Monetary

Highlights The Federal Reserve’s monetary policy stance is slightly accommodative for the U.S., but it is too tight for the rest of the world. Inflation is likely to slow further before making a durable bottom toward year-end. The Fed will remain on an extended pause, maybe all the way through to December 2020. The trade war is not going away, and investors should not be complacent. However, it also guarantees that Chinese policymakers will redouble on their reflationary efforts. As a result, global growth is still set to improve in the second half of 2019. The dollar rally is in its last innings; the greenback will depreciate in the second half of this year. Treasury yields have limited downside and their recent breakdown is likely to be a fake-out. Use any strength in bond prices to further curtail portfolio duration. The correction in stocks is not over. However, the cycle’s highs still lie ahead. Feature Ongoing Sino-U.S. tensions and weakness in global growth are taking their toll. The S&P 500 has broken below its crucial 2,800 level, EM equities are quickly approaching their fourth-quarter 2018 lows, U.S. bond yields have fallen to their lowest readings since 2017, copper has erased all of its 2019 gains and the dollar is attempting to break out. In response, futures markets are now pricing in interest rate cuts by the Fed of 54 bps and 64 bps, over the next 12 and 24 months, respectively. Will the Fed ratify these expectations? Last week’s release of the most recent Fed’s Federal Open Market Committee meeting minutes, as well as comments from FOMC members ranging from Jerome Powell to Richard Clarida, are all adamantly clear: U.S. monetary policy is appropriate, and a rate cut is not on the table for now. However, the avowed data-dependency of the Fed implies that if economic conditions warrant, the FOMC will capitulate and cut rates. Even as U.S. inflation slows, a recession is unlikely. Moreover, the Sino-U.S. trade war will catalyze additional reflationary policy from China, putting a floor under global growth. In this context, the Fed is likely to stay put for an extended period, but will not cut rates. While the S&P 500 is likely to fall toward 2,600, the high for the cycle is still ahead. We therefore maintain our positive cyclical equity view, especially relative to government bonds, but we are hedging tactical risk. Fed Policy Is Neutral For The U.S…. If the fed funds rate was above the neutral rate – the so-called R-star – we would be more inclined to agree with interest rate markets and bet on a lower fed funds rate this year. However, it is not clear that this is the case. Chart I-1Mixed Message From The R-Star Indicator Admittedly, the inversion of the 10-year/3-month yield curve is worrisome, but other key variables are not validating this message. Currently, our R-star indicator, based on M1, bank liquidity, consumer credit, and the BCA Fed monitor, is only in neutral territory (Chart I-1). Moreover, we built a model based on the behavior of the dollar, yield curve, S&P homebuilding relative to the broad market and initial UI claims that gauges the probability that the fed funds rate is above R-star. Currently, the model gives a roughly 40% chance that U.S. monetary policy is tight (Chart I-2). Historically, such a reading was consistent with a neutral policy stance.   Chart I-2Today, Fed Policy Is At Neutral Models can be deceiving, so it is important to ensure that facts on the ground match their insights. Historically, housing is the sector most sensitive to monetary policy.1 Key forward-looking activity measures are not showing signs of stress: mortgage applications for purchases have jumped to new cyclical highs, and the NAHB homebuilders confidence index has smartly rebounded after weakening last year (Chart I-3). Also, homebuilder stocks have been in a steady uptrend relative to the S&P 500 since last October (Chart I-3, bottom panel). These three developments are not consistent with tight monetary policy. Chart I-3This Would Not Happen If Policy Were Tight The corporate sector confirms the message from the housing sector. While capex intentions have weakened, they remain at elevated levels, despite slowing profit growth and elevated global uncertainty. Moreover, the latest Fed Senior Loan Officer Survey shows that banks have again eased credit standards for commercial and industrial loans. Netting out all these factors, we are inclined to agree with the Fed that monetary policy in the U.S. is broadly neutral. If anything, the rebound in leading indicators of residential activity would argue that policy is even slightly accommodative. … But Not For The Rest Of The World Congress gave the Fed a U.S.-only mandate, but the U.S. dollar is the global reserve currency. Because the dollar is the keystone of the global financial architecture, between US$12 trillion and US$14 trillion of foreign-currency debt is issued in USDs, and the greenback is used as a medium of exchange in roughly US$800 trillion worth of transaction per year.2 Therefore, the Fed may target U.S. monetary conditions, but it sets the cost of money for the entire world. While U.S. monetary conditions may be appropriate for the U.S., they are not entirely appropriate for the world as a whole. Indeed, the green shoots of growth we highlighted two months ago are rapidly turning brown: Korean and Taiwanese exports, which are highly sensitive to the global and Asian business cycles, are still contracting at a brisk pace (Chart I-4, top panel). Japan, an economy whose variance in GDP mostly reflects global gyrations, is weakening. Exports are contracting at a 4.3% yearly pace, machine tool orders are plunging at a 33% annual rate and the coincident indicator is below 100 – a sign of shrinking activity. The semiconductor space is plunging (Chart I-4, second panel). Our EM Asia diffusion index, which tallies 23 variables, is near record lows (Chart I-4, third panel). Europe too is feeling the pain, led by Germany, another economy deeply dependent on global activity. The flash estimate for the euro area manufacturing PMI fell to 47.7 and plunged to 44.3 in Germany, its lowest level since July 2012 (Chart I-4, bottom panel). These developments show that the world economy remains weak, in part because the Chinese economy has yet to meaningfully regain any traction. The rebound in Chinese PMI in March proved short lived; in April, both the NBS and Caixin measures fell back to near the 50 boom/bust line. Since inflation lags real activity and global growth has yet to bottom, it could take some time before inflation finds a floor. A strong dollar is a natural consequence of an outperforming U.S. economy, especially when global growth weakens. Thus, the rally in the Fed’s nominal trade-weighted dollar to its highest level since March 2002 is unsurprising (Chart I-5). A strong Greenback will have implications for inflation, and thus the Fed. Chart I-4Global Growth: No Green Shoots Here Chart I-5A Strong Dollar Is A Natural Consequence Of Weak Growth   Transitory Inflation Weakness Is Not Over The Fed believes the current inflation slowdown is transitory. We agree. With a tight labor market and rising wages, the question is not if inflation will rise, but when. In the current context, it could take some time. As Chart I-6 shows, inflation has been stable for more than 20 years. From 1996 to today, core PCE has oscillated between 0.9% and 2.6%, while core CPI has hovered between 0.6% and 2.9%, with the peaks and troughs determined by the ebbs and flows of global growth. Since inflation lags real activity and global growth has yet to bottom, it could take some time before inflation finds a floor, likely around 1.3% and 1.5% for core PCE and core CPI, respectively. Chart I-6Stable U.S. Inflation Since 1996 A few dynamics strengthen this judgment: The strength in the dollar is deflationary (Chart I-7, top panel). Not only does an appreciating greenback depress import prices, it tightens U.S. and global financial conditions. It also undermines dollar-based liquidity, especially if EM central banks try to fight weakness in their own currencies. All these forces harm growth, commodity prices and ultimately, inflation. Chart I-7More Downside Ahead In Inflation For Now After adjusting for their disparate variance, the performance of EM stocks relative to EM bonds is an excellent leading indicator of global core inflation (Chart I-7, second panel). This ratio is impacted by EM financial conditions, explaining its forecasting power for prices. Since goods inflation – which disproportionally contributes to overall variations in core CPI – is globally determined, U.S. inflation will suffer as well. U.S. capacity utilization is declining (Chart I-7, third panel). The U.S. just underwent a mini inventory cycle. The 12-month moving averages of the Philadelphia Fed and Empire State surveys’ inventory indexes still stand above their long-term averages. U.S. firms will likely use discounts to entice customers, especially as a strong dollar and weak global growth point to limited foreign outlets for this excess capacity. Finally, the growth in U.S. unit labor costs is slowing sharply, which normally leads inflation lower (Chart I-7, bottom panel). Average hourly earnings may now be growing at a 3.2% annual pace, but productivity rebounded to a 2.4% year-on-year rate in the first quarter, damping the impact of higher salaries on costs. If global growth is weak and U.S. inflation decelerates further, the Fed is unlikely to raise interest rates anytime soon. As the Fed policy remains modestly accommodative and the labor market is at full employment, the balance of probability favors an extended pause over a cut. But keep in mind, next year’s elections may mean this pause could last all the way to December 2020. How Does The Trade War Fit In? An additional irritant has been added to the mix: the growing trade tensions between the U.S. and China. The trade war has resurrected fears of a repeat of the 1930 Smoot-Hawley tariffs, which prompted a wave of retaliatory actions, worsening the massive economic contraction of the Great Depression. There is indeed plenty to worry about. Today, global trade represents 25% of global GDP, compared to 12% in the late 1920s. Global growth would be highly vulnerable to a freeze in world trade. Besides, global supply chains are extremely integrated, with intra-company exports having grown from 7% of global GDP to 16% between 1993 and 2013. If a full-blown trade war were to flare up, much of the capital invested abroad by large multinationals might become uneconomic. As markets price in this probability, stock prices would be dragged down. Chart I-8Trade Uncertainty Alone Will Delay The Recovery The fear of a full-fledged trade war is already affecting the global economy. The fall in asset prices to reflect the risk of stranded capital is tightening financial conditions and hurting growth. Moreover, the rise in U.S. and global economic uncertainty is depressing capex intentions (Chart I-8). Since capex intentions are a leading variable for actual capex, global exports and manufacturing activity, the trade war is deepening and lengthening the current soft patch. Markets need to be wary of pricing in a quick end to the Sino-U.S. trade conflict. Table I-1 presents BCA’s Geopolitical Strategist Matt Gertken’s odds of various outcomes to the trade negotiations and their implications for stocks. Matt assigns only a 5% probability to a grand compromise between the U.S. and China on trade and tech. He also foresees a 35% chance that a deal on trade excluding an agreement on tech will be reached this year. This leaves 10% odds that the two sides agree to extend the negotiation deadline beyond June, 20% odds of no deal at all and a minor escalation, and 30% odds of a major escalation. In other words, BCA is currently assigning 60% odds of a market-unfriendly outcome, and only a 40% chance of a genuinely market-friendly one.3 Why the gloom? The U.S. and China are geopolitical rivals in a deadlock. Moreover, both parties are feeling increasingly emboldened to play hardball. On the U.S. side, President Donald Trump has threatened to expand his tariffs to all of China’s exports to the U.S., which would represent a major escalation in both the conflict and its cost (Chart I-9). However, despite the scale of the threat, even if it were fully borne by U.S. households, its impact should be kept in perspective. Imports of consumer goods from China only represent 2% of total household spending (Chart I-10, top panel). Moreover, households are not currently overly concerned with inflation, as goods prices are already muted (Chart I-10, middle panel) and family income is still growing (Chart I-10, bottom panel). Finally, a weak deal could easily be decried as a failure in the 2020 election. On the Chinese side, the 9.5% fall in the yuan is already absorbing some of the costs of the tariffs, and the RMB will depreciate further if the trade war escalates. Additionally, Chinese exports to the U.S. represent 3.4% of GDP, while household and capital spending equals 81% of output. China can support its domestic economy via fiscal and credit policy, greatly mitigating the blow from the trade war. The outlook for Chinese reflationary efforts is therefore paramount. In sharp contrast to its limited upside, the dollar’s downside will be much more significant once global growth improves. Not only do Chinese policymakers have the room to stimulate, they also have the will. In the first four months of 2019, Chinese total social financing flows have amounted to CNY 9.6 trillion, which compares favorably to the same period during the 2016 reflation campaign. Yet, the economy has not fully responded to the injection of credit and previously implemented tax cuts amounting to CNY 1.3 trillion or 1.4% of GDP. Consequently, GDP per capita is now lagging well behind the required path to hit the government’s 2020 development targets (Chart I-11). Moreover, Chinese policymakers’ recent comments have increasingly emphasized protecting employment. This combination raises the likelihood of additional stimulus in the months ahead. Chart I-10...But Do Not Overstate Trump's Constraints Chart I-11Chinese Stimulus: Scope And Willingness   Therein lies the paradox of the trade war. While its immediate effect on world growth is negative, it also increases the chance that Chinese authorities pull all the levers to support domestic growth. A greater reflationary push would thus address the strongest headwind shaking the global economy. It could take two to six more months before the Chinese economy fully responds and lifts global growth. Ultimately, it will. Hence, even as the trade war continues, we remain skeptical that the Fed will cut interest rates as the market is discounting. We are therefore sticking to our call that the Fed will not cut rates over the next 12 months and will instead stay on an extended pause. Investment Conclusions The Dollar So long as global growth remains soft, the dollar is likely to rally further. That being said, the pace of the decline in global growth is decelerating. As a corollary, the fastest pace of appreciation for the greenback is behind us (see Chart I-5 on page 6). The risk to this view is that the previous strength in the dollar has already unleashed a vicious cycle whereby global financial conditions have tightened enough to cause another precipitous fall in world growth. The dollar’s strong sensitivity to momentum would then kick in, fomenting additional dollar strength in response to the greater growth slowdown. In this environment, the Fed would have no choice but to cut interest rates. However, growing reflationary efforts around the world currently confine this scenario to being a risk, not a central case. Additional factors also limit how far the dollar can rally. Speculators have already aggressively bought the greenback (Chart I-12). The implication is that buyers have moved in to take advantage of the dollar-friendly fundamentals. When looking at the euro, which can be thought of as the anti-dollar, investors are imputing a large discount in euro area stocks relative to U.S. ones, pointing to elevated pessimism on non-U.S. growth (Chart I-13). It would therefore require a much graver outcome in global growth to cause investors to further downgrade the outlook for the rest of the world relative to the U.S. and bring in new buyers of greenbacks. Chart I-12USD: Supportive Fundamentals Are Already Reflected Chart I-13Plenty Of Pessimism In European Assets...   In sharp contrast to its limited upside, the dollar’s downside will be much more significant once global growth improves. The same factors that are currently putting the brakes on the dollar’s rise will fuel its eventual downturn. As global growth bounces, a liquidation of stale long-dollar bets will ensue. European growth will also rebound (Chart I-14), and euro pessimism will turn into positive surprises. European assets will be bought, and the euro will rise, deepening the dollar’s demise. We are closely following the Chinese and global manufacturing PMIs to gauge when global growth exits its funk. At this point, it will be time to sell the USD. Government Bonds Bonds are caught between strong crosscurrents. On the one hand, rising economic uncertainty caused by the trade war, slowing global economic activity and decelerating inflation are all bond-bullish. On the other hand, bond prices already reflect these tailwinds. The OIS curve is baking in 54 basis points of Fed cuts over the next 12 months, as well as a further 10 basis points over the following 12 months (Chart I-15, top panel). Meanwhile, term premia across many major bond markets are very negative (Chart I-15, middle panel). Finally, fixed-income investors have pushed their portfolio duration to extremely high levels relative to their benchmark (Chart I-15, bottom panel). Chart I-14...Creates Scope For Positive Surprises Chart I-15Fade The Treasury Rally   Last week, Treasury yields broke down below 2.34%. For this technical break to trigger a new down-leg in yields, investors must curtail their already-depressed expectations of the fed funds rate in 12-months’ time. However, the fed funds rate is not yet restrictive, and global growth should soon find a floor in response to expanding Chinese stimulus. Under these circumstances, the Fed is unlikely to cut rates, and will continue to telegraph its intentions not to do so. Hence, unless the S&P 500 or the ISM manufacturing fall below 2,500 and 50, respectively, any move lower in yields is likely to be transitory and shallow. Cyclically, yields should instead move higher. Our Global Fixed Income Strategy service’s duration indicator has already turned the corner (Chart I-16). Moreover, in the post-war period, Treasury yields have, on average, bottomed a year before inflation. Expecting an inflation trough in late 2019 or even early 2020 is therefore consistent with higher yields by year-end. Finally, when the Fed does not cut interest rates as much as the markets had been anticipating 12-months’ prior, Treasurys underperform cash. This is exactly BCA’s current Fed forecast. Chart I-16Global Yields Now Have More Upside Than Downside While we expect the bond-bearish forces to emerge victorious, yields may only rise slowly. The list of aforementioned supports for Treasury prices is long, the equity market will remain volatile and has yet to trough, and the trade war is likely to linger. We continue to closely monitor the AUD, the SEK versus the EUR, and copper to gauge if our view is wrong. These three markets are tightly linked to Chinese