chart 4, top panel), while the market priced out all expected Fed rate hikes (2nd panel). However, that also occurred alongside a 50bp decline in inflation expectations (3rd panel) and a big deceleration of U.S. growth (bottom panel), both related to a weakening global economy and collapsing oil prices. It is uncertain if the current U.S.-China trade skirmish would have an equivalent impact on both the U.S. economy and the Treasury curve, especially given a starting point of stronger global growth a far more positive demand/supply balance in world oil markets. Chart 3A Whiff Of Stagflation? Chart 42018 Is Not 2015/16 In sum, we are sticking to our view that the Treasury curve is more likely to bear-steepen through higher longer-term yields than flatten bearishly through more discounted Fed hikes or flatten bullishly through much weaker growth and inflation. We continue to recommend a below-benchmark duration stance in the U.S., within an underweight allocation in a currency-hedged global government bond portfolio. We are also are sticking with our tactical trade of staying short the 10-year U.S. Treasury versus the 10-year German Bund, even with the spread now looking a bit too wide on our fundamentals-based valuation model (Chart 5). The unrelenting string of disappointing economic data in the euro area has already resulted in a far more cautious tone from European Central Bank (ECB) officials regarding the potential for quick rate hikes after the expected end of the asset purchase program at the end of this year. The gap between the U.S. and euro area data surprise indices has proven to be a good directional indicator for the Treasury-Bund spread (Chart 6, bottom panel). Given our views on the potential for renewed bear-steepening in the Treasury curve, which is unlikely to be matched in the German curve in the next 3-6 months, we see no reason to take profits yet on our spread trade. Chart 5UST-Bund Spread Now A Bit Too Wide... Chart 6...But Too Soon For Spread Tightening Bottom Line: The U.S. Treasury curve has flattened to new cyclical lows as the market has moved to fully price in the Fed's interest rate forecasts. Inflation expectations must rise further for those forecasts to be fully realized, however. Expect renewed U.S. curve steepening through higher inflation and longer-term Treasury yields in the next 3-6 months. Stay in our recommended 10-year Treasury-Bund spread widening trade, as Treasury yield increases will not be matched in Bunds given slowing euro area economic momentum and a more balanced tone from the ECB. A Brief (And Belated) Performance Update For Our Corporate Bond Sector Allocations It has been some time (August 2017) since we last published a performance update for our investment grade (IG) corporate sector allocations for the U.S., euro area and U.K. As a reminder, those allocations come from our relative value model, which is designed to measure the valuation of each individual sector compared to the overall Barclays Bloomberg corporate bond index for each region. The methodology takes each sector's individual option-adjusted spread (OAS) and regresses it in a panel regression with all the other sectors in each region, as a function of the sector's duration, convexity (duration squared) and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and the fair value OAS is our valuation metric from the model for each region. The latest output from the models can be found in the tables and charts in the Appendix starting on Page 14. We also show the duration-times-spread (DTS) for each sector in those tables, using that as our primary way to measure the volatility of each sector. The scatterplot charts in the Appendix show the tradeoff between the valuation residual from our model and each sector's DTS. Chart 7Performance Of Our IG Sector Allocations We then apply individual sector weights based on the model output and our desired level of overall spread risk that we wish to take in our recommended credit portfolio. At our last update in August 2017, we made a decision to keep the overall (weighted) DTS of our sector tilts roughly equal to the overall IG corporate DTS for each region. With credit spreads looking tight at the time, credit spread curves flat relative to history, and with the Fed in the midst of a tightening cycle, we did not see a case for taking aggressive spread risk (i.e. having a high aggregate DTS) in the portfolio. The performance of our latest sector recommendations since our last update in August 2017, and in the first quarter of 2018, are shown in Chart 7. We show both the total return and excess return of each sector versus duration-matched government bonds. Since that last review, our U.K. sector allocations have performed the best, delivering an additional 12bps of total return and 10bps of excess return versus the U.K. IG corporate index. Our euro area corporate allocations have added 2bps of total return and 3bps of excess return, while our U.S. allocations have modestly underperformed both on total return (-1bp) and excess return. We also show the performance numbers for just the first quarter of 2018 in Chart 7, and we will present the return numbers on this quarterly basis in the future as part of our regular model bond portfolio performance reviews. The sector allocations offered a modest underperformance in Q1 2018, with -5bps of total return and -8bps of excess return coming mostly from euro area and U.K. allocations. The U.S. allocations actually outperformed by +3bps on a total return basis in Q1. The return numbers for our U.S. sector allocations can be found in Table 1. Since our last update in August, the best performing sectors (in excess return terms) for our U.S. portfolio allocation were the overweights to all Energy sub-sectors (+35bps combined), Cable & Satellite (+4bps) and Banks (+4bps). Of those names, only the Independent Energy sub-sector delivered a positive excess return (+3bps) in Q1 2018. Table 1U.S. Investment Grade Performance The return numbers for our euro area sector allocations can be found in Table 2. Since our last update in August, the best performing sectors (in excess return terms) for our euro area portfolio allocation were the overweights to Financials (+35bps, coming mainly from Banks, Senior Debt and Insurance) and Integrated Energy (+13bps). Those overweights also delivered small positive excess returns (+3bps and +1bps, respectively) in Q1 2018. The return numbers for our U.K. sector allocations can be found in Table 3. Since our last update, the best performing sector (in excess return terms) was the overweight to Financials (+6bps, coming mostly from Banks). Looking ahead, credit spread curves remain very flat by historical standards (Chart 8), which suggests there is not enough spread compensation for extending credit risk to lower quality tiers. Thus, we are sticking with keeping our target DTS for our combined sector allocations equal to that of the overall IG index for each region. We will update our sector allocations in an upcoming Weekly Report. Table 2Euro Area Investment Grade Performance Table 3U.K. Investment Grade Performance Chart 8Credit Quality Curves Remain Very Flat Bottom Line: Our investment grade (IG) sector allocations, taken from our relative value models, have added positive performance since our last update in August. We continue to recommend a cautious approach to sector allocation, targeting index levels of spread risk (in aggregate) in the U.S. euro area and U.K. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility", dated April 11, 2018, available at gps.bcaresearch.com. Appendix Appendix Chart 1U.S. Corporate Sector Valuation And Recommended Allocation* Appendix Chart 1U.S. Corporate Sector Risk Vs. Reward* Appendix Table 2Euro Area Corporate Sector Valuation And Recommended Allocation* Appendix Chart 2Euro Area Corporate Sector Risk Vs. Reward* Appendix Table 3U.K. Corporate Sector Valuation And Recommended Allocation* Appendix Chart 3U.K. Corporate Sector Risk Vs. Reward* Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Capacity cuts in China's steel and aluminum industries over the winter produced little in the way of output reductions, confounding our expectations. The resulting unintended inventory accumulation in Asian markets, reflecting high production relative to demand, and slowing Chinese steel exports are a downside risk to our neutral view. U.S. sanctions against Russian oligarchs close to President Putin could tighten the aluminum market, countering the unintended inventory accumulations. For now, we remain neutral base metals. Energy: Overweight. We are closing our long put spread position in Dec/18 Brent options at tonight's close. The fast-approaching May 12 deadline for President Trump to renew sanctions waivers against Iran shifts the balance of price risks to the upside. Base Metals: Neutral. COMEX copper rallied above $3.10/lb on the back of Chinese President Xi's remarks at the Boao Forum earlier this week, which re-hashed plans to open China's economy to imports. Precious Metals: Neutral. Gold likely becomes better bid as the May 12 deadline to waive Iran sanctions nears. Our long gold portfolio hedge is up 8.9%. Ags/Softs: Underweight. European buyers are scooping up U.S. soybeans, as Chinese purchases of Brazilian beans makes U.S.-sourced crops relatively cheaper, according to Reuters.1 China also announced plans to start selling corn stocks from state reserves this week, offering an alternative protein for animals to partially offset the price impact of tariffs on their imports of U.S. soybeans. Feature Chart of the WeekAluminum Rebounds On U.S. Sanctions Despite much-ballyhooed capacity reductions in China's steel and aluminum capacity, these markets - both in China and globally - remained relatively well supplied over the winter. Higher global supplies, and falling Chinese steel exports, will result in unintended inventory accumulation, which already is showing up in Shanghai Futures Exchange (SHFE) inventories. While we remain neutral base metals, continued unintended inventory accumulation could cause us to downgrade the sector. The MySteel Composite Index we use to track steel prices is down more than 10% since the beginning of the year (Chart of the Week). Similarly, the first-nearby primary aluminum contract on the LME was down ~ 12% year-to-date (ytd) early last week, before regaining most of these losses on news of U.S. sanctions against Russian oligarchs, which hit shares of Rusal very hard. Given that these sanctions will restrict access to up to 6% of global aluminum supply, ex-China supply dynamics will dominate the aluminum market this year making the outlook relatively favorable, putting a floor beneath the London Metal Exchange Index (LMEX).2 Ex-Post Winter Production Production cuts over the winter - when Chinese mills in 28 smog-prone northern cities were ordered to reduce capacity by up to 50% - did not live up to our expectations.3 China's steel and aluminum sectors have undergone major supply-side reforms, particularly re the removal of outdated capacity, most of which has been completed. In addition to the winter capacity cuts, past reforms that have already been implemented, and have shaped current market conditions, are as follows: In an effort to eliminate outdated and unlicensed facilities, China removed an estimated 3-4 mm MT of annual capacity in 2017 - amounting to approximately 10% of total aluminum smelting capacity. In the case of steel, Beijing announced plans to shut down 150 mm MT of annual steel capacity between 2016 and 2020. To date, 115 mm MT of capacity have already been eliminated. Another estimated 80-120 mm MT of induction furnace capacity was shuttered in 1H17. Going forward, China's steel and aluminum markets will be driven by: An estimated 3-4 mm MT of updated aluminum capacity is expected to come on line this year, offsetting constraints from last year's supply cuts. 30 mm MT of steel capacity shutdowns are planned this year, putting Beijing on track to meet its five-year target two years ahead of schedule. The Chinese National Development and Reform Commission (NDRC) has communicated its resolve to keep shuttered capacity offline. Major steelmaking cities in Hebei province - accounting for 22% of 2017 Chinese crude steel output - have announced plans to extend the capacity cuts to November 2018. The mid-November to mid-March capacity cuts implemented this past season are expected to be a recurring event. Winter Shutdowns Minimally Impact China's Steel Output ... According to steel production data released by the World Steel Association (WSA), winter capacity closures in China did not significantly affect overall output levels. Crude steel output from China was up 3.9% year-on-year (y/y) in the November to February period (Chart 2). At the same time, production from the rest of the world increased by 3.6% y/y in the November to February. Thus global crude steel supply remained in excess over the winter season, as global steel output increased 3.8% y/y. A caveat to these data: China does not account for the historical output of induction furnaces, which produced an estimated ~30-50 mm MT of steel in 2016. As mentioned in our previous research, the output of these furnaces was illegal and thus not carried in statistics we use to track supply.4 These data problems mean it is possible that actual output in the November 2016 to February 2017 period was higher than suggested by the data, and as a result, actual output during this year's winter season may actually be lower than last year. As induction-furnace data lie in the statistical shadows, we cannot ascertain this with certainty. Nevertheless, a buildup in China inventories - which we discuss below - indicates an oversupplied market. It is also likely producers - incentivized by high steel prices earlier this year - kept capacity utilization at maximum levels throughout the winter. ... And Aluminum Output According to International Aluminum Institute data, primary aluminum output in China fell 2.3% y/y in the November to February period, suggesting the winter cuts likely had an impact on aluminum supply (Chart 3). Data from the World Bureau of Metal Statistics (WBMS) show an even sharper decline in winter aluminum output: primary production in China fell 8.7% y/y in the November to January period. Chart 2Steel Output Grew##BR##Amid Winter Cuts Chart 3China Aluminum Market In Surplus##BR##Despite Production Decline Both sources reveal an especially pronounced contraction in November, at the onset of the winter cuts. Despite reduced supply, WBMS data indicate a positive Chinese aluminum market balance throughout the winter. A large contraction in demand offset the supply shortfall, and kept primary aluminum in a physical surplus throughout the winter, ultimately leading to a buildup