Sectors

Overweight (High Conviction) The S&P air freight index has been on a tear in recent months, after putting in a bottom earlier this year. It appears the market is valuing rising global trade driving a surge in revenues over a run up in fuel costs that will be a headwind for margins. We would concur. Domestic business conditions are nearly as good as they get, which has historically coincided with rising global air freight volumes (second panel). This rising demand, combined with relatively flat capacity growth, puts pricing power squarely in the hands of the logistics providers (third panel). We think the necessary conditions are in place to improve profit despite rising input costs. While the performance of the S&P air freight index has been solid recently, the growth in forward EPS estimates has been stronger, meaning valuations have barely budged from their steep discount to both normal and the market (bottom panel). We expect this situation is unlikely to persist with the most likely scenario being strong stock price performance, particularly if input costs begin to recede. Accordingly, we reiterate our high conviction overweight recommendation on the air freight index. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD. Global Trade Is LIfting Air Freight Global Trade Is LIfting Air Freight

Highlights One of Europe's major success stories is the structural and broad-based increase in female labour participation rates. The trend is set to continue for the next decade. Stay overweight the Personal Products sector as a long-term position. Italy's decade-long stagnation is not a deep-seated structural malaise. It is a protracted cyclical downturn resulting from a banking system that was never repaired after the 2008 financial crisis combined with wholly inappropriate fiscal austerity. We expect Italy's new government to push back against the EU's misguided fiscal rules and correct this decade-long error. Buy exposure to Italian real estate as a new long-term position either directly or through Italy's small real estate equity sector. Feature Some analysts persist on comparing economic performances on the basis of real GDP per head of total population. But the total population includes children and the elderly who cannot contribute to economic output. Therefore, a correct assessment of economic performance should look at real GDP per head of working-age population. Chart I-1AWomen Are Powering The European Economy... Women Are Powering The European Economy... ...Less So In The U.S. Women Are Powering The European Economy... ...Less So In The U.S. Chart I-1B ...Less So In The U.S. Women Are Powering The European Economy... ...Less So In The U.S. Women Are Powering The European Economy... ...Less So In The U.S. Admittedly, as the retirement age rises, the definition of 'working-age' will gradually change, but the general principle still holds: only count in the denominator those who can contribute to economic output. GDP per head of working-age population can grow in several ways. One way is to get more output or better output from each hour worked through improvements in efficiency and/or quality. As this improvement is theoretically limitless, it is the main source of productivity gains in the long run. A second way is for each worker to work more hours. But given the physical and legal constraints on productive working time, there is only limited scope to increase output in this way. How Women Are Powering The European Economy There is one other way to increase GDP per head of working-age population: increase the percentage of the working age population that is in the labour force.1 In other words, structurally increase the labour participation rate. If this participation rate is already high - as it is for men - then there is little scope to increase it much further. But if the participation rate is low - as it is for European women - then there is considerable scope to increase it. This brings us to one of Europe's major, and largely untold, success stories - the structural and broad-based increase in female participation rates (Chart I-1-Chart I-5). Over the past twenty years, the EU28 female participation rate has risen from 57% to 68%, with an especially large contribution from the socially conservative southern countries. In Spain, female participation has surged from 47% to 70%. In Italy, it has shot up from 42% to 56% and has clear scope to rise much further. Chart I-2Italy: Labour Force Participation Rate Italy: Labour Force Participation Rate Italy: Labour Force Participation Rate Chart I-3Spain: Labour Force Participation Rate Spain: Labour Force Participation Rate Spain: Labour Force Participation Rate Chart I-4Germany: Labour Force Participation Rate Germany: Labour Force Participation Rate Germany: Labour Force Participation Rate Chart I-5France: Labour Force Participation Rate France: Labour Force Participation Rate France: Labour Force Participation Rate What is driving this structural trend? Two things. First, the employment sectors that are growing structurally - healthcare, social care, and education - tend to employ more women than men. Second, European countries have legislated a raft of policies encouraging women to join and remain in the labour force: generous paid maternity leave and subsidised childcare. The trend is for further improvements, with the focus now on improving paternity leave. Sharing parental and family responsibilities between mothers and fathers allows more women to enter and stay in the labour force.2 For the ultimate end-point in the trend, look to the Scandinavian countries which started such policies in the early 1970s. In Sweden, labour force participation for women and men is almost identical: 81% versus 84%. If the EU eventually adopts the Scandinavian model, it would mean another 20 million European women in employment and contributing to economic output (Chart I-6). Chart I-6Another 20 Million European Women ##br##Could Join The Labour Force Another 20 Million European Women Could Join The Labour Force Another 20 Million European Women Could Join The Labour Force Dispelling Two Myths: The Euro Area And Italy Having established that economic performances should be compared on the basis of GDP per head of working age population, we can now dispel two common myths. The first myth is that the U.S. generates superior productivity growth than the euro area. It is true that the U.S. has been better at getting more output from each hour worked, so on this measure, the U.S. does win. Against this, the euro area has been much better at getting more of its working-age population - albeit mostly women - into employment. So on this measure, the euro area wins (Chart of the Week). The net result is that, over the past twenty years, the U.S and the euro area have generated exactly the same growth in real GDP per working-age population (Chart I-7). Of course, the euro area's structural improvement in female participation rates cannot continue forever, but it can certainly continue for another decade or so, and this is generally the longest time horizon that most investors care about. Chart I-7The Euro Area And The U.S.: Identical Growth In Real GDP Per Head Of Working-Age Population The Euro Area And The U.S.: Identical Growth In Real GDP Per Head Of Working-Age Population The Euro Area And The U.S.: Identical Growth In Real GDP Per Head Of Working-Age Population The second myth concerns the subject du jour: Italy. Many people claim that Italy's economic stagnation is due to deep-seated structural problems which differentiate it from other major economies. The problem with this narrative is that from the mid-1990s until 2008 