growth. If China’s stimulus is working, these three variables will rebound, and our bond view will be validated. If these three variables fall much further, U.S. yields could experience significantly more downside. Equities Equities are at a difficult juncture. The trade war is a bigger problem for Wall Street than for Main Street, as 43.6% sales of the S&P 500’s are sourced abroad. Moreover, the main mechanism through which trade tensions impact the stock market is through the threat that capital will be stranded – and thus worthless. This is a direct hit to the S&P 500, especially as global growth has yet to clearly stabilize and the Chinese are only beginning to make clearer retaliatory threats. Oil could also hurt stocks. Energy prices have proven resilient, despite weaker global economic activity. OPEC and Russia have been laser-focused on curtailing global crude inventories; even after the U.S. declined to extend waivers on Iranian exports, the swing oil producers have not meaningfully increased supply. Problems in Venezuela, Libya, and potential Iranian adventurism in Iraq could easily send oil prices sharply higher, especially as the U.S. does not have the export capacity to fulfill foreign demand. Thus, the oil market could suddenly tighten and create a large drag on global growth. This backdrop also warrants remaining overweight the energy sector. Stocks remain technically vulnerable. Global and U.S. stock market breadth has deteriorated significantly, as shown by the number of countries and stocks above their 200-day moving averages (Chart I-17). Moreover, since March, the strength in the S&P 500 has been very narrow, as shown by the very poor performance of the Value Line Geometric Average Index (Chart I-18). Meanwhile, the poor relative performance of small-cap stocks in an environment where the dollar is strong, where U.S. growth is holding steady compared to the rest of the world and where multinationals have the most to lose from a trade war, is perplexing. Chart I-17Stocks Remain Technically Fragile Chart I-18Dangerous Internal Dynamics   The U.S. stock market has the most downside potential in the weeks ahead. Like last summer, U.S. equity prices remain near record highs while EM and European stocks, many commodities and bond yields have been very weak. Moreover, the broad tech sector, the U.S.’s largest overweight, has defied gravity, despite weakness in the semiconductor sector, the entire industry’s large exposure to foreign markets, and the consequential slowdown in our U.S. Equity Strategy service's EPS model (Chart I-19).4 Thus, any bad news on the trade front or any additional strength in the dollar could prove especially painful for tech. This would handicap U.S. equities more than their already beaten-up foreign counterparts. Chart I-19The Tech Sector Profit Outlook Remains Poor These forces mean that the global equity correction will last longer, and that U.S. equities could suffer more than other DM markets. However, we do not see the S&P falling much beyond the 2,700 to 2,600 zone. Again, the fed funds rate is slightly accommodative and a U.S. recession – a prerequisite for a bear market (Chart I-20) – is unlikely over the coming 12 months. Moreover, global growth should soon recover, especially if China’s reflationary push gathers force. Additionally, an end to the dollar’s rally would create another welcomed relief valve for stocks. Chart I-20The Absence Of A Recession Means This Is A Correction, Not A Bear Market In this context, we recommend investors keep a cyclical overweight stance on stocks. Balanced portfolios should also overweight stocks relative to government bonds. However, the near-term risks highlighted above remain significant. Consequently, we also recommend investors hedge tactical equity risks, a position implemented by BCA’s Global Investment Strategy service three weeks ago.5 As a corollary, if stocks correct sharply, the associated rise in implied volatility will also cause a violent but short-lived pick up in credit spreads. In Section II, we look beyond the short-term gyrations. One of BCA’s long-term views is that inflation is slowly embarking on a structural uptrend. An environment of rising long-term inflation is unfamiliar to the vast majority of investors. In this piece, Juan-Manuel Correa, of our Global Asset Allocation team, shows which assets offer the best inflation protection under various states of rising consumer and producer prices. Mathieu Savary Vice President The Bank Credit Analyst May 30, 2019 Next Report: June 27, 2019 II. Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises U.S. inflation is on a structural uptrend. Monetary and fiscal policy, populism, and demographics will tend to push inflation higher over the coming decade. How can investors protect portfolios against inflation risk? We look at periods of rising inflation to determine which assets were the best inflation hedge. We find that the level of inflation is very important in determining which assets work best. When inflation is rising and high, or very high, the best inflation hedges at the asset class level are commodities and U.S. TIPS. When inflation is very high, gold is the best commodity to hold and defensive sectors will minimize losses in an equity portfolio. However, hedges have a cost. Allocating a large percentage of a portfolio to inflation hedges will be a drag on returns. Investors should opt for a low allocation to hedges now, and increase to a medium level when inflation rises further. Some 38 years have passed since the last time the U.S. suffered from double-digit inflation. The Federal Reserve reform of 1979, championed by Paul Volcker, changed the way the Fed approached monetary policy by putting a focus on controlling money growth.1 The reform gave way to almost four decades of relatively controlled inflation, which persists today. But times are changing. While most of today’s investors have never experienced anything other than periods of tame inflation, BCA expects that rising inflation will be a major driving force of asset returns over the coming decade.2 The main reasons behind this view are the following: 1. A rethink in the monetary policy framework: At its most recent meeting, the FOMC openly discussed the idea of a price-level target, implying that it would be open to the economy running hot to compensate for the past 10 years of below-target inflation (Chart II-1.1A, top panel). Chart II-1.1AStructural Forces Point To Higher Inflation In The Coming Decade (I) Chart II-1.1BStructural Forces Point To Higher Inflation In The Coming Decade (I)   2. Procyclical fiscal policy: The U.S. is conducting expansionary fiscal policy while the economy is at near-full employment (Chart II-1.1A, middle panel). The last time this happened in the U.S., during the 1960s, high inflation followed, as the fiscal boost made the economy run substantially above capacity. 3. Waning Fed independence: President Trump has openly questioned the hiking campaign undertaken by the Fed. Moreover, he has tried to nominate Fed governors with dovish tendencies. Historically around the world, a lack of central bank independence has often led to higher inflation rates (Chart II-1.1A, bottom panel). 4. Peak in globalization: Globalization accelerated significantly in the 1990s and 2000s, flooding the global economy with cheap labor (Chart II-1.1B, top panel). However, we believe that globalization has peaked. Instead, populism and protectionism will be the dominant paradigms for years to come, reducing the cheap pool of workers and goods previously available. 5. Demographics: The population in the U.S. is set to age in coming years (Chart II-1.1B, middle panel). As the percentage of U.S. retirees increases, the number of spenders relative to savers will begin to rise (Chart II-1.1B, bottom panel). Higher spending and lower savings in the economy should create upward pressure on inflation. If our view is correct, how should investors allocate their money? We attempt to answer this question by evaluating the performance of five major asset classes during periods when inflation was rising. Furthermore, we look into sub-asset class performance to determine how investors should position themselves within each asset class to take advantage of an inflationary environment. In our asset-class analysis, we use a data sample starting in 1973 and we limit ourselves to five publicly traded assets that have adequate history: global equities, U.S. Treasuries, U.S. real estate (REITs), U.S. inflation-linked bonds,3 and commodities. We compare asset classes according to their Sharpe ratios: average annualized excess returns divided by annualized volatilities.4  BCA expects that rising inflation will be a major driving force of asset returns over the coming decade. In our sub-asset class analysis, we analyze global equity sectors, international vs U.S. equities, and individual commodities. In some of the sections in our sub-asset class analysis, our sample is slightly reduced due to lack of historical data. Moreover, since in some instances all sectors have negative returns, we compare sub-asset classes according to their excess returns only. We base our analysis on the U.S. Consumer Price Index, given that most of the assets in our sample are U.S. based. We opt for this measure because it tends to track the living expenses for most U.S. citizens and it is the preferred measure to index defined-benefit payments. Finally, we decompose the periods of rising inflation into four quartiles in order to examine whether the level of inflation has any impact on the performance of each asset. Chart II-1.2 and Table II-1.1 show the different ranges we use for our analysis as well as a description of the typical economic and monetary policy environments in each of them. Summary Of Results Table II-1.2 shows the summary of our results. For a detailed explanation on how each asset class and sub-asset class behaves as inflation rises, please see the Asset Class section and the Sub-Asset Class section below. Which assets perform best when inflation is rising? Rising inflation affects assets very differently, and is especially dependent on how high inflation is. Global equities performed positively when inflation was rising and low or mild, but they were one of the worst-performing assets when inflation was rising and high or very high. Importantly, equities underperformed U.S. Treasuries in periods of both high and very high inflation. Commodities and U.S. TIPS were the best performers when inflation was high or very high. U.S. REITs were not a good inflation hedge. Which global equity sectors perform best when inflation is rising? Energy and materials outperformed when inflation was high. Every single sector had negative excess returns when inflation was very high, but defensive sectors such as utilities, healthcare, and telecommunications5 minimized losses. Which commodities perform best when inflation is rising? With the exception of energy, most commodities had subpar excess returns when inflation was in the first two quartiles. Industrial metals outperformed when inflation was high. Gold and silver outperformed when inflation was very high. Additionally, gold had consistent returns and low volatility. What is the cost of inflation hedging? To answer this question, we construct four portfolios with different levels of inflation hedging: 1. Benchmark (no inflation hedging): 60% equities/40% bonds. 2. Low Inflation Hedging: 50% equities/40% bonds/5% TIPS/5% commodities 3. Medium Inflation Hedging: 40% equities/30% bonds/15% TIPS/15 % commodities 4. Pure Inflation Hedging: 50% TIPS/50% commodities. While increased inflation hedging provides better performance when inflation is high and rising, these hedges are costly to hold when inflation is at lower ranges or when it is falling (Chart II-1.3, panels 1 & 2). However, adding moderate inflation hedging (low or medium) to a portfolio achieved the right balance between cost and protection, and ultimately improved risk-adjusted returns over the whole sample (Chart II-1.3, panel 3). What about absolute returns? The benchmark outperformed over the whole sample. However, the low and medium inflation hedging did not lag far behind, while avoiding the big drawdowns of high inflation periods (Chart II-1.3, panel 4). Investment Implications High inflation may return to the U.S. over the next decade. Therefore, inflation hedging should be a key consideration when constructing a portfolio. Based on our results, our recommendations are the following: 1. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. 2.  However, these hedges are costly to hold as they will create a drag on returns in periods when inflation is not high or very high. Therefore, a low allocation to inflation hedges is warranted now. 3.   Inflation will probably start to pick up in the 2020s. A medium allocation to inflation hedges will then be appropriate. 4.   When inflation is high (3.3%-4.9%), investors should overweight energy and materials in their equity portfolios. Likewise, they should overweight industrial metals and energy within a commodity portfolio. 5.   When inflation is very high (4.9% or more), investors should overweight defensive sectors in their equity portfolio to minimize losses. Moreover, investors should overweight gold within a commodity portfolio. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. Asset Classes Global Equities The relationship between equity returns and rising inflation depends on how high inflation is, with outstanding performance when inflation is rising but low or mild, and poor performance as it gets higher (Chart II-2.1, top panel). This relationship can be explained by the interaction between interest rates, inflation, earnings, and valuations: Earnings growth was usually slightly negative when inflation was recovering from low levels. However, given that interest rates were very low in this environment and growth expectations were high, multiple expansion boosted equity returns (Chart II-2.1, bottom panel). When inflation was mild, the Fed typically started to raise rates, resulting in a declining multiple. However, equities had the best performance in this range thanks to very high earnings growth – a result of the economy growing strongly due to a healthy level of inflation. When inflation climbed into the high or very high range, earnings growth was usually positive but beginning to slow, as high inflation weighed on growth. Meanwhile the multiple started to decline rapidly due to rising interest rates and declining growth expectations. With the exception of the mild inflation range, the return profile of equities during inflationary periods was similar to its normal profile: negative skew and excess kurtosis (Table II-2.1). However, the consistency of returns decreased at higher levels of inflation, with only 45% of months with positive returns when inflation was rising and in its highest quartile. U.S. Treasuries U.S. Treasuries reacted in a similar fashion to equities when inflation was rising (Chart II-2.2). However, while Treasuries underperformed equities when inflation was low or mild, they actually outperformed equities when inflation was high or very high. This was in part due to the fact that at higher inflation ranges, U.S. Treasuries offer a higher coupon return when rates are high, at least partially counteracting losses from falling prices. The steady stream of cash flows from the coupons helped Treasuries achieve positive returns roughly two-thirds of the time at the highest levels of inflation (Table II-2.2). However, this consistency in returns came at a cost: very high inflation resulted in negative skew and high excess kurtosis. Therefore, while Treasuries provided frequent positive returns when inflation was very high, they were prone to violent selloffs. U.S. REITs While REITs had high risk-adjusted returns when inflation was rising but mild, much like equities they had subpar performance in every other quartile and particularly poor performance when inflation was high or very high (Chart II-2.3). These results confirm our previous research showing that REITs performance is very similar to that of equities.6 The return consistency for REITs was generally poor in inflationary periods, with the second-lowest percentage of positive return of any asset class (Table II-2.3). Moreover, REIT returns had excess kurtosis and negative skew throughout all inflation quartiles. Commodity Futures Commodities performed positively in every quartile, and did particularly well when inflation was mild (Chart II-2.4, top panel). However, total return and price return were very different due to the behavior of the roll and collateral return: Total risk-adjusted returns were lower than spot risk-adjusted returns when inflation was low and rising. This happened because during these periods, commodity supply was high relative to demand, as the economy was recovering from a deflationary shock. Thus, there was an incentive for producers to conserve inventories, making the futures curve upward-sloping (contango). Thus, roll return was negative (Chart II-2.4, bottom panel). When inflation was in the upper two quartiles, total risk-adjusted returns were much higher than risk-adjusted spot returns. This was because high inflation was the product of supply shocks. These supply shocks resulted in a downward-sloping futures curve (backwardation), which, in turn, resulted in a positive roll return. Additionally, high rates during these regimes contributed to a high collateral return. Commodities provided good return consistency during inflationary periods, with roughly 60% of positive return months in the upper two inflation quartiles (Table II-2.4). The skew of returns was neutral or positive in the top two quartiles. This means that although volatility was high for commodities, extreme return movements were normally positive. U.S. Inflation-Protected Bonds While inflation-protected bonds provided meager returns when inflation was rising but in the mild range, they provided excellent performance at the highest levels of inflation (Chart II-2.5). Moreover, this high Sharpe ratio was not just simply the result of low volatility, since U.S. TIPS had excess returns of 4.6% when inflation was high and 5.7% when inflation was very high.7 The return profile of inflation-protected bonds during inflationary periods was also attractive in our testing period. Average skew was positive, while kurtosis was relatively low (Table II-2.5). The percentage of positive months across all quartiles was also the highest of all asset classes, with a particularly high share of positive returns in the periods of highest inflation. Sub-Asset Classes Global Equity Sectors For the sector analysis, we looked at information technology, financials, energy, materials, utilities, healthcare, and telecommunications. We excluded industrials, consumer discretionary, and consumer staples given that they do not have adequate back data. Once again, we separate rising inflation periods into four quartiles, arriving at the following results: When inflation was low, information technology had the best excess returns while utilities had the worst (Chart II-3.1, panel 1). This matches our observations at the asset class level, as IT is highly responsive to changes in the valuation multiple. When inflation was mild, energy had the best performance, followed by information technology (Chart II-3.1, panel 2). Meanwhile, financials had the worst performance, as rates were normally rising in these periods. When inflation was high, sectors highly correlated with commodity prices such as energy and