Asset Allocation

Special Report

According to market lore, one should never say, "It's Different This Time". But every time is always different: there is a never a previous period that perfectly matches the current environment. That is why forecasting is so difficult and why all model-based predictions should be treated with caution. Yet, some basic common sense can go a long way in helping to assess investment risks and potential rewards. As I look at the world, it looks troubled enough to warrant a very conservative investment stance, but that clearly puts me at odds with the majority of investors. In aggregate, investors and market analysts are upbeat. Major equity indexes are close to all-time highs, earnings expectations are ebullient and surveys of investor sentiment do not imply much concern about the outlook. There is a strong consensus that a U.S. recession will not occur before 2020, meaning that risk assets still have decent upside. That may indeed turn out to be true, but I can't shake off my concerns about a number of issues: The consensus may be too complacent about the timing of the next U.S. recession. The dark side of current strong growth is growing capacity pressures that warn of upside surprises for inflation and thus interest rates. Uncertainty about trade wars represents a risk to the global economic outlook beyond the direct impact of tariffs because it also gives companies a good reason to hold back on investment spending. Profit growth in the U.S. has remained much stronger than I expected, but the forces driving this performance are temporary. Rising pressures on wages suggest that labor's share of income will rise, leading to lower margins. The geopolitical environment is ugly, ranging from a shambolic Brexit process to rising populist pressures in Europe, a flaring in U.S./Iran tensions and possible disappointment with North Korea negotiations. The Debt Supercycle may be over, but global debt levels remain worryingly high in several major economies. This could become a problem in the next economic downturn. It would be easier to live with the above concerns if markets were cheap, but that is far from the case - especially in the U.S. Credit spreads in the corporate bond market are below historical averages while equities continue to trade at historically high multiples to earnings. Even if equity prices do move higher, the upside from current levels is likely to be limited. Yes, there could be a final, dramatic blow-off phase similar to that of the late 1990s, but that would be an incredibly risky period and not one that I would want to participate in. Timing The Next Recession Sad to say, economists do a very poor job of forecasting recessions. As I showed in a report published last year, the Fed has missed every recession in the past 60 years (Table 1).1 One could argue that the Fed could never publish a forecast of recession because it would be an admission of policy failure: they generally have to be seen aiming for soft landings. But private forecasters have not done any better. For example, the consensus of almost 50 private forecasters published in mid-November 2007 was that the U.S. economy would grow by 2.5% in the year to 2008 Q4.2 The reality was that the economy was then at the precipice of its worst downturn since the 1930s. Table 1Fed Economic Forecasts Versus Outcome The U.S. economy currently is very strong, but that often is the case just a few quarters before a recession starts. Strong growth today is not a predictor of future strong growth. As has been widely acknowledged, the yield curve has been one of the few indicators to give advance warning of economic trouble ahead. Yet, in the past, its message typically was ignored or downplayed, with the result that most forecasters stayed too bullish on the economy for too long. History is repeating itself with a flurry of reports explaining why the recent flattening of the yield curve is giving a misleading signal. The principal argument is that term premiums have been artificially depressed by the Fed's bond purchases. However, the curve has flattened even as the Fed has pulled back from quantitative easing. As usual, the flattening reflects the tightening in monetary policy and, therefore, should not be discounted. To be fair, there is still a positive slope across the curve, so this indicator is not yet flashing red. But it is headed in that direction (Chart 1). Chart 1Recession Indicators: Not Flashing Red...Yet The other series to watch closely is the Conference Board's Leading Economic Index. Typically, the annual rate of change in this index turns negative ahead of recessions, although once again, there is a history of forecasters ignoring or downplaying the message of this signal. Currently, the growth in the index is firmly in positive territory, so no alarm bells are ringing. Overall, there are no indications that a U.S. recession is imminent. At the same time, late cycle pressures and thus risks are building. Anecdotal evidence abounds of labor shortages and supply bottlenecks in a number of industries. Wage growth has stayed relatively muted given the low unemployment rate, but that is starting to change. My colleague Peter Berezin has shown compelling evidence of a "kinked" relationship between wage growth and unemployment whereby the former accelerates noticeably after the latter drops below its full employment level (Chart 2). We are at the point where wage growth should accelerate and it is significant that the 2.8% rise in the employment cost index in the year to the second quarter was the largest rise in a decade. It also should be noted that the Fed's preferred inflation measure (the core personal consumption deflator) has been running at around a 2% pace in the past three quarters, in line with its target (Chart 3). As capacity pressures build, an overshoot of 2% seems inevitable, forcing the Fed to react. Current market expectations that the funds rate will rise by only 25 basis points over the remainder of this year and by 100 basis points in 2019 are likely to prove too optimistic. Chart 2Faster Wage Growth Ahead Chart 3Core Inflation At The Fed's Target Admittedly, there is huge uncertainty about what interest rate level will be restrictive enough to damage growth. Historically, recessions did not occur until the fed funds rate reached at least the level of potential GDP growth. The Congressional Budget Office estimates that potential GDP growth will average around 4% over the coming year, and the funds rate probably will not reach that level in 2019. However, additional restraint is coming from the strong dollar, and lingering high debt burdens mean that rates are likely to bite at lower levels than past relationships would suggest. Chart 4U.S. Trade Performance: No Major Surprises Trade Wars Etc. President Trump appears to believe that the large U.S. trade deficit is largely a reflection of unfair trade practices. The reality is obviously more complicated, even if there is truth to the claim that the playing field with China is far from level. The key drivers of trade imbalances are relative economic growth rates and relative real exchange rates. The trend in the volume of U.S. non-oil merchandise imports has been exactly in line with that of domestic demand for goods (Chart 4). In other words, there is no indication that the U.S. is being "taken advantage of". The growth in U.S. non-oil exports has been a little on the soft side relative to overseas growth in recent years, but that occurred against the background of a rising real dollar exchange rate. Overall, the trend in the ratio of U.S. real non-oil imports to exports has broadly followed the ratio of U.S. real GDP to that of other OECD economies. The periods where the trade ratio deteriorated somewhat faster than the GDP ratio were times when the real trade-weighted dollar was strong, such as in the past few years. The irony, which seems to escape the administration, is that recent policy actions - tax cuts and efforts to boost private investment spending - are bound to further boost the trade deficit. This may partly explain the clumsy attempt to encourage the Fed to slow down its rate hikes in order to dampen the dollar's ascent. Of course, that will not work - the Fed will not be deflected from its policy course by political interference. Meanwhile, the administration's imposition of tariffs will not change the underlying drivers of the U.S. trade deficit. I have no way of knowing whether current trade skirmishes will degenerate into an all-out war. There are some glimmers of hope with the EU and U.S. promising to engage in talks about reducing trade barriers. But the more important issue is what happens with China. While China has an economic incentive to make concessions, I cannot imagine that President Xi wants to be seen as giving ground in the face of U.S. bullying. My rather unhelpful conclusion is that trade wars are a serious risk that need watching but are unforecastable at this stage. Earnings Galore, But... It's confession time. The performance of U.S. corporate earnings has been far better than I have been predicting during the past few years. In several previous reports, I argued that earnings growth was bound to slow sharply as labor's share of income eventually climbed from its historically low level. I certainly had not expected that the annual growth in S&P 500 operating earnings would average 20% in the two years to 2018 Q2 (Chart 5). In defense, my original argument was not completely wrong. Labor's share of corporate income bottomed in the third quarter of 2014 and that marked the peak in margins, based on national income data of pre-tax profits (Chart 6). Margins have fallen particularly sharply for the national income measure of non-financial profits before interest, taxes and depreciation (EBITD). I believe this is a good measure of the underlying performance of the corporate sector as it is unaffected by policy changes to taxes, depreciation rates and monetary policy. This measure of margins used to be very mean reverting but currently is still far above its historical average. Given the tightness in the labor market, there is still considerable downside in margins as wage costs edge higher. Chart 5Spectacular U.S. Earnings Growth Chart 6Profit Margins Have Peaked An unusually large gap has opened up in recent years between S&P earnings data and the national accounts numbers. While there are several definitional differences between the two datasets, this cannot explain the large divergence shown in Chart 7. The national income data are generally believed to be less susceptible to accounting gimmicks and are thus a better reflection of underlying trends. Analysts remain extraordinarily bullish on future earnings prospects. Not only are S&P 500 earnings forecast to rise a further 14% over the next 12 months, but the current expectation of 16% per annum long-run earnings growth was only exceeded at the peak of the tech bubble (Chart 8). And we know how that episode ended! Chart 7A Strange Divergence in Profit Data Chart 8Insanely Bullish Long-Term Earnings Expectations I am inclined to stick to my view that earnings surprises will disappoint over the next year. The impact of corporate tax cuts will disappear, and both borrowing costs and wage growth are headed higher. A marked slowdown in earnings growth will remove a major prop under the bull market. Brexit As a Brit, I am totally appalled with the Brexit fiasco. It was all so unnecessary. Yes, the EU has an intrusive bureaucracy that imposes some annoying rules and regulations on member countries. However, OECD data show that the U.K. is one of the world's least regulated economies and it scores high in the World Bank's Ease of Doing Business rankings. In other words, there is no compelling evidence that EU bureaucratic meddling has undermined business activity in the U.K. The vote for Brexit probably had more to do with immigration than anything else, and that also makes little sense given that the U.K. has a tight labor market and needs a plentiful supply of immigrant workers. History likely will dictate that former Prime Minister David Cameron's decision to call for the Brexit referendum was the U.K.'s greatest political miscalculation of the post-WWII period. Not only was the decision to hold the referendum a mistake, but it also was foolhardy to base such a momentous vote on a simple majority rather than a super-majority of at least 60%. Adjusting the referendum result by voter turnout, those backing Brexit represented only around 37% of the eligible voting public.3 Clearly, the government was unprepared for the vote result and divorce proceedings have moved ahead with no viable plan to achieve an acceptable separation. Meanwhile, the inevitable confusion has created huge uncertainty for businesses and is doing significant damage to the economy. This is not the place to get into the minutiae of the Brexit morass such as the Northern Ireland border issue and the difficulty of agreeing new trade relationships. Those have been well aired in the press and by many other commentators. My lingering hope is that the enormous challenges of coming up with a mutually acceptable deal with the EU will prove intractable, resulting in a new referendum or election that will consign the whole idea to its grave. We should not have to wait too long to discover whether that is a futile wish. Investment Strategy Chart 9The U.S. Equity Market Is Expensive Equities are still in a bull market and we are thus in a period where investors are biased to be optimistic. Bears have been discredited and the current strength of the economy gives greater credence to the market's cheerleaders. I have been in the forecasting business for long enough (45+ years) to be suitably humble about my ability to forecast where markets are headed. I am very sympathetic to the famous Keynes quote that "the market can stay irrational longer than you can stay solvent". Investors will have their own set of preferences and constraints about whether it makes sense to stay heavily invested during times when markets appear to have diverged from fundamentals. The U.S. equity market's price-earnings ratio (PER) currently is about 20% above historical averages, based on both trailing and 12-month forward earnings and more than 30% above based on cyclically-adjusted earnings (Chart 9). Yes, interest rates are low by historical standards, giving scope for higher PERs, but rates are going up and profit margins are at historically elevated levels with lots of downside potential. I fully accept that equity markets can continue to rise over the next year, beating the meagre returns available from cash and bonds. For those investors being measured by quarterly performance, it is difficult to stay on the sidelines while prices march higher. Nevertheless, I believe this is a time for caution. The perfect time for equity investing is when markets are cheap, earnings expectations are overly pessimistic and the monetary environment is highly accommodative. Currently, the opposite conditions exist: valuations are stretched, earnings expectations are euphoric and the Fed is in tightening mode. It does not seem a propitious time to be aggressive. The future is always shrouded in mist, but there currently is an unusually large number of important economic and political questions hanging over the market. These include the timing of the next recession, the related path of monetary policy, the outcome of the U.S. midterm elections, trade wars, U.S.-Sino relations and Brexit, just to name a few. The good news is that our Annual Investment Conference on September 24/25 will be tackling these issues head on with an incredible group of experts. I am looking forward to hearing, among others, from Janet Yellen on monetary policy, Leland Miller and Elizabeth Economy on China, Greg Valliere on U.S. politics, and Stephen King and Stephen Harper on global trade. It promises to be an exceptional event and I hope to see you there. Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com 1 BCA Special Report "Beware The 2019 Trump Recession," March 7, 2017. Available at bca.bcaresearch.com. 2 Source: Federal Reserve Bank of Philadelphia, Survey of Professional Forecasters (www.philadelphiafed.org). 3 The referendum result was 51.9% in favor of Brexit, with a voter turnout of close to 72%.