in domestic inventories. A Look At The Trade Data Despite our disappointment regarding the impact of the winter cuts on steel and aluminum markets, trade data increasingly suggests China's steel exports have peaked. Aluminum exports from China, on the other hand, are likely to continue rising. Chinese Steel Exports Continue To Fall ... Chinese steel product net exports have been falling since mid-2016, and have continued falling in y/y terms throughout the winter. According to Chinese customs data, steel product net exports fell 35.1% y/y in the November to February period, driven by both falling exports as well as rising imports (Chart 4). Steel product exports plunged 30% y/y in the November to February period, more or less in line with the 2017 average. The decline mirrors the 2017 contraction in domestic supply, bringing exports to their lowest level since 2012. This indicates fears of a China slowdown leading to a flood of metal onto global markets have not materialized, at least not yet. In fact, Customs data show a 1.7% y/y increase in Chinese steel imports during the November to February period - a reversal from falling imports prior to the winter season. The conclusion we draw from this is that, while in the past, China was a source of supply for the world, ongoing capacity cuts and production controls could mean China will lack the ability to ramp up output in case of a global physical supply deficit. If this becomes the new normal, price volatility will likely increase. This trend is important, especially given our expectation of strong world ex-China demand this year. As such, global steel prices may find support amid this new normal. ... But Aluminum Exports Move Higher In the case of aluminum, Chinese net exports were up 28.7% y/y during the winter, continuing their upward trend. Customs data show a 14.8% y/y increase in aluminum exports in November to February, bringing exports in this period to their highest level since 2014/15 (Chart 5). At the same time, imports of aluminum have come down during this period - by 37.2% y/y. According to China customs data, 2017 imports over these winter months registered their lowest level since 1994. Chart 4Steel Exports Continue Falling ... Chart 5...While Aluminum Exports Are On the Uptrend The combination of growing exports amid falling imports puts China's net exports in expansionary territory. This will be especially true given the planned increase in capacity this year amid weak Chinese demand. All in all, ceteris paribus global supply of aluminum looks set to increase. However, we do not live in a ceteris paribus world and, as we explore below, sanctions against the top aluminum producer outside of China will have massive implications on the global aluminum supply chain. Are Inventories Due For A Turnaround? Chart 6Larger Than Expected##BR##Seasonal Inventory Buildup China Iron and Steel Association data indicate that since the beginning of the year, steel product inventories have been re-stocked to levels last seen in 1Q14. Inventories of the five main steel products we track have more than doubled since the beginning of the year (Chart 6). Although the Q1 build is seasonal, the re-stocking since the beginning of the year has been especially pronounced. This buildup occurred in an environment of stable supply - with minimal impact from the winter capacity cuts - amid weak exports, indicating domestic demand for the metal was subdued. However, steel inventories have turned around, and we expect further destocking as demand accelerates post the Chinese New Year. The question remains whether this destocking will bring inventories back down to their 5-year average. Aluminum inventories on the SHFE show similar dynamics. However in this case, it is part of the larger trend of rising stocks since the beginning of last year. Aluminum inventories at SHFE warehouses are up more than nine-fold - or 0.87 mm MT - since the end of 2016. In fact, the pace of buildup seems to have accelerated: the average weekly build of 16.6k MT of aluminum coming into warehouse inventories since the beginning of the year stands above the 2017 average weekly build of 12.6k MT. This brought SHFE aluminum inventories to almost 1 mm MT, more than double their previous record in 2010. Although the Chinese physical aluminum surplus weighed down on prices in 1Q18, we expect global aluminum prices to remain supported from here due to the impact of U.S. sanctions on world ex-China aluminum supply. U.S. Russian Sanctions Could Be A Game-Changer Chart 7Sanctions Will Restrict##BR##Marketable Aluminum Supply Last Friday, the U.S. announced sanctions on Russian oligarchs close to President Vladimir Putin. Among those sanctioned is Oleg Deripaska who controls EN+ Group, which owns a controlling interest in top aluminum producer United Company Rusal. Given that UC Rusal accounts for ~6% of global aluminum production, we view this move as significant to global aluminum markets. As the top producer of the metal outside China, Rusal aluminum likely makes up the majority of Russian supply, which account for 14% of U.S. imports (Chart 7). In fact, almost 15% of Rusal's revenues comes from its business with the U.S. While it is clear that these sanctions will, in effect, terminate aluminum trade between Russia and the U.S., more significant are the implications on the global supply chain. A clause in the U.S. Treasury Department's order extending the restrictions to non-U.S. citizens dealing with U.S. entities means the impact could be far-reaching, requiring a major re-shuffle in global aluminum trade. Earlier this week, the LME announced that it will no longer accept Rusal aluminum produced after April 6, effectively preventing the company's products from being delivered on the LME. These sanctions will likely turn global aluminum buyers off from Rusal products, as they can no longer deliver it to the LME. The net effect will be a contraction in global usable aluminum supply. Furthermore, these sanctions will likely disrupt supply chains as aluminum users scramble to avoid purchasing metal from the Russian producer. While the details of these restrictions are still unclear, the sanctions are a game changer in the global aluminum market - effectively restricting access to a major source of the metal. As such, primary aluminum on the LME is up more than 10% since the announcement last Friday. Bottom Line: While China's crude steel output increased y/y during government-mandated output cuts over the winter, seasonally weak demand meant that the metal piled up in inventories. Falling exports indicates that at least for now, the domestic surplus is not flooding global markets. The main risk to our neutral view here is that demand in China remains weak, and that this will lead to the offloading of Chinese metal to global markets, i.e. a pickup in exports. This has not yet materialized, so we are holding on to our neutral view for now. China's primary aluminum production declined y/y during the winter cuts. However the decline in domestic demand was greater - likely due to the decline in auto production and sales following the loss of tax credit incentives. Consequently, China's aluminum market remained in surplus throughout the winter. Some of the excess supply was exported, but SHFE inventories continued building. Our outlook on the aluminum market had been bearish, due to additional capacity coming online this year amid an uncertain China demand environment. However, the sanctions on Rusal could be a game changer, putting a floor beneath aluminum prices. This improves our near term outlook for the aluminum market. This makes our outlook on aluminum prices much more favorable. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see "As U.S. and China trade tariff barbs, others scoop up U.S. soybeans," published by reuters.com on April 8, 2018. 2 The six non-ferrous metals represented in the LMEX and their respective weights are as follows: aluminum: 42.8%, copper: 31.2%, zinc: 14.8%, lead: 8.2%, nickel: 2.0%, and tin: 1.0%. 3 China's winter smog "battle plan" targeted polluting industries in the northern China region by mandating cuts on steel, cement and aluminum production during the smog-prone mid-November to mid-March months. Steel and aluminum production cuts targeted a range between 30-50% during this period. This event is expected to be an annually recurring event until 2020. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "China's Environmental Reforms Drive Steel & Iron Ore," dated January 11, 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 Q1 Performance Breakdown: The GFIS recommended model bond portfolio returned -0.55% (hedged into U.S. dollars) in the first quarter of 2018, underperforming the custom benchmark index by -11bps. The overweight to U.S. corporate bonds was the main drag on performance. Stress Test & Scenario Analysis: We introduce a simple framework to conduct scenario analysis and stress testing of the model bond portfolio. Our conclusion is that some shifting in our corporate bond allocations - reducing exposure to U.S. investment grade, increasing exposure to euro area and emerging market corporates - can actually help eliminate expected losses in scenarios that run counter to our base case. Feature This week, we present our regular quarterly report on the performance of the BCA Global Fixed Income Strategy (GFIS) model bond portfolio. As a reminder to existing readers (and for new clients), the portfolio is a part of our service that is a departure from the usual BCA macro analysis of global fixed income markets. The model portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors, by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. This framework also gives us a vehicle to discuss many of the typical bond portfolio management issues that our clients face on a daily basis. In that vein, we are introducing a new element to our framework in this report - estimating future portfolio performance using scenario analysis, and conducting stress testing of outcomes that are contrary to our base case expectations for global bond markets. Q1/2018 Model Portfolio Performance Breakdown: An Unexpected Hit From U.S. Corporates Chart of the WeekShifting Correlations Hurt##BR##The Model Portfolio In Q1 The surge in global market volatility in the first quarter of the year weighed on the returns for the GFIS model bond portfolio. The portfolio had a total return of -0.55% (hedged into U.S. dollars), which lagged that of our custom benchmark index by -11bps.1 The quarter started out on a good note, with the portfolio outperforming by +12bps in January, as gains from our below-benchmark duration stance offset some underperformance from our overweight on global spread product. The story changed in early February, however, as the U.S. wage inflation "scare" and the associated VIX spike resulted in wider U.S. corporate bond spreads. This counteracted the gains on the government bond side of the portfolio as bond yields continued to climb. After yields peaked in mid-February, the portfolio gave back much of the outperformance from duration, with no recovery of the early February losses from spread product (Chart of the Week). In terms of the breakdown between the government bond and spread product allocations in our model portfolio, the former generated +9bps of outperformance versus our custom benchmark index while the latter underperformed by -19bps (Table 1). The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. The main individual sectors of the portfolio that drove the excess returns were the following: Biggest outperformers Underweight U.S. Treasuries (+16bps) Underweight emerging market (EM) U.S. dollar (USD) denominated corporate debt (+5bps) Overweight Japanese government bonds (JGBs) with maturities of ten years or less (+4bps) Underweight EM USD-denominated sovereign debt (+2bps) Biggest underperformers Overweight U.S. investment grade (IG) Financials (-14bps) Overweight U.S. IG Industrials (-8bps) Underweight JGBs with maturities beyond ten years (-8bps) Overweight U.S. Ba-rated high-yield (HY) corporates (-4bps) Table 1GFIS Model Bond Portfolio Q1-2018 Overall Return Attribution Chart 2GFIS Model Bond Portfolio Q1-2018 Government Bond Performance Attribution By Country Chart 3GFIS Model Bond Portfolio Q1-2018 Spread Product Performance Attribution By Sector The hits from the overweight positions in U.S. corporate debt were the most surprising, given that the U.S. economy and corporate profits are still expanding at a solid pace. That would typically keep corporate credit spreads well-behaved, especially when U.S. Treasury yields are rising or stable as was the case in the first quarter. Yet volatility has spiked and stayed elevated in response to heightened uncertainty over slowing global growth momentum, rising U.S. inflation and worries about future U.S. trade policy. Investors have demanded moderately higher credit risk premiums in the U.S. as a result, to the detriment of U.S. corporate bond performance. This can be seen in Chart 4, which presents the returns of the individual countries and spread product sectors in the GFIS model bond portfolio. The returns are hedged into U.S. dollars (we do not take active currency risk in this portfolio) and also adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market.2 On this "apples-for-apples" basis, U.S. IG corporates were the worst performing fixed income market in the first quarter of 2018. Chart 4Ranking The Winners & Losers From The Model Portfolio In Q1 Looking ahead, we see no need yet to get out of our recommended overweight in global spread product or underweight in global government bond exposure (Chart 5). While there are some signs of slowing growth momentum in major economies (euro area, China), a deeper slowdown is not being heralded by leading economic indicators, which continue to rise. Much of the global economy continues to operate at or beyond full employment, which will continue to put moderate upward pressure on inflation rates. This will force central banks to maintain a relatively hawkish bias, despite more elevated financial market volatility. The most likely outcomes are still more bearish for government bonds than for corporate credit. Chart 5We're Sticking With Our##BR##Spread Product Overweight Having said that - the higher volatility environment does argue for some reduction in the size of the spread product overweight in the model portfolio. Especially after we consider some scenario analysis on returns, as we discuss in the next section. Bottom Line: The GFIS recommended model bond portfolio returned -0.55% (hedged into U.S. dollars) in the first quarter of 2018, underperforming the custom benchmark index by -11bps. The overweight to U.S. corporate bonds was the main drag on performance, thanks to the more