materials outperformed. Meanwhile, IT was the worst performer (Chart II-3.1, panel 3). When inflation was very high, every sector had negative excess returns. Overall, investing in energy minimized losses (Chart II-3.1, panel 4). However, this performance was in part attributable to the oil spikes of the 1970s. Alternatively, defensive sectors such as utilities, telecommunications, and healthcare also minimized losses. International vs U.S. Equities How do equities outside of the U.S. behave when inflation is rising? While the high share of U.S. equities in the global index causes U.S. equities to be the main driver of global stock prices, is it possible to improve returns in inflationary environments by overweighting international equities? The answer once again depends on the level of inflation. When inflation was rising but low, U.S. stocks outperformed global ex-U.S. equities in both common currency and local currency terms (Chart II-3.2, panel 1). This was in part due to the inherent tech bias in U.S. stocks. Additionally, the low level of inflation was often accompanied by slowing global growth in our sample, helping the U.S. dollar. When inflation was mild, U.S. stocks once again outperformed international stocks in both local and common currency terms, though to a lesser degree (Chart II-3.2, panel 2). The dollar was roughly flat in this environment. U.S. stocks started to have negative excess returns when inflation was high (Chart II-3.2, panel 3). On the other hand international equities had positive excess returns in dollar terms, partly because of their energy and material bias and partly because the dollar was generally weak in this period. U.S. equities outperformed global ex-U.S. equities by a small margin when inflation was very high, given that defensive sectors such as telecommunication were over-represented in the U.S. index (Chart II-3.2, panel 4). The dollar was roughly flat in this period. Individual Commodities Our analysis above confirmed that commodities were one of the best assets to hold when inflation was rising. However, which commodity performed best?8 Total return for every commodity was lower than spot return when inflation was low (Chart II-3.3, panel 1). This was due to the upward-sloping term structure of the futures curve (contango), resulting in a negative roll yield. In this range, energy had the best performance, followed by industrial metals. Precious metals had negative excess returns. When inflation was mild, energy had the best performance of any commodity by far (Chart II-3.3, panel 2). Precious and industrial metals had low but positive excess returns in this period. When inflation was high, industrial metals had the highest excess returns, followed by energy (Chart II-3.3, panel 3). We omit energy for the last quartile since there is not enough data available. Overall, when inflation was very high, both gold and silver had the highest excess returns (Chart II-3.3, panel 4). However, gold’s return volatility was much lower, while it also had positive returns 64% of the time compared to 52% for silver. Other Assets U.S. Direct Real Estate Our asset-class analysis confirmed that public real estate (REITs) as an asset class offered poor risk-adjusted returns during inflationary periods. But how did direct real estate perform? We analyzed direct real estate separately from all other assets because of a couple of issues: Our return dataset is available only on a quarterly basis, versus a monthly basis for the rest of the assets in our sample. Even when annualized, volatility is not directly comparable when using data with different frequencies. The NCREIF Real Estate Index that we used is a broad aggregate, which is not investable. Individual property prices might differ from this aggregate. Finally, real estate returns are measured on an appraisal basis. Appraisal-based indices are not reflective of real transactions. Moreover, prices tend to be sticky. To attenuate this issue we unsmoothed the capital returns by removing return autocorrelation. Overall, the Sharpe ratio of direct real estate was solid throughout the first three quartiles of rising inflation (Chart II-4.1, top panel). There is not enough data available for the fourth quartile. However, judging by the performance of U.S. housing in the 1970s from OECD, risk-adjusted returns when inflation was very high was likely positive (Chart II-4.1, bottom panel).   Cash Cash (investing in a 3-month U.S. Treasury bill) outperformed inflation over our sample (Chart II-4.2, top panel). Moreover, cash provided positive real returns when inflation was mild, or high, or when it was decreasing (Chart II-4.2, bottom panel). However, cash was not a good inflation hedge at the highest inflation quartile, with an average annualized real loss of almost 2%. Juan Manuel Correa Ossa Senior Analyst Global Asset Allocation   III. Indicators And Reference Charts Last month, we argued that the S&P 500 would most likely enter a period of digestion after its furious gains from December to April. This corrective episode is now upon us as the S&P 500 is breaking below the crucial 2,800 level. Moreover, our short-term technical indicators are deteriorating, as the number of stocks above their 30-week and 10-week moving averages have rolled over after hitting elevated levels, but have yet to hit levels consistent with a durable trough. This vulnerability is especially worrisome in a context where pressure will continue to build, as Beijing is only beginning to retaliate to the U.S.’s trade belligerence. Our Revealed Preference Indicator (RPI) is not flashing a buy signal either. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. It will require either cheaper valuations, a pick-up in global growth or further policy easing before stocks can resume their ascent. On the plus side, our Willingness-to-Pay (WTP) indicator for the U.S. and Japan continues to improve. However, it remains flat in Europe. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The current readings in major advanced economies thus suggest that investors are still inclined to add to their stock holdings. Hence, stock weaknesses are likely to prompt buy-the-dip behaviors by investors. Therefore, the expected downdraft will remain a correction and stocks have more cyclical upside. Our Monetary Indicator remains in stimulative territory, supporting our cyclical constructive equity view. The Fed is firmly on hold and global central banks have been opening the monetary spigots, thus monetary conditions should stay supportive. The BCA Composite Valuation Indicator, an amalgamation of 11 measures, is in overvalued territory, but it is not high enough to negate the positive message of our Monetary Indicator, especially as our Composite Technical Indicator has moved back above its 9-month moving average. These dynamics confirm that despite the near-term downside, equities have more cyclical upside. According to our model, 10-year Treasurys are slightly expensive. Moreover, our technical indicator flags a similar picture. However, duration surveys show that investors have very elevated portfolio duration, and both the term premium and Fed expectations are very depressed. Taking this positioning into account, BCA’s economic view is consistent with limited yield downside in the short-run, and higher yields on a 6 to 12 month basis. On a PPP basis, the U.S. dollar is only getting ever more expensive. Additionally, our Composite Technical Indicator is not only in overbought territory, it is also starting to diverge from prices. Normally, this technical action points to a possible trend reversal, especially when valuations are so demanding. However, this downside will only materialize once global growth shows greater signs of strength. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes   Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1       Edward E. Leamer, "Housing is the business cycle," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 149-233, 2007. 2       This includes both real and financial transactions. 3       Please see Geopolitical Strategy Weekly Report, “How Trump Became A War President,” dated May 17, 2019, available at gps.bcaresearch.com 4       Please see Global Investment Strategy Special Report, “Stay Cyclically Overweight Global Equities, But Hedge Near-Term Downside Risks From An Escalation Of A Trade War,” dated May 10, 2019, available at gis.bcaresearch.com 5       Please see U.S. Equity Strategy Weekly Report, “Trader's Paradise,” dated January 28, 2019, available at uses.bcaresearch.com 6       Please see Carl E. Walsh, “October 6, 1979,” FRSBF Economic Letter, 2004:35, (December 3, 2004). 7       Please see Global Investment Strategy Special Report, “1970s-Style Inflation: Could it Happen Again? (Part 1), ” dated August 10, 2018, and “1970s-Style Inflation: Could it Happen Again? (Part 2),” dated August 24, 2018, available at gis.bcaresearch.com. 8       We use a synthetic TIPS series for data prior to 1997. For details on the methodology, please see: Kothari, S.P. and Shanken, Jay A., “Asset Allocation with Inflation-Protected Bonds,” Financial Analysts Journal, Vol. 60, No. 1, pp. 54-70, January/February 2004. 9       Excess returns are defined as asset return relative to a 3-month Treasury bill. 10       Sector classification does not take into account GICS changes prior to December 2018.  11       Please see Global Asset Allocation Strategy Special Report "REITS Vs Direct: How To Get Exposure To Real Estate," dated September 15, 2016, available at gaa.bcaresearch.com. 12       It is important to note that the synthetic TIPS series does not completely match actual TIPS series for the periods where they overlap. Specifically, volatility is significantly higher in the synthetic series. Thus, results should be taken as approximations. 13       We decompose the returns into the same 4 quartiles to answer this question. However, due to lower data availability, we start our sample in 1978 instead of 1973. Moreover, our sample for energy is smaller beginning in 1983. This mainly reduces the amount of data available at the upper quartile. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Highlights Huge imbalance #1 is the euro area’s $150 billion trade surplus with the United States. Huge imbalance #1 has resulted from the ECB holding interest rates at the lower bound while the Fed tightened policy. The upshot is that the Fed now has the scope to cut rates while the ECB does not. Huge imbalance #2 is the euro area’s €1.5 trillion TARGET2 banking imbalance. Huge imbalance #2 means that Germany effectively has hundreds of billions of ‘Italian’ euro assets, making a euro break-up unthinkable for the euro area’s dominant economy. New structural recommendation for bond investors: overweight a 50:50 portfolio of U.S. T-bonds and Italian BTPs versus a 50:50 portfolio of German bunds and Spanish Bonos. Feature Huge Imbalance #1: The Euro Area’s $150 Billion Trade Surplus With The United States While the recent focus has been on the brewing trade war between the United States and China, trade tensions between the U.S. and Europe have also been escalating. The euro area trade surplus with the U.S. – standing near an all-time high of $150 billion – is extreme; and it is extreme because the undervaluation of the euro has made the euro area grossly over-competitive vis-à-vis the U.S., as claimed by the ECB’s own analysis (Chart I-2 and Chart I-3)! Chart of the WeekThe U.S./Euro Area Trade Imbalance Is A Near-Perfect Function Of Relative Monetary Policy Chart I-2Relative Monetary Policy Has Driven The Euro's Undervaluation... Chart I-3...And The Euro's Undervaluation Has Driven The U.S./Euro Area Trade Imbalance A common counterargument is that the euro area trade surplus is simply a structural issue. If a country, such as Germany, consistently consumes less than it produces, it must show up as a structural surplus. This argument is flawed. At least half of the surplus, including for Germany, has appeared since 2014, meaning it cannot be a structural issue (Chart I-4). In any case, if an economy consumes less than it produces, a higher exchange rate should help to facilitate the adjustment, encouraging under-consuming households to buy more imports, and discouraging over-producing firms from selling into foreign markets. Chart I-4Half Of Germany's Export Surplus Appeared After 2014 The Chart of the Week shows the true and damning reason for the trade imbalance. The euro area’s surplus with the U.S. is a near-perfect function of relative monetary policy. To be clear, the ECB is not explicitly depressing the exchange rate to make the euro area over-competitive, the ECB is just targeting its definition of price stability. However, the ECB’s definition of price stability omits owner-occupied housing (OOH) costs, and thereby understates true euro area inflation by 0.5 percent. To the extent that the ECB thinks in terms of real interest rates based on seemingly low (excluding OOH) inflation, this means that the ECB is setting real interest rates that are far too low for the euro area economy including OOH. This has resulted in the grossly over-competitive euro and the associated $150 billion surplus with the United States. The euro area trade surplus with the U.S. is a near-perfect function of relative monetary policy. Still, for 85 percent of the euro area, even inflation excluding OOH is reliably running within a 1.5-2 percent range, very close to the ECB’s definition of price stability. And bank lending is growing at a very healthy clip. For this vast majority of the bloc, the ECB’s zero and negative interest rate policy is wholly inappropriate. However, for the 15 percent of the euro area that is called Italy, ultra-loose monetary policy does seem more appropriate. Inflation is struggling to stay above 1 percent, and bank lending is still failing to gain traction (Chart I-5 and Chart I-6). Chart I-5Italian Inflation Is Struggling To Stay Above 1 Percent Chart I-6Italian Banks Have Not ##br##Been Lending Therefore, an important way of thinking of the ECB’s stance is one of self-preservation – protecting the euro area’s obvious source of fissure. Effectively, the ECB is setting policy for the weakest link in the euro area, even if that policy means exacerbating strains outside the euro area – specifically, by generating a huge trade surplus with the United States. But in the interests of self-preservation, the external strain is a price worth paying. This leads us to believe that the inevitable convergence of euro area and U.S. monetary policies is now much more likely to happen via the Federal Reserve ultimately cutting rates, than by the ECB raising rates. Huge Imbalance #2: The Euro Area’s €1.5 Trillion TARGET2 Imbalance The euro area Target2 banking imbalance now stands close to €1.5 trillion (Chart I-7). What is this huge imbalance (Box 1), and why does it matter? Box 1: What Is Target2? Target2 stands for Trans-European Automated Real-time Gross settlement Express Transfer system. It is the settlement system for euro payment flows between banks in the euro area. These payment flows result from trade or financial transactions such as deposit transfers, sales of financial assets or debt repayments. If the banking system in one member country has more payment inflows than outflows, its national central bank (NCB) accrues a Target2 asset vis-à-vis the ECB. Conversely, if the banking system has more outflows than inflows, the respective NCB accrues a Target2 liability vis-à-vis the ECB. Target2 balances therefore show the cumulative net payment flows within the euro area.   The ECB delegated its QE sovereign bond purchases to the respective national central banks. In the case of Italian BTPs, Italian investors sold their bonds to the Bank of Italy and deposited the cash in banks healthier than those in Italy – for example, in Germany. Strictly speaking, this outflow of Italian cash to German banks is not the same as the deposit flight during the depths of the euro debt crisis in 2012. Rather, we might call it precautionary cash management. Nevertheless, in Eurosystem accounting terms it still means that the Bank of Italy has a new asset – the BTP – denominated in ‘Italian’ euros, while the Bundesbank has a new liability to German banks denominated in ‘German’ euros. The Target2 imbalance is the aggregate of such mismatches between Eurosystem assets denominated in ‘Italian and other periphery’ euros and liabilities denominated in ‘German and other core’ euros. If Italy owes Germany half a trillion euros then it is Germany that has the problem. Does the €1.5 trillion imbalance really matter? No, as long as an ‘Italian’ euro equals a ‘German’ euro, the imbalance is just an accounting identity within the Eurosystem. But if Italy and Germany started using different currencies, then suddenly it would matter with a vengeance. The Bank of Italy asset would be redenominated into lira, while the Bundesbank liability to German banks would be redenominated into deutschemarks. Thereby the ECB would end up with fewer assets than liabilities, and a solvency shortfall potentially equivalent to hundreds of billions of euros would end up on the shoulders of the ECB’s shareholders – largely, German taxpayers. To paraphrase John Maynard Keynes, if Italy owes Germany half a billion euros, then Italy has a problem; but if Italy owes Germany half a trillion euros, then it is Germany that has the problem (Chart I-8 and Chart I-9). In effect, the Target2 huge imbalance is a huge force for euro area self-preservation – because break-up means mutually assured destruction. Chart I-8The Target2 Imbalance Reflects The Cross-Border Flow Of Italian Investor Cash... Chart I-9...To German##br## Banks A New Structural Recommendation For Bond Investors To sum up, the euro area has two huge imbalances: one external, the other internal. The external imbalance is the $150 billion trade surplus with the United States. This huge imbalance has resulted from the ECB holding interest rates at the lower bound while the Fed tightened policy. The upshot is that the Fed now has the scope to cut rates while the ECB does not. And this makes the U.S. T-bond a much better haven asset than the German bund. The Target2 imbalance is a huge force for euro area self-preservation. The internal imbalance is the €1.5 trillion euro area Target2 imbalance. This huge imbalance means that Germany effectively has hundreds of billions of Italian ‘euro’ assets, making a euro break-up unthinkable for the euro area’s dominant economy. On this premise, the Italian BTP – which is offering a generous yield premium for such a break-up risk – is a good structural investment. Therefore, our new structural recommendation for bond investors is to overweight: A 50:50 portfolio of U.S. T-bonds and Italian BTPs Versus A 50:50 portfolio of German bunds and Spanish Bonos. Since 2018, the T-bond/BTP combination has underperformed by 20 percent and has considerable scope for ultimate catch-up one way or another (Chart I-10). Chart I-10A U.S. T-Bond/Italian BTP Combo Can Catch Up With A German Bund/Spanish Bono Combo Fractal Trading System * There are no new trades this week. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