Highlights Global QE has made bonds as risky as equities. Thereby, global QE has forced investors to accept identically depressed returns from equities and from bonds, requiring equity and other risk-asset valuations to surge. The good news is that record high valuations of risk-assets are fully justified if global bond yields remain at current levels or fall. The bad news is that risk-asset valuations will become dangerously unstable if global bond yields march much higher. The 'rule of 4' for equity/bond allocation: sum the three 10-year yields - the German bund, the U.S. T-bond, and the JGB. Above 3.5 means a neutral stance in equities... ... Above 4 means it's time to go underweight equities and overweight bonds. Feature Chart of the WeekAt Higher Bond Yields, The Correlation With Equity Prices Has Flipped From Positive To Negative The end is nigh for QE. The ECB will exit its asset purchase program at the end of the year. In doing so, it will mark the end of an epoch which began in the aftermath of the global financial crisis, a ten year period in which at least one of the world's major central banks has been buying a defined quantity of assets every month (Chart I-2). Approaching the end of the epoch, it is fitting to ask: how did the global QE stimulant work, and what will be the withdrawal symptoms? Chart I-2The End Is Nigh For QE As far back as 2011, in a provocative report titled QE And Riots we predicted that: "QE... will exacerbate already extreme income inequality and the consequent social tensions that arise from it" Events in the subsequent seven years have fully vindicated our prediction. Simply put, QE has front-loaded asset returns which would ordinarily have accrued in the distant future to the here and now - in the form of sharply higher capital values. So if you were invested in the financial markets or most housing markets, congratulations, you have received a bonanza; if you weren't, bad luck, there's not much left for you (Chart I-3). Chart I-3Equities Are Now Priced To Generate A Measly Long-Term Return To understand why, we need to delve deeper into behavioural economics. QE: Why The Stimulant Was So Powerful Central banks admit that there is a lower bound for interest rates below which there would be an exodus of bank deposits. Once policy rates hit the lower bound, central banks can unleash a 'plan B': a commitment to keep policy rates at this lower bound for an extended period. QE is simply a powerful signalling tool for this commitment. As ECB Chief Economist Peter Praet explains: "There is a signalling channel inherent in asset purchases, which reinforces the credibility of forward guidance on policy rates. This credibility of promises to follow a certain course for policy rates in the future is enhanced by the asset purchases, as these asset purchases are a concrete demonstration of our desire (to keep policy rates at the lower bound)" The credible commitment to keep policy rates near the lower bound for an extended period depresses bond yields towards the lower bound too (Chart I-4). Chart I-4The Credible Commitment To Keep Policy Rates##br## Low Pulls Down Bond Yields Now comes the part of the story that is not well understood, even by central bankers, because it derives from recent breakthroughs in behavioural economics. When bond yields approach the lower bound, the asymmetry in their future direction makes bonds very risky investments. The short-term potential for capital appreciation - nominal or real - vanishes, while the potential for vicious losses increases dramatically (Chart I-5). The technical term for this unattractive asymmetry is negative skew. Years of research in behavioural economics has led Nobel Laureate Professor Daniel Kahneman to conclude: negative skew is the measure that best encapsulates our perception of an investment's risk. Chart I-5Bonds Become Much Riskier ##br## At Low Bond Yields Professor Kahneman's work reveals a profound truth: global QE has made bonds as risky as equities (Chart I-6). The ramification is that equities and other risk-assets no longer need to lure investors with an excess return over bond returns. QE has forced investors to accept identically depressed returns from equities and from bonds, requiring equity and other risk-asset valuations to surge.1 Chart I-6Global QE Has Made Bonds ##br##As Risky As Equities One counterargument we hear is that bonds offer investors a diversification benefit and, because of this, investors will still accept a lower return from bonds. But this argument is flawed. Just as bonds are a diversifier for equity investors, equities are a diversifier for bond investors. Indeed in recent years, equities have protected bond investors during vicious sell-offs in the bond market such as after Trump's shock victory in 2016. So we could equally argue that equities require the lower return. In fact, with the same negative skew and symmetrical diversification properties, both assets must offer the same prospective return. The breakthroughs in behavioural economics provide some good news and some bad news. The good news is that record high valuations of risk-assets are fully justified if bond yields remain at current levels or fall. The bad news is that risk-asset valuations will become dangerously unstable if bond yields march much higher (Chart I-7). Chart I-7At Low Bond Yields The Required Return On ##br##Equities Plunges, So Equity Valuations Surge Financial Markets Dwarf The World Economy One common misunderstanding about QE is that it has been the bond purchasing itself that has held down bond yields. This seems a natural assumption because we connect the act of buying with higher prices (lower yields). Moreover, the $10 trillion of bonds that the 'big four' central banks have bought is not far short of the size of the euro area economy. But let's put this into context. The global bond market exceeds $100 trillion. Long-term bank loans amount to something similar. In this $217 trillion2 global fixed income market, $10 trillion of QE is peanuts. To reiterate, QE's impact came not from the $10 trillion of central bank purchases in itself, but from the signal that interest rates would remain at the lower bound for a long time, mathematically requiring bond yields to approach the lower bound too;3 and from the consequent equalization of negative skew on bonds and risk-assets, mathematically requiring an exponential rerating of all risk-asset valuations (Chart I-8). Chart I-8Equities Are Now Priced To Generate A Measly Long-Term Return Now note that the combination of equities and correlated risk-assets such as corporate and EM debt is worth around $160 trillion, and real estate is worth $220 trillion. World GDP is worth much less, around $80 trillion. So if returns from these richly valued risk-assets were reallocated from the here and now back to the distant future, through lower capital values today, there would be a very real risk that current spending could take a dive. Supporting this broad thesis, central bank measures of 'financial conditions easiness' are just tracking the level of the stock market (Chart I-9). Chart I-9Financial Conditions Are Just##br## Tracking The Stock Market The 'Rule Of 4' For Equities And Bonds On February 1 this year, we advised that the big threat to risk-asset valuations "comes from the global 10-year bond yield rising to 2% - broadly equivalent to the German 10-year bund yield rising to 1% or the U.S. 10-year T-bond yield rising to 3%." This advice has proved to be remarkably prescient. Whenever bond yields have been at the lower end of recent ranges, the correlation with equities has been positive, meaning equities have risen in tandem with bond yields. But whenever bond yields have moved to the upper end of recent ranges, the correlation has abruptly flipped to negative, meaning equities have fallen as bond yields have risen (Chart of the Week). While many strategists and commentators are fixated on the risks from trade wars and/or the global economy, our non-consensus call is that the biggest threat to risk-assets comes from rich valuations which will become dangerously unstable if bond yields march much higher. In this regard the bond yield that matters is the global bond yield. Previously we defined this in terms of the German 10-year bund yield and the U.S. 10-year T-bond yield. But today for completeness, we would like to add another important component: the Japanese 10-year government bond yield. The global bond yield is a weighted average of the three components. But for a useful rule of thumb, just sum the three 10-year yields - the German bund, the U.S. T-bond, and the JGB. A sum above 3.5 means a neutral stance to equities. A sum above 4 - which broadly equates to the global yield rising above 2% - means it's time to go underweight equities and overweight bonds. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Consider what happens to valuations when bond yields decline from 4% to 2%. At a 4% bond yield, equities possess significantly more negative skew than 10-year bonds. So investors will demand a comparatively higher return from equities, let’s say 8% a year. Whereas, at a 2% bond yield, equities and 10-year bonds possess the same negative skew. So investors will demand the same return from equities as they can get from bonds, 2% a year. At the lower bond yield, the bond must deliver 2% a year less for ten years compared to previously, meaning its price must rise by 22%. But equities must deliver 6% a year less for ten years, so the equity market must surge by 80%. 2 Source: The Institute of International Finance (IIF) https://www.iif.com/publication/global-debt-monitor/global-debt-monitor-june-2017 3 In contrast, if the market feared bond purchases would cause inflation and thereby imply a higher path of interest rates, QE would push up bond yields! Fractal Trading Model* This week we note that the underperformance of emerging market versus developed market equities is technically stretched and ripe for at least a brief countertrend reversal. The 65-day trade is long EM versus DM with a profit target of 2.5% and a symmetrical stop-loss. 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-10 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 Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Feature GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of July 31, 2018. The quant model lifted its U.S. allocation to be in line with the benchmark weight at the expense of Spain. No major changes in other country weights, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 59 bps in July, largely driven by Level 2 model which outperformed its benchmark by 146 bps. Level 1 model slightly unperformed its MSCI world benchmark by 5 bps in July. Since going live, the overall model has outperformed its benchmarks by 132 bps, driven by the Level 2 outperformance of 375 bps offset by the 2 bps of Level 1 underperformance. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) 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 July 31, 2018. Following the developments on the trade front and increasing worries of a growth slowdown, the model continues to maintain a defensive bias with an aggregate overweight of 5.8% relative to cyclical sectors. The relative tilts within cyclicals and defensives remain the same as the previous month. However, both discretionary and financials are going through unfavorable technical and momentum indicators. Energy remains the only resource based sector with an overweight, primarily driven by attractive long-term valuations. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," dated July 27, 2016, available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Aditya Kurian, Senior Analyst adityak@bcaresearch.com

Feature Downside Risks Haven't Gone Away We downgraded risk assets to neutral in last month's Quarterly Portfolio Outlook,1 citing an increasing number of risks to the equity bull market. Specifically, we warned about the slowdown and desynchronization of global growth, rising U.S. inflation, further deterioration in the trade war, and the ongoing slowdown in China. Markets - particularly in the U.S. - have stabilized somewhat over the past few weeks on the expectation that these risks are not particularly grave, that global growth remains robust, and that central banks will be slow to tighten. We accept that there remain upside risks (which is why we are neutral, not underweight, equities) but think many investors remain too sanguine about the downside risks. On desynchronized growth, it is true that the slowdown in the euro zone seems to have bottomed. The Citi Economic Surprise Indexes (Chart 1) suggest that downward surprises to euro zone and Japanese growth have ended, and that the U.S. is no longer surprising significantly to the upside. However, the likely path of inflation in the two regions looks very different, with U.S. core PCE inflation likely headed towards 2.5% over the next few quarters, while euro zone core inflation is stuck around 1% (Chart 2). Table 1Recommended Allocation Chart 1A Resynchronization Of Growth? Chart 2Core Inflation: Higher In The U.S. Than In The Euro Zone In particular, we think it is only a matter of time before U.S. wages start to accelerate. Unemployment has not been this low since the late 1960s. As happened then, there is typically a lag between the labor market becoming tight and inflation emerging (Chart 3). With the employment/population ratio for the key working-age demographic now back close to its 2007 level (Chart 4), and 601,000 new entrants to the labor force last month alone, that point is probably not far away. Note, too, that people switching jobs are now seeing large wage rises; those staying are not (Chart 5). With strong corporate profit growth, companies will soon start to raise wages to keep staff and fill vacancies. Chart 3Just A Matter Of Time Before Inflation Accelerates Chart 4Little Slack Left In The Labor Market Chart 5Switchers Getting Wage Rises; Stayers Not This all suggests that markets are too nonchalant about the risk of further Fed tightening. The futures market is pricing in only four rate hikes from the Fed over the next 24 months (Chart 6). We think it likely that the Fed will continue to hike by 25 basis points a quarter until something gives. By contrast, the ECB has clearly signaled that it will wait until at least September next year before raising rates; when it does so, it may hike by only 10 basis points. The futures market is close to pricing this correctly (Chart 6, panel 2). We remain concerned about further exacerbation of the retaliatory tariff war. In late July, the European Union and President Trump seemed to agree a truce, especially with regard to auto tariffs. But, even if this proves more than transitory, it is unlikely to be repeated between the U.S. and China. Both sides have raised the stakes so much that it will be politically difficult for either to back down. Further aggressive moves are likely, including a 10% tariff on all USD500 billion of Chinese imports into the U.S, and the Chinese authorities engineering a further depreciation of the Chinese yuan, and making life difficult for U.S. companies that manufacture and sell in China (where their sales total USD350 billion). Businesses around the world have woken up to this risk: capex intentions among U.S. companies have slipped recently and, in the Global ZEW survey, future expectations are now the lowest relative to current conditions since 2007, a bearish indicator (Chart 7). Chart 6Fed Is Likely To Hike more Than This Chart 7Businesses Expect Things To Get Worse Moreover, we don't see China launching a massive reflationary stimulus, as it did in 2009 and 2015. In the past few weeks, it has announced some minor easing of monetary policy, targeted tax cuts, and an acceleration of this year's fiscal spending. This will be enough to cushion the downside. But interest rates have not fallen anything like as much as in previous episodes (Chart 8). The authorities have reiterated that structural reform remains the priority. Given the significant slowdown in credit growth over the past year, we expect a further deceleration in the Chinese industrial economy (and, therefore, in imports) through the end of the year. If our macro outlook is correct, it is likely to have the following consequences for financial markets: further rises in long-term interest rates (we forecast 3.3-3.5% for the 10-year U.S. Treasury bond yield by early 2019), a further appreciation of the U.S. dollar (as monetary policy divergences with the euro area and Japan widen further), and negative performance for emerging market assets (hurt by higher U.S. rates, the rising USD, and the slowdown in China). This points to small negative returns from global government bonds over the next 12 months. Equities are more complicated. Earnings growth remains strong. If S&P500 companies really achieve the 20% EPS growth this year and 10% next year that analysts (and BCA's models) are forecasting, the forward multiple will fall from 16.5x now to 14.0x by end-2019. We would expect to see low single-digit positive returns from global equities over the rest of the year. We accordingly remain neutral on equities, where we can see both upside and downside risks. One key is the timing of the peak in profit margins. This has typically come a few quarters before the start of a recession. Currently margins continue to improve (Chart 9). They are likely to peak around the end of this year, when wages (and input prices, partly because of higher import tariffs) begin to rise faster than sales. We expect to move underweight equities around that time, when this and other recession indicators start to flash warning signals. Chart 8Not 2015 Redux In China Chart 9Watch For The Peak In Profit Margins Currencies: The outlook for the USD remains the key to the performance of other asset classes, particularly emerging markets and commodities. We see the risk of a short-term pullback, since long speculative positions in the dollar have recently built up (Chart 10). But differences in growth, inflation, monetary policy, and long-term rates between the U.S. and other developed economies suggest further moderate dollar appreciation over the coming 12 months. We remain very negative on EM currencies. Central banks in many emerging markets have been forced to raise rates sharply in recent weeks to defend their currencies. This is likely to slow growth over coming quarters. Those central banks that have resisted hiking (for example, Turkey and Brazil) are likely to see sharp rises in inflation. Equities: We prefer developed market equities over emerging ones. Our two overweights are the U.S. and Japan. The U.S. is a defensive market, with a beta to global equities of only 0.9 over the past 20 years. But, if there were to be a last-year equity market melt-up (along the lines of 1999), it is likely to be led by internet stocks, in which the U.S. is particularly overweight, and so the U.S. overweight also acts as a hedge against this upside risk. Our overweight in Japan is based on our view that the Bank of Japan will continue its ultra-accommodative monetary policy (bolstered by the recent tweaks to the operation of the policy), even while other DM central banks are moving towards tightening. There are also some signs of wage growth picking up, which should be positive for consumer sectors. Fixed Income: We remain underweight bonds and, within the asset class, are neutral between government bonds and spread product. U.S. junk bonds continue to have some attraction as long as economic growth remains strong (and the oil price does not fall). But junk bonds typically peak one or two quarters before equities. And, in this cycle, U.S. corporate leverage began to rise rather early, which suggests that at the start of the next recession leverage will be worryingly high (Chart 11) and that junk bonds will, therefore, perform particularly poorly. Chart 10Dollar Long Positions Building Up Again Chart 11Leverage Is High For This Stage Of The Cycle Commodities: Oil has become much harder to forecast in recent weeks, with downside risk to the price of crude coming from the recently announced OPEC production increases, but upside risk from Iran (which is threatening to close the straits of Hormuz in the face of renewed U.S. sanctions) and the collapse in Venezuelan production. BCA's energy strategists see Brent falling a little to average USD70 a barrel in 2H, and at USD75 on average next year, with greater risk of upside surprises than downside.2 Industrial metals prices are likely to remain under pressure if the USD appreciates and China slows further, as evidenced by significant downside moves in copper, iron ore and other metals over the past few weeks. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Global Asset Allocation Quarterly Portfolio Review, "Lowering Risk Assets To Neutral," dated 2 July 2018, available at gaa.bcaresearch.com 2 Please see Commodity & Energy Strategy Special Report, "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," dated 19 July 2018, available at ces.bcaresearch.com GAA Asset Allocation

Special Report

Dear Client, This week I am sending you a Special Report written by Mark McClellan, Chief Strategist of the monthly Bank Credit Analyst. Mark deals with the implications of the U.S./Sino trade war for U.S. equity sectors. He identifies the next products to be targeted with higher tariffs on both sides of the dispute. A higher U.S. tariff wall will shield some industries from competition, but rising input costs will be widely felt because of extensive supply chains between and within industries. There is only a small handful of industries that will be winners in absolute terms. I trust you will find his report very informative. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Highlights In this Special Report, we shed light on the implications of the U.S./Sino trade war for U.S. equity sectors. The threat that trade action poses to the U.S. equity market is greater than in past confrontations. Perhaps most importantly, supply chains are much more extensive, globally and between the U.S. and China. Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The USTR claims that it is being strategic in the Chinese goods it is targeting, focusing on companies that will benefit from the "Made In China 2025" initiative. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad import categories. The only major items left for the U.S. to hit are apparel, footwear, toys and cellphones. Beijing is clearly targeting U.S. products based on politics in order to exert as much pressure on the President's party as possible. Based on a list of products that comprise the top-10 most exported goods of Red and Swing States, China will likely lift tariffs in the next rounds on civilian aircraft, computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits. Supply chains within and between industries and firms mean that the impact of tariffs is much broader than the direct impact on exporters and importers. We measure the relative exposure of 24 GICs equity sectors to the trade war based on their proportion of foreign-sourced revenues and the proportion of each industry's total inputs that are affected by U.S. tariffs. The Semiconductors & Semiconductor Equipment sector stands out, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. China may also attempt to disrupt supply chains via non-tariff barriers, placing even more pressure on U.S. firms that have invested heavily in China. Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance are most exposed. U.S. technology companies are particularly vulnerable to an escalating trade war. Virtually all U.S. manufacturing industries will be negatively affected by an ongoing trade war, even defensive sectors such as Consumer Staples. The one exception is defense manufacturers, where we recommend overweight positions. Our analysis highlights that the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, and the S&P Financial Exchanges & Data subsector is one of our favorites. Feature The trade skirmish is transitioning to a full-on trade war. The U.S. has imposed a 25% tariff on $50 billion worth of Chinese goods, and has proposed a 10% levy on an additional $200 billion of imports by August 31. China retaliated with tariffs on $50 billion of imports from the U.S., but Trump has threatened tariffs on another $300 billion if China refuses to back down. That would add up to over $500 billion in Chinese goods and services that could be subject to tariffs, only slightly less than the total amount that China exported to the U.S. last year. BCA's Geopolitical Strategy has emphasized that President Trump is unconstrained on trade policy, giving him leeway to be tougher than the market expects.1 This is especially the case with respect to China. There will be strong pushback from Congress and the U.S. business lobby if the Administration tries to cancel NAFTA. In contrast, Congress is also demanding that the Administration be tough on China because it plays well with voters. Trump is a prisoner of his own tough pre-election campaign rhetoric against China. The U.S. primary economic goal is not to equalize tariffs but to open market access.2 The strategic goal is much larger. The U.S. wants to see China's rate of technological development slow down. Washington will expect robust guarantees to protect intellectual property and proprietary technology before it dials down the pressure on Beijing. The threat that the trade war poses to the U.S. equity market is greater than in past confrontations, such as that between Japan and the U.S. in the late 1980s. First, stocks are more expensive today. Second, interest rates are much lower, limiting how much central banks can react to adverse shocks. Third, and perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Nearly every major S&P 500 multinational corporation is in some way exposed to these supply chains. Chart 1 shows that Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The Global Value Chain Participation rate, constructed by the OECD, is a measure of cross-border value-added linkages.3 Chart 1Measuring Global Supply Chains In this Special Report, we shed light on the implications of the trade war for U.S. equity sectors. Complex industrial interactions make it difficult to be precise in identifying the winners and losers of a trade war. Nonetheless, we can identify the industries most and least exposed to a further rise in tariff walls or non-tariff barriers to trade. We focus on the U.S./Sino trade dispute in this Special Report, leaving the implications of a potential trade war with Europe and the possible failure of NAFTA negotiations for future research. Trade Channels There are at least five channels through which rising tariffs can affect U.S. industry: 1. The Direct Effect: This can be positive or negative. The impact is positive for those industries that do not export much but are provided relief from stiff import competition via higher import tariffs. The impact is negative for those firms facing higher tariffs on their exports, as well as for those firms facing higher costs for imported inputs to their production process. These firms would be forced to absorb some of the tariff via lower profit margins. Some industries will fall into both positive and negative camps. U.S. washing machines are a good example. Whirlpool's stock price jumped after President Trump announced an import tariff on washing machines, but it subsequently fell back when the Administration imposed an import tariff on steel and aluminum (that are used in the production of washing machines); 2. Indirect Effect: The higher costs for imported goods are passed along the supply chain within an industry and to other industries that are not directly affected by rising tariffs. This will undermine profit margins in these indirectly-affected industries to the extent that they cannot fully pass along the higher input costs; 3. Foreign Direct Investment: Some Chinese exports emanate from U.S. multinationals' subsidiaries in China, or by Chinese or foreign OEM suppliers for U.S. firms. Even though it would undermine China's economy to some extent, the Chinese authorities could make life more difficult for these firms in retaliation for U.S. tariffs on Chinese goods. 4. Macro Effect: A trade war would take a toll on global trade and reduce GDP growth globally. Besides the negative effect of uncertainty on business confidence and, thus, capital spending, rising prices for both consumer and capital goods will reduce the volume of spending in both cases. Moreover, corporate profits have a high beta with respect to economic activity. We would not rule out a U.S. recession in a worst-case scenario. Obviously, a recession or economic slowdown would inflict the most pain on the cyclical parts of the S&P 500 relative to the non-cyclicals, in typical fashion. 5. Currency Effect: To the extent that a trade war pushes up the dollar relative to the other currencies, it would undermine export-oriented industries and benefit those that import. However, while we are bullish the dollar due to diverging monetary policy, the dollar may not benefit much from trade friction given retaliatory tariff increases by other countries. Some of the direct and indirect impact can be mitigated to the extent that importers facing higher prices for Chinese goods shift to similarly-priced foreign producers outside of China. Nonetheless, this adjustment will not be costless as there may be insufficient supply capacity outside of China, leading to upward pressure on prices globally. Targeted Sectors: (I) U.S. Tariffs On Chinese Goods As noted above, the U.S. has already imposed tariffs on $50 billion of Chinese imports and has published a list of another $200 billion of goods that are being considered for a 10% tariff in the second round of the trade war. The first round focused on intermediate and capital goods, while the second round includes consumer final demand categories such as furniture, air conditioners and refrigerators. The latter will show up as higher prices at retailers such as Wal Mart, having a direct and visible impact on U.S. households. Appendix Table 1 lists the goods that are on the first and second round lists, grouped according to the U.S. equity sectors in the S&P 500. The U.S. Trade Representative (USTR) claims that the Chinese items are being targeted strategically. It is focusing on companies that will benefit from China's structural policies, such as the "Made In China 2025" initiative that is designed to make the country a world leader in high-tech areas (see below). Table 1 reveals the relative size of the broad categories of U.S. imports from China, based on trade categories. The top of the table is dominated by Motor Vehicles, Machinery, Telecommunication Equipment, Computers, Apparel & Footwear and other manufactured goods. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad categories in Table 1. The only major items left for the U.S. to hit are Apparel and Footwear, as well as two subcategories; Toys and Cellphones. These are all consumer demand categories. Table 1U.S. Imports From China (January-May 2018) (II) Chinese Tariffs On U.S. Goods Total U.S. exports to China were less than $53 billion in the first five months of 2018, limiting the amount of direct retaliation that China can undertake (Table 2). The list of individual U.S. products that China has targeted so far is long, but we have condensed it into the broad categories shown in Table 3. The U.S. equity sectors that the new tariffs affect so far include Food, Beverage & Tobacco, Automobiles & Components, Materials and Energy. China has concentrated mainly on final goods in a politically strategic manner, such as Trump-supported rural areas and Harley Davidson bikes whose operations are based in Paul Ryan's home district in Wisconsin. Table 2U.S. Exports To China (January-May 2018) Table 3China Tariffs On U.S. Goods What will China target next? Chart 2 shows exports to China as percent of total state exports, and Chart 3 presents the value of products already tariffed by China as a percent of state exports. Other than Washington, the four states most targeted by Beijing are conservative: Alaska, Alabama, Louisiana and South Carolina. Chart 2U.S. Exports To China By State Chart 3Value Of U.S. Products Tariffed By China (By State) Beijing is clearly targeting products based on politics in order to exert as much pressure on the President's party as possible. To identify the next items to be targeted, we constructed a list of products that comprise the top-10 most exported goods of Red States (solidly conservative) and Swing States (competitive states that can go either to Republican or Democratic politicians). Appendix Tables 2 and 3 show this list of products, with those that have already been flagged by China for tariffs crossed out. Table 4 shows the top-10 list of products that are not yet tariffed by China, but are distributed in a large proportion of Red and Swing states. What strikes us immediately is how important aircraft exports are to a large number of Swing and Red States. In total, 27 U.S. states export civilian aircraft, engines and parts to China. This is an obvious target of Beijing's retaliation. In addition, we believe that computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits are next. Table 4Number Of U.S. States Exporting To China By Category Market Reaction Chart 4 highlights how U.S. equity sectors performed during seven separate days when the S&P 500 suffered notable losses due to heightened fears of protectionism. Cyclical sectors such as Industrials and Materials fared worse during days of rising protectionist angst. Financials also generally underperformed, largely because such days saw a flattening of the yield curve. Tech, Health Care, Energy and Telecom performed broadly in line with the S&P 500. Consumer Staples outperformed the market, but still declined in absolute terms. Utilities and Real Estate were the only two sectors that saw absolute price gains. Chart 4S&P 500: Impact Of Trade-Related Events The market reaction seems sensible based on the industries caught in the cross-hairs of the trade action so far. At least some of the potential damage is already discounted in equity prices. Nonetheless, it is useful to take a closer look at the underlying factors that should determine the ultimate winners and losers from additional salvos in the trade war. Determining The Winners And Losers The U.S. sectors that garner the largest proportion of total revenues from outside the U.S. are obviously the most exposed to a trade war. For the 24 level 2 GICS sectors in the S&P 500, Table 5 presents the proportion of total revenues that is generated from operations outside the U.S. for the top five companies in the sector by market cap. Company reporting makes it difficult in some cases to identify the exact revenue amount coming from outside the U.S., as some companies regard "domestic" earnings as anything generated in North America. Nonetheless, we believe the data in Table 5 provide a reasonably accurate picture. Table 5Foreign Revenue Exposure (2017) Semiconductors, Tech Equipment, Materials, Food & Beverage, Software and Capital Goods are at the top of the list in terms of foreign-sourced revenues. Not surprisingly, service industries like Real Estate, Banking, Utilities and Telecommunications Services are at the bottom of the exposure list. U.S. companies are also exposed to U.S. tariffs that lift the price of imported inputs to the production process. This can occur directly when firm A imports a good from abroad, and indirectly, when firm A sells its intermediate good to firm B at a higher price, and then on to firm C. In order to capture the entire process, we used the information contained in the Bureau of Economic Analysis' Input/Output tables. We estimated the proportion of each industry's total inputs that are affected by already-implemented U.S. tariffs and those that are on the list for the next round of tariffs. These estimates, shown in Appendix Table 4 at a detailed industrial level, include both the direct and indirect effects of higher import costs. At the top of the list is Motor Vehicles and Parts, where Trump tariffs could affect more than 70% of the