elevated level of market volatility and spread widening during the quarter. Stress Tests & Scenario Analysis A common analytical tool used by professional fund managers is to perform "stress tests" on their portfolios. This is done to estimate the size of potential losses that could occur after major market moves, typically those that went against current positioning in a portfolio. Those estimates are critical to the effective risk management of a portfolio. As part of the ongoing development of the infrastructure for our model bond portfolio framework, we are introducing scenario analysis and stress testing of our current recommended allocations. The goal is to determine the magnitude of potential returns that could be expected under our base case and alternative scenarios. This is meant to complement the main risk management tool that we added last year, a "risk budget" based on the tracking error (i.e. volatility difference) of the portfolio versus our custom benchmark.3 We have deliberately been targeting a modest tracking error for our model portfolio, given the historical richness (low yields, tight spreads) of so many parts of the global bond universe. Yet our estimate of the GFIS model bond portfolio's tracking error has fallen even below the low end of the 40-60bp range that we have been targeting (Chart 6).4 Chart 6Lower Tracking Error Through Higher##BR##Corporate Bond Volatility This appears to be due to an odd development. The model bond portfolio's volatility was running below that of its benchmark index over the past year, but with the increase in the return volatility of U.S. IG corporate debt - the biggest overweight within spread product - the portfolio's volatility has been converging to that of the benchmark from below, hence lowering the tracking error. In other words, being overweight U.S. IG was a portfolio diversifier last year, but that is no longer the case. This obviously highlights some of the limitations of using tracking error as the sole risk management tool for a bond portfolio. Shifting cross-asset correlations and volatilities can wreak havoc on any "guesstimate" of a portfolio's underlying risk. A more simple solution is to conduct scenario analysis of expected returns, then shock the analysis for changes in the underlying assumptions. The key is having a reasonable framework for estimating returns for various asset classes. For our purposes in the model portfolio, we are using a simple approach to forecast the expected returns. We use a factor-based framework that models changes in global bond yields as a function of changes in the following four variables: the U.S. dollar, the price of oil, the fed funds rate and the VIX index. We show the regression results of our factor-based modeling of yield changes for each spread sector in our model bond portfolio in Table 2A. We ran the regressions for different time horizons, but we decided on using the post-crisis period since 2009 in all cases. We also attempted to model the yield changes of government bonds using those same four factors, but the R-squareds for all those regressions were far too low to make them useful. We instead used a simple approach of calculating the beta since 2009 of changes in individual bond yields to changes in U.S. Treasury yields for each corresponding maturity bucket. We present those yield betas in Table 2B. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes Table 2BEstimated Government Bond Yield Betas To U.S. Treasuries With these tools, we can forecast returns for each bond sector under different scenarios. We can then use those forecasts to predict the expected return for our model bond portfolio under those same scenarios. In Tables 3A & 3B. We show three differing scenarios, with all the following changes occurring over a one-year horizon: Table 3AScenario Analysis For The GFIS Model Portfolio Table 3BU.S. Treasury Yield Assumptions For The Scenario Analysis Our Base Case: the Fed delivers another 75bps of rate hikes, the U.S. dollar rises by 5%, oil prices rise by 20% (the non-consensus view of BCA's commodity strategists), the VIX index stays unchanged at current elevated levels and there is a modest bear steepening of the U.S. Treasury curve. A Very Hawkish Fed: the Fed delivers 150bps of rate hikes, the U.S. dollar rises by 10%, oil prices fall by 10%, the VIX index increases by ten points from current levels and there is a sharp bear flattening of the U.S. Treasury curve. Chart 7U.S. IG Corporates Have A##BR##High Yield Beta (a.k.a. Duration) A Very Dovish Fed: the Fed only hikes rates by 25bps, the U.S. dollar falls by 5%, oil prices fall by 5%, the VIX index increases by five points from current levels and there is a modest bull steepening of the U.S. Treasury curve. In Table 3A, we also show the expected yield changes generated by our regressions for each spread product sector and the yield betas to U.S. Treasuries for each government bond market. This produces expected returns for the GFIS model bond portfolio, which are shown in the top part of the table. In our base case, the portfolio is expected to outperform the benchmark by +42bps, but underperform by nearly equivalent amounts in both alternative scenarios. In the bottom part of the table, we show expected returns where we reduce our large overweight to U.S. IG corporates. The latter has a high sensitivity to rising global government bond yields compared to some of our other significant overweights like Japanese government debt and U.S. high-yield (Chart 7). We then take that reduced U.S. IG weighting and increase the exposure to euro area and EM corporate bonds. This adjusted portfolio results in higher excess returns not only in our base case (now +78bps) but even in the "very hawkish Fed" scenario (now +8bps). The "very dovish Fed" scenario produces a similar loss in this scenario (now -37bps), but that is to be expected since this includes a fall in global bond yields that would hurt our current underweight duration stance (Chart 8). Importantly, this adjusted portfolio would not alter the positive carry of the model portfolio (i.e. the portfolio yield remains at 16bps above that of the custom benchmark index, Chart 9) Chart 8Flattening Yield Curves##BR##Have Also Hurt Returns Chart 9Some Help From##BR##Positive Carry Based on this scenario analysis, we are going to implement the changes in the bottom half of Table 3A. We are cutting our overweight to U.S. IG corporates in half (which still leaves us overweight), raising euro area IG and HY corporate exposure to neutral and reducing the size of our EM corporate underweight. The changes to the model portfolio can be found on Page 14. These changes will reduce our exposure to a sector that not only has become riskier, but which also looks relatively expensive to U.S. high-yield (Chart 10) and which has been underperforming euro area (Chart 11) and EM equivalents (Chart 12). Chart 10U.S. IG Looks More##BR##Expensive Than U.S. HY Chart 11An Unexpected Underperformance##BR##Of U.S. IG vs. European Corporates Chart 12An Unexpected Underperformance##BR##Of U.S. IG Vs. Versus EM Corporates Bottom Line: We introduce a simple framework to conduct scenario analysis and stress testing of the model bond portfolio. Our conclusion is that some shifting in our corporate bond allocations - reducing exposure to U.S. investment grade, increasing exposure to euro area and emerging market corporates - can actually help eliminate expected losses in scenarios that run counter to our base case. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 For Italy & Spain, the bars have two colors since the portfolio weights were changed in mid-February, when we upgraded Italian debt to neutral at the expense of a reduction in Spanish government bond exposure. 3 Please see BCA Global Fixed Income Strategy Special Report, "Adding A Risk Management Framework To Our Model Bond Portfolio", dated June 20th 2017, available at gfis.bcaresearch.com. 4 In general, we aim to target a tracking error no greater than 100bps. We think this is reasonable for a portfolio where currency exposure is fully hedged and less than 5% of the portfolio benchmark is in bonds with ratings below investment grade. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Q1 earnings season looks robust, but trade policy is an uncertainty. Sizeable shifts in equity technicals and sentiment since the start of the year; valuation still stretched. Global growth may have peaked but fiscal, monetary and legislative backdrop remains supportive. The market is coming to terms with President Trump's willingness to put his policies where his campaign rhetoric was, at least on trade policy. Feature Chart 1Despite Setback In March, ##br## U.S. Labor Market Remains Strong U.S. equity prices fell last week as trade policy remained on the front pages. Gold was one of the few beneficiaries of the tariff talk. Investors hope to turn the page this week as the Q1 2018 earnings season kicks into high gear, but trade-related market volatility is here to stay. The bar is high for 2018 earnings growth, and the focus may shift to the prospects for 2019 sooner rather than later. The modest selloff in the S&P 500 since late January led to a shift in sentiment, but the technical picture for U.S. equities is mixed. Global growth may be rolling over, but we find that risk assets perform well anyway, if fiscal, monetary and legislative policy is aligned. Trump's actions on tariffs do not mean that we are necessarily headed for a trade war. The tariffs proposed but both sides have not yet been implemented and there is still time for compromise. We do not see March's modest 103,000 increase in non-farm payrolls as signaling a weaker labor market. First, the monthly data can be volatile. The soft increase in March follows an outsized 326,000 gain in February. The 3-month average, more reflective of the underlying trend, is a solid 202,000. Second, average hourly earnings increased by 0.3% m/m, which nudged the annual wage inflation rate to 2.7% from 2.6%. Firming earnings growth is a sign of a strong labor market (Chart 1). Despite the soft increase in March payrolls, the U.S. labor market and economy are on a firm footing. Aggregate hours worked increased by 2.0% at a quarterly annualized rate in Q1. Such a pace is consistent with about 3% GDP growth. Firm growth will allow inflation to head back to the 2% target and allow the Fed to continue with its gradual rate hikes. S&P 500 Earnings: Q1 2018 The consensus expects an 18% year-over-year increase in the S&P 500's EPS in Q1 2018 versus Q1 2017, and 20% in 2018. Energy, materials, financials and technology will lead the way in earnings growth in Q1, while real estate and consumer discretionary will struggle. Excluding the energy sector, the consensus expects a stout 17% increase in profits. The robust profit environment for Q1 2018 and the year ahead reflects sharply higher oil prices compared with early 2017 and the impact of last year's Tax Cut and Jobs Act. Moreover, improved global growth and still modest labor costs will support the Q1 results. Trade policy will likely replace tax cuts as a key topic when corporate managements report Q1 outcomes and provide guidance for Q2 and beyond. While no tariffs have yet been imposed, analysts will want to understand the impact that the proposed actions will have on input costs and margins. Moreover, investors must gauge to what extent trade policy-related uncertainty is weighing on business sentiment (details below in "Trade Skirmish...Or Trade War?"). Market volatility, rising interest rates and the modest upswing in U.S. labor costs will also be discussed during the Q1 earnings calls. As always, guidance from corporate leaders for Q2 2018 and ahead are more important than the actual results for Q1 2018. The markets probably have already priced in a robust 2018 earnings profile due to the Tax Cut and Jobs Act, and are looking ahead to 2019 (Chart 2). Investors typically stay focused on the current calendar year's EPS through to at least Q3 before turning their attention to the next year. However, this year may be different. The consensus is looking for 10% EPS growth in 2019, a sharp deceleration from the 20% increase expected this year. Chart 2The Bar Is High For 2018 EPS, But The Focus Is On 2019 Chart 3 shows that elevated readings on the ISM provide a very favorable backdrop for EPS in 2018. As indicated in Chart 4, industrial production (IP), a proxy for S&P 500 sales, is poised to advance in 2018 and lift corporate profits. Industrial production growth may be peaking, but we don't expect it to soften much on a year-over-year basis. Chart 3Elevated ISM Good News For 2018 EPS Growth Chart 4Stout Readings On IP Support S&P 500 Revenue Gains Global GDP growth estimates for 2018 and 2019 continue to move steadily higher in sharp contrast with prior years when forecasters relentlessly lowered GDP estimates (Chart 5). Chart 5U.S. And Global Growth Estimates Are Still Accelerating... ##br## But For How Much Longer? Chart 6The Dollar Should Not Be A Big Concern ##br## In Q1 Earnings Season The greenback should not be an issue for corporate results in Q1 2018 based on minimal references to a robust dollar in the past six Beige Books. This significantly differs from 2015 and early 2016 when there were surges in Beige Book mentions (Chart 6). The last time that six consecutive Beige Books had so few remarks about a strong dollar was in late 2014. BCA's stance is that the dollar will move modestly higher in 2018. The appreciation would trim EPS growth by roughly 1 to 2 percentage points, although most of this would occur next year due to lagged effects. Movements in the U.S. dollar also explain the divergent paths of profits, sales and margins of domestically focused corporations versus globally oriented ones. In recent quarters, a modestly weaker dollar has allowed profit and sales gains of global firms to rebound and outpace those of domestic businesses (Chart 7). Margins for U.S. companies have been steady at record heights since 2014, while margins for global businesses dipped along with oil prices in 2014-2016, but rebounded last year and are higher than margins of domestic companies. Nonetheless, a slowdown in growth outside the U.S. may reverse these trends (Please read below, "Global Growth Has Peaked, Now What?"). Investors are skeptical that margins can advance in Q1 2018 for the seventh consecutive quarter. BCA's view is that we are in a temporary sweet spot for margins, which should continue for the next couple of quarters. However, the secular mean reversion of margins will resume beyond that time as wage pressures begin to percolate. Chart 7Global EPS, Margins Outpacing Domestic Chart 8Strong S&P Growth Ahead, Will Start To Slow Soon Bottom Line: BCA expects that the earnings backdrop will be