Highlights A financial market riot point remains likely over the coming few months to force policymakers, including those in China, to address the economic weakness that a full-tariff scenario will entail. The near-term outlook is bearish for China-related assets, but investors should stay cyclically bullish in anticipation of a strong reflationary response. It is not clear whether further monetary easing will occur over the coming year, given that monetary conditions have already eased substantially. But an RRR cut coupled with a benchmark lending rate cut is now a real possibility, and would signal that the monetary policy dial has been turned to “maximum stimulus”. Monthly credit growth needs to be approximately 2.8-3 trillion RMB per month in May and June in order to be consistent with a 2015/2016-magnitude policy response. May’s number may fall short of this, but that would set up June as a make-it or break-it month for credit creation. Chinese credit growth surged in 2012, but economic activity did not significantly accelerate. A repeat of this scenario is a risk to our cyclically bullish stance, but three reasons suggest it is not likely to occur. Investors should stay long USD-CNH over the cyclical horizon despite warnings from Chinese policymakers not to short the RMB. Feature Tensions between China and the U.S. have worsened materially over the past two weeks, in line with our view that an actual trade agreement this year (not just continued negotiations) is much less likely. The Huawei blacklist, stalled negotiations, a sharp escalation in preparatory nationalist rhetoric in China, and President Xi Jinping’s declaration in a Jiangxi province speech that the country is embarking on a new “Long March”1 significantly diminishes the possibility of a deal that addresses the U.S.’ structural concerns. Chart 1A Market Riot Point Is Coming This implies that any agreement would require President Trump to capitulate and accept a temporary deal relating simply to the balance of trade between the two countries. It is possible that this occurs over the coming 6-12 months (in time for Trump to attempt a declaration of victory before the 2020 election), but it is not likely to occur before real economic (and thus financial market) pain arrives. This supports our view that a major financial market riot point is likely over the coming few months to force policymakers, including those in China, to address the economic weakness that a full-tariff scenario will entail (Chart 1). Given this, we would not recommend a long position in Chinese stocks, either in absolute terms or relative to the global benchmark, for investors with a time horizon of less than 3 months. However, over a strictly cyclical (i.e. 6-12 month) time horizon, we would recommend staying long/overweight Chinese stocks (in hedged currency terms) on the basis that policymakers will ultimately respond as needed, lest they face an unstable deceleration in economic activity that may become difficult to stop. In this week’s report we address the following three questions facing China-exposed investors over the coming year, before concluding with a brief note about the RMB: Can the PBOC provide more of a reflationary impulse if needed, and if so, how? How can investors tell whether policymakers are stimulating as required from the monthly credit data? What are the odds that China will stimulate aggressively and the economy does not meaningfully reaccelerate? How Can The PBOC Ease Further? We argued in our May 15 Weekly Report that a 2015/2016-magnitude policy response will again be required in order for policymakers to be confident that the upcoming trade shock will be overcome.2 In our view, this response, instead of aggressive and broad-based bank lending, will likely have to come in the form of quasi-fiscal spending, e.g. a significant increase in infrastructure-oriented local government bond issuance (which we include as “credit” in our adjusted total social financing calculation). However, we have received several questions from clients asking about the outlook for monetary policy in a full-tariff scenario, particularly the question of what the PBOC can do to provide even more of a reflationary response. Most investors would simply assume that the PBOC would cut interest rates even further, and this is certainly a possible outcome over the coming year. But even if the PBOC were to cut interest rates, it is not always clear to investors what rate should or will be cut. Confusion surrounding China’s monetary policy landscape has been high ever since the PBOC established an interest rate corridor system in 2015, and a review of what has occurred over the past 2½ years is warranted in order to better understand the implications of future policy decisions. A 2015/2016-magnitude policy response will again be required in order for policymakers to be confident that the upcoming trade shock will be overcome. Chart 2The Simple (But Incomplete) View Of China's New Monetary Regime Chart 2 outlines how China’s new monetary regime is officially described by the PBOC. The benchmark lending rate, China’s “old” policy rate that established a base regulated rate for banks to price their loans, was replaced in 2015 with a corridor system. The target rate in this system is the 7-day interbank repo rate, which can be seen in Chart 2 is often at the low end of the corridor. However, we explained in a February 2018 Special Report why Chart 2 is only half of the story.3Charts 3 - 5 show the other half: Chart 3 shows that while the 7-day repo rate rose in late-2016 and 2017, the rise was fairly small (on the order of 60 basis points). By contrast, the 3-month repo rate surged, which appears to have been caused by macro-prudential policy changes aimed at severely curtailing the issuance of wealth management products by non-depository financial institutions. Chart 4 highlights that there is a strong (and leading) relationship between changes in China’s 3-month interbank repo rate and 1) changes in the percentage of loans issued above the benchmark rate and 2) changes in the gap between the weighted-average interest rate and the benchmark rate. Chart 5 shows that China’s weighted average interest rate can be successfully modelled by a regression on the benchmark lending rate and the 3-month interbank repo rate. Chart 3The 3-Month Repo Rate Has Been More Important Than The 7-Day Chart 4A Strong Link Between 3-Month Repo Rates And Economy-Wide Rates       The relationships shown in Charts 3 - 5 are weaker if the 3-month repo rate is replaced with the 7-day rate, highlighting that while the latter is the new de jure policy rate in China, the former has been the de facto policy and market-driven lending rate among banks and non-financial institutions over the past 2½ years. Chart 5The Benchmark Lending And 3-Month Repo Rates Explain Effective Lending Rates Our framework for examining China’s monetary policy environment leads us to conclude that there are three things the PBOC can do to meaningfully ease further, were they to decide to do so: The most impactful action that the PBOC could take is to cut the benchmark lending rate. While banks in China are no longer required to price loans in reference to the benchmark rate, in practice many still do. Roughly 2/3rds of loans in China have been priced at an interest rate above the benchmark over the past year, and Chart 5 noted that the weighted average interest rate is a direct function of the benchmark rate. As such, a cut to the benchmark rate is likely to feed directly into lower lending rates. Chart 3 showed that the substantial spread between the 3-month and 7-day repo rates that prevailed from late-2016 to mid-2018 has all but disappeared, implying that the PBOC cannot lower interest rates much further by dialing back on macro-prudential regulation. Instead, if it wants interbank rates to fall meaningfully, lowering the corridor around the 7-day rate by cutting the floor (the PBOC’s 7-day reverse repo rate) will likely be required. This would be carried out with further reductions to the reserve requirement ratio (RRR). Third, while Chart 5 showed that our model for the weighted average lending rate has done a very good job over the past few years, it is clear that a gap has opened up between the actual rate and that predicted by the model. The most likely explanation of this gap is that it is due to a risk premium applied by banks, possibly in response to the re-orientation of riskier funding demands that had previously been fulfilled by the shadow banking sector to on-balance sheet loans from depository institutions. It is not clear what policy tools are at the PBOC’s disposable to reduce the gap, but doing so has the potential to lower average interest rates by a non-trivial amount. The relative easiness of monetary conditions is the key difference between today and 2012. It is not clear yet which option the PBOC will pursue over the coming year or whether further monetary easing will occur, but an RRR cut coupled with a benchmark lending rate cut is now a real possibility. If it happens, it would be a clear signal for investors that the monetary policy dial has been turned to “maximum stimulus”. Inferring Reluctance Or Capitulation From Monthly Credit Growth The second issue that investors will be wrestling with over the coming few months relates to the question of whether the month-to-month pace of credit growth is consistent with the magnitude of the reflationary response that we believe will be required. To the extent that significantly more monetary easing occurs over the coming year, it is likely to have happened because policymakers were overly reluctant to green-light a renewed and substantial re-acceleration in credit growth and were then forced to fight a destabilizing slowdown in the economy. Chart 6A Strong Credit Response Will Be Required In Response To A Full Tariff Scenario We have used the metric of new credit to GDP as the primary method to judge the relative size of previous credit booms, and have argued that a return to 30% on this measure will likely be required in response to a full 25% tariff scenario (Chart 6). Unfortunately, China’s unique seasonality patterns and the lack of official seasonally adjusted data make it difficult for investors to judge whether incoming credit data is consistent with the required policy response. Previously, we have shown seasonally adjusted measures of credit using a simple application of X12 ARIMA, the statistical seasonal adjustment program used by the U.S. Census Bureau. But Charts 7 and 8 present a different approach. The charts show the average cumulative amount of adjusted total social financing as the calendar year progresses, along with a ±0.5 standard deviation band, based on the 2010 to 2018 period. The thick black line in both charts shows the progress in new credit creation this year, assuming an 8% annual nominal GDP growth rate for the remainder of the year. Chart 7 shows the cumulative progress in credit assuming a 27% new credit to GDP ratio for the year (corresponding to a half-strength credit cycle relative to past episodes), whereas Chart 8 assumes 30%. In our view, these charts are revelatory. First, Chart 7 provides evidence that policymakers have been reluctant to allow credit growth to surge. The chart shows that credit growth ran well above a half-strength credit cycle pace in the first quarter of the year; following this, through either administrative controls or jawboning, policymakers lowered the pace of credit growth in April such that it moved back within the range. By contrast, Chart 8 highlights that the pace of Q1 credit growth was exactly right in a 30% new credit to GDP scenario, and that April fell short. In order to be back within the range by June, Chart 8 suggests that monthly credit growth needs to be on the order of 2.8-3 trillion RMB per month in May and June, just a slightly slower pace than what investors observed in March. It is quite possible that May’s credit number will fall short of 2.8-3 trillion RMB, given that the increase in the second round tariffs only occurred on May 10 and that Chinese policymakers have so far seemed reluctant to pull the trigger. But this also heightens the risk of a serious near-term selloff in the domestic equity market, and would set up June as a make-it or break-it month for credit creation. Stimulus Without A Recovery? Revisiting The 2012 Scenario Chart 9The 2012 Scenario: Strong Credit, But A Modest Improvement In Activity A final question facing investors this year is whether it is possible that the Chinese economy fails to respond to strong efforts by policymakers to stimulate the economy. Chart 9 shows that a similar situation occurred in 2012; while the surge in new credit to GDP did stabilize economic activity and caused a modest uptrend, the economic improvement was much smaller than what the relationship shown in the chart would imply. In our view, there are three reasons to believe that a 2012 scenario will not repeat itself: First, Chart 10 shows that the Q1 rebound in new credit to GDP appears to have halted the decline in investment-relevant Chinese economic activity. There is no basis to suggest that an uptrend in activity has begun, but the fact that the economy has even started to respond to the pickup in credit growth is a positive sign. Second, Chart 11 highlights one important difference between 2012 and today. The chart shows that our leading indicator for China’s economy did not rise as much as new credit to GDP, and that this occurred because monetary conditions remained relatively tight from the beginning of 2012 all the way through to early-2015. This relative tightness in monetary conditions occurred because of fairly elevated interest rates, and due to a persistent rise in the real effective exchange rate. However, the collapse in the weighted average lending rate following the 2015/2016 economic slowdown has eased monetary conditions in a lasting way, suggesting that a similar rise in new credit to GDP should have a strongly positive effect on Chinese economic growth. This also underscores our earlier point: monetary policy has already largely returned to 2015/2016 levels, meaning that it is fiscal/administrative action to boost credit growth that is missing. Third, Chart 12 highlights that the pace of inventory accumulation represents another key difference between the current economic environment and that of 2012. The chart shows that the change in China’s level of industrial inventories relative to exports (both measured in value terms) rose sharply in 2011 and 1H 2012, only to slow significantly over the following year (which may have weighed on the rebound in activity in 2012 and 2013). In contrast, the chart shows that inventories have recently been contracting at their fastest pace relative to exports since 2011, implying that the drag on production from potential destocking may be minimal. Chart 10A (Very) Tentative Sign Of Stabilization Chart 11Monetary Conditions Are Considerably Easier Today There are, however, two caveats to the above analysis. First, on the inventory front, Chart 12 shows that the level of industrial inventories to exports is fractionally higher than it was in 2012, even though it has declined significantly from its 2017 high. The level of inventories has been rising relative to exports for some time, and thus the “equilibrium” level is not clear. But to the extent that a prolonged trade war with the U.S. requires meaningfully lower inventory levels in China, then destocking may become more of a drag than we expect. Second, Chart 11 shows that while monetary conditions are much easier today than they were in 2012, money growth is much weaker. A weaker-than-expected recovery in Chinese economic activity is much more likely if money growth remains weak, although we cannot reasonably envision an outcome where credit growth surges and growth in the money supply does not. A Brief Note On The RMB We noted in our May 15 Weekly Report4 that a significant rise in new credit to GDP and a meaningful decline in the currency would be required to stabilize China’s economy if the U.S. proceeds with 25% tariffs on all imports from China. Consequently, we recommended that investors hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks by opening a long USD-CNH trade, with the expectation that a break above 7 in the coming weeks was likely (Chart 13). Chart 12Inventories Have Been Meaningfully Reduced   Chart 13In A Full Tariff Scenario, A Defense Of 7 Is Only A Near-Term Event Recently, Xiao Yuanqi, the spokesman for the China Banking and Insurance Regulatory Commission, was quoted as saying that “those who speculate and short the yuan will [surely] suffer heavy loss[es]”,5 which many investors took to mean that China will defend USD-CNY = 7 at all costs. In our view this may be true in the short-term, but is unlikely to occur over a 6-12 month time horizon in a full 25% tariff scenario. Policymakers have become much more attuned to sharp declines in the currency after the major episode of capital flight that occurred in 2015 and 2016, and are keen to ensure that any movements in the exchange rate are orderly. However, complete currency stability in the face of a major shock to the export sector means that the required rise in the “macro leverage ratio” to stabilize the economy will be even higher, highlighting that an orderly depreciation in the currency is the lesser of two evils. As such, we interpret these recent comments from policymakers as an attempt to prevent a breach in USD-CNY = 7 over the short-term, and an attempt to control the pace of decline over the longer term in a full-tariff scenario. The conclusion for investment strategy is that China-exposed investors should stay long USD-CNH over the cyclical horizon, but should limit the leverage of the position and should expect frequent short-term reversals.   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1      Please see Geopolitical Strategy Weekly Report, “Is  Trump Ready For The New Long March?” dated May 24, 2019, available at gps.bcaresearch.com. 2      Please see China Investment Strategy Weekly Report, “Simple Arithmetic,” dated May 15, 2019, available at cis.bcaresearch.com. 3      Please see China Investment Strategy Special Report, “Seven Questions About Chinese Monetary Policy,” dated February 22, 2018, available at cis.bcaresearch.com. 4      Please see China Investment Strategy Weekly Report, “Simple Arithmetic,” dated May 15, 2019, available at cis.bcaresearch.com. 5      Reuters News, “China’s top banking regulator says yuan bears will suffer ‘heavy losses’,” dated May 25, 2019.   Cyclical Investment Stance Equity Sector Recommendations

