Sectors

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Arthur Budaghyan, Senior Vice President Chief Emerging Markets Strategist Highlights The authorities in China have begun easing liquidity conditions but that is not sufficient to turn positive on mainland growth. For the next six months at least, the mainland's growth conditions will continue deteriorating and that warrants a negative stance on China-related risk assets, including commodities and EM. The path of least resistance for the dollar is up. This will continue to weigh on EM risk assets. A narrowing interest rate differential between China and the U.S. will continue exerting downward pressure on the RMB's value versus the dollar. Our credit stress test on Turkish banks suggests their stocks are not yet cheap assuming the non-performing loan ratio rises to 15%. Stay short banks and the lira. Feature China's economic slowdown, ongoing trade wars and accumulating U.S. inflation pressures will continue propping up the U.S. dollar, thereby sustaining a perfect storm for EM financial markets. This is taking place amid the poor structural fundamentals in the developing economies and the existing overhang of investor positions in EM. Altogether this argues for more downside in EM financial markets. A strong dollar is also a bad omen for developed markets' stock indexes. The reason being that the dollar is a countercyclical variable, and the greenback's rallies usually coincide with global trade downturns that are bearish for global cyclical equity sectors (Chart I-1). Needless to say, tariffs on imports are ultimately negative for global trade, and will exacerbate the global growth slowdown that has been occurring since early this year. In fact, there is anecdotal evidence that global trade has so far temporarily benefited from mounting expectations of tariffs.1 Companies have ordered more inputs and shipped more goods in advance of higher tariffs coming into effect. This is why global shipments and manufacturing production have so far held up reasonably well, while business expectations have plummeted (Chart I-2). Consequently, global trade and manufacturing production will likely record considerable weakness later this year. Since markets are typically forward looking, asset prices will adjust beforehand. Chart I-1Global Industrial Stocks And U.S. Dollar Global Industrial Stocks And U.S. Dollar Global Industrial Stocks And U.S. Dollar Chart I-2Global Trade Is Heading South Global Trade Is Heading South Global Trade Is Heading South We are maintaining our negative stance on EM stocks, currencies, credit markets and high-yielding local bonds. China Is Easing Liquidity, But Don't Hold Your Breath Chart I-3Chinese Interest Rates And EM Stocks: ##br##Positively Correlated Chinese Interest Rates And EM Stocks: Positively Correlated Chinese Interest Rates And EM Stocks: Positively Correlated China's softening industrial data, growing anecdotal evidence of a worsening credit crunch in the economy, U.S. tariffs, and plunging domestic share prices have been sufficient for the authorities to ease liquidity conditions in the Chinese banking system. Not surprisingly, many investors are wondering whether the worst is over for Chinese stocks and China-related financial markets worldwide, including those in EM. At the current juncture, liquidity easing by the PBOC is a necessary but not sufficient condition to turn positive on this nation's industrial cycle as well as EM risk assets. We have the following considerations on this topic: First, China's risk-free interest rates - government bond yields - led the selloff in both EM and Chinese stocks (Chart 3). These bond yields have plunged since November, foreshadowing the slowdown in China's growth and the carnage in EM/Chinese financial markets. By and large, there has been a positive correlation between EM share prices and China's local bond yields and interbank rates as illustrated on Chart I-3. For example, EM stocks, currencies and credit markets rallied substantially in 2017 in the face of rising interest rates in China. Likewise, they dropped in the second half of 2015 as bond yields and money market rates in China plunged. The rationale behind the positive correlation between EM risk assets and Chinese interest rates is that the latter rise and EM risk assets rally when the mainland economy is improving. The opposite is also true. At the moment, Chinese risk-free bond yields will likely continue to drop as additional slowdown in growth is in the cards. This heralds a further drop in EM financial markets. Second, any major stimulus will constitute a retraction of the Chinese government's policy of deleveraging and containing financial risks. The latter is the code phrase Chinese authorities use to stop fueling bubbles and speculative excesses. Hence, any policy stimulus will for now be measured and insufficient to boost growth this year. China is saddled with massive debt and money overhangs and a bubbly property market. Ongoing enormous expansion in money supply (i.e., RMB deposits)2 (Chart I-4) and a narrowing interest rate differential over the U.S. will continue exerting downward pressure on the RMB's value (Chart I-5). Chart I-4'Helicopter Money' In China Helicopter Money' In China Helicopter Money' In China Chart I-5The RMB Will Depreciate Further The RMB Will Depreciate Further The RMB Will Depreciate Further Even though capital controls have tightened since 2015, the capital account is not perfectly closed. As such, shrinking interest rate deferential versus the U.S. warrants further yuan depreciation. In short, the authorities cannot reduce interest rates further and expand money/credit growth at a double-digit rate without tolerating sizable currency deprecation. If the Chinese authorities opt for a large fiscal and credit stimulus again, the nation's structural imbalances will grow further. In this scenario, the Middle Kingdom's secular growth outlook will deteriorate, and policymakers' manoeuvring room to stimulate in the future will narrow. Chart I-6China: The Industrial Cycle Is Slumping China: The Industrial Cycle Is Slumping China: The Industrial Cycle Is Slumping Crucially, China's enormous money and credit creation are entirely unrelated to its high savings rate. Money and credit in China have been driven by speculative behavior of Chinese banks and borrowers not households' high savings rate. We have discussed these issues in detail in our past special reports3 and will not expand on them here. Third, there has been money/credit tightening on three fronts in China - liquidity, regulatory and anti-corruption. Even though liquidity conditions in the banking system are now ameliorating, as evidenced by the plunge in interbank rates, the regulatory clampdown on the shadow banking system as well as the anti-corruption campaign targeting the financial industry are still underway. The latter policy initiatives will continue to curb credit creation by suppressing banks' and shadow banking institutions' ability and willingness to finance the real economy. In fact, it is not inconceivable that the regulatory clampdown and anti-corruption campaign will have a larger impact on credit supply than the decline in borrowing costs. Finally, policy easing and tightening works with a time lag. China's business cycles and related financial markets do not always respond swiftly to changes in policy stance. Specifically, monetary and fiscal policies were easing substantially from the middle of 2015, yet EM/China-related risk assets continued to plummet for six months until February 2016. Conversely, policy was tightening in China throughout 2017, yet EM/China-related asset markets did well in 2017. In brief, there could be a long lag between a change in policy stance and a reversal in financial markets. For now, we reckon that the cumulative effect of policy tightening of the past 18 months will continue to seep through the Chinese economy till the end of this year. Chart I-6 demonstrates that various industrial cycle indicators continue to deteriorate. Bottom Line: The authorities in China have begun easing liquidity conditions but that is not sufficient to turn positive on Chinese growth and China-related risk assets, including commodities and EM. For the next six months at least, the mainland's growth conditions will continue deteriorating and that warrants a negative stance on China-related risk assets. More Downside The indicators that have been useful in foretelling the turmoil in EM financial markets this year are signaling that a negative stance is still warranted: One indicator that gave an early warning signal for the current EM selloff was EM sovereign and corporate bond yields. At the moment, the average of EM dollar-denominated corporate and sovereign bond yields continues to presage lower EM stock prices, as demonstrated in Chart I-7 - bond yields are shown inverted in this chart. Chart I-7Rising EM Borrowing Costs Are Bearish For Their Stocks Rising EM Borrowing Costs Are Bearish For Their Stocks Rising EM Borrowing Costs Are Bearish For Their Stocks Notably, EM share prices display lower correlation with U.S. bond yields and U.S. TIPS yields than with EM corporate and sovereign bond yields (Chart I-8). Why are EM share prices exhibiting a stronger correlation with EM bond yields rather than with U.S. Treasury yields? The basis is that EM equities are sensitive to EM - not U.S. - borrowing costs. So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate and sovereign U.S. dollar bond yields - i.e. EM borrowing costs in dollars - will decline, and EM share prices will rally (Chart I-7). But when EM corporate (or sovereign) yields rise - irrespective of whether because of rising U.S. Treasury yields or widening EM credit spreads - EM borrowing costs in dollars rise, and consequently equity prices come under considerable selling pressure. In other words, a drop in U.S. bond yields on its own is not enough for EM share prices to advance, and conversely, a rise in U.S. bond yields is not sufficient for EM stocks to drop. It is movements in EM U.S. dollar bond yields, which are comprised of U.S. Treasury yields and EM credit spreads, that matter for the direction of EM equity prices. Regarding local bond yields, EM share prices typically exhibit a strong negative correlation with EM domestic government bonds yields - the latter are shown inverted on this chart (Chart I-9). Since we expect EM currencies to depreciate further and, given the negative correlation between EM currency values and their local bond yields, the latter will continue rising. Chart I-8EM Stocks And U.S. Rates: ##br##Mixed Relationship EM Stocks And U.S. Rates: Mixed Relationship EM Stocks And U.S. Rates: Mixed Relationship Chart I-9EM Equities And Local Bond Yields: ##br##Strong Correlation EM Equities and Local Bond Yields: Strong Correlation EM Equities and Local Bond Yields: Strong Correlation The risky-to-safe-haven currency ratio4 continues to fall after experiencing a major breakdown early this year (Chart I-10, top panel). Historically, this ratio has been correlated with EM share prices and currently heralds further downside (Chart I-10, bottom panel). This ratio also is agnostic to the dollar's direction - it swings between risk-on versus risk-off regimes in financial markets, regardless of the general trend in the greenback. Hence, this indicator answers the question of the direction of EM share prices, regardless of the dollar's trend. Finally, key to EM performance has been corporate profits. Presently, the outlook for EM corporate profits is still negative, as suggested by the negative readings on China's money and credit (Chart I-11). Chart I-10Are Risk Assets In A Bear Market? bca.ems_wr_2018_07_12_s1_c10 bca.ems_wr_2018_07_12_s1_c10 Chart I-11EM Corporate Profits Will Likely Shrink EM Corporate Profits Will Likely Shrink EM Corporate Profits Will Likely Shrink Bottom Line: EM risk asset will continue selling off and underperforming their DM counterparts. Stay short/underweight EM risk assets. The Dollar's Trend Is Still Up The U.S. dollar is instrumental to EM financial market trends. We expect the dollar rally to persist for now - at least through the end of this year. The underlying inflation gauge measure calculated by New York Fed points to further acceleration in U.S. consumer price inflation (Chart I-12). Furthermore, America's job market is continuing to tighten. In brief, U.S. domestic demand will stay robust even as global trade slumps. These will limit the Federal Reserve's ability to back off from tightening, even if EM financial markets continue to sell off. Chart I-12U.S. Inflation Risks Are To The Upside U.S. Inflation Risks Are To The Upside U.S. Inflation Risks Are To The Upside Remarkably, a strong U.S. exchange rate is needed to cap America's growth and inflation and to boost growth in the rest of the world, especially in Asia. Given the widening growth momentum between the U.S. and Asia, the dollar will likely need to rally significantly to reverse the growth differential currently moving in favor of America. This will be especially true if more trade tariffs are imposed. Odds are that the RMB will depreciate further given the backdrop of lower interest rates in China - discussed above. That will cause a downturn in emerging Asian currencies. A strong dollar, a slowdown in Chinese/EM demand for commodities and large net long positions by investors in oil and copper all argue for a considerable drop in commodities prices in the months ahead. This is bearish for Latin American and many other EM exchange rates. Bottom Line: The path of least resistance for the dollar is up. This will continue to weigh on EM risk assets. With respect to currency positions, we recommend investors to continue to short a basket of EM currencies such as BRL, ZAR, TRY, MYR and IDR versus the dollar. CLP and KRW are also among our shorts given our bearish outlook for copper prices, global trade and Asian currencies. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Turkish Banks: A Bargain Or Value Trap? 12 July 2018 Turkish bank stocks have now fallen by 40% in local currency terms and by 55% in U.S. dollar terms since their peak early this year (Chart II-1), prompting the question whether they have become a bargain or are still a value trap. Banks represent 30% of the Turkey MSCI index and are integral to the performance of this bourse. Although Turkish banks appear to be cheap with their price-to-trailing earnings ratio at 4.5 and their price-to-book value ratio at 0.62, they are still vulnerable to a substantial rise in non-performing loans (NPL) and ensuing provisioning, write-off and equity dilution. Turkey has been experiencing an enormous credit binge for years and its interest rates have risen by 600 basis points since the start of the year. Yet, current NPLs and provisions stand at a mere 3% and 2.3% of total outstanding loan, respectively (Chart II-2). Chart II-1Turkish Stocks: A Long-Term Perspective Turkish Stocks: A Long-Term Perspective Turkish Stocks: A Long-Term Perspective Chart II-2Turkish Banks Are Underprovisioned Turkish Banks Are Underprovisioned Turkish Banks Are Underprovisioned The creditworthiness of debtors is worse when one takes into account that Turkish companies have large foreign currency debt and a record amount of foreign debt obligations due in 2018 (Chart II-3). In our credit stress test, we assume that in the baseline scenario the non-performing credit assets (NPCA) ratio will rise to 15% (Table II-1). Taking into account that the NPL-to-total loan ratio reached 18% in 2002 after the 2001 currency crisis, we believe 15% is a reasonable estimate. Chart II-3Turkey: Record High Foreign Debt Obligations Turkey: Record High Foreign Debt Obligations Turkey: Record High Foreign Debt Obligations Table II-1Credit Stress Test For Turkish Banks EM: A Perfect Storm EM: A Perfect Storm To put this number further into perspective, India - one of the very few countries within the EM universe to have somewhat fully recognized its NPLs - currently has an NPL ratio of 15% on its public banks. Chart II-4Turkish Equities: ##br##A Cyclically-Adjusted P/E Ratio Turkish Equities: A Cyclically-Adjusted P/E Ratio Turkish Equities: A Cyclically-Adjusted P/E Ratio If we assume that Turkish bank stocks at the end of this cycle will trade at a price-to-book ratio of 1 after adjusting for all credit losses, then banks' stock prices are currently about 17% overvalued in the baseline scenario of 15% NPCA (Table II-1, the middle row). In all three scenarios, we assume a recovery rate of 40%. With regards to the overall equity market, Chart II-4 demonstrates that the cyclically-adjusted P/E (CAPE) ratio for Turkish stocks is currently around 5, compared to the historical average of 8. For the bourse's CAPE ratio to drop to two standard deviations below its mean, share prices have to fall by another 20-25%. This is plausible given the outlook for more populist economic policies following the recent elections. Besides, corporate profits will contract considerably because of the monetary tightening that has occurred since early this year. The exchange rate is critical for Turkish financial markets. As such, revisiting currency valuation is also important. Our favorite measure of currency valuation is the real effective exchange rate based on unit labor costs. This takes into account both wages and productivity. Hence, it gauges competitiveness much better than the measures of real effective exchange rate based on consumer and producer prices. Using this measure, as of July 11 the lira was slightly more than one standard deviation below its historical mean (Chart II-5). For it to reach two standard deviations below its mean, it would roughly take another 15-17% depreciation, versus an equal-weighted basket of the dollar and euro. Given the current macroeconomic backdrop and the outlook for more unorthodox policies, including possible capital controls following President Erdogan's appointment of his son-in law as the key economic policymaker, the lira will likely undershoot. Meantime, foreign holdings of Turkish local bonds and stocks were not yet depressed as of June 29 (Chart II-6). Chart II-5Turkish Lira: An Undershoot Is Likely Turkish Lira: An Undershoot Is Likely Turkish Lira: An Undershoot Is Likely Chart II-6Foreign Ownership Is Still High Foreign Ownership Is Still High Foreign Ownership Is Still High Bottom Line: Provided Turkey's political outlook has deteriorated further after the recent elections, we assess that only after a 15% depreciation in the lira versus an equal-weighted basket of the dollar and euro, in combination with a 15-20% drop in stocks in local currency terms, will Turkish equities be a true bargain and warrant a positive stance. For now, dedicated EM equity and fixed income portfolios (both credit and local currency bonds) should continue to underweight Turkey. Our open directional trades at the moment remain: Short Turkish bank stocks Short TRY / long USD. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the following article Global automakers hail more ships as trade battles heat up. 2 Please see Emerging Markets Strategy Weekly Report "Follow The Money, Not The Crowd," dated July 26, 2017, available on ems.bcaresearch.com 3 Please see Emerging Markets Strategy Special Report "The True Meaning Of China's Great 'Savings' Wall," dated December 20, 2017, available on ems.bcaresearch.com; and Emerging Markets Strategy Special Report "Is Investment Constrained By Savings? Tales Of China And Brazil," dated March 22, 2018, link is available on page 17. 4 Average of cad, aud, nzd, brl, clp & zar total return indices relative to average of jpy & chf total returns (including carry); rebased to 100 at January 2000. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Dhaval Joshi, Senior Vice President Chief European Investment Strategist Feature We live in strange economic times. Financial markets applauded President Trump's Keynesian stimulus package, even though it will lift the U.S. structural deficit to a crisis-era level approaching 7% of GDP. Yet markets seem uncomfortable about the merest hint of fiscal stimulus in Italy, where the government finances are close to a structural balance! (Table I-1) Table I-1Italy's Structural Deficit Has Almost Disappeared Monetarists Vs Keynesians: The 21st Century Battle Monetarists Vs Keynesians: The 21st Century Battle Meanwhile the ECB must supposedly maintain negative interest rates to support a fragile Italy; and the Fed must supposedly hike rates many more times to prevent the U.S. overheating. In this Special Report, we ask: might the policy prescription of tight fiscal/loose monetary for Italy and loose fiscal/tight monetary for the U.S. be completely back to front? For Italy, Mainstream Economists Are Prescribing Wrong Remedies For many years, mainstream economists prescribed remedies for sluggish growth in southern Europe on the basis of three articles of blind faith. First, that the ailment in Italy (and previously in Spain and Portugal) arose from structural impediments to growth; second, that in response to an ailing economy, ultra-loose monetary policy is always and everywhere effective; and third, that government borrowing is at best a necessary evil and at worst a recipe for disaster; As a result, European policymakers have expended much time and energy attempting structural reforms, experimenting with ultra-loose monetary policy, and aggressively shrinking government deficits. Of course, carefully chosen structural reforms are no bad thing for an economy. But can you name an economy in the world that would not benefit from carefully chosen structural reforms? The misguided obsession with structural reforms has caused mainstream economists to miss the real cause of Italy's ailment - its crippled banking system (Feature Chart). Feature ChartItaly's Problem In One Picture: A Crippled Banking System Italy's Problem In One Picture: A Crippled Banking System Italy's Problem In One Picture: A Crippled Banking System In a normal world, the task of ensuring that private sector savings are borrowed and spent falls on the banks, which take in the savings and debt repayments and lend them out to others in the private sector who can make the best use of the funds. But if a dysfunctional banking system fails this task, the savings generated by the private sector will find no borrowers. The unrecycled funds become a leakage to the national income stream generating a deflationary headwind for the economy. This headwind will persist until the banks are repaired to fulfil their intermediation task of recycling savings and debt repayments. Since 2008, the stock of loans to Italian households and firms has been stagnant while in real terms it has fallen (Chart I-2). The upshot is that the real money supply has shrunk despite low private sector indebtedness (Chart I-3 and Chart I-4), record low interest rates and massive injections of liquidity into the banking system. Why? Chart I-2Italian Bank Lending Has Fallen In Real Terms Italian Bank Lending Has Fallen In Real Terms Italian Bank Lending Has Fallen In Real Terms Chart I-3Italy Is Less Indebted... Italy Is Less Indebted... Italy Is Less Indebted... Chart I-4...Than France ...Than France ...Than France The simple reason is that after the 2008 global financial crisis Italian banks' balance sheets were left unrepaired and undercapitalized (Chart I-5 and Chart I-6). For an individual bank whose solvency is impaired, the right thing to do is shrink its loan book relative to its equity capital. But when the entire banking system is doing this simultaneously, the economy falls into a massive fallacy of composition: what is right for an individual bank becomes very deflationary when all banks are doing it together. Under these circumstances, an agent outside the fallacy of composition - namely, the government - must counter this deflationary headwind by borrowing and spending the un-recycled private sector savings. Chart I-5After The 2008 Crisis Italian Banks ##br##Were Left Unrepaired... After The 2008 Crisis Italian Banks Were Left Unrepaired... After The 2008 Crisis Italian Banks Were Left Unrepaired... Chart I-6...And ##br##Undercapitalized ...And Undercapitalized ...And Undercapitalized When To Use Fiscal Stimulus, And When Not To Deficit spending is often associated with crowding out and misallocation of resources. But when the banking system is not recycling savings and debt repayments within the private sector, the opposite is true. Government borrowing and spending causes no crowding out because the government is simply utilising the un-recycled private sector savings and debt repayments. And importantly, this deficit spending prevents a deflationary shrinkage of the broad money supply. Unfortunately, this concept has met with great resistance. Most people are aware of the size of government debt and deficits, but few people are aware of the leakage to the national income stream that occurs when a dysfunctional banking system is unable to recycle savings and debt repayments within the private sector. By not making this crucial connection, people believe that government spending would be profligate. They do not realise that if the private sector as a whole is saving money, the public sector must borrow and spend the money to keep the economy afloat. This leads to important lessons on when Keynesian stimulus is highly effective and when it is ineffective. When the solvency of the private sector - including, crucially, the banking system - is healthy, bank lending responds well to changes in interest rates (Chart I-7 and Chart I-8). Hence, in such a world, monetary policy should be the main tool for regulating economic activity. This describes the recent situation in most developed economies, including the U.S. Fiscal stimulus is largely ineffective because it leads to crowding out, and a sub-optimal allocation of resources. Chart I-7Lower Interest Rates Have Stimulated ##br##Bank Lending In Germany... Lower Interest Rates Have Stimulated Bank Lending In Germany... Lower Interest Rates Have Stimulated Bank Lending In Germany... Chart I-8...And ##br##France... ...And France... ...And France... However, when the private sector and/or the banking system is insolvent and dysfunctional, it is monetary stimulus that becomes ineffective. No extent of depressing interest rates and/or central bank liquidity injections will stimulate bank lending (Chart I-9). This describes the recent situation in Italy. The broad money supply becomes very dependent on government spending, making fiscal stimulus highly effective. Chart I-9...But Not In Italy ...But Not In Italy ...But Not In Italy But can monetary stimulus still help via the exchange rate channel? A weaker euro boosts the competitiveness of firms selling euro priced products in international markets. Therefore, firms exporting discretionary goods and services which are price elastic could benefit. Against this, the weaker euro makes everyone in the euro area poorer in terms of the goods and services they can buy from outside the euro area. This is particularly significant for non-discretionary items - food and energy - of which Europe is a large importer. Given that the volumes of these purchases tend to be inelastic, their price increase in euro terms can weigh down the real spending power of euro area consumers. The upshot is that a weaker exchange rate's aggregate impact on an economy depends on how the winners and losers net out. Italy might become more competitive vis-à-vis its non-euro trading partners, but Italian consumers may suffer a loss of real spending power - which would partly or wholly cancel out the benefit to the exporters. What Is The Prescription Right Now? In summary, neither the monetarists nor the Keynesians are all-powerful. In a world where the private sector is dysfunctional, the effectiveness of both monetary and fiscal policies are opposite to those in a world in which the private sector is functional. Therefore, it is crucial to recognise which of these two phases the economy is in, and then implement the economic policies, monetary or fiscal, most effective in that phase. What are the key messages right now? In Italy, the banking system is still healing and not fully functional. This suggests that for Italy, the ECB's ultra-loose monetary policy is largely ineffective whereas fiscal stimulus - even modest - would be highly effective (Chart I-10). But in the other major economies, including the U.S., the private sector is fully functional. This means that monetary policy is effective, whereas fiscal stimulus will be largely ineffective (Chart I-11). Interestingly, in a just-released paper 'Fiscal Policy in Good Times and Bad' the Federal Reserve Bank of San Francisco reaches exactly the same conclusion, pointing out that:1 Chart I-10A Strong Recent Connection Between ##br##Fiscal Thrust And GDP Growth In Italy A Strong Recent Connection Between Fiscal Thrust And GDP Growth In Italy A Strong Recent Connection Between Fiscal Thrust And GDP Growth In Italy Chart I-11A Weak Connection Between Fiscal##br## Thrust And GDP Growth In The U.S. A Weak Connection Between Fiscal Thrust And GDP Growth In The U.S. A Weak Connection Between Fiscal Thrust And GDP Growth In The U.S. "A number of macroeconomic forecasters expect the Tax Cuts And Jobs Act to boost 2018 GDP growth by around a percentage point... (but) the true boost is more likely to be well below that, as small as zero..." Pulling all of this together, we end with two takeaways for investors: don't bet on the ultra-loose monetary policy in the euro area continuing indefinitely; and as the San Francisco Fed advises, don't bet on President Trump's Keynesian stimulus being a game changer for U.S. growth. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the FRBSF Economic Letter 'Fiscal Policy in Good Times and Bad', Tim Mahedy and Daniel J. Wilson, July 9, 2018 available at https://www.frbsf.org/economic-research/files/el2018-18.pdf