cost of all material inputs to the production process. Electrical Equipment, Machinery and other materials industries are also high on the list, together with Furniture, Computers & Electronic Parts and Construction. Unsurprisingly, service industries and Utilities are in the bottom half of the table.4 We then allocated all the industries in Appendix Table 4 to the 24 GICs level 2 sectors in the S&P 500, in order to obtain an import exposure ranking in S&P sector space (Table 6). Chart 5 presents a scatter diagram that compares import tariff exposure (horizontal axis) with foreign revenue exposure (vertical axis). The industries clustered in the top-right of the diagram are the most exposed to a trade war. Table 6U.S. Import Tariff Exposure Chart 5U.S. Industrial Exposure To A Trade War With China The Semiconductors & Semiconductor Equipment sector stands out by this metric, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. Food, Beverage & Tobacco lies between the two extremes. Joint Ventures And FDI Table 7Stock Of U.S. Direct Investment In China (2017) As mentioned above, most U.S. production taking place in China involves a joint venture. The Chinese authorities could attempt to disrupt the supply chain of a U.S. company by hindering production at companies that have ties to U.S. firms. Data on U.S. foreign direct investment (FDI) in China will be indicative of the industries that are most exposed to this form of retaliation. The stock of U.S. FDI in China totaled more than $107 billion last year (Table 7). At the top of the table are Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance. Apple is a good example of a U.S. company that is exposed to non-tariff retaliation, as the iPhone is assembled in China by Foxconn for shipment globally with mostly foreign sourced parts. Our Technology sector strategists argue that U.S. technology companies are particularly vulnerable to an escalating trade war (See Box 1).5 BOX 1 The Tech Sector The U.S. has applied tariffs on the raw materials of technology products rather than finished goods so far. At a minimum, this will penalize smaller U.S. tech firms which manufacture in the U.S. and provide an incentive to move production elsewhere. Worst case, the U.S. tariffs might lead to component shortages which could have a disproportionately negative impact, especially on smaller firms. Although it has not been proposed, U.S. tariffs on finished goods would be devastating to large tech companies such as Apple, which outsources its manufacturing to China. China appears determined to have a vibrant high technology sector. The "Made In China 2025" program, for example, combines ambitious goals in supercomputers, robotics, medical devices and smart cars, while setting domestic localization targets that would favor Chinese companies over foreigners. The ZTE sanctions and the potential for enhanced export controls have had a traumatic impact on China's understanding of its relatively weak position with respect to technology. As a result, because most high-tech products are available from non-U.S. sources, Chinese engineers will likely be encouraged to design with non-U.S. components; for example, selecting a Samsung instead of a Qualcomm processor for a smartphone. Similarly, China is a major buyer of semiconductor capital equipment as it follows through with plans to scale up its semiconductor industry. Most such equipment is also available from non-U.S. vendors, and it would be understandable if these suppliers are selected given the risk which would now be associated with selecting a U.S. supplier. The U.S. is targeting Chinese made resistors, capacitors, crystals, batteries, Light Emitting Diodes (LEDs) and semiconductors with a 25% tariff. For the most part these are simple, low cost devices, which are used by the billions in high-tech devices. Nonetheless, China could limit the export of these products to deliver maximum pain, leading to a potential shortage of qualified parts. A component shortage can have a devastating impact on production since the manufacturer may not have the ability to substitute a new part or qualify a new vendor. Since the product typically won’t work unless all the right parts are installed, want of a dollar’s worth of capacitors may delay shipping a $1,000 product. Thus, the economic and profit impact of a parts shortage in the U.S. could be quite severe. Conclusions: When it comes to absolute winners in case of a trade war, we believe there are three conditions that need to be met: Relatively high domestic input costs. Relatively high domestic consumption/sales; the true beneficiaries of a tariff are those industries who are allowed to either raise prices or displace foreign competitors, with the consumer typically bearing the cost. Relatively low direct exposure to global trade - international trade flows will certainly slow in a trade war. There are very few manufacturing industries that meet all of these criteria. Within manufacturing, one would typically expect the Consumer Staples and Discretionary sectors to be the best performers. However, roughly a third of the weight of Staples is in three stocks (PG, KO and PEP) that are massively dependent on foreign sales. Moreover, a similar weight of Discretionary is in two retailers (AMZN and HD) that are dependent on imports. As such, consumer indexes do not appear a safe harbor in a trade war. Nevertheless, if the trade war morphs into a recession then consumer staples (and other defensive safe-havens) will outperform, although they will still decrease in absolute terms. Transports are an industry that has relatively high domestic labor costs and an output that is consumed virtually entirely within domestic borders. However, their reliance on global trade flows - intermodal shipping is now more than half of all rail traffic - means they almost certainly lose from a prolonged trade dispute. There is one manufacturing industry that could be at least a relative winner and perhaps an absolute winner: defense. Defense manufacturers certainly satisfy the first two criteria above, though they do have reasonably heavy foreign exposure. However, we believe high switching costs and the lack of true global competitors mean that U.S. defense company foreign sales will be resilient. After all, a NATO nation does not simply switch out of F-35 jets for the Russian or Chinese equivalent. Further, if trade friction leads to rising military tension, defense stocks should outperform. Finally, the ongoing global arms race, space race and growing cybersecurity requirements all signal that these stocks are a secular growth story, as BCA has argued in the recent past.6 Still, as highlighted by the data presented above, the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, especially the S&P Financial Exchanges & Data subsector (BLBG: S5FEXD - CME, SPGI, ICE, MCO, MSCI, CBOE, NDAQ). Another appealing - and defensive - sector is Health Care Services. With effectively no foreign exposure and a low beta, these stocks would outperform in the worst-case trade war-induced recession. Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 3 For more information, please see: "Global Value Chains (GVSs): United States." May 2013. OECD website. 4 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 5 Please see BCA Technology Sector Strategy Special Report "Trade Wars And Technology," dated July 10, 2018, available at tech.bcaresearch.com 6 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. Appendix Table 1Allocating U.S. Import Tariffs To U.S. GICS Sectors Appendix Table 2Exports By U.S. Red States Appendix Table 3Exports By U.S. Swing States Appendix Table 4Exposure Of U.S. Industries To U.S. Import Tariffs Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights President Trump has taken the next step in the trade war by charging some of America's major trading partners with outright currency manipulation. However, we are not headed for Plaza Accord 2.0, because neither the ECB nor the PBOC will re-orient policy until their own economic and inflation dynamics warrant it. Moreover, we doubt the FOMC will be bullied into keeping rates lower than policymakers deem appropriate. With the labor market showing signs of overheating, the Fed will stick with its current game plan and ignore President Trump's tweets. The worsening trade dispute is the key risk that investors face and there are growing signs that uncertainty regarding the future of the world trade order is dampening animal spirits and global capital spending. Risk tolerance should be no more than benchmark. Based on previous late cycle periods, the fact that S&P 500 profit margins are still rising suggests that most risk assets will outperform bonds and other defensive sectors in the near term. Nonetheless, timing is always difficult and we have decided to focus on capital preservation given extended valuations and a raft of risks that could cause a premature end to the bull market. The flattening U.S. yield curve is also worrying. We would not ignore the signal if the curve inverts, although there are reasons to believe that it is not as good a recession signal as it has been in the past. We wish to see corroborating evidence from our other favorite indicators before trimming risk asset exposure to underweight. A peak in the S&P 500 operating margin would be a strong sign that the end of the cycle is drawing close. Even if trade tensions soon die down and global growth holds up, the extended nature of the U.S. economic and profit cycle make asset allocation particularly tricky. Attractive late-cycle assets to hold include structured product, Timberland and Farmland. High-quality bonds will of course outperform in the next recession, but yields are likely to rise in the meantime. We believe that U.S. Agency MBS are unattractively valued, but should remain insulated from negative shocks such as a trade war or higher Treasury yields. We also like Agency CMBS. Oil and related plays are not a reliable late-cycle play, but we are bullish because of the favorable supply-demand outlook. However, this does not carry over to base metals, where we are more cautious. Feature We warned in last month's Overview that investors had not yet seen "peak pessimism" on the global trade front. Right on cue, President Trump raised the stakes again in July by threatening to impose tariffs on virtually all imports of Chinese goods. Congress is pushing the President to be tough on China because American voters have soured on trade. China will not easily back down with the authorities responding in kind to the U.S. President's trade threats. They have also allowed the RMB to depreciate to cushion the trade blow (Chart I-1). It is not clear whether the authorities purposely depressed the RMB or whether they simply failed to lean against market pressures. Either way, it is a dangerous approach because it has clearly raised the U.S. President's ire. Chart I-1RMB Is Much Weaker Across The Board President Trump has taken the next step in the broader trade war by charging some major trading partners with outright currency manipulation. The script appears to be following previous times that the U.S. sought trade adjustment via tariffs and currency re-alignment: the early 1970s and the 1985 Plaza Accord. Adjusting currencies on a sustained basis requires much more than simply "talking down" the dollar. There must be major changes in relative monetary and/or fiscal policies vis-à-vis U.S. trading partners. On the fiscal front, expansionary U.S. policy is working at cross purposes with the desire to have a weaker dollar and a smaller trade gap. We do not foresee the U.S. President having any success in changing the broad thrust of monetary policy either. Europe and Japan enjoyed booming economies in the early 1970s and mid-1980s, and thus had the luxury of placating the U.S. by adjusting monetary policy and thereby appreciating their currencies. Today, it is difficult to see how either Europe or China can afford significant monetary policy tightening that generates major bull markets in their currencies. Neither the ECB nor the People's Bank of China (PBOC) will re-orient policy until their own economic and inflation dynamics warrant it.1 It is also unlikely that the Bank of Japan will raise the 10-year yield target to either strengthen the yen or to help bank profits. This is not Plaza Accord 2.0. Powell Isn't Arthur Burns As for the Fed, we doubt the FOMC will be bullied into keeping rates lower than policymakers deem appropriate. The Fed is more open and independent today than in the 1970s and 1980s. Even if Fed Chair Powell were amenable, any hint that he is being politically manipulated to change course would result in a bond market riot that would rattle investors to their core. More likely, the Fed will stick with its current game plan and ignore President Trump's tweets. Powell could not be any clearer in his July Congressional Testimony: "With a strong job market, inflation close to our objective, and the risks to the outlook roughly balanced, the FOMC believes that-for now-the best way forward is to keep gradually raising the federal funds rate." Investors should not be fooled by the uptick in the U.S. unemployment rate in June. The rise reflected a pop in the labor force participation rate. However, the labor force figures are volatile and there is no upward trend evident in the participation rate. The real story is that the labor market continues to tighten. The number of people outside the labor force who want a job, as a percentage of the total working-age population, is back to pre-recession lows. The Employment Cost Index for private-sector workers shows that wage growth is accelerating. Moreover, the New York Fed's Underlying Inflation Gauge, which leads core CPI inflation by 18 months, has already jumped to almost 3 ½% (Chart I-2). Small businesses are increasingly able to pass on cost increases to consumers (Chart I-3). Chart I-2U.S. Inflation Is Percolating Chart I-3U.S. Pricing Power On The Rise The Minutes from the mid-June FOMC meeting included a lengthy discussion of the growing signs of inflation pressure and labor shortage. Firms are responding to the lack of qualified labor by offering training, automating, and boosting wages. Anecdotal evidence suggests that bottlenecks and other cost pressures are boiling over in the transportation sector. Despite an acute shortage of truck drivers, the average hourly earnings data do not show any acceleration in their wages (Chart I-4, second panel). However, these data do not include bonuses, which have been on the rise. The PPI for truck transportation services was up 7.7% year-over-year in June, while the Cass Freight Index that tracks full-truckload prices rose 15.9% year-over-year. The latter does not even include fuel costs. These pipeline cost pressures have implications not only for the Fed, but for corporate profit margins as well (see below). Chart I-4U.S. Transportation Is Boiling Over The U.S. Yield Curve: A Red Flag? The FOMC expects that the fed funds rate will continue to rise and will temporarily exceed its 2.9% estimate of the neutral rate. If the true neutral rate is higher than the Fed's estimate, then the FOMC could find itself hiking too slowly and the economy could severely overheat. And vice versa if the true neutral rate is below 2.9%. We are keeping a close eye on the yield curve as an indication of policy tightness. If the curve inverts with a few more Fed rate hikes, it would signal that the market believes that policy is turning restrictive. It is possible that the yield curve is not as good a recession signal as it has been in the past. First, there is a lot of uncertainty regarding the neutral fed funds rate in the post-GFC world. The collective market wisdom on this could be wrong. Indeed, BCA's Chief Global Strategist, Peter Berezin, makes the case that the neutral rate is rising faster than most investors believe.2 Structural factors have depressed the neutral rate, including population aging and low productivity growth. However, these structural tailwinds for bond prices are now slowly turning into headwinds. Moreover, as Peter argues, cyclical pressures are acting to lift the neutral rate. Private credit growth is rising faster than nominal GDP growth again. The same is true for housing and equity wealth, at a time when the personal saving rate is falling. All this implies strong desired spending which, in turn, suggests a higher neutral rate of interest. It will be important to watch the housing market; if it remains healthy in the face of rate hikes, it means that the neutral rate is still north of the actual fed funds rate. Chart I-5 presents today's market expectation for the real fed funds rate, based on the forward OIS curve and the forward CPI swaps curve. Technical issues may be distorting forward rates in 2019, but we are more interested in expectations further into the future. The real fed funds rate is expected to hover in the 55-75 basis point range until 2024. It then rises to about 1%, but not until almost the end of the next decade. This appears overly complacent to us, suggesting that the risks are to the upside for market expectations of the terminal, or neutral, short-term interest rate. If the neutral rate is indeed higher than the market is currently discounting, then an inverted curve may be premature in signaling that policy is too tight and that an economic slowdown is on the horizon. Moreover, the term premium on long-term bonds may still be depressed by asset purchases by the Fed and the other major central banks, again suggesting that the curve will more easily invert than in the past. There is much disagreement on this issue, even among FOMC members and among BCA strategists. This publication is sympathetic to the work done by the Fed Staff which suggests that the term premium has been substantially depressed by quantitative easing. Chart I-6 shows the annual change in the size of G4 central bank balance sheets (inverted), along with an estimate of the term premium in the 10-year government bonds of the major countries. The chart is far from conclusive, but it is consistent with the view that QE has