Highlights Corporate Bonds: Corporate bond spreads have been slow to price-in the escalation of the U.S./China trade dispute. Nimble investors should take steps to mitigate their near-term (0-3 month) exposure to credit spreads, but remain overweight corporate bonds (both investment grade and high-yield) on a 6-12 month investment horizon. Duration: With 50 bps of rate cuts already priced into the market for the next 12 months, there is very little money to be made from extending duration and potentially a lot of money to be made by keeping duration low. This is especially true given that the Fed has so far done nothing to suggest that rate cuts are on the table. TIPS: Long-maturity TIPS breakeven inflation rates look cheap on our model, and the core PCE deflator’s sharp drop probably overstates the deflationary pressures in the economy. Maintain an overweight allocation to TIPS versus nominal Treasuries in U.S. bond portfolios. Feature Concerns that the ongoing U.S./China trade war will exacerbate the decline in global growth flared again last week, and our geopolitical strategists see high odds of further near-term escalation.1 For starters, China has not yet retaliated to the U.S. Commerce Department’s blacklisting of Huawei and a handful of other Chinese tech firms. Meanwhile, the U.S. stands ready to extend tariffs across the full slate of imported Chinese goods. To cap it all off, there are currently no firm plans for the resumption of talks between the countries’ respective negotiating teams, and no assurance that Presidents Donald Trump and Xi Jinping will speak to each other at the G20 Summit in Japan on June 28-29. Credit Spreads Are Too Complacent Chart 1Corporate Bonds At Risk While Treasury yields responded to the turmoil by dropping for the second consecutive week, the spillover to corporate bond markets has been less severe. Chart 1 on page 1 shows that corporate bond excess returns have de-coupled from the CRB Raw Industrials index during the past 12 months. The CRB Raw Industrials index tracks a broad basket of commodity prices, making it an excellent real-time indicator of the market’s assessment of global growth. Like Treasury yields, the CRB index has fallen sharply during the past two weeks. The wide gulf between corporate bond and commodity returns suggests that we will soon see either a sell-off in the corporate bond market or a positive re-rating of global growth that sends the CRB index higher. Recent history provides examples of both cases (Chart 2). The CRB index rose to meet corporate bond returns in 2012, but dragged corporate bond returns lower in 2014. Given the long list of potential negative trade catalysts, some near-term downside for corporate bond excess returns appears more likely. But it’s not just political headlines that make us cautious about the near-term outlook for credit spreads. The uncertainty created by the U.S./China trade dispute is now finding its way into the economic survey data. Flash Manufacturing PMIs for the U.S., Eurozone and Japan all fell in May, with respondents quick to blame the decline on global trade tensions. Much like the CRB index, PMI readings are sending a starkly different message than credit spreads. Either trade tensions will ease during the next couple of months, sending PMIs higher, or corporate bond spreads will widen. A model of U.S. capacity utilization based on lagged junk spreads predicts that capacity utilization will rise from its current 78% to 80% during the next six months (Chart 3). However, both the Markit and ISM Manufacturing PMIs suggest a further decline is more likely. Once again, either trade tensions will ease during the next couple of months, sending the PMIs higher, or corporate bond spreads will widen. Chart 2Position For Reconvergence Chart 3Capacity Utilization & Junk Spreads   We recommend that investors take measures to limit their near-term (~3-month) exposure to corporate spread risk. Stay Positive On A Cyclical (6-12 Month) Horizon Chart 4Expect More Stimulus From China While near-term caution is warranted, we would still position for positive corporate bond excess returns (both investment grade & high-yield) on a 6-12 month investment horizon. Ultimately, the U.S. and China will navigate toward some sort of truce, and the negative impact from tariffs is unlikely to derail the U.S. economic recovery.2 What’s more, Chinese policymakers will accelerate their stimulus efforts to mitigate the negative impact of higher tariffs. Our China Investment Strategy service tracks a composite of six money and credit growth indicators that lead Chinese economic activity. This leading indicator has already bottomed, and our strategists anticipate a return to stimulus levels reminiscent of mid-2016 (Chart 4).3 As long as a U.S. recession is avoided, corporate bond spreads will eventually settle near levels seen in the late stages of previous economic cycles (Chart 5A & Chart 5B).4 Chart 5AInvestment Grade Spread Targets Chart 5BHigh-Yield Spread Targets   Bottom Line: Corporate bond spreads have been slow to price-in the escalation of the U.S./China trade dispute. Nimble investors should take steps to mitigate their near-term (0-3 month) exposure to credit spreads, but remain overweight corporate bonds (both investment grade and high-yield) on a 6-12 month investment horizon. Risk & Reward In The Treasury Market Unlike credit spreads, Treasury yields have responded aggressively to the negative news flow. The 10-year Treasury yield currently sits at 2.32%, 7 bps lower than at this time last week. Meanwhile, the overnight index swap curve is priced for two full 25 basis point rate cuts over the next 12 months. Interestingly, while market prices imply 50 bps of rate cuts during the next year, the New York Fed’s Survey of Market Participants shows that, as of the May FOMC meeting, investors didn’t actually expect rate cuts any time soon. The shaded region in Chart 6 shows the interquartile range of the surveyed investors’ fed funds rate forecasts, while the dashed black line shows the median forecast. The survey responses convey widespread consensus that the fed funds rate will remain flat until the end of the year – the 25th percentile, median and 75th percentile are all equal until the end of 2019. Then, heading into 2020, the 75th percentile of the distribution starts to forecast rate hikes. The 25th percentile doesn’t move in the direction of rate cuts until Q4 2020, and the median forecaster sees the fed funds rate staying put at least through the second half of 2021. Chart 6Market And Survey Expectations Differ Why would market prices imply a much lower path for the fed funds rate than actual investor survey responses? The most likely reason relates to assessments about the balance of risks. When responding to surveys, investors will usually provide their modal (or most likely) outcome. However, investor bets in financial markets will reflect a dollar-weighted average of different possible scenarios. It’s possible that while investors think a flat fed funds rate is the most likely outcome, they also view rate cuts as a higher probability tail risk than rate hikes. They therefore invest some of their money to hedge that risk, even if it does not reflect their base case view. The intuition that rate cuts remain a “tail risk” is confirmed by another question from the survey. This question asks investors to consider a time period between now and the end of the year, and then attach a probability to the Fed’s next move i.e. whether it will be hike, a cut, or whether there will be no change in the funds rate until the end of 2019 (Chart 7). As of the April/May survey, market participants thought the odds of a hike were 23%, odds of a cut were 17% and the odds of flat rates until the end of the year were 59%. Before the Fed meeting in March, investors saw 50% chance of a hike, 13% chance of a cut, and 37% chance of no change. The overall message is that investors continue to view a 2019 rate cut as a tail risk, but one that’s perceived probability is rising. In any event, for our purposes it doesn’t really matter how investors respond to surveys. According to our Golden Rule of Bond Investing, if the actual change in the fed funds rate over the next 12 months exceeds what is currently priced into the OIS curve for that period, then below-benchmark portfolio duration positions will pay off.5 In fact, the Golden Rule even gives us a framework for translating different rate hike/cut scenarios into expected 12-month Treasury returns (Table 1). Table 1The Golden Rule Of Bond Investing Based on current prices, if the fed funds rate holds steady for the next 12 months – as the median market participant expects – we calculate that the Bloomberg Barclays Treasury Master Index will lose between 1.98% and 2.41% relative to cash. Even in the scenario where the Fed delivers two rate cuts during the next 12 months, we would still expect Treasury index returns to lag cash by 12-13 bps. Negative excess returns in the “two rate cut” scenario are due to the negative carry in the Treasury index. Capital gains/losses would be close to zero in that scenario, since the change in the fed funds rate is exactly equal to the market’s expectations. Investors continue to view a 2019 rate cut as a tail risk, but one that’s perceived probability is rising. What’s evident from those figures is that there is currently very little money to be made betting on rate cuts, and quite a bit to be made betting on rate hikes. The risk/reward balance in the Treasury market clearly favors keeping portfolio duration low. But What Will The Fed Actually Do? The minutes from the last FOMC meeting show broad consensus around the Fed’s current “on hold” policy stance, though it’s notable that “a few” participants thought rate hikes would be appropriate if the economy evolved in line with their expectations. The minutes contain no mention of a possible rate cut. Our sense is that it would require a further sharp tightening of financial conditions or significantly worse economic data before the Fed seriously considers cutting rates. Our Fed Monitor – an aggregate indicator that measures economic growth, inflation and financial conditions – is currently very close to the zero line, a level consistent with the Fed’s “on hold” stance (Chart 8). The ISM Manufacturing PMI is also firmly above the 50 boom/bust line. Historically, Fed rate cuts are usually preceded by a negative reading from our Fed Monitor and a sub-50 PMI. We would be looking for those two signals before expecting the Fed to cut rates. Chart 8Sub-50 ISM Required Before The Fed Cuts Rates Bottom Line: With 50 bps of rate cuts already priced into the market for the next 12 months, there is very little money to be made from extending duration and potentially a lot of money to be made by keeping duration low. This is especially true given that the Fed has so far done nothing to suggest that rate cuts are on the table. Inflation & TIPS Chart 9Adaptive Expectations Model It’s not just nominal Treasury yields that dropped during the past two weeks. Long-maturity TIPS breakeven inflation rates – the spread between nominal Treasury yields and TIPS yields – also fell precipitously. The 10-year TIPS breakeven inflation rate is currently 1.76% and the 5-year/5-year forward breakeven is only 1.9%. These figures suggest that the market does not trust the Fed to meet its inflation target in the long-run. Our main valuation tool for the 10-year TIPS breakeven rate is our Adaptive Expectations Model.6 It derives a fair value for the 10-year breakeven based on: The 10-year rate of change in the core consumer price index The 12-month rate of change in the headline consumer price index The New York Fed’s Underlying Inflation Gauge At present, the 10-year TIPS breakeven rate is 20 bps below the model’s fair value (Chart 9). It shouldn’t be too surprising that TIPS look cheap relative to nominals. Recent inflation data have been weak and the Fed has written off the weakness as “transitory”, leading to doubts about whether it will keep rates low enough to meet its target. For our part, we think investors should take advantage of low breakevens and overweight TIPS versus nominal Treasuries in U.S. bond portfolios. In fact, the Fed’s characterization of low inflation as “transitory” seems correct. Chart 10 shows both the core and trimmed mean PCE deflators. The dramatic fall in the core measure, which strips out food and energy prices from the headline number, is what has caught the market’s attention. But it’s important to note that trimmed mean PCE inflation has not confirmed the decline. In fact, it remains in a multi-year uptrend. Recent inflation data have been weak, but the Fed has written off the weakness as “transitory”. Chart 10Low Inflation Looks "Transitory" This is the third time during this cycle that core PCE inflation has diverged negatively from the trimmed mean. Core eventually rebounded and re-converged with the trimmed mean in both of the prior two episodes. The Fed is banking on the third time playing out the same way, and we think it would be unwise to bet against them. Recently released research from the Federal Reserve Bank of Dallas shows that trimmed mean PCE inflation provides a less-biased real-time estimate of the headline figure than the traditional core measure. The latter tends to run too low. The trimmed mean is also more closely related to labor market slack.7 Bottom Line: Long-maturity TIPS breakeven inflation rates look cheap on our model, and the core PCE deflator’s sharp drop probably overstates the deflationary pressures in the economy. Maintain an overweight allocation to TIPS versus nominal Treasuries in U.S. bond portfolios. Ryan Swift U.S. Bond Strategist rswift@bcaresearch.com 1      Please see Geopolitical Strategy Weekly Report, “Is Trump Ready For The New Long March?” dated May 24, 2019, available at gps.bcaresearch.com 2      The potential economic impact from tariffs is discussed in Global Investment Strategy Weekly Report, “Tarrified,” dated May 16, 2019, available at gis.bcaresearch.com 3      Please see China Investment Strategy Weekly Report, “Simple Arithmetic,” dated May 15, 2019, available at cis.bcaresearch.com 4      For details on how we determine the spread targets shown in Charts 5A & 5B, please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 5      Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 6      For details on the model’s construction please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market,” dated November 20, 2018, available at usbs.bcaresearch.com 7      https://www.dallasfed.org/-/media/Documents/research/papers/2019/wp1903… Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Falling Yields: There have been three main drivers of the latest decline in global bond yields: slower global growth, softer inflation expectations and increased safe-haven demand for bonds given the intensifying U.S.-China trade conflict. The first two are more than fully discounted in current yield levels, but the latter is likely to persist in the near-term with no resolution of the trade conflict in sight. Model Portfolio Adjustments: We are tactically reducing the sizes of the overall strategic tilts in our model bond portfolio – below-benchmark duration exposure and overweight global corporates vs. governments. There is a growing risk of deeper selloffs in global equity and credit markets if the June G-20 meeting produces no positive signals on ending the trade dispute. We do not yet see a case to position more defensively on a medium-term horizon, however, given the pickup in “early” global leading economic indicators. Feature Chart of the WeekYields Discount A Lot Of Bad News The investment backdrop at the moment – slowing global growth momentum, softening inflation expectations, an increasingly prolonged U.S.-China trade dispute with no immediate sign of resolution, and a strengthening U.S. dollar– is fairly bond bullish. Unsurprisingly, government bond yields in the developed markets have fallen to levels more consistent with a less certain macro environment. At one point last week, the 10-year U.S. Treasury yield dipped as low as 2.30%, while the 10-year German Bund fell deeper into negative territory at -0.13%. There are now expectations of easier monetary policy discounted in yield curves of several countries, most notably the U.S. where markets are priced for 50bps of Fed rate cuts over the next year – despite no indication from the Fed that cuts are coming anytime soon. From a valuation perspective, bond yields are starting to look a bit stretched to the downside (Chart of the Week). The term premium component of yields has fallen to near post-crisis lows in the majority of countries, while the U.S. dollar has surged despite lower U.S. interest rate expectations – both indications of investors driving up the value of traditional safe-havens at a time of uncertainty. Looking purely at the growth side of the equation, the downward momentum in bond yields should start to fade with the global leading economic indicator now in the process of bottoming out. That does not mean, however, that yields could not fall further in the near-term if the trade headlines get worse and risk assets sell off more meaningfully – an outcome that grows increasingly likely as the two sides in the trade war seem to be digging in for a longer battle. The State Of The World Since The “TTT” Our colleagues at BCA Geopolitical Strategy now believe that there is only a 40% chance of a U.S.-China trade deal by the end of June. This could trigger a deeper selloff in global equity and credit markets if investors begin to price in a larger and more prolonged hit to economic growth and corporate profits from the U.S. tariffs. This would trigger even greater safe-haven flows into government bonds, pushing yields lower through a more negative term premium. The much lower level of U.S. Treasury yields has helped limit the hit to risk asset prices from the elevated uncertainty over global trade. Since the “Trump Tariff Tweet” (TTT) of May 5, when the new round of tariffs on U.S. imports from China was announced which sparked the new leg of the trade war, the fall in benchmark 10-year government bond yields across the developed world can be fully explained by the fall in the term premium (Table 1). For example, the 10-year U.S. Treasury yield has fallen -14bps since the TTT, while our estimate of the term premium on the 10-year Treasury as decreased by -20bps. Over the same time period, 10-year U.S. inflation expectations have also fallen -11bps, but the market has only priced in an additional -5bps of Fed rate cuts over the next year according to our Fed Discounter. Table 1Decomposing 10-Year Government Bond Yield Changes Since The "Trump Tariff Tweet" The big difference between last December and today is the much lower level of U.S. Treasury yields. Lower yields have helped mute the hit to risk asset prices from the elevated uncertainty over global trade since the TTT (Chart 2). The Fed’s more dovish pivot in the early months of 2019 has helped push Treasury yields lower as investors have moved from pricing in rate hikes to discounting rate cuts. Even traditional “risk-off” measures like the VIX, U.S. TED spreads, the price of gold and the Japanese yen have only risen modestly since the TTT compared to the big moves seen back in December when investors feared that the Fed would tighten right into a U.S. recession (Chart 3). Chart 2Risk Assets Remain Relatively Calm Chart 3Falling Bond Yields Helping Keep Vol Subdued Easier monetary policy, if delivered, can help underwrite a rebound in equity and credit markets. When looking across the array of financial market returns since the TTT (Table 2), the only developed economies that have seen equities appreciate are Australia and New Zealand – countries where rate cuts are being signaled by policymakers (or already delivered, in the case of New Zealand). Table 2Asset Returns By Country Since The "Trump Tariff Tweet" In the case of the U.S., however, numerous Fed officials have stated recently that no changes to U.S. monetary policy are likely without decisive evidence that the new round of China tariffs and trade uncertainty was having a major negative impact on U.S. growth. On that front, forward-looking measures of U.S. economic activity, like the Conference Board leading economic indicator or our models for U.S. employment and capital spending, are not pointing to an imminent sharp slowing of U.S. growth (Chart 4). At the same time, leading indicators like our global LEI diffusion index and the China credit impulse are both signaling that global growth momentum may soon start surprising to the upside (Chart 5). Chart 4No U.S. Recession Signal Yet From These Indicators Chart 5Some Reasons For Optimism On Global Growth If the Fed does not see a case to deliver the rate cuts that are now discounted, or even to just signal to the markets that easier policy is coming soon, then there is a greater chance of a deeper pullback in U.S. equity and credit markets from any new negative news on trade. This suggests that the risk-aversion bid for U.S. Treasuries will result in an even more deeply negative U.S. term premium and lower bond yields. Easier monetary policy, if delivered, can help underwrite a rebound in equity and credit markets. Already, we are seeing such increasingly negative correlations between returns on equities and government bonds across the major developed markets. In Charts 6 & 7, we show the rolling 52-week correlation between local government bond and equity returns for the U.S., euro area, Japan, U.K., Canada and Australia. For each country, we also plot that correlation versus our estimate of the term premium on 10-year government bond yields. Chart 6Safe Haven Demand For Bonds ... Chart 7... Helping Drive Down Term Premia It is clear that there is a significant “risk-aversion bid” for government bonds right now, given the increasingly negative stock/bond correlations and falling term premia. One possible interpretation is that falling bond yields are being driven more by fears of a risk-off selloff in global equity and credit markets rather than rational pricing of future monetary policy or inflation expectations because of slowing growth. Interestingly, Australia – where the central bank has been signaling that rate cuts are imminent – is the only exception in this list of countries where the stock/bond correlation is not negative. There, the deeply negative term premium is more about weakening growth and low inflation expectations, which is forcing a dovish response from the Reserve Bank of Australia, rather than a risk aversion bid for safe assets from investors. It is clear that there is a significant “risk-aversion bid” for government bonds right now, given the increasingly negative stock/bond correlations and falling term premia. Net-net, while bond yields discount a lot of bad news and now look too low compared to tentative signs of improving global growth, it is hard to build a case for an imminent rebound in global bond yields without signs that U.S. and China are getting closer to a trade deal. Bottom Line: There have been three main drivers of the latest decline in global bond yields: slower global growth, softer inflation expectations and increased safe-haven demand for bonds given the intensifying U.S.