Neutral In our July 3rd Weekly Report, we made good on our recent upgrade alerts and raised the S&P pharma and biotech groups to neutral from underweight, locking in relative gains of 14.5% and 13.9%, respectively. In our report, we highlighted five key drivers for our more sanguine view, namely firming operating metrics, late cycle dynamics, likelihood of pricing power regulatory relief, the rising U.S. dollar and investor and analyst capitulation. With respect to the first of these, our pharma productivity proxy (industrial production / employment) is putting in its best performance of the past several years, implying that earnings seem likely to exceed the pessimistic sell-side estimates (second panel). This seems particularly likely as the pace of improvement in drug shipments exceeds inventory growth by a fairly wide margin (third and bottom panels). Bottom Line: Lift the S&P pharma and S&P biotech indexes to a benchmark allocation and remove the S&P pharma group from the high-conviction underweight list; see our Weekly Report for more details. The ticker symbols for the stocks in the S&P biotech and S&P pharma indexes are: BLBG: S5BIOTX - ABBV, AMGN, GILD, CELG, BIIB, VRTX, REGN, ALXN, INCY and BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO, NKTR, respectively. Operating Improvements Could Cure Pharmas Ills Operating Improvements Could Cure Pharmas Ills

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Ryan Swift, Vice President U.S. Bond Strategy Highlights Chart 1Inflations Expectations Hard To Shake Inflations Expectations Hard To Shake Inflations Expectations Hard To Shake Low inflation expectations are proving difficult to shake. Year-over-year core PCE inflation moved to within 5 bps of the Fed's 2% target in May, but long-maturity TIPS breakeven inflation rates barely budged (Chart 1). Instead, breakevens are taking cues from commodity prices which are being held down by flagging global growth (bottom panel). The minutes from the June FOMC meeting revealed that "one participant" advocated postponing rate hikes in an attempt to re-anchor inflation expectations, but we do not expect the Fed to pursue this course. Instead, the Fed will continue to lift rates at a pace of 25 bps per quarter until a risk-off episode in financial markets prompts a delay, hoping that the incoming inflation data are strong enough to send TIPS breakevens higher in the meantime. Ultimately we think that strategy will be successful, but Fed hawkishness in the face of weakening global growth threatens the near-term performance of corporate credit. We recommend only a neutral allocation to spread product versus Treasuries, while maintaining a below-benchmark duration bias. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 60 basis points in June, dragging year-to-date excess returns down to -181 bps. Value is no longer stretched in the investment grade corporate bond market, though it is not attractive enough to compensate for being in the late stages of the credit cycle or for the looming collision between a hawkish Fed and decelerating global growth. These factors led us to reduce exposure to corporate bonds two weeks ago.1 With inflation running close to the Fed's 2% target and the 2/10 Treasury slope between 0 bps and 50 bps, our research shows that small positive excess returns are the best case scenario for corporate bonds. The likelihood that leverage will rise in the second half of this year is also a concern (Chart 2). Profit growth is only just keeping pace with debt growth and will soon have to contend with rising wage costs and the drag from recent dollar strength. The Fed's staunch hawkishness in the face of decelerating global growth is reminiscent of 2015. Then, the end result was a period of spread widening that culminated in the Fed pausing its rate hike cycle. In recent weeks we also explored how to position within the investment grade corporate bond sector, considering both the maturity spectrum and the different credit tiers.2 We concluded that in the current environment investors should favor long maturities and maintain a balanced or slightly up-in-quality bias (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Deflationary Mindset The Deflationary Mindset Table 3BCorporate Sector Risk Vs. Reward* The Deflationary Mindset The Deflationary Mindset High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 40 basis points in June, bringing year-to-date excess returns up to +76 bps. The average index option-adjusted spread widened 1 bp on the month, and currently sits at 365 bps. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses has widened to 262 bps, just above its long-run mean (Chart 3). This tells us that if default losses during the next 12 months are in line with our expectations, we should expect excess high-yield returns of 262 bps over duration-matched Treasuries, assuming also that there are no capital gains/losses from spread tightening/widening. However, we showed in last week's report that the default loss expectations embedded in our calculation are extremely low relative to history (panel 4).3 Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.03% during the next 12 months. The only historical period to show significantly lower default losses was 2007, a time when corporate balance sheets were in much better shape than they are today. While most indicators suggest that default losses will in fact remain low for the next 12 months, historical context clearly demonstrates that the risks to that forecast are to the upside. It will be critically important to track real-time indicators of the default rate such as job cut announcements, which remain low relative to history but have perked up in recent months (bottom panel), for signals about whether current default forecasts are overly optimistic. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in June, bringing year-to-date excess returns up to -24 bps. The conventional 30-year zero-volatility MBS spread widened 1 bp on the month, driven entirely by a 1 bp widening of the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) held flat. The MBS option-adjusted spread has widened since the beginning of the year (Chart 4), though by much less than the investment grade corporate bond spread (panel 3). The year-to-date OAS widening has been offset by a contraction in the option cost component of spreads, and this has kept the overall nominal MBS spread flat at very tight levels (bottom panel). Going forward, rising interest rates will limit mortgage refinancing activity and this will ensure that MBS spreads remain low. In other words, while MBS valuation is not attractive, the downside is limited. Our Bond Maps show an unfavorable risk/reward trade-off in the MBS sector. This analysis, based on volatility-adjusted breakeven spreads, shows that only 7 days of average spread widening are required for the MBS sector to lose 100 bps versus duration-matched Treasuries. While this speaks to the low spread buffer built into current MBS valuations, the message from the Bond Map must be weighed against the macro outlook which suggests that the odds of significant spread widening are quite low. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 5 basis points in June, bringing year-to-date excess returns up to -35 bps. Sovereign debt outperformed the Treasury benchmark by 33 bps on the month, bringing year-to-date excess returns up to -210 bps. Foreign Agencies outperformed by 10 bps on the month, bringing year-to-date excess returns up to -46 bps. Local Authorities underperformed by 9 bps on the month, dragging year-to-date excess returns down to +28 bps. Supranationals outperformed by 5 bps on the month, bringing year-to-date excess returns up to +7 bps. Domestic Agency bonds underperformed by 7 bps, dragging year-to-date excess returns down to zero. The escalating tit-for-tat trade war and increasing divergence between U.S. and non-U.S. growth is a clear negative for USD-denominated Sovereign debt. Relative valuation also shows that U.S. corporate bonds are more attractive than similarly rated Sovereigns (Chart 5). Maintain an underweight allocation to Sovereign debt. Within the universe of Emerging Market Sovereign debt, we showed in a recent report that only Russian debt offers an attractive spread relative to the U.S. corporate sector.4 In contrast, the Foreign Agency and Local Authority sectors continue to offer a favorable risk/reward trade-off compared to other fixed income sectors (please see the Bond Maps). Maintain overweight allocations to these two sectors. The Bond Maps also show that the Supranational and Domestic Agency sectors are very low risk, but offer feeble return potential compared to other sectors. The Supranational and Domestic Agency sectors should be avoided. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 10 basis points in June, bringing year-to-date excess returns up to +120 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio fell 1% in June to reach 85%, close to one standard deviation below its post-crisis mean. It is also only slightly higher than the average 81% level that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. The technical picture remains favorable for Muni / Treasury yield ratios. Fund inflows increased in recent weeks, and visible supply has contracted substantially compared to this time last year (Chart 6). State & local government credit fundamentals are also fairly robust. Net borrowing is on the decline and this should ensure that municipal ratings upgrades continue to outpace downgrades (bottom panel). Despite relatively tight valuation compared to history, the Total Return Bond Map on page 16 shows that municipal bonds offer a fairly attractive risk/reward trade-off compared to other U.S. fixed income sectors, particularly for investors exposed to the top marginal tax rate. Given the favorable reading from our Bond Map and the steadily improving credit fundamentals, we recommend an overweight allocation to Municipal bonds. Treasury Curve: Favor 7-Year Bullet Over 1/20 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened in June. The 2/10 Treasury slope flattened 10 bps and the 5/30 slope flattened 7 bps. At present, the 2/10 slope sits at 29 bps, its flattest level of the cycle. The yield curve has flattened relentlessly in recent months as the impact of Fed rate hikes at the short-end of the curve have not been offset by higher inflation expectations at the long end. As explained in a recent report, we think it is unlikely that curve flattening can maintain this rapid pace.5 At 2.34%, the 1-year Treasury yield is already priced for 100 bps of Fed rate hikes during the next 12 months, assuming no term premium. Meanwhile, long-maturity TIPS breakeven inflation rates remain below levels that are consistent with the Fed's 2% inflation target. While curve flattening will proceed as the Fed lifts rates, higher breakeven inflation rates at the long-end of the curve will offset some flattening pressure during the next few months. With that in mind, we continue to recommend a position long the 7-year bullet and short the duration-matched 1/20 barbell. According to our models, this butterfly spread currently discounts 41 bps of 1/20 curve flattening during the next six months (Chart 7). This is considerably more than what is likely to occur. Table 4 of this report shows the output from our valuation models for each butterfly combination across the entire yield curve, as explained in a recent Special Report.6 Table 4Butterfly Strategy Valuation (As Of July 6, 2018) The Deflationary Mindset The Deflationary Mindset TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 35 basis points in June, bringing year-to-date excess returns up to +129 bps. The 10-year TIPS breakeven inflation rate increased 4 bps on the month and currently sits at 2.12%. The 5-year/5-year forward TIPS breakeven inflation rate increased 5 bps and currently sits at 2.16% (Chart 8). Both the 10-year and 5-year/5-year TIPS breakeven inflation rates remain below the range of 2.3% to 2.5% that has historically been consistent with inflation expectations that are well-anchored around the Fed's 2% target. We expect breakevens will return to that target range as investors become increasingly convinced that the risk of deflation has faded. Consistent inflation prints at or above the Fed's 2% target will be the deciding factor that eventually leads to this upward re-rating of inflation expectations. In that regard, the current outlook is promising. Core PCE inflation has printed above the 0.17% month-over-month level that is consistent with 2% annual inflation in four of the past five months (panel 4). Year-over-year trimmed mean PCE inflation is at 1.84% and should continue to rise based on the 2.03% reading from the 6-month trimmed mean PCE (bottom panel). Finally, our Pipeline Inflation Indicator continues to point toward mounting inflationary pressures in the economy (panel 3). Maintain an overweight allocation to TIPS relative to nominal Treasury securities. We will reduce exposure to TIPS once long-maturity TIPS breakeven inflation rates return to our 2.3% to 2.5% target range. ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 1 basis point in June, bringing year-to-date excess returns up to -2 bps. The index option-adjusted spread for Aaa-rated ABS widened 2 bps on the month and now stands at 43 bps, 16 bps above its pre-crisis low. The Bond Maps show that consumer ABS continue to offer relatively attractive return potential compared to other low-risk spread products. However, we maintain only a neutral allocation to this space because credit quality trends are moving against the sector. The household debt service ratio on consumer credit ticked down slightly in the first quarter, but its multi-year uptrend remains intact (Chart 9). Consumer credit delinquency rates follow the household debt service ratio with a lag. Meanwhile, banks are noticing the decline in credit quality and have begun tightening lending standards (bottom panel). Tighter lending standards tend to coincide with upward pressure on delinquencies and spreads. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 11 basis points in June, dragging year-to-date excess returns down to +61 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 4 bps on the month and currently sits at 74 bps (Chart 10). The gap between decelerating commercial real estate prices and tight CMBS spreads continues to send a worrying signal for CMBS (panel 3). However, delinquencies continue to decline and banks recently started to ease lending standards on nonfarm nonresidential loans (bottom panel). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 6 basis points in June, dragging year-to-date excess returns down to +6 bps. The index option-adjusted spread widened 2 bps on the month and currently sits at 51 bps. The Bond Maps show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this defensive sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of July 6, 2018) The Deflationary Mindset The Deflationary Mindset Chart 12Total Return Bond Map (As Of July 6, 2018) The Deflationary Mindset The Deflationary Mindset Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, for further details on positioning across different credit tiers. Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, for further details on positioning across the maturity spectrum. Both reports available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Threats & Opportunities In Emerging Markets", dated June 12, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

A number of factors have fallen into place, allowing an exploitable market- and industry-neutral opportunity to surface by going long the S&P homebuilding index/short the S&P REITs index. Our thesis is supported by four key pillars: Favorable macro tailwinds for residential vs. commercial real estate (prices, credit, interest rates), Firm relative demand dynamics, Supportive relative supply backdrop, Compelling relative valuations and technicals. With respect to the first of these, we show in our chart at the side that real commercial real estate (CRE) prices have overtaken the previous top, whereas house prices deflated by inflation remain significantly below the 2006 zenith. In nominal terms, CRE prices are one standard deviation above the previous high, while residential real estate prices just recently made all-time highs. The implication is that the pricey CRE sector is relatively more vulnerable to a downturn. Bottom Line: We initiated a long S&P homebuilding/short S&P REITs pair trade yesterday. Please see Monday's Special Report for more details. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME - LEN, PHM, DHI and BLBG: S5REITS - IRM, MAA, AMT, BXP, PLD, ESS, CCI, PSA, O, VTR, VNO, WY, EQIX, DLR, EXR, DRE, FRT, WELL, SBAC, HCP, GGP, KIM, EQR, UDR, REG, MAC, HST, SPG, AVB, AIV, SLG, ARE, respectively. UnReal Estate Opportunity UnReal Estate Opportunity

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA’s Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA’s 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA’s Geopolitical Strategy (GPS) in 2012. It is the financial industry’s only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers’ options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA’s Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating “geopolitical alpha;” Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant “war games,” which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Anastasios Avgeriou, Vice President U.S. Equity Strategy An exploitable market- and industry-neutral opportunity has surfaced to generate alpha by going long the S&P homebuilding index/short the S&P REITs index. This ratio has only recently reclaimed its upward sloping long-term time trend, leaving ample room for additional gains as the business cycle is long in the tooth (Chart 1). Chart 1Ratio Is Only Back To Trend Line Ratio Is Only Back To Trend Line Ratio Is Only Back To Trend Line Four key pillars form the thesis for this intra-real estate pair trade: Favorable macro tailwinds for residential vs. commercial real estate (prices, credit, interest rates), Firm relative demand dynamics, Supportive relative supply backdrop, Compelling relative valuations and technicals. Of Prices, Credit And Rates... Commercial real estate (CRE) is in a slightly different stage of the real estate cycle than its brethren, the residential real estate sector. Chart 2 shows that real CRE prices have overtaken the previous top, whereas house prices deflated by inflation remain significantly below the 2006 zenith. In nominal terms, CRE prices are one standard deviation above the previous high, while residential real estate prices just recently made all-time highs. This makes the CRE sector extremely vulnerable, as there is no cushion for any potential mishap. Importantly, our CRE occupancy rate composite has peaked for the cycle and is actually contracting, warning that CRE prices will likely suffer the same fate (bottom panel, Chart 3). The residential occupancy rate is the mirror image of the CRE one. Not only are new plus existing home inventories extremely tight by historical standards in the housing market, but the ultra-low vacancy rate is also a harbinger of additional house price gains in the coming months (top two panels, Chart 3). Chart 2Trade Opportunity In Diverging... Trade Opportunity In Diverging... Trade Opportunity In Diverging... Chart 3...Real Estate Markets ...Real Estate Markets ...Real Estate Markets As with every bubble, ultra-cheap credit has fueled the excesses in the CRE sector. Total CRE credit outstanding has ballooned to over $2.1tn, and comprises more than half of the commercial banks' overall real estate loan portfolios (Chart 4). While CRE loan growth is no longer galloping north of 10%/annum, it is still expanding. The stock of residential real estate loans on U.S. commercial bank's balance sheets also hit fresh all-time highs recently, but CRE dwarfs its residential cousin both in growth and level terms. Real estate investors know all too well that, ultimately, rising interest rates prick bubbles and the specter of tightening monetary policy concentrates minds. While both sectors will suffer from rising interest rates, given that the excesses this cycle are concentrated in CRE, in a relative sense, residential real estate is more insulated from a hawkish Fed (Chart 5). Keep in mind that housing was at the epicenter of the Great Recession, a once in a life time crisis, whose ramifications are still reverberating across the financial system one decade later. We doubt another big bust looms large in the residential real estate market. Chart 5 also shows that relative share prices are not only positively correlated with the fed funds rate, but also with the 10-year Treasury yield. True, rising 10-year interest rates filter right through to 30-year fixed mortgages denting housing affordability, but homebuilders are less sensitive to interest rates than REITs. Thus, a rising interest rate backdrop, which remains one of BCA's key themes for the year, is not detrimental to the relative share price ratio, but conducive to relative gains. In more detail, rising interest rates are likely to cause more pain in CRE than in the residential market, given the different starting points for delinquencies. Chart 6 shows a steep divergence between the two real estate sectors in their respective delinquency rates. In fact, since data is available, the CRE delinquency rate has never been lower than its current 0.75%. The Fed continues to raise interest rates, but some CRE borrowers are having trouble serviving this debt as rental income growth (for more details refer to the supply section below) is under pressure. Thus, delinquency rates, charge-offs and foreclosures will shoot higher. Chart 4CRE Excesses This Cycle CRE Excesses This Cycle CRE Excesses This Cycle Chart 5Higher Interest Rates Are A Boon For The Ratio Higher Interest Rates Are A Boon For The Ratio Higher Interest Rates Are A Boon For The Ratio Chart 6Unsustainably Low CRE Delinquencies Unsustainably Low CRE Delinquencies Unsustainably Low CRE Delinquencies What About Relative Demand... On the demand front, our comparative demand proxy also corroborates the positive correlation of relative share prices with interest rates. Rising interest rates deal a blow to refinancing mortgage applications, but do not prohibit first-time homebuyers from making one of the largest purchase decisions of their lives (Chart 7). Moreover, there is a preference switch that is gaining steam on the horizon. The own versus rent dilemma has likely hit a multi-decade nadir. Rising job certainty and wages at a time when the economy is at full employment argue for a switch out of rent and into home ownership. Already, the ratio of home owners to renters has gone from 1.7 to 1.8 in the past 18 months; yet, it is still hovering near a generationally low level. Put differently, only 64.2% of the housing stock are owners and 35.8% are renters. This differential remains depressed and if there is a modest renormalization toward the historical mean, the ratio would have to revert closer to 1.9, and thus further lift relative share prices (Chart 8). Chart 7Relative ##br##Demand... Relative Demand... Relative Demand... Chart 8...Gauges Favor Residential Vs.##br## Commercial Real Estate ...Gauges Favor Residential Vs. Commercial Real Estate ...Gauges Favor Residential Vs. Commercial Real Estate ...And Supply Backdrops? The relative supply backdrop also favors homebuilders versus REITs. Multi-family housing starts have been running near previous cyclical peak levels and 33% above the historical mean for the better part of the past five years adding roughly 2mn apartment units in aggregate. In contrast, single family home construction has been in recovery mode and continues to trail its historical average, with single family housing starts also adding a similar amount of units since 2013. To put this number in perspective, on average single family home construction should be triple multi-family starts (Chart 9). This construction backdrop does not bode well for CRE prices relative to residential real estate prices. Another related source of CRE pricing pressures are CRE rents. Rental income is in danger of stalling from this massive multi-family supply overhang and so is REITs cash flow growth. The opposite is happening in residential housing. Household formation is still running higher than housing starts, underscoring that recent house price inflation rests on a solid foundation. Chart 9Mind The Massive CRE Supply Overhang Mind The Massive CRE Supply Overhang Mind The Massive CRE Supply Overhang Chart 10Alluring Entry Point Alluring Entry Point Alluring Entry Point Compelling Entry Point One final reason why we are warming up to this pair trade is valuations and technicals. Relative value has been restored with our Valuation Indicator correcting to one standard deviation below the historical mean, offering investors a great reward/risk tradeoff. Similarly, technicals are no longer waving a red flag; our Technical Indicator has also unwound extremely overbought conditions and recently sunk below the neutral line (Chart 10). Risks To Monitor Chart 11Monitor This Risk Monitor This Risk Monitor This Risk Nevertheless, there are two key risks that can put our thesis, and thus the relative share price ratio, offside. While both sectors are 100% domestically geared and appear insulated from all the trade war / protectionism risks, homebuilders have to contend with rising input costs both in terms of building materials (lumber in particular, as well as concrete and steel), but also with rising construction-related wage inflation. REITs, in contrast, are free of both such risks. Most importantly, the Fed's Senior Loan Officer Survey is waving yellow flags. Both in terms of demand for respective loans and bankers' willingness to extend credit, CRE has the upper hand. While loan officers are tightening standards in CRE and mortgage loans, they are more prudent with credit origination in residential housing than in CRE. Similarly in a relative sense, bankers are reporting a steeper decline in demand for residential mortgages than for CRE loans (Chart 11). Adding it up, four key drivers - favorable macro tailwinds for residential versus commercial real estate on the price, credit and interest rate fronts, firming relative demand dynamics, supportive relative supply backdrop and appealing relative valuations and technicals - argue for opening a long S&P homebuilders/short S&P REITs pair trade. Bottom Line: Initiate a long S&P homebuilding/short S&P REITs pair trade today. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME - LEN, PHM, DHI and BLBG: S5REITS - IRM, MAA, AMT, BXP, PLD, ESS, CCI, PSA, O, VTR, VNO, WY, EQIX, DLR, EXR, DRE, FRT, WELL, SBAC, HCP, GGP, KIM, EQR, UDR, REG, MAC, HST, SPG, AVB, AIV, SLG, ARE, respectively. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA’s Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA’s 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA’s Geopolitical Strategy (GPS) in 2012. It is the financial industry’s only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers’ options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA’s Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating “geopolitical alpha;” Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant “war games,” which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Peter Berezin, Chief Global Strategist U.S. Housing Will Drive The Global Business Cycle... Again Highlights Housing is the main channel through which changes in U.S. monetary policy affect the real economy. The U.S. housing sector is in good shape, which means that the Fed will be able to raise rates more than the market anticipates. The Fed's tightening efforts are coming at a time when cyclical factors are raising the neutral rate of interest. Higher U.S. rates will push up the dollar, which will adversely affect emerging markets. Stay overweight developed market equities relative to their EM peers, while underweighting deep cyclical sectors relative to defensives. Feature U.S. Housing Back In The Spotlight The Global Financial Crisis began in the U.S. and quickly spread to the rest of the world. The U.S. housing market was at the epicenter of the last crisis and it could be the main source of global financial turbulence once again. Unlike ten years ago however, the problem is not that U.S. housing has become too vulnerable to a downturn. Rather, the problem, as we explain below, is that housing has become too resilient. Housing starts were slow to recover after the Great Recession. To this day, they are still 40% below their 2006 peak (Chart 1). As a result, the homeowner vacancy rate stands at only 1.5%, the lowest level since 2001. Mortgage lenders remain guarded. The ratio of mortgage debt-to-disposable income is 31 percentage points below where it stood in 2007. Mortgage-servicing costs, expressed as a share of disposable income, are near all-time lows. FICO scores among new borrowers are well above pre-crisis levels. The Urban Institute's Housing Credit Availability Index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, remains in extremely healthy territory (Chart 2). Chart 1No Oversupply Of U.S. Homes No Oversupply Of U.S. Homes No Oversupply Of U.S. Homes Chart 2Mortgage Lenders Are Being Prudent Mortgage Lenders Are Being Prudent Mortgage Lenders Are Being Prudent Housing And The Monetary Transmission Mechanism Chart 3Residential Investment Collapsed ##br##In Response To Higher Interest Rates##br## In The Early 80s... While Business Investment ##br##Was Barely Affected Residential Investment Collapsed In Response To Higher Interest Rates In The Early 80s... While Business Investment Was Barely Affected Residential Investment Collapsed In Response To Higher Interest Rates In The Early 80s... While Business Investment Was Barely Affected Housing is the main channel through which the Federal Reserve affects the real economy. When the Fed hiked rates in the early 1980s, residential investment collapsed but business investment barely contracted (Chart 3). "Housing is the business cycle," as Ed Leamer likes to say. To quote Leamer's timely 2007 Jackson Hole paper:1 Of the components of GDP, residential investment offers by far the best early warning sign of an oncoming recession. Since World War II we have had eight recessions preceded by substantial problems in housing and consumer durables. Housing did not give an early warning of the Department of Defense Downturn after the Korean Armistice in 1953 or the Internet Comeuppance in 2001, nor should it have. By virtue of its prominence in our recessions, it makes sense for housing to play a prominent role in the conduct of monetary policy. Neutral Rate: Structural Versus Cyclical Chart 4Market Expectations Versus The Fed Dots Market Expectations Versus The Fed Dots Market Expectations Versus The Fed Dots The market is pricing in only 90 basis points in rate hikes between now and the end of 2020 (Chart 4). Yet, if U.S. housing is in as good shape as it appears, what is stopping the Fed from hiking rates much more than investors currently anticipate? The answer, one presumes, is that most investors share Larry Summers' view that the neutral rate of interest is very low. We have a great deal of sympathy for Summers' position. In fact, we ourselves have argued many times that a variety of secular factors are pushing down the neutral rate of interest. These include slower potential GDP growth, the shift to a capital-lite economy, and high levels of income inequality. That said, it is critical to distinguish between the secular and cyclical determinants of the neutral rate. While secular factors are pushing down the neutral rate, cyclical factors are pushing it up. Credit And Household Wealth On The Upswing Credit is one such cyclical factor. Private credit is now growing faster than GDP. The ratio of nonfinancial private debt-to-GDP has increased by an average of 1.2 percentage points during the past three years, which is close to its historic trend (Chart 5). Not all the new credit is used to finance domestic spending - some of it can flow into imports as well as the purchase of financial assets - but if one assumes that every additional dollar of credit boosts domestic demand by 50 cents, today's pace of credit growth is adding 0.6% of GDP to aggregate demand relative to a situation where the ratio of credit-to-GDP is stable.2 In addition, housing and equity wealth have been rising much more quickly than GDP. Household real estate wealth fell from a peak of 182% of GDP in 2006 to 115% of GDP in 2012. It has since clawed its way back to 142% of GDP, equivalent to where it stood in 2002. Equity wealth reached nearly 150% of GDP earlier this year, on par with the prior peak set in 2000. Historically, there has been a robust relationship between the ratio of household net worth-to-disposable income and the personal savings rate (Chart 6). At present, the former stands at an all-time high. This helps explain today's low savings rate. All things equal, a lower savings rate implies more desired spending which, in turn, implies a higher neutral rate of interest.3 Chart 5Rising Household Credit And Wealth Rising Household Credit And Wealth Rising Household Credit And Wealth Chart 6High Net Worth Explains Today's Low Savings Rate U.S. Housing Will Drive The Global Business Cycle... Again U.S. Housing Will Drive The Global Business Cycle... Again Loose Fiscal Policy Warrants A Higher Neutral Rate U.S. fiscal policy has also become extremely stimulative. The IMF estimates that the cyclically-adjusted primary budget deficit will reach 4.2% of GDP in 2019, a deterioration from a deficit of 1.7% of GDP in 2015. That is more accommodative than Japan, which is set to have a deficit of 2.7% of GDP next year; or the euro area, which is expected to record a surplus of 0.8% of GDP (Chart 7). Assuming a fiscal multiplier of one, fiscal policy will add a whopping 5% more to aggregate demand in the U.S. than in the euro area next year. If one combines this fact with all the other reasons we have listed for why the neutral rate is higher in the U.S. than the euro area, the market's expectation that the ECB will be hard-pressed to raise rates by very much over the next few years is probably not far from the mark.4 An Overheated Economy Will Lift The Neutral Rate The fact that the U.S. jobless rate has fallen below most estimates of full employment means that the Fed may have to bring rates above their neutral level for a while to cool the economy. An overheated economy may also push up the neutral rate itself, at least temporarily. Chart 8 shows that labor's share of income rose during the late 1990s, as businesses were forced to pay higher wages to attract workers. Workers tend to spend more of every dollar of income than companies. Thus, any shift in the distribution of income towards the former raises aggregate demand. Chart 7U.S. Fiscal Policy Is More Stimulative Than Abroad U.S. Fiscal Policy Is More Stimulative Than Abroad U.S. Fiscal Policy Is More Stimulative Than Abroad Chart 8Tight Labor Market And Rising Labor Share Of Income: ##br##A Replay Of The 1990s? Tight Labor Market And Rising Labor Share Of Income: A Replay Of The 1990s? Tight Labor Market And Rising Labor Share Of Income: A Replay Of The 1990s? Today, employers are complaining about a "shortage" of qualified workers. While the business press usually takes such comments at face value, the word "shortage" is highly misleading. Except in a few isolated cases, the number of workers a company employs is much smaller than the number of qualified workers it could theoretically hire. Even the internet giants compete for the same well-educated, tech-savvy workers. When companies say they cannot find good workers, what they usually mean is that they do not want to raise wages to entice good workers to move from competing firms. Fortunately for potential job-switchers, that is starting to change. The difference between wage growth among job switchers and job stayers in the Atlanta Fed's Wage Growth Tracker has risen to close to where it was in 2000 (Chart 9). Surveys suggest that companies are increasingly willing to raise wages (Chart 10). Higher wages and falling unemployment will boost spending, raise consumer confidence, and probably further supercharge the housing market. Chart 9Things Are Perking Up For Job Switchers Things Are Perking Up For Job Switchers Things Are Perking Up For Job Switchers Chart 10Surveys Show Employers More Willing To Raise Compensation Surveys Show Employers More Willing To Raise Compensation Surveys Show Employers More Willing To Raise Compensation Investment Considerations The 30-year U.S. prime mortgage rate has risen from a low of 3.78% last September to 4.55% at present, but still remains more than 2.5 percentage points below where it stood in 2006. In real terms, today's mortgage rate is significantly lower than the average rate since 1980 (Chart 11). For the first time in a decade, the Federal Reserve wants to slow GDP growth to prevent the economy from overheating. This means the Fed must tighten financial conditions. If housing does not buckle as the Fed raises rates, the tightening in financial conditions must come through a stronger dollar, higher corporate borrowing costs, and lower equity prices. We remain long the dollar and recently downgraded global equities from overweight to neutral. We also recommended that clients cut exposure to credit. Chart 12 shows that a rising dollar usually corresponds to wider high-yield corporate bond spreads. Chart 11U.S. Mortgage Rates Are Still Low U.S. Mortgage Rates Are Still Low U.S. Mortgage Rates Are Still Low Chart 12Rising Dollar Usually Corresponds ##br##To Wider High-Yield Spreads Rising Dollar Usually Corresponds To Wider High-Yield Spreads Rising Dollar Usually Corresponds To Wider High-Yield Spreads The rest of the world will feel the repercussions of Fed tightening, perhaps even more so than the U.S. itself. Emerging market equities almost always fall when U.S. financial conditions are tightening (Chart 13). One can believe that EM stocks will go up; one can also believe that the Fed will do its job and tighten financial conditions in order to prevent the U.S. economy from boiling over. One cannot believe that both these things will happen at the same time. As a share of GDP, dollar-denominated debt in emerging markets is now back to late-1990s levels (Chart 14). Local-currency debt has also mushroomed (Chart 15). This puts emerging market policymakers in the unenviable position of having to decide whether to hurt domestic borrowers by hiking rates or keeping rates low and risking a steep devaluation of their currencies. Neither outcome would be good for EM assets. As such, equity investors should overweight developed market stocks over their EM peers. An underweight in global cyclical sectors relative to defensives is also appropriate at this juncture. Chart 13Tightening U.S. Financial Conditions ##br##Do Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Chart 14EM Dollar Debt Is High EM Dollar Debt Is High EM Dollar Debt Is High Chart 15EM Local Credit Is High Too EM Local Credit Is High Too EM Local Credit Is High Too Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Edward E. Leamer, "Housing Is The Business Cycle," Proceedings, Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, (2007). 2 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). Thus, credit growth affects GDP and, by extension, the change in credit growth (the so-called credit impulse) affects GDP growth. 