the growth in Italy's real GDP per head of working age population was little different to that in Germany, France or the U.S. (Chart I-8). Chart I-8Italy Performed In Line With Other Major Economies Until 2008 Italy Performed In Line With Other Major Economies Until 2008 Italy Performed In Line With Other Major Economies Until 2008 Italy's economic stagnation only started after the 2008 global financial crisis. After a financial crisis which cripples the banking system, there are two golden rules: unleash fiscal stimulus; and repair the banking system as quickly as possible. The U.S. and U.K. followed the golden rules perfectly and immediately; Ireland followed a couple of years later; Spain waited until 2013. But in each case, the economies rebounded very strongly as the fiscal stimulus kicked in and the banks recuperated. Italy neither unleashed fiscal stimulus, nor repaired its banks - so its economy has stagnated for a decade. Moreover, if output stagnates for a decade, it follows arithmetically that productivity growth will also look poor. In a back-to-front argument, critics have pounced on this as evidence of excessive 'red tape' and 'structural problems'. But this is a misdiagnosis of the malaise. To reiterate, Italy's real GDP per working-age population was growing very respectably before 2008. Italy's misfortune is that its indebtedness has an unusual profile: more public debt than private debt. France and Spain (and other major euro area economies) have the usual profile: less public debt than private debt. So the EU's fiscal rules - which can see only public debt and are blind to private debt - have severely and unfairly constrained Italy's ability to respond to financial crises. While every other major economy followed the golden rules to recover from the 2008 crisis, Italy could neither unleash fiscal stimulus to kick start the economy nor recapitalise its dysfunctional banking system. We expect Italy's new government to push back against the EU's misguided fiscal rules and correct this decade-long error. Two Structural Investment Conclusions This week's two investment conclusions are both long term, and require a buy and hold mentality. The first conclusion reiterates a structural position: overweight the Personal Products sector. This is based on our expectation that, in Europe, female participation rates will continue their structural uptrend; while in the U.S. we expect female participation rates to continue outperforming male participation rates. Therefore the sales and profits of the Personal Products sector, in which female spending dominates, will benefit from a multi-year tailwind, at least relative to other sectors. And the extent of this tailwind is not fully discounted in valuations. The second conclusion is a new long-term recommendation: buy exposure to Italian real estate. This is based on our assessment that Italy's decade-long stagnation is not a deep-seated structural malaise. Instead, it is a protracted cyclical downturn resulting from a banking system that was never repaired after the 2008 financial crisis combined with wholly inappropriate fiscal austerity. Removing these shackles will allow a long-term recovery, just as it did for Spain in 2013. If we are right, the best multi-year buy and hold play is Italian real estate which has been in a decade-long bear market (Chart I-9). For those that cannot directly invest in property, Italy has a small real estate equity sector which faithfully tracks the long term profile of real estate prices (Chart I-10), and whose main component is Beni Stabili. The caveat is that the stock has a market cap of just €2 billion; the appeal is that it offers a juicy dividend yield of 4.5%. Chart I-9Italian Real Estate Has Suffered ##br##A Decade-Long Bear Market Italian Real Estate Has Suffered A Decade-Long Bear Market Italian Real Estate Has Suffered A Decade-Long Bear Market Chart I-10Italian Real Estate Equities##br## Track Real Estate Prices Italian Real Estate Equities Track Real Estate Prices Italian Real Estate Equities Track Real Estate Prices Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 And in employment. 2 Please see the European Investment Strategy Special Report "Female Participation: Another Mega-Trend" published on April 6, 2017 and available at eis.bcaresearch.com Fractal Trading Model* This week, we note that the 130-day fractal dimension for platinum versus nickel is close to its lower bound, a level which has consistently predicted a tradeable countertrend move over the following 130 days. Hence, this week's trade is long platinum/short nickel on a 130 horizon before expiry. The profit target is 14% with a symmetric stop-loss. Our two other open trades, long SEK/GBP and long PLN/USD, are both in profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Long Platinum / Short Nickel Long Platinum / Short Nickel The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Underweight (Upgrade Alert) It is a well-established rule that where jet fuel prices go, airline stock prices will go the opposite direction. Thus, it is no surprise that the most recent peak in the S&P airlines index coincided with the most recent trough in jet fuel prices in early 2017; the former has since fallen steeply as the latter has soared (fuel prices shown inverted in top panel). Easing oil prices are a likely catalyst for a significant rerating in depressed relative valuations. Fuel hedges no longer play a significant role in earnings and lower fuel costs would translate directly to the bottom line. As a reminder, nearly all major players reiterated their pledge to avoid kerosene hedging earlier this year. Adding it up, we think downside risks to airlines have abated considerably and are well reflected in beaten down valuations (bottom panel). We are therefore compelled to add this transportation sub-index to our upgrade watch list. If there is any letup in jet fuel prices, we would not hesitate to crystallize relative profits north of 21% since our underweight inception. Bottom Line: Stay underweight the S&P airlines index for now, but put in on upgrade alert; please see Monday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. Could Jet Fuel Be The Tailwind Airlines Need? Could Jet Fuel Be The Tailwind Airlines Need?

Overweight (High Conviction) The S&P software index is on the cusp of breaching the 2000 relative performance all-time peak, and we reiterate the high-conviction overweight status of this key tech sub-index, that is up over 11% versus the SPX since the late-November inception.1 BCA's synchronized global capex upcycle theme is the fundamental driver of our sanguine software industry view. Currently, software investment is outpacing overall capital outlays (second panel). These software capex market share gains on the back of a growing overall capex pie bode well for relative profit growth. Our S&P software EPS growth model corroborates this encouraging news (third panel), pointing to ongoing exceptionally strong earnings growth. Meanwhile, the S&P software index has a pristine balance sheet with virtually no net debt (bottom panel); if our virtuous capex upcycle thesis further bolsters software sales/profits in the coming months, then more gains are in store for the S&P software index that will likely grow into its pricey valuations. Bottom Line: We reiterate our high-conviction overweight status in the S&P software index. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, RHT, ADSK, CTXS, ANSS, SNPS, SYMC, TTWO, CDNS, CA. Stick With Software Stocks Stick With Software Stocks 1 Please see BCA U.S. Equity Strategy Weekly Report, "2018 High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com.