-China trade conflict. The first two are more than fully discounted in current yield levels, but the latter is likely to persist in the near-term with no resolution of the trade conflict in sight. Tactical Risk-Reduction Adjustments To Our Model Bond Portfolio Chart 8Easier Monetary Policy Required In Europe & Australia Given the growing potential for a larger selloff in global risk assets if no U.S.-China trade deal comes out of next month’s G-20 meeting (where Presidents Trump and Xi will both be in attendance), we think it is prudent to make some tactical adjustments to the recommended weightings within our model bond portfolio. These moves will provide a partial hedge against any near-term widening of global credit spreads or further reduction in government bond yields in the event of a complete breakdown of the trade talks. Specifically, we are making the following changes: Duration Exposure: We are increasing the overall duration of the model bond portfolio by 0.5 years, which still leaves a duration position that is 0.5 years below the custom benchmark index of the portfolio. We are doing this by increasing allocations to the longer maturity buckets in the U.S., Japan and France. Credit Exposure: We are cutting the sizes of our recommended overweight tilts for U.S. corporates in half for both investment grade and high-yield. This is a combined reduction of nearly 4% of the portfolio that will be used to fund the increase in duration on the government bond side. We are making no other changes to our government bond country allocations, staying overweight in core Europe (Germany plus France), Japan and Australia where our Central Bank Monitors are calling for a need for easier monetary policy (Chart 8). We are also staying overweight U.K. Gilts, where yields continue to trade more off Brexit uncertainty than domestic economic growth or inflation pressures. We are not making any changes to the model bond portfolio exposure to euro area corporate debt or Italian governments, riskier spread products where we are already underweight. We are, however, maintaining our weightings for U.S. dollar denominated EM sovereign and corporate debt at neutral. EM debt has performed relatively well versus developed market equivalents since the May 5 “Trump Tariff Tweet” (TTT). We understand that not downgrading EM seems counterintuitive when we are trying to position more defensively in the model portfolio. We prefer to reduce exposure to U.S. credit, however, given that EM debt has performed relatively well versus developed market equivalents since the May 5 TTT (Table 3), and with EM spreads now at more attractive levels relative to U.S. investment grade (Chart 9). In addition, EM credit tends to perform better during periods when Chinese credit growth is accelerating, as is currently the case (bottom panel) – and which may continue if China’s policymakers eventually turn to more domestic stimulus measures to combat the effects of U.S. tariffs, as seems likely. Table 3Credit Market Performance Since The "Trump Tariff Tweet" Chart 9EM Credit Offers Value Versus U.S. Corporates Importantly, these are all only tactical changes to our model portfolio to partially protect against the risk of U.S. credit spread widening in the event of more negative news on the U.S.-China trade front. We still have not changed our strategic (6-12 month) views on global bond yields (higher) and global corporates (outperforming government bonds) given the tentative signs of improving global growth from the leading indicators. Bottom Line: We are tactically reducing the sizes of the overall strategic tilts in our model bond portfolio – below-benchmark duration exposure and overweight global corporates vs. governments. There is a growing risk of deeper selloffs in global equity and credit markets if the June G20 meeting produces no positive signals on ending the trade dispute. We do not yet see a case to position more defensively on a medium-term horizon, however, given the pickup in “early” global leading economic indicators.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com 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 Treasury yields have tumbled despite a solid U.S. economy: The 10-year Treasury bond yielded just under 3% when we started beating the below-benchmark-duration drum last summer; now it’s hovering around 2.3%. The golden rule of bond investing argues against positioning for further declines, … : The returns to duration strategies hinge on the difference between actual and expected moves in the fed funds rate. With the money market looking for two cuts over the next twelve months, the fed funds rate is more likely to surprise to the upside than the downside. … but could a lack of borrowing keep yields low?: If debt-fueled spending has gone out of fashion in the U.S., global savings could overwhelm investment, and rates might have to fall further to bring them back into balance. Feature The ride has gotten bumpier as the trade tensions between the U.S. and China have heated up, but our recommendations have held up well since last summer. Equal-weighting equities, underweighting bonds and overweighting cash helped preserve capital during the fourth-quarter selloff, while our early and late January upgrades of equities (while downgrading cash) and spread product (while further downgrading Treasuries), respectively, have proven to be beneficial.1 On a total return basis, the S&P 500 is up over 12% since our upgrade, and the Barclays Bloomberg Corporate and High Yield Indexes have generated excess returns over Treasuries of around 175 and 75 basis points (“bps”), respectively, despite ceding much of their previous leads.2 Even the TIPS ETF (TIP) has held its own with the equivalent-duration nominal-Treasury ETF (IEF). The below-benchmark duration call has eroded some of the overall outperformance, however, and there has been some debate within BCA about whether or not we should change the view. We still do not believe the monetary policy outlook merits a duration-view change. We remain constructive on the outlook for global growth, despite the escalation in tensions between U.S. and Chinese trade negotiators, and therefore do not see a fundamental reason to expect lower real rates. The idea that soft credit growth could hold rates down is interesting, but one would have to believe the spendthrift U.S. leopard really has changed its spots to position a portfolio in line with it. Fed Policy Chart 1Caution: Falling Rate Expectations As of Thursday’s close, the money market was pricing in a 100% chance of a 25-bps rate cut by Thanksgiving, a 100% chance of a 50-bps rate cut by this time next year, and a 45% chance of a third cut by Thanksgiving 2020 (Chart 1, bottom panel). The FOMC has paused its rate-hiking campaign, to be sure, but the idea that it will soon embark on a rate-cutting campaign seems like a stretch. The minutes from the FOMC’s April 30th-May 1st meeting, released last week, painted a picture of a fundamentally solid economy. The balance between hawks and doves remained roughly equal, with “a few participants” calling for a coming need to firm policy, given the swiftness with which inflation pressures can build in a tight labor market, while “a few other participants” noted that the unemployment rate is not the be-all and end-all measure of resource utilization. From an investment strategy perspective, we think our U.S. Bond Strategy service’s golden rule provides the best insight. Below-benchmark-duration positioning will outperform if the Fed cuts less (or hikes more) over the next twelve months than markets expect; above-benchmark-duration will win if the Fed cuts more (or hikes less) than markets expect. Some strategists within BCA have raised the possibility that market expectations could force the Fed’s hand. The reason that the Fed is especially loath to disappoint markets in what might be called the forward-guidance era of central banking, but we think there’s an important distinction between taking care not to surprise markets and surrendering one’s free will to them, as parents of young children can attest. Bottom Line: We think the money markets are significantly overestimating the possibility that the Fed will soon cut the fed funds rate, increasing the potential returns from below-benchmark-duration positioning. The Rates Checklist Table 1Rates View Checklist We developed our rates checklist3 to provide a list of real-time measures that bear on our rates view. Of the eleven items on the list, only three have met our threshold for reassessing our bearish rates call at any point over the last eight months, so we have stayed the course (Table 1). The checked boxes indicate that the evidence has been moving against us, though we would argue that the stingy 10-year Treasury yield has gotten overly carried away with discounting that evidence (Chart 1, top panel).  Policy Perceptions The spread between our monetary policy expectations and the markets’ remains wide, so the prospective returns from our Fed call remain ample, and the first box remains unchecked. Thanks to last week’s two-day, 11-bps decline in the 10-year Treasury yield, we have again checked the inverted yield curve box, which first inverted for five days near the end of March, and has inverted for four days so far in May. Our empirical study of the inverted curve’s recession-signaling properties used month-end closes for the 10-year Treasury yield and the 3-month Treasury Bill rate, and found that an inverted curve had called the seven recessions that have occurred over the last 50 years with just one false positive (Chart 2). Now that the curve has inverted over a couple of daily stretches, clients have asked us just what constitutes bona fide inversion. Chart 2Accurate Yield Curve Signals Tend To Last Per the curve’s moves over the last 50 years, we would say inversion doesn’t issue an actionable signal until it persists for at least a few months (Table 2). 1998’s false alarm encompassed just seven days between late September and early October, and covered just one month end. The intuition behind the inverted yield curve’s predictive power is that the bond market sniffs out economic weakness before the Fed officially changes course. Recognizing that the Fed will have to begin cutting rates soon, bond investors buy longer-maturity instruments to reap the biggest rewards. Investors shouldn’t overreact to tentative inversions of the yield curve. Table 2Yield Curve Inversions We have argued that the next recession will not occur until the Fed has hiked the fed funds rate to a level above the equilibrium fed funds rate. Since we cannot observe the equilibrium rate in real time, we have looked to interest-rate-sensitive segments of the economy to gauge if higher rates are beginning to bite. Housing is on the front line of interest-rate sensitivity, and it remains quite affordable relative to history, suggesting that monetary policy has not yet become restrictive. Every time the inverted curve preceded a recession, the affordability index was below its long-run mean or rapidly making its way there (mid-1973); when the yield curve briefly inverted in September 1998, homes remained more affordable than average (Chart 3). Chart 3If Higher Rates Aren't Squeezing The Economy, The Yield Curve May Be Crying Wolf Inflation We concede that realized inflation measures (Chart 4), and inflation expectations as proxied by the difference in TIPS and nominal Treasury yields (Chart 5), have lost momentum since last summer. Washington’s unexpected grant of six-month waivers for importing Iranian oil caused crude prices to plunge, taking headline inflation measures and inflation expectations down with them (Chart 6). Given our Commodity And Energy Strategy team’s view that oil prices will extend their rebound across the rest of this year and into next, we expect that they will again move higher. Chart 4Consumer Price Indexes, ... chart 5... And Inflation Breakevens, ... Chart 6... Are Joined At The Hip With Oil Prices The Labor Market And Imbalances At Home And Abroad The labor market remains tight, so none of the labor market indicators argue for easier monetary policy and lower rates across the term structure. As far as the instability indicators go, there is as yet no sign of unsustainable activity in the economy’s key cyclical sectors. The Fed has stopped emphasizing the idea that financial sector imbalances alone might justify tighter policy, but anecdotal reports about lending standards suggest that potential vulnerabilities remain. There has not yet been an outbreak of major international distress that could deter the Fed from tightening policy, but worsening trade tensions and continued dollar strength would seem to make it slightly more likely. Bottom Line: We have checked a few boxes on our rates checklist, but the available evidence does not support adopting a more constructive view on rates. Hey, Big Spender The American consumer has long been a punching bag for Austrian School adherents and other moralists. As much as they scorn American households for living beyond their means, U.S. consumption has long played a symbiotic role in the global economy. As the engine powering the world’s largest economy, it makes an essential contribution to global aggregate demand, and provides an outlet for export powerhouses like China and Germany. An economy can only run a current account surplus provided that there are other economies running current account deficits capable of offsetting it. Measured inflation and inflation expectations were beginning to get some traction before oil collapsed upon the issuance of Iranian import waivers. In a recent blog post, former BCA Editor-in-Chief Francis Scotland posited that interest rates may not go anywhere as long as American households embrace their nascent post-crisis frugality. Using U.S. household demand as a proxy for global aggregate demand, Francis argues that if households don’t borrow and spend the way they did throughout the pre-crisis postwar era, global aggregate demand will suffer unless another profligate spender emerges to pick up the slack. Add China to the mix, and global savings could swamp global investment. Against that backdrop, savings and investment would only realign if rates fell. Newly frugal U.S. households may be helping to cap interest rates, but it’s too early to declare the end of the Debt Supercycle. Broadening the scope to include all public- and private-sector U.S. borrowing, the nominal 10-year Treasury yield has taken some cues from growth in aggregate borrowing (Chart 7). The relationship with real yields is not as strong (Chart 8), but if borrowing has some relationship to inflation, as under the guns-and-butter fiscal policy of the late sixties, nominal yields might well be a better measure. We can easily go along with the supply-and-demand intuition behind the observed relationship: when there’s stronger demand for credit, rates have to rise to entice savings and discourage investment to bring them back into balance, and vice versa. Chart 7Nominal Treasury Yields Have Been Tightly Linked With The Pace Of Loan Growth, ... Chart 8... And Real Yields Have Broadly Followed The Pattern As Well Government borrowing filled the void left by retrenching households and corporations in the immediate aftermath of the crisis. Household and corporate loan demand has been choppy since, however, and growth in aggregate borrowing has bumped around its mid-1950s lows throughout the expansion. We are not ready to declare that Americans have turned over a new, parsimonious leaf. The federal budget deficit soared following the passage of the stimulus package, and the CBO projects that it will continue to widen. Household debt growth is at its pre-crisis lows, but it has been accelerating ever since 2010 (Chart 9), and with debt service as a share of disposable income at its lowest level in at least 40 years, households have plenty of capacity to borrow. Chart 9Don't Count Consumers Out Just Yet Bottom Line: Interest rates have moved directionally with aggregate loan growth across the postwar era. Tepid loan demand growth may well keep a lid on rates, but we are not convinced that the Debt Supercycle has really breathed its last. Investment Implications Now that the 10-year Treasury yield has drifted back down to 2.3%, we believe the distribution of potential rate outcomes a year from now is skewed to the upside. We are thereby sticking with our recommendation that investors underweight Treasuries and maintain below-benchmark-duration positioning in all fixed-income portfolios. Even if there is not a clear catalyst on the immediate horizon for higher rates, we do not think that either the U.S. or the global economy is so fragile that investors should position for further rate declines. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the January 7 and January 28, 2019 U.S. Investment Strategy Weekly Reports, “What Now?” and “Double Breaker,” available at usis.bcaresearch.com. 2 All return data calculated as of the Thursday, May 23rd close. 3 Please see the September 17, 2018 U.S. Investment Strategy Weekly Report, “What Would It Take To Change Our Bearish Rates View?” available at usis.bcaresearch.com.