depressed term premia worldwide. Moreover, forward guidance and the low level of inflation since the GFC have undoubtedly dampened interest-rate volatility, which theory suggests is a key driver of the term premium. Chart I-5Policy Rate Expectations Chart I-6Depressed Term Premiums ##br##Distort Yield Curves The factors that have depressed the term premium are beginning to reverse, including G4 central bank balance sheets. Still, the premium will trend higher from a low starting point, suggesting that an inverted curve today may not necessarily signal a recession. That said, it would be wrong to completely dismiss a U.S. curve inversion, given its excellent track record. Historically, the 3-month/10-year Treasury slope has worked better than the 2/10 yield slope in terms of calling recessions. An inversion of the 3-month/10-year curve has successfully heralded all seven recessions in the past 50 years with one false positive signal. Nonetheless, the curve tends to be very early, inverting an average of almost 12 months before the recession. And, given the possible distortion to the term premium, we would want to see corroborating evidence before jumping to the conclusion that an inverted curve is sending a correct recession signal. For example, the U.S. and/or global Leading Economic Indicator would need to turn negative. The bottom line is that a curve inversion would not be enough on its own to further trim risk asset exposure to underweight. Nonetheless, we are not dismissing the message from the yield curve either, especially in the context of a trade war that could prematurely end the expansion. Trade War Hitting Economy? Estimates based on macro models suggest that the damage to global GDP growth from higher tariffs would be quite small. Nonetheless, these models do not incorporate the indirect, or second-round, effects of rising tariff walls. Business leaders abhor uncertainty, and will no doubt hold off on major capital expenditure plans until the trade dust settles. The uncertainty can then ripple through the economy to industries that are not directly affected by the trade action. The extensive use of global supply chains reinforces this ripple effect. Labor is not free to move between countries or between industries to facilitate shifts in production that are required by changing tariffs. Capital is more mobile, but it is still expensive to shift machinery. Some of the world's capital stock could become "stranded", raising the cost of the tariffs to the world economy. Finally, important economies-of-scale are lost when firms no longer have access to a single large global market. This month's Special Report, beginning on page 18, sorts out the U.S. equity sector winners and the losers from a trade war with China. Spoiler alert: there are not many winners! The bottom line is that the trade threat for the global economy and risk assets is far from trivial. The negative trade headlines have not had a meaningful economic impact so far, but there are some worrying signs. A number of indicators suggest that global growth continues to slow, including the BCA Global Leading Economic Indicator diffusion index, the Global ZEW sentiment index and the BCA Global Credit Impulse index (Chart I-7). The softness in these indicators predates the latest flaring of trade tensions. Nonetheless, business confidence outside the U.S. has dipped (fourth panel). Growth in capital goods imports for an aggregate of 20 countries continues to decelerate, along with industrial production for capital goods and machinery & electrical equipment in the major advanced economies (production related to energy, consumer products and IT remain strong; Chart I-8). Chart I-7Global Growth Is Still Moderating... Chart I-8...In Part Due To Capital Spending None of these data are flagging a disaster, but they all support the view that uncertainty regarding the future of the world trade order is dampening animal spirits and global capital spending. Even if trade tensions soon die down, the extended nature of the U.S. economic and profit cycle make asset allocation particularly tricky. Late Cycle Investing Some of our economic and policy analysis over the past year has focused on previous late-cycle periods. Specifically, we analyzed the growth, inflation and policy dynamics after the point when the economy reached full employment (i.e. when the unemployment rate fell below the CBO estimate of full employment). This month we look at asset class returns during late cycle periods. We wanted to use as broad a range of asset classes as possible, although data limitations mean that we can only analyze the late-cycle periods at the end of the 1990s and the mid-2000s (Chart I-9). To refine the analysis, we split the late-cycle periods into two parts: before and after S&P 500 profit margins peak. One could use other signposts to split the period, such as a peak in the ISM manufacturing index. However, using the S&P operating profit margin proved to be a more useful break point across the cycles in terms of timing trend changes in risk assets. Table I-1 presents total returns for the following periods: (1) the full late-cycle period - i.e. from the point at which full employment is reached until the following recession; (2) from the point of full employment to the peak in the S&P margin; (3) from the peak in the margin to the recession; and (4) during the subsequent recession. All returns are annualized for comparison purposes, and the data shown are the average of the late 1990s and mid-2000 late-cycle periods. Chart I-9Margin Peak Signals Very Late Cycle Table I-1Late-Cycle Asset Returns We must be careful in interpreting the results because no two cycles are exactly the same, and we only have two cycles in our sample of data. Nonetheless, we make the following observations: Treasury bond returns are positive across the board, which seems odd at first glance. However, in both cases the selloff occurred before the late-cycle period began. Yields then fluctuated in a range, and then began to fall after margins peaked. Global factors also contributed to Greenspan's "conundrum" of stable bond yields in the years before the Great Recession. We do not expect a replay this time around given the low starting point for real yields and the fact that the Fed is encouraging an overshoot of the inflation target. Bonds are unlikely to provide positive returns on a six month horizon. Similar to Treasurys, investment-grade (IG) corporate bond returns were positive across the board for the same reason. However, IG underperformed Treasurys after margins peaked and into the recession. High-yield bonds followed a similar pattern, but suffered negative absolute returns after margins peaked. U.S. stocks began to sniff out the next recession after margins peaked. Small caps outperformed large caps in the recessions, but relative performance was mixed after margins peaked. We are avoiding small caps at the moment based on poor fundamentals and valuations. Growth stocks had a mixed performance versus value stocks before and after margins peaked, but tended to outperform in the recessions. Dividend Aristocrats performed well relative to the overall equity market after margins peaked and into the recessions on average, but the performance was not consistent across the two late cycles. EM stocks performed well before margins peak, and poorly during the recessions. However, the performance is mixed in the period between the margin peak and the recession. We recommend an underweight allocation because of poor macro fundamentals and tightening financial conditions. In theory, Hedge Funds are supposed to be able to perform well in any environment, but returns were a mixed bag after margins peaked. The return performance of Private Equity, Venture Capital and Distressed Debt were similar to the S&P 500, albeit with more volatility. Avoid them after margins peak. Structured Product is one of the few categories that performed well across all periods and cycles. The index we used includes MBS, CMBS and ABS. Farmland and Timberland returns were attractive across all periods and cycles, except for Timberland during one of the recessions. Oil and non-oil commodities tended to perform poorly during recession, but returns were inconsistent in the other phases shown in the table. Gold was also a mixed bag. The historical return analysis underscores that it is dangerous to remain aggressively positioned late in an economic cycle because risk assets can begin to underperform well before evidence accumulates that the economy has fallen into recession. Using the peak in the S&P 500 operating profit margin as a signal to lighten up appears prudent. Based on this approach, investors should generally remain overweight risk assets generally, including stocks, corporate bonds, hedge funds, private equity and real estate, as long as margins are still rising. Investors should scale back in most of these areas as soon as margins peak. For fixed income, investors should be looking to raise exposure but move up in quality after margins peak. Oil and related plays are not a reliable late-cycle play, but we are bullish because of the favorable supply-demand outlook. However, this does not carry over to base metals, where we are more cautious. There are some assets other than government bonds that generated a positive average return late in the cycle and during the recession periods, suggesting that they are good late-cycle assets to hold. However, this is misleading because in some cases they experienced a significant correction either during or slightly before the recession (see the maximum drawdown columns in Table I-1; blank cells indicate that the asset did not experience a correction). These include IG credit, CMBS, ABS, Gold and Dividend Aristocrats. The only assets in our list that provided both a positive return across all the phases in Table I-1 and avoided a correction during the recessions, were mortgage-backed securities, Timberland and Farmland. A Special Report from BCA's Global Asset Allocation service found that Timberland is a superior inflation hedge to Farmland, but the latter is a superior hedge against recessions and equity bear markets.3 We believe that Agency MBS are unattractively valued, but should remain insulated from negative shocks such as a trade war or higher Treasury yields (as long as the Treasury selloff is not extreme). Our fixed income team also likes Agency CMBS.4 When Will U.S. Margins Peak? It is impressive that S&P 500 after-tax operating margins are extremely elevated and still rising. The trend has been aided by tax cuts, but corporate pricing power has improved and wage growth has not yet accelerated enough to damage margins. Chart I-10 presents some indicators to monitor as we await the cyclical peak in profit margins. These are generally not leading indicators, but they do provide some warning when they roll over late in the cycle. The first is the BCA Margin Proxy, which is the ratio of selling prices for the non-financial corporate sector to unit labor costs. Margins have tended to fall historically when the growth rate of this ratio is below zero. The same is true for nominal GDP growth minus aggregate wages. The aggregate wage bill incorporates both changes in wages/hour and in total hours worked. We are also watching a diffusion index of the changes in margins for the industrial components of the S&P 500, as well as BCA's Corporate Pricing Power indicator. The latter takes into consideration price changes at the detailed industry level. Chart I-10U.S. Profit Margin Indicators To Watch None of these indicators are signaling an imminent top in margins, but all appear to have peaked except the Corporate Pricing Power indicator. An equally-weighted average of these four indicators, labelled the U.S. Composite Margin Indicator in Chart I-10, is falling but is still above the zero line. We would not be surprised to see S&P 500 margins peak for the cycle late early in 2019. Conclusions: The S&P 500 has so far been largely immune to shocking trade headlines with the help of a solid start to the U.S. Q2 earning season. Based on previous late cycle periods, the fact that S&P 500 profit margins are still rising suggests that investors should remain fully-exposed to most risk assets. Nonetheless, timing is always difficult and we have decided to focus on capital preservation given extended valuations and a raft of risks that could cause a premature end to the bull market. These risks include a possible hard economic landing in China, crises in one or more EM countries, and an escalation in the trade war among others. Some investors appear to believe that the U.S. can "win" the trade war, but there are no winners when tariff walls are rising. We are not yet ready to go underweight on risk assets, but risk tolerance should be no more than benchmark. This includes equities, corporate bonds, EM assets and other risky sectors. An inversion of the yield curve could trigger a shift to underweight, although this signal would have to be corroborated by our other favorite U.S. and global indicators. Attractive late-cycle assets to hold include structured product, Timberland and Farmland. The first statements by Jay Powell as FOMC Chair underscored that it is too early to hide in Treasurys. Market expectations for real short-term interest rates are overly benign out to the middle of the next decade. Moreover, the Fed is not in a position to be proactive in leaning against the negative impact of rising tariffs because inflation is near target and the labor market is showing signs of overheating. This means that bond yields are headed higher until economic pain is clearly evident. Keep duration short of benchmark. Long-term rate expectations for the Eurozone appear even more complacent than they do for the U.S. The real ECB policy rate is expected to remain in negative territory until 2028 (Chart I-5)! At some point there will be a convergence of real rate expectations with the U.S., which will boost the value of the euro. Nonetheless, we believe that it is too early to position for rate convergence. Core inflation is still well below target and Eurozone economic growth has softened recently, suggesting that the ECB will be in no hurry to lift rates once asset purchases have ended. ECB policymakers will be disinclined to cater to President's Trump's desire for tighter monetary policy in Europe, which means that the U.S. dollar has more upside versus the euro and in broad trade-weighted terms. An escalation in the trade war would augment upward pressure on the greenback. As the dollar's behavior during the Global Financial Crisis illustrates, even major shocks that originate from the U.S. tend to attract capital inflows into the safe-haven Treasury market. Emerging market assets are particularly vulnerable to another upleg in the dollar because of the high level of U.S. dollar-denominated debt. Favor DM to EM equity markets and currencies. Mark McClellan Senior Vice President The Bank Credit Analyst July 26, 2018 Next Report: August 30, 2018 1 For more information on why a replay of the 1985 Plaza Accord is unlikely, please see BCA Geopolitical Strategy Weekly Report "The Dollar May Be Our Currency, But It Is Your Problem," dated July 25, 2018, available on gps.bcaresearch.com 2 Please see BCA Global Investment Strategy Weekly Report "U.S. Housing Will Drive the Global Business Cycle...Again," dated July 6, 2018, available on gis.bcaresearch.com 3 Please see BCA Global Asset Allocation Service Special Report "U.S. Farmland & Timberland: An Investment Primer," dated October 24, 2017, available on gaa.bcaresearch.com 4 Please see BCA's U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem," dated July 17, 2018, available on usbs.bcaresearch.com II. U.S. Equity Sectors: Trade War Winners And Losers In this Special Report, we shed light on the implications of the U.S./Sino trade war for U.S. equity sectors. The threat that trade action poses to the U.S. equity market is greater than in past confrontations. Perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The USTR claims that it is being strategic in the Chinese goods it is targeting, focusing on companies that will benefit from the "Made In China 2025" initiative. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad import categories. The only major items left for the U.S. to hit are apparel, footwear, toys and cellphones. Beijing is clearly targeting U.S. products based on politics in order to exert as much pressure on the President's party as possible. Based on a list of products that comprise the top-10 most exported goods of Red and Swing States, China will likely lift tariffs in the next rounds on civilian aircraft, computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits. Supply chains within and between industries and firms mean that the impact of tariffs is much broader than the direct impact on exporters and importers. We measure the relative exposure of 24 GICs equity sectors to the trade war based on their proportion of foreign-sourced revenues and the proportion of each industry's total inputs that are affected by U.S. tariffs. The Semiconductors & Semiconductor Equipment sector stands out, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. China may also attempt to disrupt supply chains via non-tariff barriers, placing even more pressure on U.S. firms that have invested heavily in China. Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance are most exposed. U.S. technology companies are particularly vulnerable to an escalating trade war. Virtually all U.S. manufacturing industries will be negatively affected by an ongoing trade war, even defensive sectors such as Consumer Staples. The one exception is defense manufacturers, where we recommend overweight positions. Our analysis highlights that the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, and the S&P Financial Exchanges & Data subsector is one of our favorites. The trade skirmish is transitioning to a full-on trade war. The U.S. has imposed a 25% tariff on $50 billion worth of Chinese goods, and has proposed a 10% levy on an additional $200 billion of imports by August 31. China retaliated with tariffs on $50 billion of imports from the U.S., but Trump has threatened tariffs on another $300 billion if China refuses to back down. That would add up to over $500 billion in Chinese goods and services that could be subject to tariffs, only slightly less than the total amount that China exported to the U.S. last year. BCA's Geopolitical Strategy has emphasized that President Trump is unconstrained on trade policy, giving him leeway to be tougher than the market expects.1 This is especially the case with respect to China. There will be strong pushback from Congress and the U.S. business lobby if the Administration tries to cancel NAFTA. In contrast, Congress is also demanding that the Administration be tough on China because it plays well with voters. Trump is a prisoner of his own tough pre-election campaign rhetoric against China. The U.S. primary economic goal is not to equalize tariffs but to open market access.2 The strategic goal is much larger. The U.S. wants to see China's rate of technological development slow down. Washington will expect robust guarantees to protect intellectual property and proprietary technology before it dials down the pressure on Beijing. The threat that the trade war poses to the U.S. equity market is greater than in past confrontations, such as that between Japan and the U.S. in the late 1980s. First, stocks are more expensive today. Second, interest rates are much lower, limiting how much central banks can react to adverse shocks. Third, and perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Nearly every major S&P 500 multinational corporation is in some way exposed to these supply chains. Chart II-1 shows that Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The Global Value Chain Participation rate, constructed by the OECD, is a measure of cross-border value-added linkages.3 In this Special Report, we shed light on the implications of the trade war for U.S. equity sectors. Complex industrial interactions make it difficult to be precise in identifying the winners and losers of a trade war. Nonetheless, we can identify the industries most and least exposed to a further rise in tariff walls or non-tariff barriers to trade. We focus on the U.S./Sino trade dispute in this Special Report, leaving the implications of a potential trade war with Europe and the possible failure of NAFTA negotiations for future research. Chart II-1Measuring Global Supply Chains Trade Channels There are at least five channels through which rising tariffs can affect U.S. industry: The Direct Effect: This can be positive or negative. The impact is positive for those industries that do not export much but are provided relief from stiff import competition via higher import tariffs. The impact is negative for those firms facing higher tariffs on their exports, as well as for those firms facing higher costs for imported inputs to their production process. These firms would be forced to absorb some of the tariff via lower profit margins. Some industries will fall into both positive and negative camps. U.S. washing machines are a good example. Whirlpool's stock price jumped after President Trump announced an import tariff on washing machines, but it subsequently fell back when the Administration imposed an import tariff on steel and aluminum (that are used in the production of washing machines); Indirect Effect: The higher costs for imported goods are passed along the supply chain within an industry and to other industries that are not directly affected by rising tariffs. This will undermine profit margins in these indirectly-affected industries to the extent that they cannot fully pass along the higher input costs; Foreign Direct Investment: Some Chinese exports emanate from U.S. multinationals' subsidiaries in China, or by Chinese or foreign OEM suppliers for U.S. firms. Even though it would undermine China's economy to some extent, the Chinese authorities could make life more difficult for these firms in retaliation for U.S. tariffs on Chinese goods. Macro Effect: A trade war would take a toll on global trade and reduce GDP growth globally. Besides the negative effect of uncertainty on business confidence and, thus, capital spending, rising prices for both consumer and capital goods will reduce the volume of spending in both cases. Moreover, corporate profits have a high beta with respect to economic activity. We would not rule out a U.S. recession in a worst-case scenario. Obviously, a recession or economic slowdown would inflict the most pain on the cyclical parts of the S&P 500 relative to the non-cyclicals, in typical fashion. Currency Effect: To the extent that a trade war pushes up the dollar relative to the other currencies, it would undermine export-oriented industries and benefit those that import. However, while we are bullish the dollar due to diverging monetary policy, the dollar may not benefit much from trade friction given retaliatory tariff increases by other countries. Some of the direct and indirect impact can be mitigated to the extent that importers facing higher prices for Chinese goods shift to similarly-priced foreign producers outside of China. Nonetheless, this adjustment will not be costless as there may be insufficient supply capacity outside of China, leading to upward pressure on prices globally. Targeted Sectors: (I) U.S. Tariffs On Chinese Goods As noted above, the U.S. has already imposed tariffs on $50 billion of Chinese imports and has published a list of another $200 billion of goods that are being considered for a 10% tariff in the second round of the trade war. The first round focused on intermediate and capital goods, while the second round includes consumer final demand categories such as furniture, air conditioners and refrigerators. The latter will show up as higher prices at retailers such as Wal Mart, having a direct and visible impact on U.S. households. Appendix Table II-A1 lists the goods that are on the first and second round lists, grouped according to the U.S. equity sectors in the S&P 500. The U.S. Trade Representative (USTR) claims that the Chinese items are being targeted strategically. It is focusing on companies that will benefit from China's structural policies, such as the "Made In China 2025" initiative that is designed to make the country a world leader in high-tech areas (see below). Table II-1 reveals the relative size of the broad categories of U.S. imports from China, based on trade categories. The top of the table is dominated by Motor Vehicles, Machinery, Telecommunication Equipment, Computers, Apparel & Footwear and other manufactured goods. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad categories in Table II-1. The only major items left for the U.S. to hit are Apparel and Footwear, as well as two subcategories; Toys and Cellphones. These are all consumer demand categories. Table II-1U.S. Imports From China (January-May 2018) (II) Chinese Tariffs On U.S. Goods Total U.S. exports to China were less than $53 billion in the first five months of 2018, limiting the amount of direct retaliation that China can undertake (Table II-2). The list of individual U.S. products that China has targeted so far is long, but we have condensed it into the broad categories shown in Table II-3. The U.S. equity sectors that the new tariffs affect so far include Food, Beverage & Tobacco, Automobiles & Components, Materials and Energy. China has concentrated mainly on final goods in a politically strategic manner, such as Trump-supported rural areas and Harley Davidson bikes whose operations are based in Paul Ryan's home district in Wisconsin. Table II-2U.S. Exports To China (January-May 2018) Table II-3China Tariffs On U.S. Goods What will China target next? Chart II-2 shows exports to China as percent of total state exports, and Chart II-3 presents the value of products already tariffed by China as a percent of state exports. Other than Washington, the four states most targeted by Beijing are conservative: Alaska, Alabama, Louisiana and South Carolina. Chart II-2U.S. Exports To China By State Chart II-3Value Of U.S. Products Tariffed By China (By State) Beijing is clearly targeting products based on politics in order to exert as much pressure on the President's party as possible. To identify the next items to be targeted, we constructed a list of products that comprise the top-10 most exported goods of Red States (solidly conservative) and Swing States (competitive states that can go either to Republican or Democratic politicians). Appendix Tables II-A2 and II-A3 show this list of products, with those that have already been flagged by China for tariffs crossed out. Table II-4 shows the top-10 list of products that are not yet tariffed by China, but are distributed in a large proportion of Red and Swing states. What strikes us immediately is how important aircraft exports are to a large number of Swing and Red States. In total, 27 U.S. states export civilian aircraft, engines and parts to China. This is an obvious target of Beijing's retaliation. In addition, we believe that computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits are next. Table II-4Number Of U.S. States Exporting To China By Category Market Reaction Chart II-4 highlights how U.S. equity sectors performed during seven separate days when the S&P 500 suffered notable losses due to heightened fears of protectionism. Cyclical sectors such as Industrials and Materials fared worse during days of rising protectionist angst. Financials also generally underperformed, largely because such days saw a flattening of the yield curve. Tech, Health Care, Energy and Telecom performed broadly in line with the S&P 500. Consumer Staples outperformed the market, but still declined in absolute terms. Utilities and Real Estate were the only two sectors that saw absolute price gains. The market reaction seems sensible based on the industries caught in the cross-hairs of the trade action so far. At least some of the potential damage is already discounted in equity prices. Nonetheless, it is useful to take a closer look at the underlying factors that should determine the ultimate winners and losers from additional salvos in the trade war. Chart II-4S&P 500: Impact Of Trade-Related Events Determining The Winners And Losers The U.S. sectors that garner the largest proportion of total revenues from outside the U.S. are obviously the most exposed to a trade war. For the 24 level 2 GICS sectors in the S&P 500, Table II-5 presents the proportion of total revenues that is generated from operations outside the U.S. for the top five companies in the sector by market cap. Company reporting makes it difficult in some cases to identify the exact revenue amount coming from outside the U.S., as some companies regard "domestic" earnings as anything generated in North America. Nonetheless, we believe the data in Table II-5 provide a reasonably accurate picture. Table II-5Foreign Revenue Exposure (2017) Semiconductors, Tech Equipment, Materials, Food & Beverage, Software and Capital Goods are at the top of the list in terms of foreign-sourced revenues. Not surprisingly, service industries like Real Estate, Banking, Utilities and Telecommunications Services are at the bottom of the exposure list. U.S. companies are also exposed to U.S. tariffs that lift the price of imported inputs to the production process. This can occur directly when firm A imports a good from abroad, and indirectly, when firm A sells its intermediate good to firm B at a higher price, and then on to firm C. In order to capture the entire process, we used the information contained in the Bureau of Economic Analysis' Input/Output tables. We estimated the proportion of each industry's total inputs that are affected by already-implemented U.S. tariffs and those that are on the list for the next round of tariffs. These estimates, shown in Appendix Table II-A4 at a detailed industrial level, include both the direct and indirect effects of higher import costs. At the top of the list is Motor Vehicles and Parts, where Trump tariffs could affect more than 70% of the cost of all material inputs to the production process. Electrical Equipment, Machinery and other materials industries are also high on the list, together with Furniture, Computers & Electronic Parts and Construction. Unsurprisingly, service industries and Utilities are in the bottom half of the table.4 We then allocated all the industries in Appendix Table II-A4 to the 24 GICs level 2 sectors in the S&P 500, in order to obtain an import exposure ranking in S&P sector space (Table II-6). Table II-6U.S. Import Tariff Exposure Chart II-5 presents a scatter diagram that compares import tariff exposure (horizontal axis) with foreign revenue exposure (vertical axis). The industries clustered in the top-right of the diagram are the most exposed to a trade war. Chart II-5U.S. Industrial Exposure To A Trade War With China The Semiconductors & Semiconductor Equipment sector stands out by this metric, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. Food, Beverage & Tobacco lies between the two extremes. Joint Ventures And FDI Table II-7Stock Of U.S. Direct ##br##Investment In China (2017) As mentioned above, most U.S. production taking place in China involves a joint venture. The Chinese authorities could attempt to disrupt the supply chain of a U.S. company by hindering production at companies that have ties to U.S. firms. Data on U.S. foreign direct investment (FDI) in China will be indicative of the industries that are most exposed to this form of retaliation. The stock of U.S. FDI in China totaled more than $107 billion last year (Table II-7). At the top of the table are Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance. Apple is a good example of a U.S. company that is exposed to non-tariff retaliation, as the iPhone is assembled in China by Foxconn for shipment globally with mostly foreign sourced parts. Our Technology sector strategists argue that U.S. technology companies are particularly vulnerable to an escalating trade war (See Box II-1).5 BOX II-1 The Tech Sector The U.S. has applied tariffs on the raw materials of technology products rather than finished goods so far. At a minimum, this will penalize smaller U.S. tech firms which manufacture in the U.S. and provide an incentive to move production elsewhere. Worst case, the U.S. tariffs might lead to component shortages which could have a disproportionately negative impact, especially on smaller firms. Although it has not been proposed, U.S. tariffs on finished goods would be devastating to large tech companies such as Apple, which outsources its manufacturing to China. China appears determined to have a vibrant high technology sector. The "Made In China 2025" program, for example, combines ambitious goals in supercomputers, robotics, medical devices and smart cars, while setting domestic localization targets that would favor Chinese companies over foreigners. The ZTE sanctions and the potential for enhanced export controls have had a traumatic impact on China's understanding of its relatively weak position with respect to technology. As a result, because most high-tech products are available from non-U.S. sources, Chinese engineers will likely be encouraged to design with non-U.S. components; for example, selecting a Samsung instead of a Qualcomm processor for a smartphone. Similarly, China is a major buyer of semiconductor capital equipment as it follows through with plans to scale up its semiconductor industry. Most such equipment is also available from non-U.S. vendors, and it would be understandable if these suppliers are selected given the risk which would now be associated with selecting a U.S. supplier. The U.S. is targeting Chinese made resistors, capacitors, crystals, batteries, Light Emitting Diodes (LEDs) and semiconductors with a 25% tariff. For the most part these are simple, low cost devices, which are used by the billions in high-tech devices. Nonetheless, China could limit the export of these products to deliver maximum pain, leading to a potential shortage of qualified parts. A component shortage can have a devastating impact on production since the manufacturer may not have the ability to substitute a new part or qualify a new vendor. Since the product typically won't work unless all the right parts are installed, want of a dollar's worth of capacitors may delay shipping a $1,000 product. Thus, the economic and profit impact of a parts shortage in the U.S. could be quite severe. Conclusions: When it comes to absolute winners in case of a trade war, we believe there are three conditions that need to be met: Relatively high domestic input costs. Relatively high domestic consumption/sales; the true beneficiaries of a tariff are those industries who are allowed to either raise prices or displace foreign competitors, with the consumer typically bearing the cost. Relatively low direct exposure to global trade - international trade flows will certainly slow in a trade war. There are very few manufacturing industries that meet all of these criteria. Within manufacturing, one would typically expect the Consumer Staples and Discretionary sectors to be the best performers. However, roughly a third of the weight of Staples is in three stocks (PG, KO and PEP) that are massively dependent on foreign sales. Moreover, a similar weight of Discretionary is in two retailers (AMZN and HD) that are dependent on imports. As such, consumer indexes do not appear a safe harbor in a trade war. Nevertheless, if the trade war morphs into a recession then consumer staples (and other defensive safe-havens) will outperform, although they will still decrease in absolute terms. Transports are an industry that has relatively high domestic labor costs and an output that is consumed virtually entirely within domestic borders. However, their reliance on global trade flows - intermodal shipping is now more than half of all rail traffic - means they almost certainly lose from a prolonged trade dispute. There is one manufacturing industry that could be at least a relative winner and perhaps an absolute winner: defense. Defense manufacturers certainly satisfy the first two criteria above, though they do have reasonably heavy foreign exposure. However, we believe high switching costs and the lack of true global competitors mean that U.S. defense company foreign sales will be resilient. After all, a NATO nation does not simply switch out of F-35 jets for the Russian or Chinese equivalent. Further, if trade friction leads to rising military tension, defense stocks should outperform. Finally, the ongoing global arms race, space race and growing cybersecurity requirements all signal that these stocks are a secular growth story, as BCA has argued in the recent past.6 Still, as highlighted by the data presented above, the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, especially the S&P Financial Exchanges & Data subsector (BLBG: S5FEXD - CME, SPGI, ICE, MCO, MSCI, CBOE, NDAQ). Another appealing - and defensive - sector is Health Care Services. With effectively no foreign exposure and a low beta, these stocks would outperform in the worst-case trade war-induced recession. Mark McClellan Senior Vice President The Bank Credit Analyst Marko Papic Senior Vice President Geopolitical Strategy Chris Bowes Associate Editor U.S. Equity Strategy 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 3 For more information, please see: "Global Value Chains (GVSs): United States." May 2013. OECD website. 