supportive of equity prices in 2018 (Chart 8). However, investors may have already priced in the benefits of the Tax Cut and Jobs Act on corporate results and are focused on 2019 figures. EPS growth will be more of a headwind for stock prices as we enter 2019 (Chart 8). Stay overweight stocks versus bonds. Technical, Sentiment And Valuation Update BCA's Technical Indicator is not at an extreme (Chart 9, panel 1) and the 7.8% pullback in the S&P 500 since January 26, 2018 leaves the index in the middle of its recovery trend channel (panel 2). The failure of the index to break out of this channel earlier this year suggests that a period of consolidation for equities awaits. Moreover, the upward slope in the NYSE advance/decline line (panel 3) is in jeopardy. The final panel of Chart 9 shows that stocks are no longer extremely overvalued, but they remain overvalued nonetheless. Stretched valuations say more about medium- and long-term returns than near-term performance.1 Chart 9Technicals And Valuations For U.S. Equities Chart 10Bullish Sentiment Took A Hit In Early 2018 But Is Still Elevated The shift in the equity sentiment since the market top in January is notable. BCA's investor sentiment composite index, which hit an all-time high at the end January, has pulled back in the past few months (Chart 10, panel 1). However, this metric has not yet returned to its long-term average (solid line on top panel of Chart 10). The drop in sentiment is broadly based; individual investors and advisors who serve them (panels 2 and 4) along with traders (panel 3) have lately curtailed their bullishness. Recent shifts in several other sentiment surveys are also worth noting: The American Association of Individual Investors, a contrary indicator of sentiment, turned bullish in recent weeks. The percentage of respondents who were bearish moved above 30%, while the percentage of bulls dipped to 32%. Neither measure is at an extreme (Chart 11). The National Association of Active Investment Managers (NAAIM) says that active managers have reduced equity risk since the beginning of Q4 2017 (Chart 12). At 52%, the average equity exposure of institutional investors is at the lowest level since March 2016 and is nearly half the 102% exposure at the start of 2017. In contrast, the March 2017 reading was the highest since 2007, just before the S&P 500 peak in October 2007. As in previous bear markets, BCA's equity speculation index moved into "high speculation" territory in early 2017 and has remained there. The index is at its highest point since the 2000 market peak (Chart 13, panel 1). Moreover, net speculative positions of S&P 500 stocks are roughly in balance, but have turned net short in recent weeks. Nonetheless, this metric is not at an extreme (panel 3). Chart 11Individual Investors Have Turned More Bearish Chart 12Active Managers Still Overweight Equities... Chart 13Equity Speculation Is High... Chart 14Pullback Has Relieved Some Technical Pressure The S&P 500 is close to its 200-day moving average. In late 2017, this indicator was at the upper end of its post-2000 range (Chart 14, panel 1). BCA's composite technical measure is in the middle of the 2007-2017 range and is not a concern (Chart 14, panel 5). Moreover, the percentage of NYSE stocks above their 10- and 30-week highs are below average and at the low end of their recent ranges. Furthermore, new highs minus new lows is at neutral (panel 2). Bottom Line: The 7.8% pullback in the S&P 500 since January 26 has relieved some technical pressure on the market, and sentiment levels are less stretched than at the late January 2018 peak. Moreover, institutions have cut their equity exposures. Nonetheless, stock speculation is rampant and valuations are elevated, which suggests lower returns in the coming decade. Moreover, a slowdown in global growth in ongoing trade tensions suggest that the risk/reward balance for equities has deteriorated. Global Growth Has Peaked, Now What? Chart 15Is Global Growth Peaking? In last week's report we stated that while BCA expects global growth to be solid this year, there are signs that global growth may near a top.2 March's PMI data support that view. Chart 15 shows that the Markit Global PMI dipped to 53.4 in March from 54.1 in February; the 0.7 drop was the largest since February 2016 (panel 2). Last month,3 we discussed 5 episodes in the past 35 years when global growth surged and fiscal, monetary and regulatory policies were aligned to boost the U.S. economy. The current episode of synchronized policy commenced in January 2016. Risk assets perform well when these policy tailwinds are in place, but these assets tend to struggle for 12 months after the tailwinds abate. BCA expects the ongoing era of pro-growth policies to end next year as the Fed raises rates into restrictive territory. However, some investors wonder if the peak in global growth changes our view of how risk assets will perform during periods of harmonized policy. We do not expect the peak in global growth to lead to a recession this year or next. Chart 16 and Table 1 show the performance of U.S.-based financial assets, gold, oil, the dollar and S&P 500 earnings when Fed, fiscal and legislative policies are stimulative and global growth is rolling over but still positive. There has been only a handful of such episodes, so investors should be cautious when interpreting these results. The S&P 500 beats Treasuries, investment-grade and high-yield credit outperforms Treasuries, and small caps outpace large caps. Gold and oil perform well in these periods, perhaps aided by a weaker dollar. S&P 500 earnings are positive. Chart 16Positive Policy Backdrop As Global Growth Is Rolling OverTable 1Three Periods Where Global Growth Rolled Over But Policy Backdrop Was Stimulative Bottom Line: A peak in global growth reduces the risk/reward balance for risk assets, and provides another reason to be cautious. Equity valuation, although improved recently, is still stretched. Central banks are slowly removing the punchbowl, margins have limited upside and the economic cycle is at a late stage. Long-term investors should already be scaling back on risk. Short-term investors should stay overweight risk for now, on the view that fiscal stimulus will provide a tailwind for earnings for the remainder of the year. Trade Skirmish...Or Trade War? BCA's Geopolitical Strategy service notes4 that the market is coming to terms with President Trump's willingness to put his policies where his campaign rhetoric was, at least on trade policy. U.S. equities are down by 5.7% since the White House announced tariffs on steel and aluminum and 2.34% since it declared impending levies against China. Although we have cautioned clients since November 2016 that protectionism is a real risk to global growth and risk assets, the U.S. demands on China justify the moniker of a trade skirmish, rather than a full-on war. In view of our position, we think the 5.7% drawdown is appropriate, if a bit sanguine. President Trump remains unconstrained on trade policy, giving him leeway to be tougher than the market expects. Therefore, it is appropriate for the market to price in a 20%-30% probability of a trade war developing. Given that the market drawdown in such a scenario could be 20% or more, the market is appropriately discounting the risks. Why would a trade war between the U.S. and China elicit a bear market in U.S. equities when a similar confrontation in the 1980s between Japan and the U.S. did not? First, the overvaluation of stocks is much greater today. Secondly, interest rates are much lower, restricting how much policymakers can react to adverse risks. Thirdly, supply chains are much more integrated, both globally and between China and the U.S. The U.S. Administration's trade policy is not haphazard. President Trump and U.S. Trade Representative Robert Lighthizer are on the same page: they have made China, and not NAFTA trade partners or South Korea, the target of U.S. protectionism (Chart 17). Chart 17China, Not NAFTA, In The Crosshairs Table 2U.S. Gradually Exempting Allies From Tariffs The rapid pace at which the Administration pivoted from global tariffs to targeting China is an indication of what lies ahead. The U.S. uses the threat of tariffs to cajole its allies into tougher trade enforcement against China (Table 2). This strategy can work, as outlined last week,5 but there is plenty of room for mistakes. Trump also wants to change the U.S. policy on immigration and he may use NAFTA negotiations to gain leverage over Mexico. Therefore, there is a slight probability that Trump may trigger Article 2205 to leave NAFTA, but we believe the risk has declined substantively since our 50% estimate in November 2017. Bottom Line: The Trump Administration has pursued a well-considered but tough trade policy toward China. Nonetheless, Trump's actions do not mean that we are necessarily headed for a trade war. The tariffs proposed by both sides have not yet been implemented and there is still time for compromise. The U.S. Treasury will release a list of exemptions on May 1. On May 21, Treasury will reassess its list of China's investments in the U.S. and China will likely retaliate. June 5 marks the end of a 60-day negotiation period when the Administration must decide whether to implement the announced tariffs. There still is a 30% chance that the trade skirmish will morph into a trade war. Trump could significantly escalate matters if he declares a national emergency on trade in June. Expect more trade-related volatility in U.S. financial markets until that time. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Global Asset Allocation Special Report, "What Returns Can You Expect?", dated November 15, 2017, available at gaa.bcaresearch.com. 2 Please see BCA U.S. Investment Strategy Weekly Report, "Has Global Growth Peaked?", dated April 2, 2018, available at usis.bcaresearch.com. 3 Please see BCA U.S. Investment Strategy Weekly Report, "Policy Line Up", dated March 12, 2018, available at usis.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China", dated April 4, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Taiwan Is A Potential Black Swan", dated March 30, 2018, available at gps.bcaresearch.com.

Highlights Trade wars have captured investors' imaginations, but slowing global growth is a more immediate risk for both asset prices and exchange rates. As reflationary forces ebb, slow global growth will help the dollar stage a rally. EUR/USD and GBP/USD could decline over the next two quarters. We are selling EUR/CHF. The AUD has more downside. It is too early to close short AUD/NZD or AUD/JPY. Short EUR/CAD with a first target at 1.44. Feature The growing trade skirmish between China and the U.S. has been blamed for much of the movements in risk assets this year. We do not deny that this has been a very important factor determining the price action of all assets globally; after all, market participants are trying to price in the probability that global supply chains as we currently know them will be forever impaired. If this were to happen, global growth and profits would suffer considerably. This warrants a risk premium, one that is currently being estimated by the market.1 As we have written in recent weeks, this will be a stop-and-go pattern, and behind-the-scene negotiations between China and the U.S. will remain intense until June, when the U.S. tariffs are in fact implemented. However, trade wars are not the only force impacting asset returns today. Global asset prices are also slowly adjusting to a world where reflation is ebbing and where growth may be dipping from its heightened state. This week, we examine the role of liquidity and how it is affecting growth,2 and the implications for various currency pairs. From Reflation To Less Growth Through most of 2016 and 2017, risk assets, EM plays, commodity prices and growth greatly benefited from a wave of global reflation implemented by monetary and fiscal authorities around the world in the wake of a market meltdown that culminated in January 2016. A great victim of this reflationary effort was the U.S. dollar. Once global growth and inflation perked up, the dollar sold off. The U.S. economy is not as levered to global growth as the rest of the world is, thus investors were attracted by greater shift in expected returns outside the U.S. than in the U.S. But how is this reflation story faring today? Global monetary policy is not as supportive as it once was as central banks are not adding to global base money as forcefully as before. For example, the Federal Reserve has begun the rundown of its balance sheet, and the real fed funds rate is closing in on the Laubach-Williams estimate of the neutral rate; the European Central Bank has begun tapering it asset purchases, the European shadow policy rate has increased by 400 basis points; and the Bank of Japan has not hit its JGB target of JPY80 trillion of purchases since mid-2016. Even the Swiss National Bank has not seen any increase in its sight deposits since mid-2017. We like to use excess money growth to measure the impact of these changes in base money growth. Excess money supply growth is measured as the difference between broad money supply growth and money demand as approximated by loan growth. As base money and deposits become scarcer in the banking system relative to the pool of existing loans, the liquidity position of commercial banks deteriorates. This deprives them of the necessary fuel to generate further loan growth down the road. Chart I-1 not only shows that excess money in the U.S., euro area and Japan has been decelerating sharply in recent months, but also that this decline points toward slowing global industrial activity, widening junk spreads and decline EM stock prices. Beyond quantity-based measures of liquidity, price-based measures are sending a similar signal. The widening in the LIBOR-OIS spread has now been well documented. It is true that technical factors such as the issuance of T-bills by the Treasury and the progressive move away from LIBOR as a key benchmark for the pricing of loans partly explain this phenomenon. However, this development is now spreading outside the U.S., with Australia in particular experiencing some especially sharp widening in the spread between deposit rates and the OIS. In fact, the LIBOR-OIS spread for the G-10 as a whole is now at its widest since 2012 (Chart I-2). This also portends a situation where liquidity is becoming scarcer than it once was. Chart I-1Deteriorating Liquidity Conditions Chart I-2Price Of Liquidity Is Increasing Growth is responding to these dynamics, and the softening in PMIs around the world was in full display this week. Interestingly, two bellwethers of global growth are showing especially clear signs of a slowing.3 In Korea, exports have greatly