Highlights Duration: We see current bond market behavior as very similar to mid-2016, when heightened political uncertainty obscured the economy’s true strength and kept bond yields lower for longer than was justified by the economic fundamentals. The correct strategy at that time was to sell into the bond market’s strength, and we advocate a similar strategy today. China: Any attempt by the Chinese government to retaliate in the trade war by selling U.S. Treasury securities would be either self-defeating or ineffective, depending on the exact strategy employed. In either case, U.S. Treasury yields will be unaffected. Fed: At least part of the Fed’s dovish turn might represent a desire to send the labor share of national income higher. We introduce a new data series for Fed Watchers to track. Feature The Trump Administration fired the latest salvo in the trade war two weeks ago, expanding tariffs to a broader swathe of Chinese imports. Then last week, the escalation of tensions spilled over to the bond market, sending global yields abruptly lower. Chart 1Flight To Safety The 10-year U.S. Treasury yield bounced off 2.35% last Thursday and has since settled at 2.39% (Chart 1). Meanwhile, the overnight index swap curve is now priced for 44 bps of Fed rate cuts over the next 12 months (Chart 1, bottom panel). It is possible, and even likely, that geopolitical tensions will keep yields low during the next month or two. In fact, our Geopolitical Strategy service places the odds of a complete breakdown in trade negotiations by the end of June at 50%.1  But we would encourage investors to sell into rallies, positioning for higher yields on a 6-12 month horizon. To see why, we return to a Weekly Report from early April where we walked through different factors that would be useful in the creation of a macroeconomic model for the 10-year U.S. Treasury yield.2 We consider what has changed during the past six weeks and what those developments mean for bond yields going forward. Back In The Bond Kitchen In early April, we ran through four different factors that should be included in any bond model and suggested macroeconomic indicators that best capture the trends in each. The four factors are: Global Growth: Best proxied by the Global Manufacturing PMI and Bullish Dollar Sentiment Policy Uncertainty: Best proxied by the Global Economic Policy Uncertainty Index Output Gap: Best proxied by Average Hourly Earnings Sentiment: Best proxied by the U.S. Economic Surprise Index We consider each factor in turn. Global Growth Chart 2Monitoring Global Growth The Global Manufacturing PMI, our preferred series for tracking global growth, ticked down during the past month, continuing the free-fall that has been in place since the end of 2017 (Chart 2). At 50.3, it is now only slightly above the 50 boom/bust line and is close to where it was in mid-2016, when the 10-year yield hit its cyclical low. But on a positive note, several leading indicators have hooked up in recent months, suggesting that the Global PMI could soon trough and move higher in the second half of the year. Specifically, the ZEW survey of global economic sentiment is off its lows, as is the BCA Global Leading Economic Indicator (LEI). Meanwhile, the Global LEI Diffusion Index has surged, indicating that 74% of the 23 countries in our sample are seeing improvement in their LEIs. Historically, the Global LEI Diffusion Index leads changes in both the Global LEI and the Global Manufacturing PMI (Chart 2, panel 3). Financial market prices that are highly geared to global growth had been singing a similar tune, but they rolled over as trade tensions flared during the past two weeks. For example, cyclical equity sectors recently started to underperform defensive sectors (Chart 2, bottom panel), and the important CRB Raw Industrials index took a nosedive. We place particular importance on the CRB Raw Industrials index as a timely indicator of global growth, because the ratio between the CRB index and gold correlates nicely with the 10-year Treasury yield (Chart 3).3 Unsurprisingly, the ratio’s recent dip coincides with last week’s drop in the 10-year. Several leading indicators have hooked up in recent months, suggesting that the Global PMI could soon trough and move higher in the second half of the year.  In addition to the Global Manufacturing PMI, we recommend including a survey of bullish sentiment toward the U.S. dollar in any bond model. More bullish dollar sentiment coincides with lower Treasury yields, and vice-versa. Our preferred survey shows that dollar sentiment remains elevated, but hasn’t changed much since April (Chart 4). The dollar itself, however, has begun to appreciate during the past two weeks (Chart 4, bottom panel). Chart 3A Falling CRB/Gold Ratio... Chart 4...And The Greenback Is On The Rise Bottom Line: The coincident global growth indicators that correlate best with bond yields – the Global Manufacturing PMI and Dollar Bullish Sentiment – are sending a similar message as in April. Meanwhile, leading economic indicators continue to suggest that we should expect improvement in the second half of the year. The biggest change from April is that global growth indicators derived from financial market prices – cyclical versus defensive equities, the CRB Raw Industrials index and the trade-weighted dollar – have responded negatively to heightened political risk. If this weakness persists and eventually infects the economic data, then it could prevent a second-half rebound in global growth, keeping Treasury yields low for even longer.   Policy Uncertainty Spikes in the monthly Global Economic Policy Uncertainty Index often cause capital to seek out the safety of U.S. Treasuries, and we recommend including this index in any macroeconomic bond model (Chart 5A). Spikes in the monthly Global Economic Policy Uncertainty Index often cause capital to seek out the safety of U.S. Treasuries. While there have been no updates to the monthly index since the trade war’s recent escalation, one of its components – a daily index that tracks the number of relevant news stories – has surged during the past two weeks (Chart 5B). This clearly illustrates that a sharp increase in political uncertainty has been the catalyst for the bond market rally. Investors are obviously concerned that an ongoing and intensifying trade war might derail the economic recovery, and they are seeking out Treasuries as a hedge. Chart 5AGlobal Uncertainty Set To Spike Chart 5BMarkets Are Concerned In such situations, the traditional playbook is to fade any purely uncertainty-driven rally, on the view that markets tend to overreact to headline risk. This strategy worked well following the mid-2016 Brexit vote. The uncertainty shock from the vote sent the 10-year quickly down to 1.37%, but it then increased in the second half of the year when it became apparent that the economic recovery would continue. While higher tariffs will certainly be a drag on growth going forward, accommodative Fed policy and a probable increase in Chinese economic stimulus will mitigate the impact, keeping the economic recovery intact.4 Output Gap Chart 6Wages Are Headed Higher The output gap is a concept that represents where the economy is operating relative to its peak capacity, and its progress during the past three years is the main reason why bond yields will not re-test 2016 lows. We have found that wage growth is the most reliable way to measure the output gap: higher wage growth signals less spare capacity, and less spare capacity coincides with higher bond yields. We recommend Average Hourly Earnings as the best wage measure to include in any bond model. Since April, average hourly earnings growth has been roughly flat, but leading indicators suggest that further acceleration is highly likely in the coming months (Chart 6). While the Fed is keen to let wage growth accelerate, rising wage growth also makes a rate cut difficult to justify. The combination of rising wage growth and an on-hold Fed should put a rising floor under long-maturity bond yields. Sentiment The final factor that should be included in any bond model is sentiment. In April, we suggested that the U.S. Economic Surprise Index is the best measure of sentiment. When the surprise index has been deeply negative for a long time, it usually means that investors are downbeat on the economy and that the bar for a positive surprise is low. This has actually been the case in recent months, and our simple auto-regressive model suggests that the surprise index is biased higher (Chart 7). Positioning data confirm this message, and in fact show that investors are taking as much duration risk as they were when yields troughed in mid-2016 (Chart 8). Chart 7Low Bar For Positive Surprises Chart 8Similar Positioning As In Mid-2016 The overall message is that bond investors have a very dim view of the economy, and it will not take much positive news to send yields higher. Investment Strategy We see current bond market behavior as very similar to mid-2016, when heightened political uncertainty obscured the economy’s true strength and kept bond yields lower for longer than was justified by the economic fundamentals. The correct strategy at that time was to sell into the bond market’s strength, and we advocate a similar strategy today. Timing when the next move higher in bond yields will occur is difficult, but we take some comfort in the fact that the flatness of the yield curve makes it less costly than usual to carry below-benchmark duration positions. In fact, the average yield on the Bloomberg Barclays Cash index is 7 bps higher than the average yield on the Bloomberg Barclays Treasury Master Index. Bond investors have a very dim view of the economy, and it will not take much positive news to send yields higher. To further mitigate the cost of keeping duration low, we advocate taking duration-neutral positions that are short the belly (5-year & 7-year) part of the yield curve and long the very long and very short ends of the curve. Such trades are also provide a positive yield pick-up, and will earn capital gains when Treasury yields move higher.5 A Quick Note On China’s Treasury Purchases Chart 9Do Not Expect Treasuries To Be Used As A Weapon In This War The trade war’s recent escalation has led some to speculate that China could retaliate against higher tariffs by dumping U.S. Treasury securities onto the open market. The speculation only increased when the TIC data revealed that Chinese net Treasury purchases totaled -$24 billion in March, the most deeply negative figure since October 2016 (Chart 9).   We see low odds that China will employ this tactic in the trade war, and no meaningful impact on Treasury yields in any case. To see why, let’s consider two possible scenarios. In the first scenario, China sells a large amount of U.S. Treasury securities and keeps the proceeds from the sales in its domestic currency. Assuming the amounts in question are sufficiently large, these transactions would cause the RMB to appreciate and lead to a tightening of Chinese monetary conditions. Tighter monetary conditions are exactly what the Chinese government does not want as it seeks to counteract the negative economic impact from tariffs. In fact, China is much more likely to engineer a further easing of monetary conditions, much like in 2015/16 (Chart 9, bottom panel). In the second scenario, China could sell U.S. Treasuries and purchase other foreign bonds (German bunds, for example). This would nullify any impact on Chinese monetary conditions, but it would not have much impact on U.S. Treasury yields. With Chinese money still flowing into global bond markets, the re-balancing would only push other investors out of non-U.S. bond markets and into U.S. Treasuries. Without changing the overall demand for global bonds, it is difficult to envision much of an impact on U.S. yields. Bottom Line: Any attempt by the Chinese government to retaliate in the trade war by selling U.S. Treasury securities would be either self-defeating or ineffective, depending on the exact strategy employed. In either case, U.S. Treasury yields will be unaffected. A New Data Series For Fed Watchers: Rich’s Ratio A number of recent Fed speeches have referred to the time series plotted in Chart 10: The share of national income going to labor, as opposed to corporate profits. Chart 10Introducing Rich's Ratio Vice-Chair Richard Clarida brought this analysis to the Fed, and the data series was actually once dubbed “Rich’s Ratio” by Clarida’s old PIMCO colleague Paul McCulley. The idea behind Rich’s Ratio is that while some late-cycle wage gains are passed through to prices, a portion also eat into corporate profits. Notice in Chart 10 that Rich’s Ratio has a tendency to rise late in the economic recovery. Based on his past writings, we would not be surprised if at least part of the Fed’s recent dovish turn represents a desire to send Rich’s Ratio higher, even if that goal might entail a modest overshoot of the Fed's 2 percent inflation target. We will have more to say about Rich’s Ratio in the coming weeks. For now, we simply want to make Fed Watchers aware that they have a new series to track. Stay tuned. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see Geopolitical Strategy Weekly Report, “How Trump Became A War President”, dated May 17, 2019, available at gps.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019, available at usbs.bcaresearch.com 3 The rationale for why the CRB/Gold ratio tracks the 10-year Treasury yield is found in U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com 4 Please see Global Investment Strategy Weekly Report, “Tarrified”, dated May 16, 2019, available at gis.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Feature In what has become a tradition, I met with Ms. Mea following client meetings in Europe last week. Ms. Mea is a long-term BCA client who has been following our Emerging Markets Strategy very closely over the years. It was our fourth meet-up in the past 18 months. Ms. Mea keeps our meetings interesting by always challenging our views and questioning the nuances of our analysis. The timing of our most recent meeting was particularly notable, as we had just received news that the latest U.S.-China trade talks had not produced an agreement. In light of this, Ms. Mea started our conversation with a question on the link between geopolitics and financial markets: Ms. Mea: Why have the U.S. and China failed to reach a trade accord when it is clear that without one, both global financial markets and business sentiment will be hurt? Answer: The U.S. and China are intertwined in a geopolitical confrontation that will endure for decades. Their strategic national interests are not aligned at all. Therefore, any accord on trade and other geopolitical disputes will not be lasting. It is impossible to accurately forecast and time all turns of the negotiation process and the associated event risks. Therefore, an investment process should be informed and guided by a thematic approach. The U.S. and China are intertwined in a geopolitical confrontation that will endure for decades. Our theme has been, and remains, that China and the U.S. are in a long-term geopolitical confrontation that epitomizes a rivalry between an existing and a rising superpower. This suggests that the demands of one side will be unacceptable to the other. That makes any agreement unsustainable over the long run. In brief, there was a structural regime shift in the U.S.-China relationship last year. Yet global equity markets rallied this year on rising expectations of a major trade deal. Notably, most of the gains in EM equities since late December occurred on days when there was positive news on the progress of trade talks. Hence, the EM rally can largely be attributed to expectations of a trade deal. Not surprisingly, the failure to conclude a trade accord has quickly pushed EM share prices back down to their mid-January levels (Chart I-1). As such, the majority of investors who have bought the EM equity index since early this year lost a substantial part of their gains in the recent selloff.  