4 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 5 Please see BCA Technology Sector Strategy Special Report "Trade Wars And Technology," dated July 10, 2018, available at tech.bcaresearch.com 6 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. Appendix Table II-1 Allocating U.S. Import Tariffs To U.S. GICS Sectors Appendix Table II-2 Exports By U.S. Red States Appendix Table II-3 Exports By U.S. Swing States Appendix Table II-4 Exposure Of U.S. Industries To U.S. Import Tariffs III. Indicators And Reference Charts Our equity-related indicators flashed caution again in July, despite robust U.S. corporate earnings indicators. Forward earnings estimates continued to surge in July. The net revisions ratio and the earnings surprises index remained well above average, suggesting that forward earnings still have upside potential in the coming months. However, several of our indicators suggest that it is getting late in the bull market. Our Monetary Indicator is approaching very low levels by historical standards. Equities are still close to our threshold of overvaluation, at a time when our Composite Technical Indicator appears poised to break down. An overvalued reading is not bearish on its own, but valuation does provide information on the downside risks when the correction finally occurs. Equity sentiment is close to neutral according to our composite indicator, but the low level of implied volatility suggests that investors are somewhat complacent. Our U.S. Willingness-to-Pay (WTP) indicator has fallen significantly this year, and the Japanese WTP appears to be rolling over. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Flows into the U.S. stock market are waning, and those into the Japanese market are wavering. Flows into European stocks have flattened off. Finally, our Revealed Preference Indicator (RPI) for stocks remained on a ‘sell’ signal in July. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. The U.S. 10-year Treasury is slightly on the inexpensive side and our Composite Technical Indicator suggests that the bond has still not worked off oversold conditions. This suggests that the consolidation period has further to run, although we still expect yields to move higher over the remainder of the year. This month’s Overview section discusses the upside potential for the term premium in the yield curve and for market expectations of the terminal fed funds rate. This year’s dollar rally has taken it to very expensive levels according to our purchasing power parity estimate. The long-term trend in the dollar is down, but we still believe it has some upside while market expectations for the terminal fed funds rate adjust upward. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights FTSE100 = Overweight global Oil and Gas in pounds. Eurostoxx50 = Overweight global Banks in euros. Nikkei225 = Overweight global Industrials in yen. S&P500 = Overweight global Technology in dollars. Of these four sector and four currency components, we have more conviction right now on the four sectors than on the four currencies. Through the summer, our preferred ranking of the four sectors is: Technology, Banks and Industrials (tied), Oil and Gas. Which necessarily means that our preferred ranking of the major equity markets is: S&P500, Eurostoxx50 and Nikkei225 (tied), FTSE100. Chart I-1FTSE100 Vs. S&P500 = Global Oil And Gas In Pounds Vs. Global Tech In Dollars Feature Many investors cling to the notion that the relative performance of equity markets hinges on the relative economic performance of their regions of domicile. This might have been true thirty or forty years ago when the companies that dominated the mainstream indexes had an outsize exposure to the local economy. But those days are long gone. Today, the leading companies in the mainstream equity indexes are multinationals, whose sales and profits depend on the fortunes of the global economy rather than on the local economy. Equity Market Allocation Is All About Sectors And Currencies Let's face it, BP is not really a U.K. company, it is a global company which happens to be headquartered and listed in the U.K. Likewise, Apple is not really a U.S. company, it is a global company headquartered and listed in the U.S. And so on for the vast majority of mainstream index constituents. However, BP is most certainly an oil and gas company which moves in lockstep with the global energy sector; and Apple is most certainly a technology company which moves with the global tech sector. Hence, by far the most important performance differentiator for any mainstream equity index is the sector fingerprint that distinguishes the equity index from its peers. The sector fingerprints for the four major equity markets are: overweight oil and gas for the FTSE100, overweight banks for the Eurostoxx50, overweight industrials for the Nikkei225, and overweight technology for the S&P500 (Table I-1). Table I-1The Sector Fingerprints Of The Four Major Equity Markets To complete the story, there is another matter to consider: the currency. A multinational oil company like BP receives its revenues and incurs its costs in multiple major currencies, such as euros and dollars. In this sense, there is a mismatch between BP's global business, denominated in multiple currencies, and the BP stock price, denominated in just one currency: the pound. The upshot is that if the pound strengthens, and all else is equal, the company's multi-currency profits will translate into fewer pounds and drag down the stock price. Conversely, if the pound weakens, the multi-currency profits will translate into more pounds and boost the BP stock price. Therefore, the channel through which the domestic economy can impact its stock market is the currency channel, but in a counterintuitive way: a strong economy tends to lift the currency and hinder the local stock market; a weak economy tends to depress the currency and help the local stock market. Combining the sector and currency drivers of equity market selection, we can summarize: FTSE100 = Overweight global Oil and Gas in pounds. Eurostoxx50 = Overweight global Banks in euros. Nikkei225 = Overweight global Industrials in yen. S&P500 = Overweight global Technology in dollars. The Proof Charts I-1 - I-6 show all six permutations of relative performances taken from the S&P500, Eurostoxx50, Nikkei225 and FTSE100 over the last decade. These charts should leave you in no doubt that the sector plus currency effect is all that you need to get right to allocate between these four major indexes. Chart I-2FTSE100 Vs. Nikkei225 = Global Oil And Gas In Pounds ##br##Vs. Global Industrials In Yen Chart I-3FTSE100 Vs. Eurostoxx50 = Global Oil And Gas In Pounds ##br##Vs. Global Banks In Euros Chart I-4Eurostoxx50 Vs. S&P500 = Global Banks In Euros ##br##Vs. Global Tech In Dollars Chart I-5Eurostoxx50 Vs. Nikkei225 = Global Banks In Euros ##br##Vs. Global Industrials In Yen Chart I-6S&P500 Vs. Nikkei225 = Global Tech In Dollars ##br##Vs. Global Industrials In Yen More recently also, the ranking of the four equity markets has tracked the ranking of the four 'fingerprint' sectors denominated in the respective currency. For example, at the end of May when oil and gas was briefly the top performing global sector this year, the FTSE100 was briefly the top performing major index. But both oil and gas and the FTSE100 have subsequently lost their leadership (Chart I-7 and Chart I-8). Chart I-7The Ranking Of The Four Major Sectors... Chart I-8... Explains The Ranking Of The Four Major Equity Markets One important implication of sectors and currencies driving stock market allocation is that the head-to-head comparison of stock market valuations is a meaningless exercise. Two sectors with vastly different structural growth prospects - say, oil and gas and technology - must necessarily trade on vastly different valuations. So the sector with the lower valuation is not necessarily the better-valued sector. By extension, the stock market with the lower valuation because of its sector fingerprint is not necessarily the better-valued stock market. Likewise, if investors anticipate the pound to ultimately strengthen - because they see that the pound is structurally cheap today - they might downgrade BP's multi-currency profit growth expectations in pound terms and trade the stock at an apparent discount. But allowing for the anticipated decline in other currencies versus the pound there is no discount. It follows that any multinational listed in Europe will give a false impression of cheapness if investors see European currencies as structurally undervalued. Another implication is that simple 'value' indexes may not actually offer value! In reality, they comprise a collection of sectors on the lowest head-to-head valuations which, to repeat, does not necessarily make them better-valued. Some people suggest comparing a valuation with its own history, and assessing how many 'standard deviations' it is above or below its norm. The problem is that the whole concept of standard deviation assumes 'stationarity' - meaning, no step changes in a sector's valuation through time. Unfortunately, sector valuations are 'non-stationary': they undergo major step changes when they enter a vastly different economic climate. For example, the structural outlook for bank profits undergoes a step change when a credit boom ends. Therefore, comparing a bank valuation after a credit boom with the valuation during the credit boom is like comparing an apple with an orange. The Eight Components Of Equity Market Allocation So how to allocate right now? First, break down the allocation decision into its eight components comprising the four sectors: oil and gas, banks, industrials and technology, plus the four currencies: pound, euro, yen and dollar. Then focus on where you have the highest conviction views among these eight components. Through the summer, we have more conviction on the four sectors than on the four currencies. Classically growth-sensitive sectors are closely tracking the downswing in the global 6-month credit impulse which started early this year. Such mini-downswings consistently last around eight months which suggests that our successful underweight stance to the classical cyclicals remains appropriate through the summer (Chart I-9). Of the four sectors, this implies a relative preference for technology, which is the least sensitive to a global mini-downswing. But how to rank the remaining three cyclical sectors - banks, industrials and oil and gas? Since April there has been a very unusual directional divergence between the oil and gas sector which has rallied while banks and industrials have sold off (Chart I-10). Chart I-9The Underperformance Of Cyclicals ##br##Is Closely Tracking The Global 6-Month Credit Impulse Chart I-10Oil And Gas Has Diverged From Banks And Industrials The proximate cause is that oil's supply dynamics, rather than demand dynamics, are dominating its price action. Ultimately though, a higher price based on supply constraints without stronger demand is precarious - because the higher price threatens demand destruction. On the other hand, if global economic demand does reaccelerate, it is the beaten-down industrials and bank equity prices that have the catch-up potential. On this basis, our preferred ranking of the four sectors through the summer is: Technology Banks and Industrials (tied) Oil and Gas Which necessarily means that our ranking of the major equity markets is: S&P500 Eurostoxx50 and Nikkei225 (tied) FTSE100 A final point: you might have slightly (or very) different views on the four sectors and the four currencies. That's fine. But whatever those views are, plug them into the sector and currency based approach described in this report, as this is the right - and most successful - way to allocate among the major equity markets. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* There are no new trades this week, but we have six open positions. 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 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 Interest Rate

Highlights Many investors remain overweight equities; BCA recommends a neutral stance. Investors should position portfolios for rising rates. Fed Chair Powell weighed in last week on yield curve, the impact of the Trump administration's trade policies, financial stability and the level of the neutral Fed funds rate. More evidence of trade policy-related uncertainty, rising labor costs and deteriorating margins in the latest Beige Book. Feature The S&P 500 finished the week little changed, as investors braced for a wave of Q2 earnings reports this week and next. The S&P financials sector, which tends to lead the overall market, rose more than 1% last week, as the banks reported healthy Q2 results. The dollar sold off late last week after President Trump grumbled about the Fed's rate policy. BCA's view is that Fed Chair Powell will ignore Trump's comments on monetary policy and adhere to the central bank's mandate of low and stable inflation and full employment. Gold fell 1% on the week. BCA recommends monitoring the price of gold for clues about the neutral rate of interest. Fed Chair Powell's semiannual policy testimony to Congress dominated the headlines last week. Powell discussed trade policy, the yield curve, the neutral rate and financial stability. The week's economic data was robust, suggesting that Q2 GDP will be well above the Fed's view of potential GDP. Housing starts were soft in June, but the weakness was due to supply issues, not tepid demand. Widespread supply constraints were prevalent in the Fed's latest Beige Book. The strong economic data, along with a 23-year high in the number of inflation words in the Beige Book pushed the 10-year Treasury yield up 6 bps to 2.88%. BCA's U.S. Bond Strategy team notes that the Fed's gradual pace of rate hikes toward a 3% equilibrium fed funds rate would be consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%. In late June, BCA downgraded its 12-month recommendation on global equities and credit from overweight to neutral. We still expect that the U.S. stock-to-bond ratio will grind higher in the next year, as U.S. stocks move sideways and Treasury yields climb. We recommend that investors put proceeds from the sale of equity positions into cash. Not all investors are being risk averse. The National Association of Active Investment Managers (NAAIM) says that active managers have increased their equity risk tolerance since the start of the year (Chart 1). At 89%, the average exposure of institutional investors is close to the cycle high reached in March 2017, which was the greatest since the S&P 500 zenith in October 2007. Furthermore, BCA's Equity Speculation Index remains elevated (Chart 2). Moreover, the asset allocation survey from AAII shows that investors' allocation to equites (at 69% in June) are in line with the 2007 market top (Chart 3). However, equity holdings based on this survey were higher before the peak in equity prices in 2000. Moreover, consumers' expectations for stock price returns in the next 12 months remain close to cycle highs (U of Michigan) and near 24-year extremes based on the Conference Board surveys (Chart 4). Despite the optimism, individual sentiment toward equities remains muted in some surveys (Chart 4, panel 3). Chart 1Active Managers Have Increased Equity Exposure This Year Chart 2Equity Speculation##BR##Is Elevated Chart 3Equity Allocations##BR##On The Rise... Chart 4Households Expect Higher Stock##BR##Prices In The Next 12 Months Individuals, banks and other financial institutions hold more equities today than at the height in 2007. However, insurance companies and pension funds' holdings of equites are not as elevated as they were in 2007 (Table 1). Somewhat surprisingly, households' cash positions are below the 2007 level and at a cycle low. However, the cash positions of financial institutions are four times as large as in 2007, partly due to the Fed's vigilance on financial stability. Pension funds and insurance companies have roughly the same allocation to cash today as earlier in the cycle (2012) and in 2007, just before the financial crisis. Table 1Asset Allocation: Comparison With Early 1990s Bottom Line: BCA's view is that the risk/reward balance for holding equities is much less attractive than it was at the start of the bull market in 2009. The economy is in the late stages of an expansion and is running beyond full employment. The Fed is raising rates. Moreover, equity valuations are elevated and forward earnings estimates are at their most optimistic in 20 years (not shown). The good news is already priced into the equity market. If macro developments evolve as expected, then we will shift to an outright bearish stance on risk assets later this year or early in 2019 in anticipation of a global