3 Conceptually, one can see the relationship between the savings rate and the neutral rate of interest in the Solow Growth Model. For example, the neutral real rate of interest, r*, in the Model is equal to (a/s) (n + g + d), where a is the capital share of income, s is the savings rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. An increase in the savings rate reduces the neutral rate. 4 Please see Global Investment Strategy Weekly Report, "The U.S. Needs A Stronger Dollar," dated May 4, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA’s Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA’s 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA’s Geopolitical Strategy (GPS) in 2012. It is the financial industry’s only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers’ options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA’s Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating “geopolitical alpha;” Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant “war games,” which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Mathieu Savary, Foreign Exchange Strategist Highlights On a short-term basis, the dollar is massively overextended and is likely to experience a correction over the coming weeks. EM assets and currencies are the anti-dollar, and will benefit from these dynamics. As a result, oversold commodity currencies like the AUD, CAD, and NZD should be the main beneficiaries of a dollar correction within the G-10 FX space. However, this bout of dollar weakness is unlikely to mark the end of the greenback's 2018 rally. Global liquidity conditions remain very dollar bullish as the U.S. economy is absorbing liquidity from the rest of the world. This creates a scarcity of greenbacks in international markets. It is also dollar bullish because it weighs on the outlook for global growth, flattering the countercyclical nature of the USD. Gold should be the key gauge to judge whether these dynamics will be playing out as we foresee. Feature The last quarter was dominated by the dollar's strength and weakness in EM bonds; weakness that has now spread to EM equities. After such violent moves, it is now time to reflect and to try to understand what the second half of the year may have in store for the dollar. In our view, the dollar move has become overextended. As a result, we anticipate the dollar to experience a correction over the course of the coming months - a move that should benefit risk assets, and EM plays in particular. However, while this correction is likely to be playable for tactical traders, this does not spell the end of the dollar rally and EM selloff. The global liquidity backdrop supports a continuation of the trends seen over the past few months. Short-Term Momentum Extremes The vigor of the dollar rally this year along with the violence of EM bond, currency and equity selling has been eye-catching. However, we are seeing many signs that these moves may have become overdone on a short-term basis. Let's begin with EM assets. EM assets are very important due to their high sensitivity to global liquidity, global growth and the dollar. The market breadth of EM stocks is near its most oversold levels since the financial crisis. This suggests that commodity currencies are likely to experience a relief rally in the coming weeks (Chart I-1). In fact, both the MACD and 14-day RSI oscillators of EM stocks are corroborating this message, having hit some of their lowest levels since 2016 (Chart I-2). Such a rebound could be especially beneficial for the AUD, NZD, and CAD, as speculators have accumulated large short positions in these currencies (Chart I-3). Chart I-1EM Are ##br##Oversold EM Are Oversold EM Are Oversold Chart I-2EM Oscillators Point##br## To A Rebound EM Oscillators Point To A Rebound EM Oscillators Point To A Rebound Chart I-3More Reasons For The AUD ##br##And His Friends To Rebound More Reasons For The AUD And His Friends To Rebound More Reasons For The AUD And His Friends To Rebound The key for this rally to unfold will be U.S. dollar weakness - a correction that we feel is likely to materialize. From a technical perspective, our dollar capitulation index is currently flagging massively overbought conditions, a picture that our intermediate-term indicator also highlights (Chart I-4). Looking at the euro - the largest constituent of the DXY dollar index - provides a mirror image. The EUR/USD's intermediate-term momentum measure is flagging deeply oversold levels, and the paucity of up days in this pair over the recent month is also congruent with a temporary bottom (Chart I-5). In fact, shorter-term indicators like the MACD and 14-day RSI oscillators have not only reached deeply oversold readings, but have also recently begun to form positive divergences with the price of EUR/USD itself (Chart I-6). Chart I-4The Dollar Should Correct The Dollar Should Correct The Dollar Should Correct Chart I-5Euro Is The Anti-Dollar Euro Is The Anti-Dollar Euro Is The Anti-Dollar Chart I-6Positive Divergences In The Euro Positive Divergences In The Euro Positive Divergences In The Euro What could be a catalyst for a dollar correction that would also help EM assets and thus provide a welcome boost to the euro, and even more so commodity currencies? China obviously plays a key role. One of the crucial ingredients behind the recent generalized USD strength and selloff in EM-related plays has been the rapid fall in the yuan against the dollar. As we argued last week, this remains a key risk for the remainder of the year. However, we also prophesized that Beijing is concerned by the speed of the recent decline, and could try to manage the pace of CNY's fall for now.1 Early this week, the People's Bank of China began "open-mouth" operations in an effort to support the RMB, which seems to be putting a temporary floor under the renminbi. As long as the dam resists, the DXY's rally will pause. Additionally, the speed of the divergence between U.S. growth and the rest of the world has probably reached a short-term peak that will temporarily get reversed. As Chart I-7 illustrates, European, Japanese and Australian economic surprises are attempting to form a bottom, while U.S. ones have just moved below the zero line. Finally, the dollar is likely to lose one of its key supports from last quarter: the U.S. Treasury. As Chart I-8 illustrates, when the Treasury rebuilds its cash balances, the dollar does well. Essentially, through 2017, the Treasury was draining its cash balance ahead of the debt-ceiling standoff. By spending its stash of cash, the U.S. federal government was injecting reserves - in effect liquidity - into the banking system. After the debt-ceiling extension last September, the Treasury proceeded to rebuild its pile of funds, draining reserves and liquidity out of the banking system. This process is now over, and therefore this support for the dollar will continue to fade. Chart I-7Economic Surprises And The Dollar: ##br##From Friends To Foes Economic Surprises And The Dollar: From Friends To Foes Economic Surprises And The Dollar: From Friends To Foes Chart I-8The U.S. Treasury Is Done Rebalancing##br## Its Cash Balance The U.S. Treasury Is Done Rebalancing Its Cash Balance The U.S. Treasury Is Done Rebalancing Its Cash Balance Altogether, these dynamics are likely to cause the dollar to soften in the near term, especially since, as Dhaval Joshi highlighted in BCA's European Investment Strategy, currency market players are displaying a high degree of groupthink - as measured by the trade-weighted dollar's fractal dimension - and could easily be panicked by a defusing of the growth divergence theme (Chart I-9). Chart I-9Group Think In The Dollar = Hightended Risk Of Countertrend Group Think In The Dollar = Hightended Risk Of Countertrend Group Think In The Dollar = Hightended Risk Of Countertrend Bottom Line: The dominant trends of the second quarter - a strong dollar, weak commodity currencies and EM plays - are now crowded trades. With the Chinese monetary authorities trying to limit the speed of the CNY's decline, with economic surprises outside the U.S. finding a floor, and with the U.S. Treasury backing away from reducing liquidity in the banking system, a countertrend move across the dollar, EM assets, and commodity currencies is a growing possibility. Why A Countertrend Move And Not A New Trend? Our view remains that global growth has further room to decelerate, that investors have fully anticipated an increase in global inflation, and that the renminbi has greater downside. All these support our expectation that if a period of weakness in the dollar were to materialize this summer, it would be temporary.2 However, another factor plays a big role: The evolution of liquidity flows in the global economy. Essentially, at the core of this argument lies the fact that we worry that the continued growth outperformance of the U.S. along with the revival of animal spirits in this enormous economy will suck in dollar liquidity from the rest of the world. Not only will this create a scarcity of dollars, thus bidding up the price of the greenback in the process, but it will also hurt highly indebted EM economies - nations that have high dollar debts and thus need dollar liquidity to stay afloat (Chart I-10). To begin with, U.S. banks have been slowly increasing their lending to the U.S. private sector. The upsurge in business confidence, with the NFIB small business survey and the Duke CFO survey near record highs, along with the increase in U.S. capex, confirms the durability of this rebound. Additionally, U.S. households also have the wherewithal to increase their borrowings. Not only is household debt as a percentage of disposable income near a 15-year low but, most importantly, debt servicing costs as a percentage of disposable income remain at levels last seen in the early 1980s (Chart I-11). Moreover, banks are still easing their lending standards on mortgages - which represent nearly 70% of household credit - and mortgage quality as measured by FICO scores are still well above levels that prevailed prior to the financial crisis. Chart I-10EM Dollar Debt Is High EM##br## Have A Lot Of Dollar Debt EM Dollar Debt Is High EM Have A Lot Of Dollar Debt EM Dollar Debt Is High EM Have A Lot Of Dollar Debt Chart I-11U.S. Households Have The ##br##Wherewithal To Take On Debt U.S. Households Have The Wherewithal To Take On Debt U.S. Households Have The Wherewithal To Take On Debt This is important, because when banks increase their loan books, they run down their liquidity (Chart I-12). To be more specific, rising loan issuance results in banks selling securities on their balance sheets and running down their cash balances. As Chart I-13 illustrates, when the cash and security inventories of U.S. commercial banks decrease, the U.S. dollar rallies. This relationship was very strong from 1980 to 2008 but loosened for two years during the financial crisis. Since 2010, it has re-established itself. The probability is therefore high that it will remain in place, and be a dollar-bullish factor over the medium term. Chart I-12Rapid Loan Growth Means Less Liquid Rapid Loan Growth Means Less Liquid Rapid Loan Growth Means Less Liquid Chart I-13The Dollar Abhors Liquid Bank Balance Sheets The Dollar Abhors Liquid Bank Balance Sheets The Dollar Abhors Liquid Bank Balance Sheets Moreover, by looking at the holdings of securities on banks' balance sheets, we can see that since 2012, they have even provided a leading signal on the dollar. This relationship currently points toward additional dollar strength (Chart I-14). The tighter relationship between securities holdings and the dollar than between total liquidity on banks' balance sheets and the dollar is due to the fact that securities can be re-hypothecated, and therefore can create a much greater supply of dollars in offshore markets than cash alone. The dollar-bullish liquidity backdrop is not limited to banks' balance sheets alone. Long-term portfolio flows into the U.S. have increased substantially in recent months, but still remain well below previous peaks (Chart I-15, top panel). Moreover, as the U.S.'s growing energy independence has prevented the trade deficit from expanding, the American basic balance of payments is now back in positive territory (Chart I-15, bottom panel). This too suggests that the U.S. is absorbing more dollars than it is supplying to the global economy. Chart I-14Declining Security Holdings Of Banks##br## Point To A Surge In The Dollar Declining Security Holdings Of Banks Point To A Surge In The Dollar Declining Security Holdings Of Banks Point To A Surge In The Dollar Chart I-15Money Is Flowing##br## Out Of The U.S. Money Is Flowing Out Of The U.S. Money Is Flowing Out Of The U.S. This reality is mirrored by the link between the bond issuance of U.S. firms and the dollar. When U.S. businesses increase their issuance of bonds, this tends to result in a strong dollar and weak majors (Chart I-16). The vigor of the U.S. economy and the deregulatory tendencies of the Trump administration suggest that U.S. companies could continue to issue more bonds, which will drag more liquidity out of the rest of the world and support the dollar in the process. The profit repatriation initiated by President Trump's tax reform is also supportive of the dollar. As Chart I-17 illustrates, when U.S. entities repatriate funds from abroad, the dollar tends to strengthen. Today, they are doing so with more gusto than ever. It is important to remember that this is not a reflection of American firms necessarily buying dollars directly. After all, a lot of their foreign earnings are already held in USD. Instead, it reflects the fact that when U.S. firms bring back their dollars into the U.S., the supply of high-quality collateral available in offshore markets declines, which means that acquiring dollars becomes more expensive.3 Chart I-16Rising Bond Issuance Helps The Dollar Rising Bond Issuance Helps The Dollar Rising Bond Issuance Helps The Dollar Chart I-17Trump's Tax Repatriation Is Dollar Bullish Trump's Tax Repatriation Is Dollar Bullish Trump's Tax Repatriation Is Dollar Bullish Finally, this decline in dollar liquidity is starting to be felt abroad, a phenomenon magnified by the slowdown in global trade. Global reserves are not increasing as fast as they were in 2017. As a result, a key component of global dollar-based liquidity, the Federal Reserve's accumulation of custodial holdings of securities, is also declining fast - a decrease exacerbated by the fact that the Fed is curtailing the size of its own balance sheet (Chart I-18). Historically, a decline in dollar-based liquidity is not only associated with lower global growth and a stronger greenback, but also with falling EM asset prices, EM currencies, and commodity currencies. Gold prices will provide insight on whether global liquidity remains favorable to the dollar and negative for EM assets. As Chart I-19 illustrates, gold has already broken down an intermediate upward sloping trend line, but is rebounding against the primary trend in place since the early days of 2016. If this rebound peters off and gold breaks below this primary trend line, it will be a clear indication that the decline in liquidity outside the U.S. is having a nefarious impact on global growth. This headwind to global economic activity will support additional dollar strength and asset price weakness. Chart I-18Declinning Dollar Bond Liquidity Declinning Dollar Bond Liquidity Declinning Dollar Bond Liquidity Chart I-19Litmus Test For Liquidity Litmus Test For Liquidity Litmus Test For Liquidity Bottom Line: The dollar faces near-term downside risk, but this move is likely to prove to be countertrend in nature as the global liquidity backdrop remains dollar bullish. The U.S. economy is currently sucking in global liquidity from the rest of the world, which is creating a scarcity of dollars in offshore markets. Not only is this scarcity inherently dollar bullish, but it also weighs on global growth, further flattering the dollar - a currency that performs well when global growth softens. As a result, while short-term investors should hedge some of their long-dollar exposure over the coming weeks, longer-term investors should use this correction to accumulate more dollars in order to benefit from another leg of the dollar's rally this fall. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "What Is Good For China Doesn't Always Help The World", dated June 29, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Reports, titled "What Is Good For China Doesn't Always Help The World", dated June 19, 2018, "Inflation Is In The Price", dated June 15, 2018, and "This Time Is NOT Different", dated May 25, 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, titled "It's Not My Cross To Bear", dated October 27, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was mixed: ISM manufacturing increased to 60.2 from 58.7; ISM prices paid declined to 76.8 from 79.5; Continuing and initial jobless claims both increased, disappointing expectations; Factory orders grew by 0.4% in monthly terms. After hitting deeply overbought levels, the dollar is losing momentum and risks correcting as economic surprises in the U.S. continue to decline while global ones are finding a floor, for now. Even if the dollar were to correct, budding inflationary pressures and higher growth in the U.S. are likely to prompt the Fed to hike at a faster rate than the rest of the developed world, providing the greenback with substantial upside. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 This Time Is NOT Different - May 25, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data was mixed: Manufacturing PMI improved for Italy, declined for France and remained unchanged for Germany, while decreasing for the euro area as a whole; Euro area retail sales increased by 1.4%, less than the expected 1.5%; Speculations about the ECB's actions are causing substantial movements in markets. The French 5/30 yield curve flattened by about 30 bps at rumors of an "Operation Twist" by the ECB, following the end of the APP in December. However, the euro has remained stable for around a month now, suggesting that markets have already discounted a substantially easier monetary policy. Despite this, the current slowdown in global growth is likely to have a further detrimental effect on the euro. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Housing starts yearly growth surprised to the upside, coming in at 1.3%. However, the Markit Services PMI came in at 51.4, underperforming expectations. Moreover, consumer confidence surprised to the downside, coming in at 43.7. USD/JPY has rallied by roughly 0.5% this past week. Overall we continue to be positive on the yen tactically, given that trade tensions as well as tightening in China should continue to create a risk-off environment where the yen thrives. However, on a longer term basis we maintain our bearish stance, as the BoJ will keep its ultra-dovish monetary policy in order to kick start Japan's moribund inflation. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been positive: Mortgage approvals outperformed expectations, coming in at 64.526 thousand. Moreover, Construction PMI surprised to the upside, coming in at 53.1. Finally, Markit Services PMI also outperformed expectations, coming in at 55.1. GBP/USD has risen by roughly 1% since last week. Overall, we expect that cable will continue to depreciate, as any pullback in the dollar will likely be temporary. Nevertheless, the pound should outperform the euro, given that Europe will likely suffer more from emerging market weakness than the U.K. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was disappointing: The AiG Performance of Manufacturing Index declined slightly from 57.5 to 57.4; RBA Commodity Index in SDR terms grew by 6.6% only, less than the expected 7.5%; Building permits contracted by 3.2% on a monthly basis; The trade balance came out less than expected at AUD 827 million. In its latest monetary policy statement, the RBA highlighted that Australian monetary conditions have tightened, noting lower housing credit growth and tighter lending standards. As 85% of home loans are variable-rate mortgages, the highly indebted Australian households are extremely susceptible to a direct tightening in interest rates. Furthermore, wage growth at 2.1% and inflation at 1.9% implies a paltry 0.2% real wage growth, adding additional risk to household financial conditions. Alongside a clouded global growth outlook, the RBA is therefore unlikely to hike in this environment anytime soon. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The kiwi has been relatively flat this week. Overall, even if a short-term bounce is likely over the coming weeks, we continue to be bearish on this cross, as commodity currencies like the NZD or the AUD should suffer in the current risk-off environment where liquidity is scarce. However, the New Zealand dollar will probably outperform the Australian dollar. After all, Australia is more exposed to the Chinese Industrial Cycle than New Zealand, being a large base metals exporter. Meanwhile, we remain bearish on the NZD on a longer term basis, as the new government will restrict immigration and implement a dual mandate for the RBNZ, both measures which will lower the neutral rate in New Zealand. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Despite the rapid increase in oil prices, the Canadian dollar has not been able to keep up. NAFTA tensions are placing downward pressure on the loonie, despite the Canadian economy's rosy conditions. The most recent Business Outlook Survey by the BoC shows increasing economic activity with a robust sales outlook. In addition, capacity utilization is becoming ever tighter, with the amount of firms finding it difficult to meet unexpected demand at the highest level since the history of the data. Furthermore, the labor market continues to tighten, as hiring plans continue to trend upward. This is likely to keep the BoC somewhat hawkish, despite trade worries. The strength of the Canadian economy is therefore likely to lift the CAD above other G10 currencies this year, except against the greenback. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: The KOF leading indicator outperformed expectations, coming in at 101.7. Moreover, the SVME PMI index also surprised to the upside, coming in at 61.6. However, retail sales yearly growth underperformed expectations, coming in at -0.1%. Finally, headline inflation came in line with expectations, coming in at 1.1%. EUR/CHF has risen by roughly 0.5% this week. Overall, we continue to be bullish on a tactical basis on the franc, given that trade tensions and the policy tightening in China should ultimately keep the current risk-off in place. That being said we are cyclically bearish on the CHF, as the SNB will continue to maintain an extraordinarily easy monetary policy stance in order to prevent an appreciating franc to prevent the Swiss central bank from reaching its inflation target. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been positive: Retail sales growth outperformed expectations, coming in at 1.8%. Moreover, registered unemployment continued to be very low at 2.2%, in line with expectations. USD/NOK has fallen by nearly 1% since last week, partly due to the rise in oil price, caused by a large draw in inventories. Overall we continue to be bullish on this cross, given that we maintain that the U.S. dollar will continue rising. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 A shift in stance at the Riksbank has been the major force behind the SEK's appreciation of around 2% against both USD and EUR in the past couple of days. The upward revision of CPIF inflation from 1.9% to 2.1% in both 2018 and 2019, and the downward revision of the unemployment rate were particularly important. In addition, three policymakers expressed hawkish views: Deputy Governors Flodén and Skingsley suggested a hike in October or December, while Ohlsson advocated for a higher repo rate of 25 bps now in response to stronger economic growth in both Sweden and abroad. Consistently, these members expressed similar opinions on the termination of foreign exchange interventions, as inflation is near its target. However, the underlying dovish intonations of Stegan Ingves still lurk within the Riksbank, presenting possible downside risk in the short-term. Nevertheless, these views support our longer-term bullish view of the SEK vis-à-vis the euro, based on diverging rate differentials. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Domino dynamics continue escalating within the EM universe confirming that a major bear market is underway. Several global cyclical market segments have recently experienced technical breakdowns. This confirms that global growth is slowing. It is not too late to short/sell EM risk assets. We reiterate the long Indian / short Chinese banks equity trade. Feature The selloff in global risk assets continues to exhibit a pattern of falling dominos. It began with the breakdown in the weakest spots of the EM world, Turkey and Argentina, and then spread to Brazil and Indonesia. Only weeks later it hit other vulnerable EM markets such as South Africa. During this period, north Asian stocks and currencies - Chinese, Korean and Taiwanese - displayed resilience. It was tempting to argue that the EM selloff was being driven by idiosyncratic risks and was limited to current account deficit countries vulnerable to U.S. Federal Reserve tightening. However, in recent weeks these north Asian markets have plunged - making the EM selloff largely broad-based and pervasive. In our June 14 report,1 we argued that major and drawn-out financial market downturns usually occur in phases and often resemble a domino effect. Since then, the domino effect has escalated confirming our bias that EMs are in a major bear market. Several important markets and cyclical market segments have recently broken down, and investors should heed messages from them: Copper prices fell below their 200-day moving average; they have also broken down the trading range that had persisted since last September (Chart I-1, top panel). The precious metals price index seems to be sliding through the floor of its trading range of the past 18 months (Chart I-1, bottom panel). Global cyclical equity sectors and sub-sectors such as mining, steel, chemicals and industrials have also broken their 200-day moving averages in absolute term (Chart I-2). They have also been underperforming the global equity index, which is consistent with the global trade slowdown that is beginning to escalate. Chart I-1Breakdown in Metals Prices Breakdown in Metals Prices Breakdown in Metals Prices Chart I-2Global Equities: Cyclicals Have Broken Down Global Equities: Cyclicals Have Broken Down Global Equities: Cyclicals Have Broken Down Although Chinese PMI data have not been particularly weak, anecdotal evidence from the ground suggests that the credit tightening of the past 18 months is taking its toll on China's financial system and economy. There are numerous reports about bankruptcies of Peer-to-peer lending platforms and struggles in other parts of the shadow banking system. The selloff in Chinese onshore A shares confirms this. Presently, this market has become less driven by retail investors as it was back in 2015. Hence, one can argue that portfolio managers on the mainland are selling their stocks because they believe economic conditions are worsening. Meanwhile, international investors have so far been more sanguine. Importantly, EM corporate and sovereign U.S. dollar bond yields are rising, heralding lower share prices (Chart I-3). Bond yields are shown inverted on this chart. The top panel is for EM overall and the bottom panel is for Asia only. Chart I-3EM Credit Markets Entail More Downside In EM Share Prices EM Credit Markets Entail More Downside In EM Share Prices EM Credit Markets Entail More Downside In EM Share Prices Chart I-4EM Versus U.S.: New Lows Lie Ahead EM Versus U.S.: New Lows Lie Ahead EM Versus U.S.: New Lows Lie Ahead Finally, the resilience of the U.S. equity index and corporate spreads has been due to robust domestic demand - the slowdown in global trade has not affected the U.S. However, odds are that the current global selloff continues to develop in a typical domino fashion. If so, the U.S. markets - equities and credit - will be the last dominos to fall but they will outperform their global peers. It is very unlikely that American stocks and credit markets will be able to sail through this EM storm unscathed. Notably, the resilience of the S&P 500 can be attributed to 10 large-cap stocks that are extremely overbought and likely expensive. This gives us more confidence to argue that this EM riot will meaningfully affect U.S. equity and credit markets. The link will be the U.S. dollar. The greenback will continue its unrelenting rally, which will trim U.S. multinationals' profits and weigh on the S&P 500. Bottom Line: EM risk assets are in a major bear market, and there is still a lot of downside. It is not too late to sell or underweight EM. This is despite EM's relative performance versus the S&P 500 is back to its early 2016 lows, as is the JP Morgan EM currency index (Chart I-4). News lows lie ahead. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EM: Sustained Decoupling, Or Domino Effect?" dated June 14, 2018 available on page 17. Chart II-1More Upside In Long Indian/Short ##br##Chinese Bank Stocks More Upside In Long Indian/Short Chinese Bank Stocks More Upside In Long Indian/Short Chinese Bank Stocks Reiterating Long Indian / Short Chinese Banks Trade This week we revisit our long Indian / short Chinese banks trade that we initiated on January 17.1 The trade is up only 5.7% since inception (Chart II-1), and with more monetary policy easing occurring in China and the recent sharp rise in non-performing loans (NPL) in India, it is appropriate to reassess this recommendation. Having updated the stress tests on the largest public banks in both countries and performed a new stress test on five Indian private banks, we are reiterating our strategy of being long Indian / short Chinese banks. A Perspective On Credit Cycles In India And China Both India and China have gone through major credit binges over the past 10-15 years, albeit over different time periods (Chart II-2A and Chart II-2B). Chart II-2ACredit Boom Was Smaller In India...Than In China Credit Boom Was Smaller In India...Than In China Credit Boom Was Smaller In India...Than In China Chart II-2BCredit Boom Was Smaller In India...Than In China Credit Boom Was Smaller In India...Than In China Credit Boom Was Smaller In India...Than In China India's public banks have, in recent years, recognized bad loans and provisioned meaningfully for them. Non-performing loans (NPLs) for Indian public banks now stand at a whopping 15% of total outstanding loans, while provisioning levels have spiked to 7% of total loans (Chart II-3). Chart II-3NPLs And Their Provisions: India And China NPLs And Their Provisions: India And China NPLs And Their Provisions: India And China By comparison, Chinese public banks - the largest five banks, excluding policy banks, where the central government owns 70-80% of equity - are at the early stages of dealing with their troubled assets. Their NPLs and provisions stand at mere 1.8% and 3.3% of total outstanding loans, respectively (Chart II-3). Does such a wide disparity in NPL ratios between Chinese and Indian banks make sense? We do not think so. It is unlikely that Indian public banks are more poorly managed vis-a-vis Chinese public banks. All are run by government-appointed officials and are equally prone to politically driven and inefficient lending. Further, the magnitude of the Chinese credit boom since 2009 was considerably greater than India's during the 2003-2012 period. It is therefore highly unlikely that the resulting NPLs are substantially smaller in China than in India. In fact, several cases of Chinese banks hiding bad assets have recently been publicized.2 We strongly believe this phenomenon is widespread on the mainland, and that NPLs among Chinese public banks are being grossly underreported. It's All About Regulation The true vindication for this disparity lies in the drastically different stances that financial regulators in both countries have adopted to deal with the non-performing and stressed assets that their banks sit on. The Chinese authorities have been exhibiting greater forbearance with their commercial banks. For instance, in March, they lowered the provision coverage ratio for commercial banks. This is ameliorating Chinese commercial banks' short-term profitability and capitalization ratios. In brief, Chinese regulators have been very accommodative by allowing commercial banks to pursue "window dressing" of their financial statements and ratios. Indian regulators, by contrast, have been exerting relentless pressure on their banks to swiftly deal with their stressed assets at the cost of short-term profitability. For instance, the Reserve Bank of India (RBI) recently introduced an extremely stringent framework for the recognition and resolution of NPLs. Indian commercial banks now have to immediately recognize stressed assets and find a resolution within 180 days. Failure to resolve a stressed account forces banks to take the defaulter to court in order to initiate bankruptcy procedures. Bottom Line: India has taken painful measures to push its banks to clean up their balance sheets. By comparison, China has so far been kicking the can down the road with respect to its banking system. As a result, the banks' balance sheet cleansing cycle is much more advanced in India than in China. Public Banks Stress Tests Below we present our updated stress tests which we performed on India's top seven public banks and China's top five public commercial banks (excluding policy banks). We used the following assumptions in our analysis (Tables II-1 and II-2): Table II-1Stress Test Of Top 7 Indian Public Banks Mind The Breakdowns Mind The Breakdowns Table II-2Stress Test Of Top 5 Chinese Public Banks Mind The Breakdowns Mind The Breakdowns Indian non-performing risk-weighted assets (NPA) to rise to 16% (optimistic), 18% (baseline), and 19% (pessimistic), up from 15% currently. For China, we assume NPAs to rise to 10% (optimistic), 12% (baseline), and 13% (pessimistic), up from 1.6% currently. Provided the magnitude and duration of China's credit boom has considerably surpassed that of India, the assumption of this stress test that NPAs will rise to 12% in China but 18% in India implies that Chinese public banks allocated credit much better than their Indian peers. Hence, this exercise in no way favored Indian banks over Chinese ones. We used risk-weighted assets to calculate losses. Risk-weighting adjusts bank assets for their riskiness which in turn makes comparisons between the two banking systems more sensible. Finally, we assumed a 30% recovery ratio (RR) for both countries. The RR on Chinese banks' NPLs from 2001 to 2005 was 20%. This occurred amid much stronger nominal and real growth. Thus, a 30% RR rate today is not low. The outcome of the tests are as follows: Under the baseline scenario of 18% NPA in India and 12% NPA in China, losses post recovery and provisions amount to 1.8 trillion rupees in the former (1.3% of GDP) and RMB 3.3 trillion in the latter (3.9% of GDP) (Tables II-1 and II-2, column 6). These losses would impair 41% of equity capital in India and 44% in China (Tables II-1 and II-2, column 7). Adjusting the current price-to-book value (PBV) ratios for public banks in both countries to the equity impairment under the baseline scenario lifts their PBV ratios to 1.5 in India and 1.7 in China (Tables II-1 and II-2, column 8). Assuming a 1.3 fair PBV ratio3 for banks in both countries, Indian banks appear overvalued by 15% and Chinese banks by 29% (Tables II-1 and II-2, last column). In other words, after the recognition and provisioning of reasonable levels of NPA, Indian public banks appear less overvalued than their Chinese counterparts. These results make sense to us; Indian public banks have been provisioning aggressively for their troubled assets, and bad news is somewhat discounted in their share prices. Chart II-4Loan Write-Offs Have Been Much ##br##Greater In India Than In China Mind The Breakdowns Mind The Breakdowns Remarkably, Indian public banks have also been writing off more bad loans than their Chinese counterparts. Chart II-4 shows cumulated write-offs of these public banks in India and China since 2010. Bad asset write-offs have so far amounted to RMB 1.2 trillion in China and 3 trillion rupees in India. This is equivalent to 2% and 8% as a share of current risk-weighted assets, respectively. Another way to compare and analyze NPA cycles between two countries is to assess the progress that each country has made toward resolving the full amount of outstanding bad assets - i.e. a full NPA cycle. We define a full NPA cycle in the following way: Total NPA losses under our baseline scenario, plus cumulated past write-offs. In order to measure progress toward resolving the full NPA cycle, we take the ratio of the stock of provisions plus cumulated write-offs and divide that by the full NPA cycle losses (i.e. [provisions + write-offs] / full NPA cycle losses). In India, assuming that NPAs on its largest public banks reach 18% of risk weighted assets - then the full NPA cycle for India would amount to 9.4 trillion rupees, or 26% of current risk-weighted assets (i.e. 6.4 trillion rupees in NPA remaining plus 3 trillion in write-offs made). Meanwhile, India's public banks' progress amounts to 5.6 trillion rupees. This is equal to 60% of India's full NPA cycle. By contrast, Chinese public banks' full NPA cycle would amount to RMB 8 trillion (or 14% of risk-weighted assets) under our baseline scenario. Further, China's banks progress amounts to RMB 2.6 trillion. This is equivalent to only 33% of the full NPA cycle in China. Hence, Indian public banks are closer to their peak NPA cycle versus their Chinese counterparts. Note that this particular analysis assumes no recovery in bad loans in either country. Further, the above analysis does not attune for the fact that Chinese banks have more risky off-balance sheet assets than their Indian peers. Incorporating off-balance sheet assets and liabilities would make the stress tests much more favorable for Indian public banks relative to China. Stress Test For India's Private Banks Private banks are a part of our long Indian / short Chinese banks trade. Indian private banks are also not insulated from regulatory clean-up efforts. In recent years, these lenders significantly boosted their credit to the consumer and service sectors. Higher than normal defaults have not yet transpired but this is a scenario that cannot be ruled out given the frantic pace of lending (Chart II-5). We performed a stress test on five4 large Indian private banks as well (Table II-3): Chart II-5India: Consumer And Service ##br##Credit Is Booming India: Consumer And Service Credit Is Booming India: Consumer And Service Credit Is Booming Table II-3Stress Test Of 5 Large Indian Private Banks Mind The Breakdowns Mind The Breakdowns We assumed the following NPA scenarios: 6% (optimistic), 8% (baseline), and 9% (pessimistic), up from 5% currently. Similar to the above analysis, we used risk-weighted assets to calculate asset losses, though we used a recovery ratio of 50% for private banks instead of 30% for public banks. The basis is that private banks' lending has been concentrated on consumer loans and mortgages and the recovery ratio on these loans will likely be higher - especially taking into consideration the quality of collateral. Our results are as follows: Under the baseline scenario of an 8% NPA ratio, 7% of these private banks' equity would be impaired (Table II-3, column 7). The adjusted PBV would move to 3.9. This compares to a fair value of 3.3 for Indian private banks (Table II-3, column 8), which is the historical PBV mean of private banks in India. In other words, Indian private banks are overvalued by 18% - slightly more than their public peers (Table II-3, column 9). Bottom Line: Indian private banks are overvalued too but less so than Chinese public banks. Investment Conclusions We reiterate our long Indian / short Chinese banks equity trade, initiated on January 17. We track the performance of this recommendation using the BSE's Bankex index for India and the MSCI Investable bank index for China in common currency terms - currency unhedged. In addition, among Chinese-listed banks, we maintain our short small / long large banks (Chart II-6). Smaller banks are more leveraged as well as exposed to non-standard assets and regulatory tightening than large public banks. Finally, the Indian bourse's relative performance against the EM equity benchmark negatively correlates with oil prices - the oil price is shown inverted on this chart (Chart II-7). Chart II-6Stay Short Chinese Small / Long Large Banks Stay Short Chinese Small/Long Large Banks Stay Short Chinese Small/Long Large Banks Chart II-7India's Relative Equity Performance To EM And Oil Prices India's Relative Equity Performance To EM And Oil Prices India's Relative Equity Performance To EM And Oil Prices Given BCA's Emerging Markets Strategy service expects oil prices to drop meaningfully in the second half of this year,5 this should help Indian equities outperform their EM peers. Besides, Indian banks are more advanced than many of their EM peers in terms of bad assets recognition and provisioning and that should also help the Indian bourse outperform the EM overall equity index in common currency terms. We reiterate our overweight stance on Indian equities within a fully invested EM equity portfolio. In contrast, we are neutral on China's investable stock index's relative performance versus the EM stock index. The main reason why we have not underweighted the Chinese bourse - despite our negative view on China - is the exchange rate; the potential downside in the value of the RMB versus the U.S. dollar in the next six months is less than potential downside in many other EM exchange rates. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "Long Indian / Short Chinese Banks" dated January 17, 2018 available at ems.bcaresearch.com. 2 Please see the following article: http://www.scmp.com/business/banking-finance/article/2139904/pressure-chinas-banks-report-bad-debt-good-news-foreign 3 It is the average PBV ratio for EM banks since 2011. 4 HDFC Bank, ICICI Bank, Axis Bank, Yes Bank, and IDFC Bank. 5 Please see Emerging Markets Strategy Special Report "China's Crude Oil Inventories: A Slippery Slope" dated June 21, 2018 available on page 17. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

The GAA DM Equity Country Allocation model is updated as of June 29, 2018. The model has reduced weights in Italy, the U.S., the Netherlands and France to beef up weights in Spain, Australia, Canada, Switzerland and Germany. After these adjustments, Australia is now upgraded to overweight from neutral and Italy is downgraded to neutral from overweight, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights GAA Quant Model Updates GAA Quant Model Updates As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model outperformed its benchmark by 34 bps in June, largely driven by the Level 2 model which outperformed its benchmark by 87 bps. The Level 1 model performed in line with its benchmark in June. Since going live, Level 2 and Level 1 have outperformed their respective benchmarks by 171 bps and 5bps, resulting in overall model outperformance of 47 bps. Table 2Performance (Total Returns In USD %) GAA Quant Model Updates GAA Quant Model Updates Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) GAA U.S. Vs. Non U.S. Model (Level 1) GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Mode (Chart 4) is updated as of June 30, 2018. Chart 4Overall Model Performance Overall Model Performance Overall Model Performance Table 3Allocations GAA Quant Model Updates GAA Quant Model Updates Table 4Performance Since Going Live GAA Quant Model Updates GAA Quant Model Updates Following our Quarterly Update that was released yesterday, the model corroborates the defensive stance with an aggregate underweight of 5.8% in cyclical sectors. The switch to a defensive mode was driven by a weaker growth outlook. The upgraded sectors were consumer staples and health care. Additionally, the model has turned more negative on the two largest sectors - financials and technology. Resources-based sectors remain unattractive on the back of weaker growth outlook. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," dated July 27, 2016, available at https://gaa.bcaresearch.com.