Chart I-1EM Equity Index: Between Support And Resistance Given that these two nations are embroiled in a long-term geopolitical rivalry, it will be difficult to find solutions on trade and geopolitical disputes that can simultaneously satisfy both sides. Even so, this does not imply that global risk assets will be in freefall forever. Financial markets currently need to price in both (1) a geopolitical risk premium on a structural basis; and (2) the impact of trade tariffs on global business activity on a cyclical basis. Once these two components have been priced in, markets will become less sensitive to the ebbs and flows of tensions between the U.S. and China. Finally, China’s exports to the U.S. constitute only 3.5% of mainland GDP (Chart I-2). This is considerably smaller than capital spending, which makes up 42% of China’s GDP. Further, most of the investment outlays over the past 10 years have not been in productive capacity to supply goods to the American market. On the contrary, the overwhelming share of capital expenditures since 2008 have occurred in domestic segments of the economy rather than export industries. Certainly, the trade confrontation will weigh on consumer and business sentiment in China as well as reduce the flow of U.S. dollars to the Middle Kingdom, warranting RMB depreciation. Still, there are other predicaments unrelated to the U.S. import tariffs that Chinese policymakers are facing. These include the credit, money and property bubbles that we have written about extensively. China’s exports to the U.S. constitute only 3.5% of mainland GDP. Ms. Mea: With no trade deal, the odds appear to be rising that the Chinese authorities will ramp up both credit and fiscal stimulus. Should investors not be looking through the near-term volatility and be buying EM risk assets and China-plays – because this stimulus will produce a cyclical recovery in the mainland economy? Answer: It is a safe bet that the Chinese authorities will encourage more credit creation and ramp up fiscal spending. The difficulty for investors is in gauging two unknowns: What is the lead time between the stimulus and economic growth, and what will be the multiplier effect of these stimuli. Lead time: Chart I-3 portends our aggregate credit and fiscal spending impulse. Based on the past relationship between turning points in this indicator and the business cycle in China, the latter is likely to bottom around August. Chart I-2Structure Of Chinese Economy Chart I-3China: Stimulus Works With A Time Lag   Chart I-4China's Stimulus And Financial Markets: 2012 Versus 2016 Multiplier effect: The impact of stimulus on the economy also depends on the multiplier effect. The latter is contingent on households’ and companies’ willingness to spend. If households and companies hasten the pace of spending, the economy can recover with little stimulus. If they reduce their expenditure growth, the economy may require much more stimulus. The majority of investors and commentators are comparing China’s current stimulus efforts with what occurred in 2016. However, our hunch is that the current Chinese business cycle might actually resemble the 2012-‘13 episode due to similarities in the multiplier effect. The size of credit and fiscal stimulus in 2012 was as large as in 2016. Nevertheless, the business cycle recovery in 2012-‘13 was very muted, as illustrated in Chart I-3 on page 3. Consistently, EM share prices and commodities did not stage a cyclical rally in 2012 as they did in 2016-‘17 (Chart I-4). Ms. Mea: It seems you are implying that differences between the 2012 and 2016 economic and financial markets outcomes are due to the multiplier. How does one appraise the multiplier effect? Answer: In a word, yes. Unfortunately, there is no easy way to forecast consumers’ and businesses’ willingness to spend – particularly in the midst of a clash between the positive effects of stimulus and the negative sentiment stemming from the ongoing U.S.-China confrontation. We have constructed indicators that measure the willingness to spend among households and companies in China. Our proxies for their marginal propensity to spend (MPS) are currently in decline (Chart I-5A and I-5B). Chart I-5AChina: Households' Marginal Propensity To Spend Chart I-5BChina: Enterprises’ Marginal Propensity To Spend   MPS does not affect day-to-day expenditures, but rather captures consumer spending on large-ticket items such as housing, cars and durable goods, as well as investment expenditures by companies. Consistently, mainland companies’ MPS leads industrial metal prices by several months (Chart I-5B). Chart I-6 illustrates the critical difference between 2012 and 2016 in terms of the impact of credit and fiscal stimulus. In both episodes, the size of the stimulus was roughly the same, but the manufacturing PMI did not really recover in 2012-’13, gyrating in the 49-51 range. In contrast, it did stage a cyclical recovery in 2016-‘17 (Chart I-6, second panel). In brief, the difference between the 2012 and 2016 episodes was the MPS by companies and households (Chart I-6, third and fourth panels). There are other predicaments unrelated to the U.S. import tariffs that Chinese policymakers are facing. These include the credit, money and property bubbles that we have written about extensively. Provided the not-so-upbeat sentiment among Chinese households and businesses due to their high debt levels and the ongoing trade conflict, the odds are that their MPS will remain weak for now. As a result, the impact of credit and fiscal stimulus on China’s business cycle will be muted for now. As such, more stimulus and longer lead time may be required to engineer a cyclical recovery. Interestingly, the current profiles of both EM and developed equity markets closely resemble their 2012 trajectories – both in terms of direction and magnitude (Chart I-7). Chart I-6China's Stimulus In 2012 And 2016: Beware Of Multiplier Effect Chart I-7Is 2018-2019 Akin ##br##2011-2012? Ms. Mea: So, you are suggesting risks to China-related plays and EM financial markets are skewed to the downside. How should one assess how much downside there is, and what should investors look for to gauge turnings points in financial markets? Answer: We continuously assess the investment landscape, not only based on our fundamental analysis of the global/EM/China business cycles but also on various financial market valuations, positioning and technicals. Let’s review where we stand with respect to these metrics.   Equity Valuations: EM stocks are not cheap. Our favored measure of equity valuations is the composite indicator-based 20% trimmed means of the following multiples: trailing and forward P/E, price-to-cash earnings, price-to-book value and price-to-dividend ratios (Chart I-8). On these metrics, EM stocks appear fairly valued. Nevertheless, these valuations should be viewed in the context of structural decline in EM corporate profitability. The measures of return on equity and assets for non-financial companies in EM are on par with their 2008 lows (Chart I-8, middle and bottom panels). When valuations are neutral, the equity market’s direction is dictated by the profit outlook. The latter currently remains negative for EM and Chinese companies (Chart I-9). Chart I-8EM Equities Are Not Cheap Chart I-9Downside Profit Surprises In EM And China   Currency Valuations: The U.S. dollar is only moderately (one standard deviation) expensive, according to the real effective exchange rate based on unit labor costs (Chart I-10). The latter is our most favored currency valuation measure. The greenback has been in a major structural bull market since 2011. Secular bull/bear markets do not typically end before valuations reach 1.5-2 standard deviations. We reckon that the cyclical and structural backdrop remains favorable for the dollar, and odds are it will overshoot before a major top sets in. Going forward, most of the dollar’s additional gains will not occur versus the euro or the Japanese yen – which are already modestly undervalued (Chart I-10, middle and bottom panels) – but against other currencies. In particular, commodity currencies of developed economies have not yet cheapened enough (Chart I-11). Typically, a structural bear market in commodities does not end until these commodity currencies become cheap. Hence, the current valuation profile of these commodity currencies is consistent with the notion that the secular bear markets in commodities prices and EM are not yet over. Chart I-10The Euro Is Fairly Valued, The Yen Is Cheap G3 Currency Valuations Chart I-11Commodities Currencies ##br##Are Not Cheap Yet   Unfortunately, there are no data for unit labor cost-based real effective exchange rates for the majority of EMs. However, it is a safe bet to infer that long- and medium-term cycles in EM currencies coincide with those of DM commodity currencies because they are all pro-cyclical. If DM commodity currencies have not yet bottomed, EM currencies remain vulnerable. Relative to the global equity benchmark, global materials have broken down to new cyclical lows. This could be a harbinger of EM relative equity performance making new lows. Ms. Mea: But the positioning in the U.S. dollar is long. How consistent is this with your view of further dollar strength? Positioning: While investors are long the U.S. dollar versus several DM currencies, they are short the greenback versus EM currencies. Chart I-12 illustrates the aggregate net long positions of both leveraged funds and asset managers in the BRL, MXN, RUB and ZAR. As of May 10 (the last datapoint available), investors were as long these EM high-beta currencies as they were at their cyclical peak in early 2018. As to emerging Asian currencies, ongoing RMB depreciation will drag emerging Asian currencies down. Notably, the Korean won has already broken down from its tapering wedge pattern. Concerning EM equities, investor positioning and sentiment was still very elevated before last week’s market turmoil. Chart I-13 demonstrates the number of net long positions in EM ETFs (EEM) by leveraged funds and asset managers. The last datapoint is also as of May 10. Chart I-12Investors Have Been Long EM Currencies Chart I-13Investors Have Been Bullish On EM Stocks   In short, investor sentiment on EM was bullish and long positions in EM were extended before the U.S.-China trade confrontation escalated again. Tell-tale signs and technicals: Market profiles can sometimes help us gauge whether an asset class is in a bull or bear market, and what the next move is likely to be. We have the following observations: U.S. dollar volatility is close to its record lows (Chart I-14). Following the previous three low-volatility episodes, EM shares prices in dollar terms dropped substantially over the ensuing 18 months – 60% in 1997-1998, 65% in 2007-2008 and 30% in 2014-2015. The rationale is that very low global currency volatility indicates that investors do not foresee a major tectonic macro shift. When this does inevitably occur, currency markets move violently. The RMB depreciation could be a tectonic macro shift that global markets are not prepared for. The absolute and relative performances of EM stocks resemble that of global materials stocks. Global materials are breaking below their long-term moving averages (technical support lines) in absolute terms, raising the odds that the EM equity index will do the same. Relative to the global equity benchmark, global materials have broken down to new cyclical lows. This could be a harbinger of EM relative equity performance making new lows (Chart I-15). Chart I-14U.S. Dollar Volatility And ##br##EM Equity Returns Chart I-15EM And Global Materials: Relative To Global Index Consistently, industrial metals prices as well as our Risk-on/Safe-Haven Currency Index have potentially formed a head-and-shoulders pattern and may be entering a major down leg (Chart I-16). Further weakness in these variables would be consistent with a risk-off phase in EM financial markets.   Finally, the relative performance of the MSCI China All-Share Index – which includes all onshore- and offshore-listed stocks – has relapsed relative to the global equity benchmark, failing to break above its long-term moving average (Chart I-17). This is a negative tell-tale sign, and often warrants considerable downside. Chart I-16A Head-And-Shoulder Pattern In Global Cyclical Markets? Chart I-17China All-Share Index: Absolute And Relative Performance   Ms. Mea: It seems to me that the RMB holds the key. What are your thoughts on the Chinese currency? Answer: There are several reasons why the RMB will likely depreciate. First, yuan depreciation is needed to mitigate the impact of U.S. import tariffs on Chinese exporters’ profitability. Authorities could use the RMB depreciation to fight back against U.S. import tariffs – a response that U.S. President Donald Trump will certainly not like. Second, the ongoing cyclical downturn in China and rising deflationary pressures also warrant a cheaper currency. Third, there is a vast overhang of money supply in China: The broad money supply is equivalent to US$30 trillion. More stimulus will only make this oversupply of yuans larger. This, along with the desire of mainland households and businesses to diversify their deposits into foreign currencies/assets, is like “the sword of Damocles” on the yuan’s exchange rate. Finally, the sources of foreign currency that previously offset capital outflows in China are no longer available. The current account surplus has largely evaporated. In addition, the central bank seems to be reluctant to reduce its foreign exchange reserves to fund capital outflows. In fact, at US$3 trillion, its foreign currency reserves are equivalent to only 10% of local currency broad money supply. All in all, we are structurally short the RMB versus the dollar. Chart I-18China, Commodities, & EM: Identical Cycles Ms. Mea: What are the investment implications? Where are we in the EM/China investment cycle? Answer: Our investment themes since early this decade have been that EM share prices and currencies are in a bear market, the U.S. dollar is in a structural bull market, and commodities are in a structural downtrend (Chart I-18). With the exception of 2016-‘17, these themes have played out quite well. These structural moves have not yet been exhausted. At the moment, we do not foresee a 2016-’17-type cyclical rally either. The failure of EM equities to outperform DM stocks and the resilience of the U.S. dollar during the risk-on period since early this year, give us comfort in maintaining a negative stance on EM risk assets. Importantly, a decade-long poor EM performance is likely to end with a bang rather than a whimper, especially when investors by and large remain bullish on EM. On the whole, we recommend trading EM stocks on the short side and underweighting EM equities in a global equity portfolio. Within the EM equity universe, our overweights are Russia, central Europe, Thailand, non-tech Korean stocks, Mexico, Chile, the UAE and Vietnam. Our underweights are Brazil, South Africa, Turkey, Peru, Indonesia, India, and the Philippines. Fixed-income investors should also position for higher volatility and weaker EM currencies, favoring low-beta versus high-beta markets. Russian and Mexican markets are our favored local currency and U.S. dollar bonds. Finally, we continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: ZAR, CLP, IDR, MYR, PHP and KRW. Our currency overweights are MXN, RUB, SGD and the THB as well as central European currencies. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Equity Recommendations Fixed-Income, Credit And Currency Recommendations