decelerated, industrial production is contracting and PMIs are well below 50 (Chart I-3). Taiwan is also showing some signs of weakness, as exports and export orders are both slowing sharply (Chart I-4). Chart I-3Korea: A Key Global Bellweather Is Slowing Chart I-4Taiwan Echoes Korea's Message This message is also being relayed by the Japanese economy. Japan's exports to Asia have been slowing sharply as well. As Chart I-5 illustrates, weak Japanese shipments to Asia correlate closely with a weak AUD/JPY, weak EM stock prices and widening junk spreads, suggesting that these specific shipments capture systematic developments behind global growth. Key growth-sensitive currencies are flashing a similar signal. As the top panel of Chart I-6 shows, NZD/JPY has historically rolled over and declined ahead of recessions, growth slowdowns or EM crashes. It has clearly weakened for eight months now. Meanwhile, the bottom panel of Chart I-6 shows the Swedish krona versus the euro. This cross is also a good leading indicator of global growth, and it is clearly pointing south. Chart I-5Japanese Exports Point To A Malaise Chart I-6NZD/JPY And EUR/SEK: Confirming The Risks Finally, one of our favorite gauges to measure the impact of reflation has substantially weakened: the combination of global growth and inflation surprises. This indicator clearly shows that after a massive upsurge in reflationary forces over the past two years, reflation is now waning (Chart I-7). Chart I-7Economic Surprises Are Declining If reflation is about pushing growth and prices upward, removing stimulus could have the opposite impact. While it is clear that global growth is slowing, what about inflation? We do not think that global inflation is set to slow significantly: global growth is unlikely to move back below trend, and the U.S. is experiencing increasingly potent domestic inflationary pressures supercharged by fiscal profligacy. That being said, the uptrend in global inflation is nonetheless set to flatten for now as our Global Inflation Diffusion Index based on consumer and producer prices across 27 economies has begun to fall, which normally points to lower global headline and core consumer prices (Chart I-8). Bottom Line: The market's attention has been captured by the dramatic flare-up in trade tensions between the U.S. and China, but a more imminent risk has been garnering less press: the decline of reflation. China sent the first salvo on this front; DM central banks have also slowly been either tightening outright or not expanding monetary aggregates as aggressively as before. As a result, global liquidity is tightening and global growth is slowing. Global inflation is also set to decelerate as well, suggesting the decline in economic activity will not be a real phenomenon only, but a nominal one as well. Key Currency Market Implications One of the key implications of lower global growth and ebbing inflationary pressures is likely to be a stronger dollar. As Chart I-9 illustrates, when our Global Inflation Diffusion Index declines and global inflationary pressures ebb, the dollar tends to strengthen. This makes sense: the dollar does best when global growth weakens, inflation slows and commodity prices soften. This time around, the case for a few quarters of dollar strength may be even better defined. U.S. inflation is unlikely to decelerate as much as non-U.S. inflation as U.S. capacity utilization is tighter, the U.S. labor market is at full employment and America is receiving an extraordinarily large amount of fiscal stimulus at this late stage of the business cycle. Chart I-8No Acceleration For Now In Global Inflation Chart I-9Ebbing Inflationary Pressures Will Help The Dollar Technical considerations suggest the dollar is well placed to take advantage of these dynamics. On a short-term basis, both our intermediate-term oscillator and 13-week rate-of-change measures have formed positive divergences with the DXY itself (Chart I-10). While the pattern does not look as bullish as the one registered in 2014, it evokes deep similarities with the 2011 formation. On a longer-term basis, the dollar is massively oversold, as measured by the 52-week rate of change measure. It is true that it managed to stay at similarly oversold levels for nearly a year in 2003, but back then the dollar was much more expensive than today: the U.S. current account deficit was 4.4% of GDP versus 2.4% today and the basic balance of payments deficit was at 3% of GDP versus 2% today (Chart I-11). It is reasonable that with these stronger fundamentals, the dollar will not need to hit as oversold levels as back then before staging a significant rebound. Chart I-10Positive Divergences For The Greenback Chart I-11Dollar Technicals And Valuations: 2003 Vs. Today With global growth slowing, especially in Asia, it is easy to paint a picture where the dollar only strengthens against EM and commodity currencies - the currencies most exposed to both global growth and this specific geographic area. However, while we do see downside in USD/JPY, we expect the greenback to rally against the euro toward EUR/USD 1.15. Our model for EUR/USD shows that the euro is trading 10% above its fair value determined by real rate differentials, the relative slope of yield curves and the price of copper relative to lumber (Chart I-12). In fact, since Europe is more levered to global economic activity than the U.S., these drivers are likely to deteriorate a bit further for the remainder of 2018. Chart I-12EUR/USD Is Vulnerable GBP/USD also looks set to experience a period of weakness against the greenback. Historically, GBP/USD and EUR/USD have been correlated. This is a simple reflection of the fact that the U.K. has a deeper economic relationship with the euro area than the U.S., and thus benefits from the same economic impulses as the eurozone. Chart I-13GBP/USD: ##br##Extremely Overbought Some pound-specific factors will also play against GBP/USD. As we argued last week, the British domestic economy is rather weak; this week's construction PMI confirmed this assessment.4 Additionally, the British basic balance of payments is in deficit anew. This is not only a reflection of the U.K.'s current account deficit of 4% of GDP, it also reflects the fact that FDI into the U.K. has been melting in response to uncertainty surrounding Brexit. This means the U.K. is dependent upon global liquidity to finance this large deficit. An environment where global growth is set to decelerate and where global liquidity is tightening will make it more expensive to finance this large hole. The fastest means to increase expected returns on British assets to attract foreigners' funds is to depreciate the pound today. Finally, the GBP's annual momentum has hit levels consistent with a reversal in cable (Chart I-13). Staying in Europe, another pair is currently interesting and devoid of taking on any USD risk: EUR/CHF. While we think EUR/CHF has more upside over the remainder of the economic cycle,5 this is unlikely to be the case in the second and third quarters of 2018. The Swiss franc tends to outperform the euro when reflationary forces retreat, when global growth slows and when FX volatility increases - all views we espouse for the coming quarters. Moreover, Switzerland's current account and basic balance-of-payment surpluses are 6.5% of GDP and 11.5% of GDP greater than that of the euro area, providing further attraction in a growth soft spot. Finally, EUR/CHF is massively overbought right now, pointing to heightened vulnerability to the economic risks highlighted above (Chart I-14). We are opening a short EUR/CHF trade this week. In the same vein, we remain bearish EUR/JPY. Finally, in previous reports, we highlighted the AUD as being the currency most at risk from any downshift in global growth.6 Despite its recent weakness, we think the AUD is likely to remain very vulnerable. We have been short AUD/NZD since last October, and we do believe this pair will retest 1.04 before forming a base. Australia is experiencing even less inflationary pressures than New Zealand, and is more exposed to slower global industrial production than its neighbor. Technically, AUD/NZD still has some downside. As Chart I-15 illustrates, the 13-week rate of change measure for AUD/NZD has not yet hit the kind of depressed levels associated with complete capitulation. In fact, the recent breakdown in momentum points toward such capitulation as being imminent. AUD/JPY too is not yet oversold enough to be a buy, especially in the context of slowing global growth. Thus, we continue to recommend investors stay short this pair. Chart I-14Technical Indicators Confirm ##br##The Fundamental Vulnerability Of EUR/CHF Chart I-15AUD/NZD Has A Little Bit More Downside Bottom Line: Ebbing reflationary forces suggest the trade-weighted dollar is likely to rally over the coming months. We do see upside for the USD against EM and commodity currencies, but against European currencies as well. Only the yen is anticipated to buck this trend. Within the commodity-currency complex, we foresee that the AUD will suffer the most, and the CAD the least. Within the European currency complex, we are selling EUR/CHF. We are not selling EUR/USD as we are already long the DXY. A Cyclical Opportunity To Sell EUR/CAD This trade is an attractive means to bet on global growth slowing, especially relative to the U.S. As we have argued, U.S. financial conditions have eased relative to the rest of the world, the U.S. is enjoying large injections of fiscal stimulus and it is less exposed to declining global growth. As a result, we anticipate the outperformance of the U.S. ISM to continue relative to global PMIs. Historically, this is an environment where EUR/CAD tends to depreciate (Chart I-16). This is because while 75% of Canadian exports go to the U.S., only 13% of euro area exports end up there. Thus, Canada is much more exposed to the U.S. business cycle than Europe, who is exposed to the rest of the world's. Domestic factor also argues in favor of shorting EUR/CAD. Canadian core inflation is in an uptrend, and at 2% is at the Bank of Canada's target. European core inflation meanwhile only stands at 1%. Moreover, Canada's unemployment's rate is already 0.5% below equilibrium, while the euro area's is 0.4% above such equilibrium (Chart I-17). Thus, European wages and service sector inflation is likely to continue to lag behind Canada's. As a result, we continue to expect the BoC to keep hiking in line with the Fed, or another three times this year. The same cannot be said for the ECB. Chart I-16EUR/CAD: A Play Global Vs. U.S. Growth Chart I-17No Slack In Canada, Plenty In Europe Making the trade even more attractive, EUR/CAD is currently trading at a premium on many metrics. First, our augmented interest rate parity models show that the EUR/CAD trades anywhere between 10-15% above fair value (Chart I-18).7 Relative productivity trends have been a reliable long-term indicator of the path for EUR/CAD. On this metric as well, EUR/CAD is trading at a significant 9% premium (Chart I-19). Finally, EUR/CAD has tended to trend in an inverse relationship with oil prices. Today, it is well above levels implied by various oil prices (Chart I-20). Chart I-18EUR/CAD Trades At A Premium To Rate Differentials... Chart I-19...At A Premium To Relative Productivity... In our view, a key factor explains these discounts: Fears regarding the future of the North American Free Trade Agreement. An abandonment of NAFTA would hurt Canadian growth and prompt the BoC to be much more dovish than we anticipate. However, while there will be some small tweaks to NAFTA, the probability of a major overhaul that deeply affects the North American supply chain has declined, as Canada and Mexico are being exempted from steel and aluminum tariffs and as the White House has softened its stance on the U.S. content of Canadian auto exports back to the U.S. Our Geopolitical team assesses that the probability of a major NAFTA overhaul has declined from 50% to less than 20%, especially as Trump now has bigger fish to fry with China. As a result of these improvements in negotiations, EUR/CAD is potentially set to decline toward 1.44 over the rest of 2018, especially as our oil strategists continue to expect Brent prices to average US$74/bbl this year. Meanwhile, the ratio of copper prices to oil prices, which has been a decent early directional indicator for this cross, suggests the timing is ripe to bet against euro/CAD (Chart I-21), especially as slowing global growth will further weigh on copper relative to oil. Chart I-20...And A Premium To Oil Chart I-21Where Copper-To-Oil Goes, So Does EUR/CAD Bottom Line: An attractive means to bet on slowing global growth while benefiting from the impact of the U.S.'s fiscal stimulus is to short EUR/CAD. Not only is this cross a play on the differential between international and U.S. growth, it is also currently trading at a large premium on various metrics. Dissipating risks that NAFTA will be abrogated in a major way are providing an attractive cyclical entry point to short EUR/CAD, with an initial target of 1.44. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Analyst haarisa@bcaresearch.com 1 For more analysis on trade wars and the current China/U.S. spat, please see Foreign Exchange Strategy Weekly Report, "Are Tariffs Good or Bad For The Dollar?" dated March 9, 2018, available at fes.bcaresearch.com as well as the Geopolitical Strategy Weekly Report, "Trump's Demands On China", dated April 4, 2018, available at gps.bcaresearch.com. 2 We have already gone over the role of China at length to explain the global growth slowdown. For detailed discussions on the topic, Please see Foreign Exchange Strategy Weekly Report, "The Return Of Macro Volatility", dated March 16, 2018, available at fes.bcaresearch.com. 3 For more indicators pointing toward slower global growth, Please see Foreign Exchange Strategy Weekly Report, "Canaries In the Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017 and "Canaries In the Coal Mine Alert 2: More On EM Carry Trades And Global Growth", dated December 15, 2017, available at fes.bcaresearch.com. 4 Please see Foreign Exchange Strategy Weekly Report, "Do not Get Flat-Footed By Politics", dated March 30, 2018, available at fes.bcaresearch.com. 5 Please see Foreign Exchange Strategy Special Report, "The SNB Doesn't Want Switzerland To Become Japan", dated March 23, 2018, available at fes.bcaresearch.com. 6 Please see Foreign Exchange Strategy Weekly Report, "From Davos To Sydney, With a Pit Stop in Frankfurt", dated January 26, 2018, available at fes.bcaresearch.com. 7 EUR/CAD trades 15% above a fair value model, that does not encapsulate the trend in the cross. If the recent cross is taken into account through a model that incorporates mean-reversion, EUR/CAD trades at a more modest 10% above its fair value. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: ISM Manufacturing came in slightly weaker than expected at 59.3; However, ISM Prices Paid was a very strong number, 78.1, up from the previous 74.2; Services PMI and Non-Manufacturing ISM also disappointed expectations; The trade balance in February fell to US$ -57.6 bn; Initial jobless claims, however, came in much higher than expected at 242,000. The dollar is now up more than 2% from its February lows. This has been driven by slowing global growth, particularly in Korean and Taiwanese trade data. The greenback should fare well in this environment. Report Links: Do Not Get Flat-Footed By Politics - March 30, 2018 Are Tariffs Good Or Bad For The Dollar? - March 9, 2018 The Dollar Deserves Some Real Appreciation - March 2, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was mixed: German retail sales disappointed, growing at a 0.7% monthly pace and a 1.3% annual pace; German Manufacturing PMI came in slightly lower than expected at 58.2; European unemployment dropped to 8.5% as expected; Headline inflation improved to 1.4% also as expected, but core inflation came in weaker than expected at 1%. The euro is set to experience a period of correction as inflation in the Eurozone remains weak and global growth is slowing, as Asian economic data increasingly shows. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Housing starts yearly growth outperformed despite coming in at -2.6%. The Nikkei manufacturing PMI surprised on the strong side, coming in at 53.1 However, the Markit Services PMI underperformed expectations coming in at 50.9. USD/JPY has been relatively flat this week. Overall, we expect that the yen will continue to strengthen, given that the market will continue to be rattled by the increasing a weakening in global growth. This risk off environment should benefit the yen. However, given the slowdown in Japanese economic data, the BoJ will eventually have to intervene to make sure that the rise in the yen does not derail the economic recovery and particularly, its inflation objective. Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Markit Manufacturing PMI outperformed expectations, coming in at 55.1. It also increased slightly from last month's reading. However PMI construction underperformed expectations substantially, coming in at 47. This is the lowest level in more than 2 years. GBP/USD has been relatively flat this week. Overall the latest construction PMI number confirms our analysis: the uncertainty caused by Brexit is weighing heavily on Britain's housing market. This weakness in the housing sector, coupled with a strong pound, will likely limit how high British interest rates can go. Therefore GBP/USD has downside on a tactical basis. Report Links: Do Not Get Flat-Footed By Politics - March 30, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was weak: The RBA's Commodity Index in SDR terms contracted by 2.1% annually, much more than the expected 0.1% contraction; Building permits contracted on a monthly basis at a rate of 6.2%, while also contracting at a 3.1% pace in annual terms; However, retail sales did pick up in monthly terms at a rate of 0.6%. At the monetary policy meeting on Tuesday, Governor Philip Lowe referenced the increase in short-term funding costs that have spilled over from the U.S. into foreign markets owing to higher volatility, particularly in Australia. An escalation of a trade war will also prove to be very damaging for the Australian economy, which is a large export-based and commodity-dependent nation. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has been flat this week. Overall we expect this cross to weaken going forward, given that New Zealand is one of the most open economies in the G10, and thus, it stands to risks the most from both an increasing risk of trade wars and slowing global growth. Moreover, there are also some negative aspects of New Zealand on a more structural basis, as the neutral rate is set to be lowered. This is because the populist government is looking to lower immigration while also implementing a dual mandate for the central bank. All of these factors will cause the kiwi to suffer on a long term basis. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Data out of Canada was mixed: Manufacturing PMI came in line with expectations of 55.7; Exports and Imports for February came in at CAD 45.94 bn and CAD 48.63 bn, respectively, sinking the trade balance to CAD -2.69 bn. The CAD received a fillip on Tuesday as President Trump hopes to conclude preliminary negotiations for NAFTA by the end of next week. While the outcome for these negotiations remains uncertain, the Canadian economy is still in great shape, with a tight labor market, high wage growth and a closing output gap. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Headline inflation outperformed expectations, coming in at 0.8%. Real retail sales yearly growth outperformed expectations, coming in at -0.2%. However, the SVME PMI underperformed expectations, coming in at 60.3. EUR/CHF has been relatively flat this week. Overall, we expect EUR/CHF to have further upside on a long-term basis. The Swiss economy is still weak and inflationary pressures are tepid. This means that any further appreciation by the franc will weigh heavily on the SNB's goals. While for now EUR/CHF could suffer as global growth declines, the SNB will fight this trend in order for them to achieve their inflation target. Thus, any rally in the CHF will prove temporary. Report Links: The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has been relatively flat this week. Overall, the krone should outperform most other commodity currencies given that oil should perform better than the rest of the commodity complex in the current environment. While all commodities would be affected by a possible slowdown in global growth and Chinese industrial production, oil will probably hold up the best given that advanced economies consume a greater proportion of oil than they do of other commodities, making oil less sensitive to gyrations in global industrial activity than metals. Moreover, the supply backdrop for oil remains more favorable than that of other commodities thanks to OPEC and Russia's production restrains. All of these developments should help the NOK outperform currencies like the NZD and the AUD. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish data was disappointing: Manufacturing PM came in at 55.9, below last month's 59.9; New Orders increased annually only by 1.3% compared to 8.7% in January; Industrial production contracted in monthly terms by 0.5%, and grew annually by 5.7%, but it was still a deceleration relative to the previous 7.7% reading. The SEK has been weakening because of three factors: the talk of trade wars, the slowdown in the global manufacturing sector, and Sweden's housing bubble. While these risks are very real, Sweden's favorable macro backdrop of a cheap currency, a high basic balance of payments surplus and an economy operating above capacity mean that inflation will pick up meaningfully. This will prompt the SEK to rally once global growth can find its floor. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of March 30, 2018. There are no significant changes in the model's allocation this month. The small overweight in the U.S. is scaled back to neutral with the proceeds mostly going to the euro area. In terms of absolute bet, the model still favors the euro area (mainly Italy, Germany, Netherland and Spain) vs. Japan and the U.K. , as shown in Table 1. As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model outperformed its benchmark by 19 bps in March, largely driven by Level 2 model which outperformed by 58 bps. Since going live, the overall model outperformed MSCI World by 127 bps, due to the 421 bps of outperformance from the Level 2 model which allocates funds among 11 non-U.S. countries. The Level 1 model (which allocates funds between U.S. and the non-U.S.) is on par with the MSCI World benchmark. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD, %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Chart 4Overall Model Performance Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of March 30, 2018. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live Following last month's switch to a defensive positioning, the model generated alpha of 40 bps for the month of March. Increasing risk of a global trade war has damaged growth forecasts, and the model consequently continues to produce negative signals from its growth component. As cyclical sectors such as financials and technology continue to falter, momentum signals remain unfavorable. Energy is the only cyclical sector with an overweight on the back of favorable long-term valuations. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," dated July 27, 2016, available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Highlights Recommended Allocation Due to the boost from U.S. fiscal stimulus, we do not expect recession until 2020. Despite some signs that growth is peaking, global economic fundamentals remain robust. Markets have wobbled because of the risk of trade war and rising inflation. We think neither likely to derail growth. Not one of our recession indicators is yet sending a warning signal. We are late cycle and volatility is likely to remain high (particularly if the trade war intensifies). But, given strong earnings growth and three further Fed rate hikes this year, we expect global equities to beat bonds over the next 12 months. Except for particularly risk-averse investors, who care mostly about capital preservation, we continue to recommend overweights in risk assets. We are overweight equities (especially euro area and Japan), cyclical equity sectors such as financials and industrials, credit (especially cross-overs and high-yield), and return-enhancing alternative assets such as private equity. Feature Overview Stimulus Trumps Tariffs Risk assets have been choppy so far this year, with global equities flat in the first quarter and the stock-to-bond ratio turning down (Chart 1). Markets were battered by worries about a trade war, signs of growth peaking, a rise in inflation, and bad news from the tech sector. This late in the cycle, with stock market valuations stretched and investors skittish about what might go wrong, we expect volatility to stay high. But the global economy remains robust - and will be boosted by U.S. fiscal stimulus - earnings are growing strongly, and the usual signs of recession and equity bear markets are absent. Though the going will be bumpy over coming quarters, we continue to expect risk assets to outperform at least through the end of this year. U.S. tariffs on steel and aluminum and the threat of $50 billion of tariffs on Chinese imports so far represent a trade skirmish, not a trade war. The amounts pale by comparison with the positive impact coming though from U.S. tax cuts, increased fiscal spending, and repatriation (Chart 2). In history, fights over trade have rarely had a serious impact on growth. They flared up frequently in the 1980s, which was a period of strong economic growth. Even the infamous Smoot-Hawley tariff increase of 1930 is now viewed by most economic historians as having played only a minor role in the collapse of trade during the Great Depression.1 Of course, trade war could escalate. China, as the biggest part of the U.S. trade deficit, is the White House's clear target (Chart 3). Japan in the 1980s, an ally of the U.S., agreed to voluntary exports restraints and to relocate production to the U.S. But China is a global rival.2 Chart 1A Tricky Quarter Chart 2Stimulus Tops Tariffs Chart 3China Is The Target For now, we expect the impact to be limited since some degree of compromise is the most likely outcome. President Trump sees the stock market as his Key Performance Indicator and would be likely to back off if stocks fell sharply. China knows that it has the most to lose in a prolonged fight. It might suit Xi Jinping's reformist agenda to boost consumption, cut excess capacity, and allow the RMB to appreciate modestly. While the U.S. has some justification for arguing that China's investment rules are unfair, China can also argue that it has made significant progress in recent years in reducing its dependence on exports, its current account surplus, and the undervaluation of its currency (Chart 4). But jitters will continue for a while. May could be a particularly tricky month, with the Iran sanctions waiver expiring on May 12, and the 60-day consultation period for China tariffs ending on May 21. Investors should expect that volatility, which in early January was remarkably low in all asset classes, should stay significantly higher until the end of this cycle (Chart 5). Chart 4...But Has Reduced Dependence On Exports Chart 5Volatility Likely To Stay High? Meanwhile, economic fundamentals generally remain strong. The Global Manufacturing PMI has dipped slightly from its cycle-high level in December, with recent currency strength causing some softness in the euro area and Japan (Chart 6). But the diffusion index shows that only three out of the 48 countries currently have PMIs below 50 (Egypt, Indonesia and South Africa). Consensus forecasts expect 2018 global GDP growth to come in at around 3.3%, similar to last year, and as yet show no signs of faltering (Chart 7). On the back of this, BCA's models suggest that global earnings growth will continue to grow at a double-digit pace for at least the rest of this year (Chart 8). Despite the strong growth, we see U.S. inflation picking up only steadily towards the Fed's 2% target.3 Jerome Powell in his first congressional testimony and press conference as Fed Chair showed no rush to accelerate the pace of rate hikes. We think the Fed is likely to hike four times, not three, but the market should not find this unduly hard to digest, as long as it is against a background of robust growth. Chart 6Dip In Growth Momentum? Chart 7Economists' Forecasts Not Faltering Chart 8Earnings Still Growing Strongly For the past year, we have highlighted a number of simple indicators we are watching carefully that have previously been reliable indicators of recessions and equity bear markets. Several have started to move in the wrong direction, but none is yet flashing a warning signal (Table 1, Chart 9). Table 1What To Watch For Chart 9No Warnings Flashing Here In February, BCA pushed out its forecast of the next recession to 2020, on the back of the U.S. fiscal stimulus. That would suggest turning more cautious on risk assets towards the end of this year - at which time some of these indicators may be flashing. But, until then we continue to recommend - except for the most risk-averse investors who care mainly about