Highlights Chart 1Risks To The Bond Bear Market Risks To The Bond Bear Market Risks To The Bond Bear Market Two weeks ago we flagged that large net short positioning and elevated growth expectations left the Treasury market primed to benefit from any disturbance in the economic outlook. Since then the 10-year yield fell from a peak of 3.06% to 2.77%, before climbing back to 2.92%. With positioning still deeply net short and strong odds of a further decline in the economic surprise index (Chart 1), we continue to see an elevated risk that yields move lower on a 0-3 month horizon. But beyond that, less nimble investors should remain positioned for higher yields on a 6-12 month timeframe. The major risks in the global economy - Eurozone sovereign credit concerns and a strong dollar weighing on emerging market demand - are unlikely to put the Fed off its "gradual" pace of one rate hike per quarter unless they lead to a significant risk-off event in U.S. financial markets. Absent that sort of shock, the Fed will continue to lift rates "gradually" toward a neutral level near 3%, and eventually into restrictive territory. This rate hike path is consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%, well above current levels. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 45 basis points in May, dragging year-to-date excess returns down to -122 bps. Value has improved considerably since the start of the year. The 12-month breakeven spread for a Baa-rated corporate bond is back up to its 29th percentile relative to history (Chart 2). Market-derived inflation expectations also ebbed during the past month, with the 10-year and 5-year/5-year forward TIPS breakeven inflation rates now at 2.09% and 2.12% respectively. This is below the target range of 2.3% to 2.5% that would trigger a downgrade to our corporate bond allocation. The combination of more attractive value and a somewhat more supportive monetary environment (as evidenced by the decline in TIPS breakeven rates) increases the odds of near-term corporate bond outperformance, and we would not be surprised to see spreads tighten during the next few months. However, the longer run outlook for corporates remains negative. First quarter data showed a 5.7% annualized decline in pre-tax corporate profits, dragging the year-over-year growth rate down to 5.8% (bottom panel). As employee compensation costs accelerate in the second half of the year, we expect that corporate profit growth will fall sustainably below the pace of corporate debt growth leading to rising leverage (panel 4). Strong oil prices have caused the energy sector to outperform the overall index considerably since the middle of last year. Now, many energy sub-sectors no longer appear cheap on our model. We take this opportunity to downgrade a few energy sub-sectors from overweight to neutral, and adjust some other sector recommendations as well (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Bond Bear Still Intact Bond Bear Still Intact Table 3BCorporate Sector Risk Vs. Reward* Bond Bear Still Intact Bond Bear Still Intact High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 65 basis points in May, dragging year-to-date excess returns down to +36 bps. The average index option-adjusted spread widened 24 bps on the month, and currently sits at 356 bps. High-yield spreads are increasingly at odds with Moody's default rate projections. The latter call for the 12-month speculative grade default rate to fall to 1.5% by next April. The current 12-month trailing default rate is 3.7% (Chart 3). Using the Moody's default rate projection, and our own forecast for the recovery rate, we calculate the excess spread available in the Bloomberg Barclays High-Yield index to be 284 bps (after accounting for expected default losses). This is somewhat higher than the historical average of 248 bps. The current excess spread means that in an unchanged spread environment we would expect a High-Yield excess return (relative to duration-matched Treasuries) of +278 bps during the next 12 months. If the index spread were to tighten by 100 bps, we would expect an excess return of +675 bps. If the index spread were to widen by 100 bps we would expect an excess return of -120 bps (panel 3). If the excess spread were to simply revert to its historical average, then it would imply an excess High-Yield return of +427 bps. At the sector level, Moody's expects that most defaults during the next 12 months will come from the Media: Advertising, Printing & Publishing sector, followed closely by the Durable Consumer Goods and Retail sectors. Much of the projected improvement in the overall default rate results from a continued decline in Oil & Gas sector defaults compared to the past few years. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 5 basis points in May, dragging year-to-date excess returns down to -27 bps. The conventional 30-year zero-volatility MBS spread widened 4 bps on the month, driven entirely by a 4 bps increase in the compensation for prepayment risk (option cost). The option-adjusted spread held flat at 32 bps. Value in the MBS sector is by no means exciting. The nominal spread on a conventional 30-year MBS is near its all-time low, the option-adjusted spread is close to one standard deviation below its pre-crisis mean (Chart 4) and MBS no longer look very attractive compared to investment grade corporate credit (panel 3). The most compelling reason to hold agency-backed MBS is that mortgage refinancings are likely to remain very low, owing both to rising interest rates and the large number of homeowners that have already refinanced. Depressed refi activity should keep MBS spreads near historically low levels (bottom panel), even as stresses emerge in other spread product sectors, notably corporate bonds. We recently presented a method for calculating expected total returns for all different bond sectors, only using assumptions for the number of Fed rate hikes during the next 12 months and the expected change in spreads.1 Our results showed an expected total return of 2.9% for conventional 30-year MBS in a scenario where the Fed lifts rates by 100 bps and where spreads remain flat. The same scenario corresponds to 3.4% total return for the investment grade corporate index. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 33 basis points in May, dragging year-to-date excess returns down to -40 bps. Sovereign debt underperformed the Treasury benchmark by 158 bps on the month, dragging year-to-date excess returns down to -242 bps. Foreign Agencies underperformed by 37 bps on the month, dragging year-to-date excess returns down to -56 bps. Local Authorities underperformed by 22 bps on the month, dragging year-to-date excess returns down to +37 bps. Supranationals underperformed by 2 bps on the month, dragging year-to-date excess returns down to +2 bps. Domestic Agency bonds outperformed by 7 bps, bringing year-to-date excess returns up to +7 bps. Global growth divergences and a stronger U.S. dollar weighed on Sovereign bond returns in May (Chart 5). While value in the sector improved somewhat as a result, it remains expensive relative to investment grade corporate credit (panel 2). With dollar strength likely to persist in the near-term, we remain underweight Sovereign bonds. Conversely, we reiterate our overweight recommendations on Foreign Agency and Local Authority bonds. Those sectors still offer compelling valuations and are less sensitive to a strong U.S. dollar than the lower-rated Sovereign sector. Supranationals and Domestic Agency bonds are low risk but do not offer sufficient spread to warrant much attention. Better low-risk spread product opportunities are available in the Agency CMBS and Consumer ABS sectors. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 15 basis points in May, bringing year-to-date excess returns up to +110 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio declined 2% on the month and, at 86%, it is very close to its post-crisis low (Chart 6). It remains somewhat elevated compared to the average level of 81% that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. Technically, yield ratios have been supported by robust fund flows and subdued issuance (panels 2 & 3), while fundamentally our Municipal Health Monitor suggests that ratings upgrades will continue to outpace downgrades for the time being (not shown). The message from our Health Monitor is confirmed by the trend in state & local government net borrowing (bottom panel). First quarter data, released last week, showed a sizeable drop in net borrowing as state & local governments managed to grow revenues by $46 billion while growing expenditures by only $25 billion. This is consistent with governments working hard to repair their budgets, raising taxes and slowing spending growth, as we showed in a recent report.2 Given tight municipal valuations, we continue to see better opportunities in the corporate bond space than in municipal bonds. But we will look to upgrade munis at the expense of corporates as we approach the end of the credit cycle. Hopefully, from a more attractive entry point. 