capital preservation and not about maximizing quarterly performance - an overweight allocation to risk assets. Garry Evans, Senior Vice President garry@bcaresearch.com Chart 10Not A Full Blown Trade War... For Now! What Our Clients Are Asking What Are The Implications Of U.S. Tariffs? Following recent announcements of tariffs on steel and aluminum and possible broad-based tariffs on Chinese imports, investors have started to worry about the future of global trade. But these moves should be no surprise since President Trump is merely delivering on electoral promises. From a macro-perspective, here are the key implications of rising trade barriers: An all-out trade war would certainly hurt U.S. growth, but a minor skirmish would have little impact. The U.S. is the advanced economy least exposed to global trade, which makes it harder for nations to retaliate. Running a large trade deficit, with imports from China representing 2.7% of GDP whereas exports to China are just 1.0% of U.S. GDP, gives the U.S. considerable leverage in negotiations. Additionally, the majority of Chinese imports from the U.S. are agricultural products, making it harder for China to retaliate with tariffs since these would raise prices for Chinese consumers (Chart 10). On the other hand, U.S. trade partners also have a case. With trade growth trailing output growth, other nations will be less willing to give in to U.S. threats. Additionally, unlike the Cold War era, when the U.S. had a greater influence on Europe and Japan, the world is moving toward a more multipolar structure. However, we do not believe nations will retaliate by dumping U.S. Treasuries, as that would deliver the U.S.'s desired end result of a weaker dollar. Chart 11Rising Wages Are The Missing Factor Finally, if tariffs lead to a smaller trade deficit and firms start to move production back to the U.S., aggregate demand will increase. And, given a positive output gap in the U.S., the Fed would be forced to turn more hawkish, ultimately forcing the dollar up. Equity markets do not like tariffs, and bonds will follow the path that real growth and inflation take. How the situation will develop depends on whether Trump embraces America's traditional transatlantic alliance with Europe and harnesses it for the trade war against China. If he does so, the combined forces of the U.S. and Europe will likely force China to concede. But if Trump goes it alone, a prolonged U.S.-China trade war could turn into a significant risk to global growth. How Quickly Will U.S. Inflation Rise? The equity sell-off in early February was triggered by a slightly higher-than-expected average hourly earnings number. In recent meetings, we find that clients, who last year argued that the structural pressures would keep inflation depressed ("the Philips Curve is dead"), now worry that it will quickly exceed 2%. And it is true that the three-month rate of change of core CPI has jumped recently (Chart 11, panel 1). Investors are clearly skittish about the risk of higher inflation, which would push the Fed to accelerate the pace of rate hikes. We continue to argue that core PCE inflation (the Fed's main measure) will rise slowly to 2% over the next 12 months, but we do not see it accelerating dramatically. Inflation tends to lag GDP growth by around 18 months and the pickup in growth from Q2 last year should start to feed through. This will be magnified by the 8% weakness in the US dollar over the past 12 months, which has already pushed up import prices by 2% YoY. What is missing, however, is wage pressure. Average hourly earnings are growing only at 2.6% YoY. We find that wage growth tends to lag profits by around 24 months (panel 2) and, since profits moved sideways for close to two years until Q2 last year, it may be a few quarters yet before companies feel confident enough to raise wages. Note, too, that wages have been weak compared to profits in this cycle. This is likely partly because of automation, but also because the participation rate for the core working population continues to recover towards its 2007 level, indicating there is more slack in the labor market than the headline unemployment data suggest (panel 3). Should Investors Still Own Junk Bonds? Chart 12Credit Cycle Still On The current late stage of the economic cycle has investors worried about the credit cycle and the outlook for corporate credit, in particular high-yield bonds. The number-one concern is stretched valuations. Spreads are close to all-time lows, which means investors should not expect significant capital gain. However, spreads can stay low for extended periods, especially in the late stages of the credit cycle. Junk bonds are a carry trade at this point, and investors can continue to pick up carry before a sustained period of spread widening sets in (Chart 12). A flattening yield curve is bad for junk returns, as it signals monetary policy is too restrictive. But, as inflation continues to trend higher, the curve is likely to steepen while allowing the Fed to deliver rate hikes close to its median projection. The key risk is a scenario in which inflation falters, but the Fed continues to hike. In this case a risk-off episode in credit markets would be likely, but this would be a buying opportunity and not the end of the cycle. Corporate balance-sheets have weakened, and logically investors should demand greater compensation to hold high-yield bonds. But spreads have diverged from this measure since early 2016. However, we expect improvements in corporate health since the outlook for profit growth is strong. However, a great deal of bond issuance has been used for share buybacks. If capital structures have less of an equity cushion, then recovery rates are likely to be lower when defaults do start to rise. Cross-asset volatility has returned. But credit spreads have remained calm thanks to accommodative monetary policy and easing bank lending standards. Also, stricter post-crisis bank capital regulations have mitigated the risk. Finally, the growing presence of open-ended junk bond funds and ETFs increases the risk that, once spreads start to widen, they will widen much more quickly than they would have otherwise. Who Should Invest In Hedged Foreign Government Bonds? In a recently published Special Report,4 we found that hedged foreign government bonds are a good source of diversification for bond portfolios. Hedging not only reduces the volatility of the foreign bonds, it reduces it so much that the risk-adjusted return ratio has significantly improved for investors with home currency in USD, GBP, AUD, NZD, CAD and EUR (Table 2). This is true across different time periods for most fixed income investors other than those in Japan, as shown in Chart 13. Table 2Domestic And Foreign Government Risk Return Profile (December 1999 - January 2018) Chart 13Domestic Vs. Foreign Treasury Bonds: Consistent Performance Across Time So the answer depends on investors' objectives and constraints: If investors are comfortable with the volatility in their local aggregate bond indexes, which are already a lot lower than equities, then investors in the U.S., the U.K., Canada and the euro area are better off staying home for higher returns without dealing with hedging operations. For Aussie, kiwi and Japanese investors, however, going abroad enhances returns. If investors focus on lower volatility, then all investors should invest a large portion of their portfolios overseas, with the exception of Japanese investors. If investors focus on risk-adjusted returns, then investors in Australia, New Zealand, the U.S., the U.K. and Canada are better off investing a large portion overseas. Global Economy Overview: Global growth remains robust, though momentum has slowed slightly in recent weeks. No recession is likely before 2020 at the earliest due to strong U.S. fiscal stimulus. Inflation will slowly rise towards central bank targets but there is little reason to expect it to accelerate dramatically, and so we see no need for aggressive monetary tightening. U.S.: Short-term, growth looks to have softened, with the Citigroup Economic Surprise Index turning down (Chart 14, top panel), and the regional Fed NowCasts for Q1 GDP growth pointing to 2.4%-2.7%. However, growth over the next two years should be boosted by the recent tax cuts and government spending increases, which we estimate will push up GDP growth by 0.8% in 2018 and 1.3% in 2019. Wages should start to rise from their current sluggish levels (average hourly earnings only up 2.6% YoY) given the tight labor market, which should boost consumption. Capex (panel 5) is likely to continue to recover due to tax cuts and a high level of businesses confidence. Euro Area: Growth has been steady in recent quarters, with Q4 GDP rising 2.5% QoQ annualized. However, lead indicators such as the PMI (Chart 15, top panel) have rolled over, probably because of the strong euro (up 6.2% in trade-weighted terms over the past 12 months). The effect has yet to be seen in exports, which continue to grow strongly, 6.2% YoY in February, but earnings results for Q4 surprised much less on the upside in the euro area than in the U.S. Chart 14Growth Robust, But Momentum Slowing Chart 15Strong Currencies Denting EU And Japanese Growth Japan: As an export-oriented, cyclical economy, Japan has also benefitted from better global conditions, with GDP rising by 1.6% QoQ annualized in Q4. However, like Europe, the stronger currency has begun to dent the external sector, with industrial production and the leading index slowing (Chart 15, panel 2). However, more encouraging signs are appearing domestically: retail sales rose by 2.5% YoY in January and part-time wages are up 2.0% YoY. As a result, inflation is finally emerging, with CPI (excluding food and energy) up 0.3% YoY. Emerging Markets: China's growth remains steady, with the Caixin PMI at 51 (panel 3). However, credit and money supply growth continue to point to a slowdown in coming months. This may be evident when March data (unaffected by the shifting timing of Chinese New Year) becomes available. Elsewhere in EM, growth has picked up moderately: Q4 GDP growth came in at an annualized rate of 7.2% in India, 3.0% in Korea, and even 2.1% in Brazil and 1.8% in Russia. Interest rates: A modest rise in inflation expectations (panel 4) has led to a rise in long-term rates, with the U.S. 10-year yield rising from 2.5% to almost 3% during Q1 before slipping back a little. We expect the Fed to hike four times this year, and think this will push up the 10-year Treasury yield to 3.3-3.5% by year-end. The ECB continues to emphasize that it will move only slowly to raise rates after halting asset purchases later this year, and we think the market has correctly priced the timing of the first hike for Q4 2019. We see no reason why the BoJ will end its Yield Curve Control policy, with inflation still well below the 2% target. Chart 16Cautiously Optimistic Global Equities Tip-Toeing Through The Late Cycle. Global equities experienced widespread corrections in the first quarter after a very strong start in January gave way to fear of rising inflation in the U.S., fear of slowing growth in China, and fear of rising geopolitical tensions globally. The return of macro volatility was so violent that it pushed the VIX to high readings not seen since 2015. Granted, a background of stretched valuations, complacency, and the "fear of missing out" also contributed to the market correction. The healthy correction of global equities from the high in late January has seen valuations contracting as earnings continued to grow at strong pace (Chart 16). BCA's house view is that global growth may be peaking, but should remain strong and above trend, underpinning decent earnings growth for the next 9-12 months. As such, we retain our pro-cyclical tilts in global equity allocations, overweight cyclical sectors and underweight defensive sectors; overweight high-beta DM markets (Japan and euro area); neutral on the U.S. and Canada; and underweight EM and Australia, the markets that would suffer most from a deceleration in Chinese growth. However, we are late in the cycle and valuations remain stretched by historical standards despite the recent correction. With macro volatility returning, investors should be very conscious of potential risks that could derail the uptrend in equities. For investors with higher aversion to risk, we suggest raising cash by selling into strength or dialing down the overweight of cyclicals vs defensives. Anatomy Of EM/DM Outperformance Since their low in early 2016, EM equities have outperformed DM in total return terms by more than 20%, of which 262 bps came in the first quarter of 2018, despite the rising volatility in all asset classes recently. As show in Chart 17, the outperformance of EM over DM has been dominated by three sectors: Technology, Financials and Energy. In the two-year period ending December 2017, over half of the EM outperformance came from the Tech sector, followed by Financials and Energy, accounting for 32% and 14% respectively. In Q1 2018, however, Tech's contribution dropped sharply to 0.3%, while Financials and Energy shot up to 51% and 33% respectively. Even though Energy is a relatively small sector, accounting for 6-7% of benchmark weights in both EM and DM, the diverging performance between EM and DM Energy sectors has played an important role in the EM outperformance. In the two years ending December 2017, EM Energy outperformed its DM counterpart by 32%, the same magnitude as the Tech sector (Table 3). In Q1 2018, EM Energy gained 7.6% while DM Energy suffered a 5.2% decline, resulting in a staggering 13% outperformance (Table 4). Chart 17Sector Contributions To EM/DM Outperformance Table 3Two-Year Performance Attribution* (December 2015 - December 2017) Table 4Q1/2018 Attribution* (December 2015 - December 2017) Country-wise, Brazil and China led the outperformance, helped by the Brazilian real's 30% appreciation against the U.S. dollar. BCA's EM Strategy believes that Brazilian equities and the real will both weaken given the country's weak governance and poor fiscal profile. Chart 18Style Performance We are neutral on Tech globally, and the general reliance of EM equities on Chinese growth, and the high leverage in EM do not bode well for EM equities. Remain underweight EM vs. DM. A Sector Approach To Style Year to date, the equal-weighted multi-factor portfolio has outperformed the global benchmark slightly, largely driven by the strong outperformance of Momentum and Quality, while Value and Minimum Volatility (MinVol) have underperformed (Chart 18, top three panels). This is in line with our previous regime analysis that indicated rising growth and inflation is a good environment for Momentum and Quality, but a bad one for Min Vol.5 As we have argued before, we