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 bull-flattened in May. The 2/10 Treasury slope flattened 3 bps to end the month at 43 bps. The 5/30 slope held steady at 32 bps. The short-end of the Treasury curve is still not adequately priced for the Fed's likely pace of one 25 basis point rate hike per quarter. Such a pace translates to a level of 100 bps on our 12-month discounter, which currently sits at only 73 bps (Chart 7). Similarly, the long-end of the Treasury curve is not adequately priced for the likely trend in inflation. The 10-year TIPS breakeven inflation rate is at only 2.09%, below the range of 2.3% to 2.5% that is consistent with well-anchored inflation expectations. We anticipate that higher TIPS breakevens at the long end of the curve will be roughly offset by loftier rate expectations at the short end of the curve, leaving the slope of the Treasury curve close to current levels during the next few months. In a recent report we introduced a framework for identifying the most attractively valued butterfly trades across the entire yield curve.3 The results, shown in Table 4, identify the 7-year bullet over the 1-year/20-year barbell as the most attractively valued butterfly trade that is geared toward curve steepening. According to our model, that trade is priced for 56 bps of 1/20 flattening during the next six months (panel 4). That seems excessive given the low level of long-maturity TIPS breakevens. Table 4Butterfly Strategy Valuation (As Of June 4, 2018) Bond Bear Still Intact Bond Bear Still Intact TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 65 basis points in May, dragging year-to-date excess returns down to +95 bps. The 10-year TIPS breakeven inflation rate fell 10 bps on the month and currently sits at 2.09%. The 5-year/5-year forward TIPS breakeven inflation rate fell 13 bps and currently sits at 2.12%. As we explained in a recent report, we view the first stage of the bond bear market as being driven by the re-anchoring of inflation expectations.4 We will consider inflation expectations well anchored when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are in a range between 2.3% and 2.5%, where they were the last time that inflation was well anchored around the Fed's target. Recent trends show that inflation is steadily making progress toward the Fed's 2% goal. The 12-month rate of change in the core PCE deflator is back up to 1.8%, from 1.5% in February. However, the core PCE deflator has only increased by 0.15% in each of the past two months. Consistent monthly prints above 0.165% are required to reach the Fed's 2% target (Chart 8). We expect tight labor markets and strong pipeline pressures (panel 3) to drive inflation higher in the months ahead. Although, as we discussed last week, the risk of a significant overshoot of the Fed's inflation target during the next 6-12 months is low.5 ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in May, bringing year-to-date excess returns up to -3 bps. The index option-adjusted spread for Aaa-rated ABS widened 1 bp on the month and now stands at 41 bps, 7 bps above its pre-crisis low. While consumer ABS offer reasonably attractive expected returns relative to other low-risk spread product (Agency CMBS, Domestic Agency bonds and Supranationals), credit risk is slowly starting to build in the sector. The New York Fed's Household Debt and Credit report showed that the 90+ day credit card delinquency rate rose above 8% in Q1 for the first time since 2015. Meanwhile, the overall consumer credit delinquency rate continues to increase alongside a rising debt service ratio (Chart 9). On the supply side, banks reported tightening credit card lending standards for the fourth consecutive quarter in Q1, while auto loan lending standards were tightened for the eighth consecutive quarter. Periods of tightening lending standards tend to coincide with rising delinquencies and wider spreads (bottom panel). In a recent report we forecasted 12-month total returns for each U.S. fixed income sector using inputs only for the path of spreads and the number of Fed rate hikes during the next year. In a scenario where spreads remain flat and the Fed lifts rates four times next year, we would expect Aaa-rated credit card ABS to return 2.3% and Aaa-rated auto loan ABS to return 2.4%.6 Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 1 basis point in May, bringing year-to-date excess returns up to +71 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 2 bps on the month and currently sits at 70 bps, close to one standard deviation below its pre-crisis mean. Banks eased lending standard on nonfarm nonresidential loans in Q1 for the first time since 2015, and continued easing could signal lower delinquencies in the future (Chart 10). Easier lending standards could also support commercial real estate prices, which have decelerated recently and currently pose a risk for spreads (panel 3). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 1 basis point in May, bringing year-to-date excess returns up to +13 bps. The index option-adjusted spread widened 1 bp on the month and currently sits at 48 bps. In a recent report we forecasted 12-month total returns for each U.S. fixed income sector using inputs only for the path of spreads and the number of Fed rate hikes during the next year. In a scenario where spreads remain flat and the Fed lifts rates four times next year, we would expect non-agency Aaa-rated CMBS to return 2.8% and Agency CMBS to return 2.6%.7 Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.54%. The drop in the model's fair value compared to last month stems from a decline in the global PMI from 53.5 to 53.1, and a rise in dollar bullish sentiment from 60% to 67%. While global growth has undoubtedly lost momentum in recent months, we also suspect that our 2-factor model is finally breaking down. The 2-factor model does not contain a variable to capture the degree of resource utilization in the economy. As resource slack dissipates, inflationary pressures mount and the same pace of global growth should be associated with a higher Treasury yield. This means that as we approach the end of the cycle, the 2-factor model will start producing fair value readings that are consistently too low. We can attempt to correct for this by incorporating a measure of resource slack into our model, in this case the employment-to-population ratio. A model for the 10-year Treasury yield based on the employment-to-population ratio and the Global PMI produces a fair value of 3.29% (Chart 11). As we move further toward the end of the cycle, and away from the zero-lower bound on the fed funds rate, we expect the regression coefficients shown in the bottom three panels will revert to their pre-crisis levels and Treasury fair value will revert closer to the one shown in the second panel. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Profiting From A Higher LIBOR", dated March 20, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Breaking Points", dated May 29, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Pulling Back and Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Pulling Back and Looking Ahead", dated May 22, 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)

The GAA DM Equity Country Allocation model is updated as of May 31, 2018. No significant changes in the model's allocation this month, 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 Charts 1, 2 and 3, the overall model underperformed its benchmark by 111 bps in May, largely driven by Level 2 model which underperformed by 300 bps. The model's largest overweight, Italy, turned out to be the worst performer in May as a result of Italian politics, an event that is difficult for a quantitative model to capture. Level 1 model outperformed by only 7 bps in May. Consequently, since going live, the outperformance of the Level 2 model, which allocates funds among 11 non-U.S. countries, has reduced to 52 bps, while the overall model has performed in line with the MSCI World benchmark. 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 Model (Chart 4) is updated as of May 31, 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 The largest shift was a move from underweight to overweight in the materials sector, driven by improving momentum. On the other hand, the overweight in energy was reduced by 1.7 percentage points. The aggregate model now has a small overweight on cyclicals versus defensives, although this is entirely in commodity-related cyclicals. The only other overweight sector is utilities, which saw a small decrease in its weight in the model. 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.

Highlights Portfolio Strategy A virtuous software capex upcycle will continue to bolster industry sales/profits in the coming months. We reiterate our high-conviction overweight recommendation on the S&P software index. Depressed relative valuations signal that the weak airline profit margin backdrop is baked in the cake. Rising load factors and the possibility of an easing in jet fuel prices compel us to put this transportation sub-index on our upgrade watch list. Recent Changes Put the S&P Airlines Index on upgrade alert. Table 1 Unwavering Unwavering Feature Stocks took it on the chin early last week as geopolitical risks resurfaced in a big way, but managed to bounce smartly and end the week on a high note. Not only did Trump slap new tariffs reigniting trade war fears, but Italian political instability rocked global bond and stock markets. While this mini 'risk-off' phase has rattled investors, the key question hanging over markets is: will the current global growth soft patch prove transitory or morph into a severe global growth deceleration? We side with the former. While it is too early to call the end of the global growth lull, there are high odds that the U.S. will lift the world out of its year-to-date mini-slump in the back half of the year. The third panel of Chart 1 shows that the IHS Markit U.S. manufacturing PMI has been steeply diverging from the J.P. Morgan-calculated global manufacturing PMI. The latter has ticked up recently, and given recent U.S. economic greenshoots and America's heavy weighting in global output, it should pull global growth higher. Chart 1Too Soon To Bail Too Soon To Bail Too Soon To Bail Chart 2Monitor The Greenback's Impact On Profits Monitor The Greenback's Impact On Profits Monitor The Greenback's Impact On Profits Importantly, this leading U.S. economic growth indicator is also signaling that SPX momentum will resume its ascent in the coming months, a message corroborated by the latest ISM manufacturing survey print (second panel, Chart 1). What could push our still constructive cyclical 9-12 month equity view offside is a surge in the U.S. dollar. The greenback's trough coincided with last year's peak in global growth (bottom panel Chart 1), and further dollar appreciation - resulting from either stress in emerging markets or a further flare-up of Eurozone breakup risk - would necessitate downward revisions to calendar 2019 sell-side earnings forecasts (Chart 2). We are closely monitoring Eurozone geopolitical risks, and are also awaiting the ECB's response. If persistent turmoil causes the ECB to stay easier for longer than the market expects, then the euro will come under downward pressure against the dollar, especially if the Fed continues to hike as we expect. Last week alone BCA's months-to-hike gauge for the ECB jumped by five months, implying the first hike moved to mid-year 2020 (second panel, Chart 3). We recently showed the U.S. tech sector's hefty foreign sales exposure of roughly 60% of total revenues, greater than for any other GICS1 sector by a wide margin (please refer to Chart 8 from the April 9, 2018 Weekly Report titled "Buying Opportunity?"). As such the technology sector's profits serve as a great leading indicator of any U.S. dollar appreciation related blues. Up to now, tech net EPS revisions have not been sniffing out any currency related earnings trouble that could infiltrate overall SPX EPS (U.S. trade-weighted dollar shown inverted, third panel, Chart 4). Similarly, relative tech sector stock momentum and our tech sector EPS growth model are not waving any yellow flags (Chart 4). Chart 3Steadfast ##br##SPX Steadfast SPX Steadfast SPX Chart 4Tech Stocks Will Be The First To Sniff ##br##Out U.S. Dollar Profit Woes Tech Stocks Will Be The First To Sniff Out U.S. Dollar Profit Woes Tech Stocks Will Be The First To Sniff Out U.S. Dollar Profit Woes Netting it all out, there are high odds that the U.S. will lead global growth higher in the coming quarters and result in a recoupling higher of global growth, assuming the greenback stops appreciating. This would support low double digit calendar 2019 SPX profit growth. Under such a macro backdrop, it still pays to maintain a cyclicals over defensives portfolio bent. This week we are revisiting one tech sector high-conviction overweight and putting a transport sub-index on upgrade watch. Stick With Software Stocks The S&P software index is on the cusp of breaching the 2000 relative performance all-time peak, and we reiterate the high-conviction overweight status of this key tech sub-index, that is up over 11% versus the SPX since the late-November inception.1 Although this may appear exuberant, from a longer-term perspective, relative share prices only recently reclaimed the upward sloping historical time trend mean (top panel, Chart 5). The implication is that more gains are in store prior to the end of the business cycle. BCA's synchronized global capex upcycle theme is the fundamental driver of our sanguine software industry view. In the aftermath of the dotcom bust, tech investment in general and software in particular, went into hibernation for a whole decade. Currently, software investment is outpacing overall capital outlays (middle panel, Chart 5). These software capex market share gains on the back of a growing overall capex pie bode well for relative profit growth. Animal spirits remain upbeat with both consumer and most importantly CEO confidence probing multi-year highs. Tack on the still buoyant message from our capex indicator and software spending has more room to grow (second & third panels, Chart 6). In addition, the government sector may also increase spending on IT/software services on the back of easing fiscal policy and beefing up on cybersecurity (Chart 7). Chart 5Buy The Breakout Buy The Breakout Buy The Breakout Chart 6Even Uncle Sam Is Buying Software Even Uncle Sam Is Buying Software Even Uncle Sam Is Buying Software Chart 7Margin Expansion Phase Has Legs Margin Expansion Phase Has Legs Margin Expansion Phase Has Legs While our S&P software EPS growth model corroborates this encouraging news (bottom panel, Chart 5), sell side analysts do not share our optimism. In fact, software profits are forecast to trail the broad market by 500bps, a rather low hurdle. On the operating front, sales are accelerating at a time when labor costs remain contained. Importantly, software prices are on the verge of exiting deflation, underscoring that software demand is robust. Moreover, the secular advance in cloud computing and SaaS represent a long-term positive demand backdrop. The upshot is that the mini margin expansion phase in place since early-2016 has more legs (Chart 7). Meanwhile, the S&P software index has a pristine balance sheet with virtually no net debt, a high interest coverage ratio and galloping higher free cash flow (Chart 8). Unsurprisingly, this cash rich tech subsector has also been in the middle of an M&A frenzy. This supply reduction is not only bullish for industry pricing power, and thus profit growth, but it has also led to hefty M&A premia and a significant valuation rerating (bottom panel, Chart 9). Chart 8Pristine Balance Sheet Pristine Balance Sheet Pristine Balance Sheet Chart 9Software Will Grow Into Pricey Valuations Software Will Grow Into Pricey Valuations Software Will Grow Into Pricey Valuations If our virtuous capex upcycle thesis further bolsters software sales/profits in the coming months, then more gains are in store for the S&P software index that will likely grow into its pricey valuations. Bottom Line: We reiterate our high-conviction overweight status in the S&P software index. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, RHT, ADSK, CTXS, ANSS, SNPS, SYMC, TTWO, CDNS, CA. Could Jet Fuel Be The Tailwind Airlines Need? It is a well-established rule that where jet fuel prices go, airline stock prices will go the opposite direction. Thus it is no surprise that the most recent peak in the S&P airlines index coincided with the most recent trough in jet fuel prices in early 2017; the former has since fallen steeply as the latter has soared (top panel, Chart 10). This relationship has grown more acute as the industry, having been burned when fuel prices collapsed in 2014, has all but abandoned fuel hedging. The timing for rising jet fuel prices could scarcely be less opportune; historically, airlines have been able to pass through rising fuel costs. Now, in the midst of an industry price war, pricing power and fuel costs are diverging (second panel, Chart 10). The impact is apparent on industry margins, which have been in decline for nearly two years and more pain likely lies ahead (second panel, Chart 11). The head of airline industry group International Air Transport Association (IATA), recently noted that rising oil prices would significantly bite into airline profitability next year; IATA is widely expected to lower its industry benchmark profit forecast this week. Chart 10Mind The Gap Mind The Gap Mind The Gap Chart 11Acute Margin Trouble... Acute Margin Trouble... Acute Margin Trouble... The source of industry conflict has been an uptick in capacity growth. Airlines are adding capacity faster than the economy is growing (third and fourth panels, Chart 11) and the only relief valve to preserve market share is to cut prices. In this context, it is difficult to understand analysts' 20%+ EPS growth forecast for next year, significantly outpacing the S&P 500 (bottom panel, Chart 11). However, the news is not all bad. Despite the competitive headwinds, the industry has been successful at moving unit revenues higher and airlines have been doing so at an aggressive pace in 2018 (second panel, Chart 12). Further, industry load factors (in essence, the percentage of filled seats) are near their highest level ever, indicating capacity growth is being met with lower price-induced demand growth (bottom panel, Chart 12). Rising load factors are typically a precursor to price (and profit) increases. Investors appear to have capitulated. Airlines trade at roughly half the market multiple on an EV/EBITDA basis and a substantial discount on a price/book basis (second & third panels, Chart 13). From a valuation perspective, airlines look set to take off. Chart 12...But Demand is Firming... ...But Demand is Firming... ...But Demand is Firming... Chart 13...And Most Bad News Is Likely Priced In ...And Most Bad News Is Likely Priced In ...And Most Bad News Is Likely Priced In Easing oil prices are a likely catalyst for a significant rerating in depressed relative valuations. Fuel hedges no longer play a significant role in earnings and lower fuel costs would translate directly to the bottom line. As a reminder, nearly all major players reiterated their pledge to avoid kerosene hedging earlier this year. Adding it up, we think downside risks to airlines have abated considerably and are well reflected in beaten down valuations. We are therefore compelled to add this transportation sub-index to our upgrade watch list. If there is any letup in jet fuel prices, we would not hesitate to crystallize relative profits north of 21% since our underweight inception. Bottom Line: Stay underweight the S&P airlines index for now, but put in on upgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "2018 High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Overweight Defense stocks have been range-bound in the last week as geopolitical maneuvering has seen probabilities of conflict on the Korean peninsula swinging wildly back and forth. Using this conflict to value defense equities seems fraught with forecast risk and we would argue that focusing on domestic rearmament is a better use of investors' time. In last month's data release, Department of Defense outlays showed the longest streak of increases this decade, pointing to a continued acceleration in defense spending (second panel). This is mirrored by surging government investment in defense, now at its highest level in 5 years (third panel). The Trump administration's commitment to rearmament has now made it into the federal budget; the Congressional Budget Office (CBO) estimates defense outlays will approximate wartime levels in 2019 (bottom panel). Net, we expect earnings visibility will peak through the fog of war and be the ultimate driver of stock market returns; stay overweight. The ticker symbols for the stocks in the BCA Defense index are: LMT, GD, RTN, NOC, LLL. Defense Spending Showing No Signs Of Slowing Defense Spending Showing No Signs Of Slowing

Dear Client, I will be visiting clients next week. Instead of our Weekly Report, we will be sending you a Special Report written by my colleagues Matt Gertken and Ray Park. The report addresses the North Korean situation and argues that a positive, if not perfect, diplomatic solution will result from U.S.-North Korean negotiations. Best regards, Peter Berezin, Chief Global Strategist Highlights The U.S. can withstand further rate hikes. Neither economic nor financial imbalances are especially elevated, while fiscal stimulus will offset much of the sting from tighter monetary policy. Unfortunately, America's resilience to higher rates does not extend to the rest of the world. A stronger dollar is undermining emerging markets, which are already under pressure from slower Chinese growth and the looming prospect of trade wars. The crisis in Italy will further restrain the ECB from withdrawing monetary support. Investors focused on capital preservation should remain underweight Italian bonds. More speculatively-minded investors could consider opening a long position in BTPs versus bunds, but not before the Italian 10-year yield has reached 4%. EUR/USD came within a whisker of our 1.15 target this week. We will book profits on our long DXY trade recommendation if the dollar index reaches 96. A defensive posture is appropriate for now, but risk assets should recover later this year as the global economy finds its footing. This could set the scene for a blow-off rally in stocks. Feature Gauging The Pain Threshold From Higher Rates Chart 1Market Expectations Slightly Below Fed Dots Market Expectations Slightly Below Fed Dots Market Expectations Slightly Below Fed Dots After the recent turbulence, the market is pricing in 100 basis points of Fed rate hikes between now and the end of 2020 (Chart 1). Such a pace of rate hikes would be quite slow by historic standards. In past tightening cycles, the Fed would typically raise rates by about 50 basis points per quarter. Investors expect the real fed funds rate to peak at around 1%, well below the historic average of 3%-to-5%. Underlying these expectations is the presumption that the neutral rate of interest - the rate consistent with full employment and stable inflation - is quite low, and that the Fed will not