prefer sector positioning to style positioning because 1) the major style tilts such as Value/Growth, Min Vol and Small Cap/Large Cap have seen significant sector shifts over time, and 2) sector selection offers more flexibility. As shown in Chart 18 (bottom three panels), the relative performance of Min Vol is a mirror image of Cyclicals vs Defensives, while Value/Growth is highly correlated with Cyclicals/Defensives. In a Special Report,6 we elaborated in-depth that sector selection is a better alternative to size selection, especially in the U.S. We maintain our neutral view on styles, and continue to favor Cyclicals versus Defensives. Given that we are at the late stage of the business cycle, investors with lower risk tolerance may consider gradually dialing down exposure to cyclical tilts. For stock pickers, this would mean favoring stocks with low volatility, high quality and strong momentum. Government Bonds Maintain Slight Underweight On Duration. Despite rising volatility due to changes in inflation expectations and uncertain developments in geopolitics, the investment backdrop has been evolving in line with our 2018 Strategy Outlook. Global growth continues at a strong pace (Chart 19) and our U.S. Bond Strategy has increased its yield forecast to the range of 3.3-3.6%, from 2.80-3.25% previously, reflecting both a higher real yield and higher inflation expectations. The U.S. 10-year Treasury yield increased by 34 bps in Q1 to 2.74%, still lower than our fair value estimate, implying that there is still upside risk for global bond yields. As such, investors should continue to underweight duration in global government bonds. Favor Linkers Vs. Nominal Bonds. The base case forecast from our U.S. Bond Strategy is that the U.S. TIPS breakeven will rise to 2.3-2.5% around the time that U.S. core PCE reaches the Fed's 2% target rate, likely sometime in 2H 2018. Compared to the current level of 2.05, this means the 10-year TIPS has upside of 25-45 bps, an important source of relative return in the low-return fixed income space (Chart 20). Maintain overweight TIPS vs. nominal bonds. In terms of relative value, however, TIPS are no longer cheap. For those who have not moved to overweight TIPS, we suggest "buying TIPS on dips". In addition, inflation-linked bonds (ILBs) in Australia and Japan are still very attractive vs. their respective nominal bonds (Chart 20, bottom panel). Overweight ILBs in those two markets also fits well with our macro themes. Chart 19Further Upside In Bond Yields Chart 20Favor Inflation linkers Corporate Bonds We continue to favor both investment grade and high-yield corporate bonds within the fixed-income category. High-yield spreads barely reacted to the sell-offs in equities in February and March (Chart 21). We see credit spreads as a useful indicator of recessions and equity bear markets and so the fact that they did not rise suggests no broad-based risk aversion. Moreover, this resilience comes despite significant outflows from high-yield ETFs, $4.4 billion year-to-date, almost completely reversing the inflows over the previous three quarters. We still find spreads in this space attractive. BCA estimates the default-adjusted spread is still around 250 basis points (assuming default losses of 1.3% over the coming 12 months) which, while not cheap, is less overvalued than other fixed-income categories (Chart 22). Investment grade spreads, however, have widened in recent weeks (Chart 21), with the rise concentrated in the highest-quality credits. This is most likely because investors see little value in these securities. We keep our overweight but we focus on cross-over credits and sectors where valuations are still reasonable, for example energy, airlines and insurance companies. Excessive leverage remains a concern for corporate bond losses in the next recession. BCA's Corporate Health Monitor (Chart 23) has improved in recent quarters, mostly due to stronger profitability. But the deterioration in interest coverage ratios in recent years makes companies vulnerable to higher rates. We estimate that a 100 basis point increase in interest rates across the corporate curve would lead to a drop in the ratio of EBITDA to interest expenses from 4.0 to 2.5.7 Sectors such as Materials, Technology, Consumer Discretionary and Energy appear especially at risk.8 Chart 21IG Spreads Have Widened, But Not HY Chart 22Junk Bonds Still Offer Some Value Chart 23Leverage Is A Worry For The Next Recession Commodities Chart 24OPEC Agreements Hold The Key Energy (Overweight): Demand/supply fundamentals have been driving prices in crude oil markets (Chart 24). Fundamentals remain favorable as strong global demand is keeping the market in physical deficit. However, the outlook for demand has turned cloudy as the market may start to price in the possibility of a trade war which would dent growth. Also, threats of renewed sanctions against Iran and deeper ones against Venezuela could potentially disrupt supply sufficiently to push up the crude price. Given rising uncertainties with the demand and supply outlook, we expect increased volatility in the crude price. We maintain our forecasts for the average 2018 prices for Brent and WTI at $74 and $70 respectively. Industrial Metals (Neutral): As President Trump moves ahead with protectionist policies, markets are being spooked by the possibility of a trade war. Looking past the noise, since China remains the largest source of demand, price action will follow domestic Chinese market fundamentals which are a function of how authorities handle a possible growth slowdown. The possibility of global trade disruptions, coupled with a recovery in the U.S. dollar, suggests increased price volatility. We are particularly negative on zinc. Spanish zinc has been flooding into China, depressing physical premiums and causing inventory accumulation (Chart 24, panel 3). Precious Metals (Neutral): Rising trade protectionism, geopolitical tensions, and diverging monetary policy will be sources of increased market volatility for the rest of the year. When equity markets went through a minor correction earlier this year, gold outperformed global equities by 6%. However, rising interest rates and a potentially stronger U.S. dollar are two headwinds for the gold price. We continue to recommend gold as a safe haven asset against unexpected market volatility and inflation surprises (Chart 24, panel 4). Currencies Chart 25Dollar Will Stage A Recovery Rally U.S. Dollar: Following its 7% depreciation last year, the greenback is flat year to date. A positive output gap and strong inflation readings are giving the Fed enough reasons not to fall behind the curve. Secondly, the proposed fiscal stimulus is likely to increase the U.S.'s twin deficits which has historically been bullish for the currency, as long as it is accompanied by rising real rates. Finally, speculative positions in the dollar are net short, which means any positive surprises will be bullish for the currency. We expect the U.S. dollar to stage a recovery rally in the coming months (Chart 25, panel 1). Carry Trades: Cross-asset class volatility is making a strong comeback. Carry trades fare poorly in volatile FX markets. High-yielding EM currencies like the BRL, TRY, and ZAR will underperform, whereas low yielding safe-haven funding currencies like the Swiss franc and Japanese yen, in countries with outsized net international investment positions, will be the winners. Finally, the return of volatility could hurt global economic sentiment and possibly weigh on growth-sensitive currencies like the KRW, AUD and NZD (Chart 25, panel 2). Euro: Analyzing the euro's strength, we see a 9% divergence in performance between the EUR/USD pair and the trade-weighted euro. Global synchronized growth was driven predominantly by a recovery in manufacturing which benefited the euro area more than the U.S. Also looking at history, the euro tends to appreciate relative to USD in the last two years of economic upswings driven by strong growth. Finally, the recent divergence in relative interest rates is a clear sign that other fundamental factors, such as the current account balance, have been exerting pressure. Sentiment and positioning remain extremely euro bullish, hence any disappointment with economic data will force a correction (Chart 25, panel 3). GBP: Since 2017, the pound has strengthened by over 16% vs. USD. An appreciating currency has dented inflation readings, thereby limiting the pass-through effects via the Bank of England hiking rates. A hurdle to further appreciation is negative growth in real disposable income and declining household confidence. Finally, weak FDI inflows will hurt the U.K.'s basic balance. Since the BoE will find it difficult to tighten policy much, we expect a correction in the next few months (Chart 25, panel 4). Alternatives Investors have been increasing their allocation to alternatives, pushing AUM to a record $7.7 trillion. We continue to recommend allocations through three different buckets: 1) among return enhancers, we favor private equity vs hedge funds; 2) favor direct real estate vs. commodity futures in inflation hedges; 3) favor farmland & timberland vs. structured products as volatility dampeners. But alternatives have a few challenges that require special consideration. Private Equity: Key drivers of returns have changed. In the past, managers were able to succeed by "buying low/selling high". But today, investors need to pick general partners (GPs) who can identify attractive targets and effect strategic and operational improvements. $1.7 trillion of dry powder. Global buyout value grew by 19% in 2017, but deal count grew by only 2%. High valuations multiples, stiff competition, and an uncertain macro outlook will force funds to be selective. Competition from corporate buyers. GPs are fighting with large corporations looking for growth through acquisition. Private equity's share of overall M&A activity globally declined in 2017 for the fourth year running. Competition for targets is boosting entry multiples in the middle-market segment. Hedge Funds: Net exposure for long/short managers has remained static over market cycles, which means investors pay too much for market exposure. But if we see market rotation or increased dispersion of single stock returns, this hedge fund group will benefit. Discretionary macro will benefit from differing growth outlooks, idiosyncratic events, and local rate cycles. Also, potential for more dispersion in the large-cap space and at the index level will benefit systematic macro. Event-driven funds have been hurt by deal-spread volatility as shareholder opposition, anti-trust concerns and political issues led to deal delays. But we continue to favor short-term special situations in less-followed markets such as Asia. Real Estate: After strong growth in capital values, driven by low rates and cap rate compression, investors need to focus on income-driven total returns. Additionally, income returns do not vary across markets nearly as much as capital value growth. Increase focus on core strategies. Look for properties in prime locations with long and stable lease contracts. Investors can also consider loans made to high-quality borrowers which are secured against properties with stable cash flows. Private Debt: With ultra-low yields, private debt offers attractive risk-adjusted return, diversification, and a potential cash flow profile ideal for institutional investors. However, it is critical to source a differentiated pipeline of opportunities. Infrastructure debt, with a long expected useful life, can provide effective duration for liability matching. Risk-adjusted returns can be enhanced by directly sourcing and structuring. Risks To Our View We see the risks to our main scenario (strong growth continuing through 2019, moderate inflation, late cycle volatility, and rising geopolitical risks) as balanced. There are a number of obvious downside risks, including an escalating trade war, a sharp upside surprise to inflation, and the Fed turning more hawkish (perhaps in an attempt to demonstrate its independence if President Trump pressures it not to raise rates). Among the risks less appreciated by investors is a slowdown in China. Leading indicators of the Chinese economy, particularly money supply and credit growth, continue to slow (Chart 26). Xi Jinping's recent senior appointments suggests he is serious about structural reform, which would mean accepting slower growth in the short-term to put China on a sounder long-term growth path. Linked to this, we also think investors are insufficiently concerned about the impact of rising rates on emerging market borrowers. If, as we expect, U.S. long rates rise to close to 3.5% over the next year and the dollar strengthens, the $3.5 trillion of foreign-currency borrowing by EM borrowers could become a burden (Chart 27). Chart 26What If China Slows? Chart 27Highed Indebted EM Borrowers Are A Risk Chart 28Presidents Like Markets To Rise Upside risk centers on a continuation of strong growth and dovish central banks. We may be underestimating the impact of U.S. fiscal policy. Our assumption that it will peter out in 2020 may be wrong, if President Trump goes for further stimulus ahead of the presidential election - the third and fourth years of presidential cycles are usually the best for stocks (Chart 28). Wages may stay low because of automation. In the face of this the Fed may stay dovish: it already shows some signs of allowing an overshoot of its 2% inflation target, to balance the six years that it missed it to the downside. All this could produce a stock market meltup, similar to 1999. 1 See, for example, Clashing Over Commerce: A History of U.S. Trade Policy, Douglas J, Irwin, Chicago 2017, chapter 8. 2 For an analysis of the geopolitical implications, please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 27, 2018. 3 Please see the What Our Clients Are Asking: How Quickly Will U.S. Inflation Rise? on page 8 of this Quarterly Portfolio Outlook for the reasons why this is our view. 4 Please see Global Asset Allocation Special Report, "Why Invest In Foreign Government Bonds?" dated March 12, 2018 available at gaa.bcaresearch.com 5 Please see Global Asset Allocation Special Report, "Is Smart Beta A Useful Tool In Global Asset Allocation?" dated July 8, 2016, available at gaa.bcaresearch.com 6 Please see Global Asset Allocation Special Report, "Small Cap Outperformance: Fact Or Myth?" dated April 7, 2017, available at gaa.bcaresearch.com 7 Please see The Bank Credit Analyst, "Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector," dated February 22, 2018. 8 Please see also What Our Clients Are Asking: Should Investors Still Own Junk Bonds, on page 9 of this Quarterly Update, for more analysis of this asset class. GAA Asset Allocation