have to raise rates much above neutral to cool the economy. According to the April FOMC minutes, "a few" participants thought that the fed funds rate was already close to its equilibrium level. There are many reasons to think that R-star has fallen over time, but in practice, the margin of error around estimates of the neutral rate is huge. Thus, rather than getting bogged down over technical issues, investors would be well served by taking a more practical approach and asking what they should be on the lookout for to determine whether interest rates have moved into restrictive territory. The State Of The U.S. Housing Market Housing has historically been the most important interest rate-sensitive sector, so much so that Ed Leamer entitled his 2007 Jackson Hole symposium paper "Housing Is The Business Cycle."1 Given the recent runup in mortgage yields, it is not too surprising that the latest data on U.S. housing has been on the weak side (Chart 2). Mortgage applications for purchase have come off their highs. Housing starts, building permits, and new and existing home sales all declined in April. Homebuilder sentiment improved a tad, but this was due to an increase in the current sales component; future sales expectations were flat on the month. The share of respondents who indicated that now was a good time to buy a home in the latest University of Michigan Consumer Sentiment survey declined to 69% in May, continuing its slide from a peak of 83% in December 2014. Still, we would not fret too much about the state of the U.S. housing market (Chart 3). Construction activity has been slow to increase this cycle, which has pushed vacancies to ultra-low levels. Home prices have been rising briskly, but are still 13% below their 2006 peak once adjusted for inflation. On both a price-to-rent and price-to-income basis, home prices do not appear overly stretched. Mortgage servicing costs, expressed as a share of disposable income, are near all-time lows. The homeownership rate has also been trending higher, thanks to faster household formation and an improving labor market. Chart 2U.S. Housing: Higher Mortgage##br## Rates Are A Headwind... U.S. Housing: Higher Mortgage Rates Are A Headwind... U.S. Housing: Higher Mortgage Rates Are A Headwind... Chart 3...But Don't##br## Fret Yet ...But Don't Fret Yet ...But Don't Fret Yet Household Debt Is Not Yet At Worrying Levels Lenders also remain circumspect (Chart 4). Mortgage debt has barely grown as a share of disposable income throughout the recovery, and is still 31 percentage points below 2007 levels. The average FICO score for new mortgages stands at a healthy 761, well above pre-recession standards. The Urban Institute Housing Credit Availability Index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, is nowhere close to dangerous levels. This is particularly the case for private-label mortgages, whose default risk has hovered at just over 2% during the past few years, down from a peak of 22% in 2006. A dwindling share of loan originations since the financial crisis has involved adjustable rate mortgages (Chart 5). This has made the housing market more resilient to Fed rate hikes. Other parts of the household credit arena look more menacing, but not so much that they threaten to short-circuit the economy. Banks have been tightening lending standards on auto loans since Q2 of 2016 and credit card loans since the second quarter of last year. This should help moderate the increase in default rates that has been observed in those categories (Chart 6). Chart 4Mortgage Debt Is Not ##br##A Cause For Concern Mortgage Debt Is Not A Cause For Concern Mortgage Debt Is Not A Cause For Concern Chart 5Housing Market: More Resilient To ##br##Rate Hikes Than It Used To Be Housing Market: More Resilient To Rate Hikes Than It Used To Be Housing Market: More Resilient To Rate Hikes Than It Used To Be Chart 6Lenders Are More ##br##Circumspect These Days Lenders Are More Circumspect These Days Lenders Are More Circumspect These Days Student debt has continued to trend higher, but the vast majority of these loans is backstopped by the government. While the Treasury's own finances are on an unsustainable trajectory, this is more of a long-term concern than a short-term problem. If anything, fiscal stimulus over the next two years will allow the Fed to raise rates more than it could otherwise without endangering the economy. Corporate Borrowing: High But Not Extreme Like a river, market liquidity tends to flow along the path of least resistance, rather than towards those who happen to be the most thirsty. While the household sector was piling on debt during the 2001-2007 boom, the U.S. corporate sector was still recovering from the hangover produced by the capex boom in the late 1990s. A decade later, corporate balance sheets were in good shape. Spurred on by ultra-low interest rates, corporate debt levels began to rise. Today, the ratio of corporate debt-to-GDP is near a record high. Valuations for corporate assets have reached lofty levels. In inflation-adjusted terms, commercial real estate prices are 4% above their pre-recession peak (Chart 7). U.S. equities also trade at a historically elevated multiple to earnings, sales, and book value (Chart 8). There are bright spots, however (Chart 9). Thanks to lofty corporate profits, the ratio of corporate debt-to-EBITDA is in the middle of its post-1990 range based on national accounts data. Interest payments-to-EBIT are near historic lows. Corporate bonds now represent 60% of total corporate liabilities. Bonds tend to have much longer maturities than bank loans, which provides a buffer against default risk. Although the picture is not as benign if one performs a bottom-up analysis of publicly-listed companies, the overall message is that the U.S. corporate sector can handle higher rates. Corporate stresses will eventually rise, but it will likely take a recession for this to happen, which we don't expect until 2020. Chart 7Commercial Real Estate Prices: ##br##Above Pre-Recession Levels Commercial Real Estate Prices: Above Pre-Recession Levels Commercial Real Estate Prices: Above Pre-Recession Levels Chart 8U.S. Equities##br## Are Overvalued U.S. Equities Are Overvalued U.S. Equities Are Overvalued Chart 9Corporate Debt Is High,##br## But So Are Profits Corporate Debt Is High, But So Are Profits Corporate Debt Is High, But So Are Profits Cyclical Spending Still Subdued The discussion above suggests that U.S. interest rate-sensitive sectors can withstand further rate hikes. This conclusion is buttressed by the observation that the cyclical sectors of the economy - the ones that tend to weaken the most during recessions - have yet to reach levels that make them vulnerable to a sharp retrenchment. Chart 10 shows that the sum of business capital spending, residential and commercial construction, and consumer discretionary goods purchases is still well below levels that have preceded past recessions. Along the same lines, the private sector financial balance - the difference between what the private sector earns and what it spends - is currently in surplus to the tune of 2.2% of GDP. This compares to deficits of 5.4% of GDP in 2000 and 3.8% of GDP in 2006 (Chart 11). Further monetary tightening, to the extent that it prevents any brewing imbalances in the real economy and financial markets from worsening, may be just what the doctor ordered. Chart 10Cyclical Spending Still Below Levels##br## Preceding Past Recessions Cyclical Spending Still Below Levels Preceding Past Recessions Cyclical Spending Still Below Levels Preceding Past Recessions Chart 11U.S. Private Sector Financial##br## Balance Is Healthy U.S. Private Sector Financial Balance Is Healthy U.S. Private Sector Financial Balance Is Healthy The Sneeze Felt Around The World The U.S. is not an island unto itself. Even if a bit outdated, the old adage which says that when the U.S. sneezes the rest of the world catches a cold, still rings true. As such, focusing on the neutral rate only as it pertains to the U.S. is a bit too parochial. There may be a lower "shadow" neutral rate which, if breached, causes pain outside the U.S. before it causes pain in the U.S. itself. Emerging markets are particularly sensitive to changes in U.S. financial conditions. About 80% of EM foreign-currency debt is denominated in dollars. A stronger dollar and higher U.S. interest rates make it more difficult for EM borrowers to service their debts. While EM foreign-currency debt has declined as a share of total debt outstanding, this is only because the past decade has seen a boom in local debt issuance (Chart 12). As a share of GDP, exports, and international reserves, U.S. dollar debt is at levels not seen in over 15 years (Chart 13). Most emerging markets entered 2018 with strong growth momentum. Recent tracking estimates point to some deceleration in GDP growth, but nothing too alarming (Chart 14). That could begin to change. EM financial conditions have started to tighten, which is likely to weigh on activity. BCA's Emerging Market and Geopolitical Strategy teams have flagged the prospect of policy-inducing tightening in China. Trade tensions also seem to be escalating again following President Trump's decision this week to curb Chinese investment in the U.S., impose a 25% tariff on $50 billion of Chinese imports, and slap tariffs on foreign steel. All this could put an additional dent in global growth. While this publication does not expect a full-blown EM crisis, a period of EM underperformance over the next few months is likely. Chart 12EM Borrowers Like Local Credit, ##br##But Don't Dislike Foreign-Currency Debt EM Borrowers Like Local Credit, But Don't Dislike Foreign-Currency Debt EM Borrowers Like Local Credit, But Don't Dislike Foreign-Currency Debt Chart 13EM Dollar##br## Debt Is High EM Dollar Debt Is High EM Dollar Debt Is High Chart 14EM Growth Decelerating,##br## But Not Dramatically... Yet EM Growth Decelerating, But Not Dramatically... Yet EM Growth Decelerating, But Not Dramatically... Yet Italy: If You Are Gonna Do The Time, You Might As Well Do The Crime Even if emerging markets avoid another major crisis, one can always count on Europe to try to fill the void. The Italian 10-year bond yield is up over 100 basis points since the middle of April. Assuming a fiscal multiplier of one, a standard Taylor Rule equation says that Italy would need 2% of GDP in fiscal stimulus per year to offset the tightening in financial conditions brought upon by the recent increase in borrowing costs.2 That is 20% of GDP in stimulus over the next decade to pay for a fiscal package that has yet to be implemented by a government that does not yet (and may never) exist. At this point, investors are basically punishing Italy for a crime – defaulting and possibly jettisoning the euro – it has yet to commit. If you are going to get reprimanded for something you have not done, you have more incentive to do it. The market realizes this, which is why it is locked in a vicious circle where rising yields make default more likely, leading to even higher yields (Chart 15). The fact that GDP per capita in Italy is no higher now than when the country adopted the euro in 1999, and Italian public support for euro area membership is lower than elsewhere, has only added fuel to investor concerns (Chart 16). Chart 15When A Lender Of Last Resort Is Absent, Multiple Equilibria Are Possible Who Suffers When The Fed Hikes Rates? Who Suffers When The Fed Hikes Rates? Chart 16Italy: Neither Divine Nor A Comedy Italy: Neither Divine Nor A Comedy Italy: Neither Divine Nor A Comedy As we go to press, rumours are swirling that the Five Star Movement and Lega may be able to form a government after agreeing to appoint a less euroskeptic finance minister than the one the Italian President previously rejected. Regardless of whether this happens, investors are likely to remain on edge. Support for Lega has risen by seven percent since voters went to the polls in March. Populism is here to stay. All this suggests that the brewing crisis in Italy will not blow over easily. Investors focused on capital preservation should remain underweight Italian bonds. More speculatively-minded investors should consider opening a long position in BTPs versus bunds, but not before the Italian 10-year yield reaches 4%. At that point, the risk-reward trade-off from owning Italian debt would be too good to ignore. Until the Italian bond market reaches a capitulation point, the euro will remain under pressure. The Italian sovereign debt market is the biggest in Europe and the fourth largest in the world after the U.S., Japan, and China. If foreign investors continue to shun Italian debt, that will reduce capital inflows into the euro area. This means less demand for the common currency. Investment Conclusions The softening of global growth this year, along with tensions in emerging markets and Italy, have lit a fire under the dollar. Our long DXY trade is up 10.7% inclusive of carry. We continue to think that the path of least resistance for the dollar is up, but we will be looking to book gains on our trade recommendation once the dollar index reaches 96. That's roughly 2% above current levels. Slower global growth is bad news for cyclical equities. European and Japanese equities have a greater tilt towards cyclical sectors, so it is likely that their stock markets will underperform the U.S. over the next few months. This is particularly the case for Europe, where banks have come under pressure due to slower domestic growth, rising bond yields in Italy and Spain, and heightened exposure to emerging markets. For now, our MacroQuant model, which is designed to capture short-term movements in the stock market, is recommending a somewhat below-benchmark allocation to equities. Looking further out, our 12-month cyclical view on stocks remains modestly constructive, reflecting our expectation that the next major recession in developed markets is still two years away. Keep in mind that even the EM crisis in the 1990s did not plunge the U.S. into recession. On the contrary, the crisis restrained the Fed from raising rates too quickly. The resulting dose of liquidity led to a massive blow-off rally in equities, which took the S&P 500 up 68% between October 1998 and March 2000. European stocks did even better during that period, outperforming their U.S. peers by 40% in local-currency terms. We may be heading for a similar sequence of events. 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 The original Taylor Rule introduced by John Taylor in 1992 assigns a coefficient of 0.5 on the output gap. Thus, a one hundred basis-point rise in interest rates would be necessary to offset a 2% of GDP increase in output. 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