recession in 2020. Absent a recession, we would move to underweight stocks if a wider trade war develops. We would consider temporarily moving our 12-month recommendation back to overweight if global equities sell off by more than 15% in the next few months. This shift would also be favored if our economic indicators remain constructive and the Fed either cuts rates or signals that it is on hold. 10-Year Treasuries: An Update BCA's U.S. Bond Strategy service recommends that investors remain below benchmark in duration. However, at 2.84%, the 10-year Treasury yield is 27 bps below its 2018 zenith of 3.11%, which was reached in mid-May. Chart 5 shows that the drop in yields since that time reflects both slower economic growth prospects and weaker inflation. Investors are concerned about the impact of Trump's trade policies on global growth and those fears have been stoked by the recent run of poor economic data in the U.S. Oil prices and inflation breakevens moved up in tandem earlier this year, and both are currently rolling over (not shown). U.S. inflation is back to the Fed's 2% target and the central bank remains on course to raise rates two more times in 2018 and another four times next year. The market is pricing in only three more hikes in the next 18 months. The economy is at full employment. Moreover, at 3.6%, the average of the New York Fed and Atlanta Fed's Nowcasts for Q2 GDP growth implies that the GDP expanded well above the Fed's projection of potential GDP (1.8%) in the first half of the year (Chart 6). Moreover, the lagged effect of easier financial conditions suggests that GDP growth in the second half of the year will also be far above potential (Chart 7). Chart 5Inflation Breakevens##BR##Rolling Over Again Chart 6U.S. Economy Poised For Above##BR##Potential Growth in 2018 Inflation breakevens (Chart 5) are falling again despite mounting inflation pressures. The New York Fed's Underlying Inflation Gauge (Chart 8, panel 4) climbed to 3.33% in June, its highest point since 2005. Moreover, wage inflation is trending up and the economy is beset with shortages and constraints.1 Chart 7Lagged Effect Of Easier Financial##BR##Conditions Will Boost Growth Chart 8Inflation Is##BR##Accelerating Bottom Line: Investors should position their portfolios for escalating rates. Global growth should bottom in the second half of the year and the U.S. economic activity reports will begin to outpace lower expectations. Moreover, with inflation at the Fed's target and mounting, inflation breakevens will adjust upward. BCA's position is that the Fed's gradual pace of rate hikes toward a 3% equilibrium fed funds rate would be consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%, well above current forward rates.2 Leading The Way S&P Financials provide a long lead time for market peaks. Table 2 shows that since the mid-1970s, a peak in the Financials sector relative to the S&P 500 occurs an average of 16 months before a peak in the overall index. The Bank (Industry Group) sector provides a similar warning (18 months), while the Investment Banking index's relative performance peaks 20 months before the S&P 500 tops out (Chart 9). Note that the leads times are slightly shorter in the last 15 years than in the 1976-2000 period (Table 2). Table 2Financial Stocks' Relative Performance Provides Early Warning Of Market Tops Chart 9Financials Lead The Broad Market In a recent report,3 BCA's U.S. Equity Strategy service noted that cyclicals and interest rate-sensitive sectors, including financials, perform well when U.S. fiscal policy is loose and monetary policy is tight. Furthermore, our equity strategists found that rising rates boost top-line growth for banks, while the impact of fiscal stimulus via lower taxes should support business and consumer demand for capital. Moreover, our U.S. Equity Strategy team examined sector performance in late cycles, defined as the period between the peak in the ISM Manufacturing Index and the next recession.4 Financials outperform the S&P 500 in late-cycle environments; in the early stages (peak in the ISM's index to peak in the S&P 500) financials underperform the broad market, but they outperform after the peak in the S&P 500 and the next recession. Bottom Line: Our equity strategists recommend that investors remain overweight financials relative to the S&P 500. The late-cycle environment, along with the favorable regulatory climate, suggest that financials still have some room to run. The implication is that the peak in the overall U.S. equity market is still over a year away. Until then, the Fed will continue to remain vigilant on the financial sector and financial stability. Staying The Course At his semiannual Congressional testimony last week, Fed Chair Powell reaffirmed that the Fed will maintain its gradual pace of rate hikes. Following his presentation, Powell met with legislators and discussed the yield curve, the impact of the Trump administration's trade policies, financial stability and the level of the neutral Fed funds rate. Powell repeated his June statement that the yield curve can be considered an indicator of monetary stance. Like Powell, BCA's position is that a steep curve signals that policy is stimulative and short-term rates will need to climb. The opposite holds if the yield curve inverts. A flat yield curve indicates that the policy stance is neutral. The 2/10-year curve has flattened to about 25 bps. Our view is that if the curve inverts with a few more Fed rate hikes, it would suggest that the neutral rate is lower than what the Fed believes and policy is becoming restrictive. Furthermore, BCA's U.S. Bond Strategy team anticipates that curve flattening will occur as the Fed lifts rates, but some flattening pressure will be mitigated by the re-anchoring of long-dated inflation expectations at a higher level. On tariffs, Powell stated that "in general, countries that have remained open to trade, that haven't erected barriers including tariffs, have grown faster. They've had higher incomes, higher productivity." He added that more and broader tariffs are bad for the economy. Furthermore, Powell said that the FOMC has not yet seen evidence that the trade uncertainty has affected wages, but he noted that the central bank is concerned that capital spending plans may be at risk. The latest Beige Book (see next section of this report) finds that the business community is increasingly apprehensive about trade policy. BCA's Geopolitical Strategy service anticipates that trade-related uncertainty will remain in place at least until the U.S. mid-term elections in November.5 BCA views financial stability as a third mandate for the central bank,6 along with low and stable inflation, and full employment. Powell stated last week that financial stability vulnerabilities were "moderate right now," but he remarked that "we keep our eye on that very carefully after our recent experience." Chart 10 presents several indicators that the FOMC uses to assess financial vulnerabilities. Powell acknowledged the prominent status of financial stability when asked about the Fed's role. The central bank's Monetary Policy Report,7 released on July 13, has an entire section dedicated to financial stability. Powell spoke about the shape of the yield curve, saying it can relay a message about longer run neutral interest rates. BCA also recommends monitoring the price of gold for clues about the neutral rate of interest. Chart 11 shows that when the Fed funds rate is above its neutral or equilibrium rate, the 2/10 curve is flat (panel 3). Moreover, gold tends to appreciate when the stance of monetary policy is more accommodative and then the metal depreciates when the stance becomes more restrictive (panel 4). The steep decline in the gold price between 2013 and 2016 preceded downward revisions to the Fed's estimate of the neutral rate. An upside price breakout would signal that we should bump up our estimate of the neutral rate. Conversely, a large decline in gold prices would imply that monetary policy is turning restrictive. Gold prices recently headed lower. Chart 10FOMC Is Closely Monitoring##BR##Financial Stability Chart 11The 2/10 Curve,##BR##Gold And The Neutral Rate Bottom Line: The Fed will continue with gradual rate hikes until it believes policy has returned to near neutral. The yield curve and gold will help to indicate when that point is reached. Widespread Chart 12Inflation Words At A 23 Year High The Beige Book released last week ahead of the FOMC's Jul 31-August 1 meeting suggested that uncertainty surrounding U.S. trade policy remained an important headwind in June and July. The Fed's business and banking contacts mentioned either tariffs (31) or trade policy (20) a total of 51 times, an increase from 34 in May and 44 in April. In March, as President Trump announced the first round of proposed tariffs, there were only three mentions of trade or tariff-related uncertainty. Moreover, uncertainty arose nine times in July (Chart 12, panel 4); all were related to trade policy. A recent study by the Federal Reserve Bank of St. Louis8 found that GDP per capita, wages and the investment-to-GDP ratio, all decline after tariffs are implemented (Chart 13). The study covered tariffs in 14 countries from 1980 through 2016. Importantly, the researchers noted that while the data showed that past tariff increases are followed by persistent decreases in economic activity, this evidence does not necessarily mean that higher tariffs triggered these changes. It is possible that other economic events may have driven tariff increases and ensuing recessions. Despite the headwind from trade, BCA's quantitative approach to the Beige Book's qualitative data continues to point to underlying strength in the U.S. economy, a tighter labor market and higher inflation. Moreover, references to a stronger dollar have disappeared from the Beige Book, despite the recent rise in the greenback. The report also finds widespread concern about profit margins. Chart 12, panel 2 shows that at 81% in July, BCA's Beige Book Monitor ticked up from May's 67% reading. The July reading was the highest since early 2016. The recent low in November 2017 at 53% was when doubts over the tax bill weighed on business sentiment. The number of weak words in the Beige Book hit an 18 -year low in July. On the other hand, the number of strong words climbed in July to a 30-month high. The 2017 Tax Cut and Jobs Act was noted 5 times in the latest Beige Book, up from 3 in May, but still far below 15 mentions in March and 12 in April. The legislation was cast in a positive light in three of the five mentions. The implication is that most of the good news related to the tax bill has already been discounted by businesses. BCA's stance is that the dollar will move up modestly in 2018. The trade-weighted dollar has climbed by 6% since mid-April, but the elevated value of the greenback is not yet a concern for Beige Book respondents. Furthermore, based on the handful of references to a robust dollar (only eight in the past eight Beige Books), the dollar should not be a meaningful issue for corporate profits in Q2 2018. We will provide an update on Q2 S&P 500 earnings in next week's report. The dearth of recent dollar references is in sharp contrast with a flood of comments during 2015 and early 2016 (Chart 12, panel 3). The last time that eight consecutive Beige Books had so few remarks about a strong dollar was in late 2014. The disagreement on inflation between the Beige Book and the Fed's preferred price metric widened in July as the number of inflation words surged (Chart 12, panel 1). Mentions of inflation in July's Beige Book were the greatest since at least 1995. In the past, increased remarks about inflation have led measured inflation by a few months, suggesting that core PCE may still rise. Chart 13The Economic Consequences Of Trade Wars Moreover, July's Beige Book continued to highlight labor shortages, especially among skilled workers in key areas of the economy. Shortages of qualified workers were reported in various specialized trades and occupations, including truck drivers, sales personnel, carpenters, electricians, painters and information technology professionals. Furthermore, several districts stated that a lack of workers was impeding growth. In addition, "widespread", which is part of BCA's inflation word count, was used 14 times in July to describe both labor shortages and swelling input costs, up from 11 times in May. We discussed the impact of escalating labor and input costs on margins in last week's report.9 The Beige Books released this year suggest that concerns about deteriorating margins is more prevalent in 2018 versus 2017. Only 57% of comments about margins in the first five Beige Books of 2017 noted deteriorating margins. In the 2018 Beige Books, 85% of references to margins indicated concern about higher labor, interest and raw materials costs. Bottom Line: July's Beige Book supports our stance that rising inflation pressures will result in at least two more Fed rate hikes by year-end and four next year. Moreover, the Beige Book confirms that labor shortages are restraining output of goods and services in some economic sectors. Furthermore, rising input costs are pervasive and will continue to pressure corporate profit margins. BCA expects both corporate profit growth and margins to peak later this year. The nation's tax policy still gets high marks from the business community, but the impact is fading. Ongoing uncertainty over trade policy will restrain growth. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report "Constrained", published July 16, 2018. Aailable at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary "Bond Bear Still Intact", published June 5, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA Research's U.S. Equity Strategy Special Report "Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening", published April 16, 2018. Available at uses.bcaresearch.com. 4 Please see BCA Research's U.S. Equity Strategy Special Report "Portfolio Positioning For A Late Cycle Surge", published May 22, 2018. Available at uses.bcaresearch.com. 5 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," published April 4, 2018. Available at gps.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," published July 24, 2017. Available at usis.bcaresearch.com. 7 https://www.federalreserve.gov/monetarypolicy/files/20180713_mprfullreport.pdf 8 https://research.stlouisfed.org/publications/economic-synopses/2018/04/18/what-happens-when-countries-increase-tariffs 9 Please see BCA Research's U.S. Investment Strategy Weekly Report "Constrained", published July 16, 2018. Available at usis.bcaresearch.com.

Highlights Duration Checklist: An update of our medium-term Duration Checklist highlights that the strategic backdrop for global government bonds remains bearish. A below-benchmark overall portfolio duration stance is still warranted - even after our recent move to downgrade spread product exposure. Canada: The Bank of Canada hiked rates again last week, and additional increases are likely given growing capacity constraints and accelerating Canadian inflation. Stay underweight Canadian government bonds. Feature Chart of the WeekStagflation Keeping Yields Afloat Developed market bond yields are lacking direction at the moment, pulled by competing forces. Overall global economic activity has lost some momentum and is now less synchronized. Yet the majority of major countries in the developed world are still growing at an above-potential pace that is keeping unemployment low and slowly boosting wages. This is helping underpin inflation, both realized and expected, while keeping government bond yields elevated despite increasing concerns about the future path of the global economy (Chart of the Week). The growing worries about a potential "U.S. versus the world" trade war are weighing on growth expectations, although not yet by enough to cause a meaningful pullback in global equity markets which remain supported by current solid earnings growth. Credit spreads have increased for both developed market corporate debt, but are still at historically narrow levels suggesting that investors are not overly concerned about default/downgrade risk. Emerging market (EM) debt has seen more significant spread widening in recent months, with a stronger U.S. dollar playing a large role there, but there has been little spillover from weaker EM markets into developed market credit valuations. We recently downgraded our recommended allocation to global corporate debt to neutral, while also upgrading our weighting on government bonds to neutral. Yet we maintained our below-benchmark overall duration stance, given our view that bond markets were still underpricing the potential for faster global inflation and tighter monetary policies given the persistent underlying strength of economic growth (especially in the U.S.). In light of that change in our view, an update of one of more reliable tools over the past eighteen months - our Duration Checklist - is timely. The Duration Checklist Is Still Bearish We have maintained our strategic below-benchmark stance on duration exposure for some time now, dating back to January 2017. Shortly afterward, we introduced a list of indicators to monitor going forward to determine if that defensive duration posture on U.S. Treasuries and German Bunds was still justified.1 We called that list our "Duration Checklist", and it contains elements focused on economic growth, inflation, central bank policy biases, investor risk appetite and bond market technicals. The Checklist is meant to be a purely objective read on the data and how it relates to the likely future path of bond yields. We last updated the Checklist back on January 30th of this year.2 The conclusion was that the underlying economic and inflation backdrop was still indicating more upside for yields on a 6-12 month horizon in both the U.S. and Europe. There was a risk, however, that the bond selloff could pause given heightened bullishness on risk assets and extremely oversold conditions in government bond markets. Since that last update of the Checklist, the 10-year U.S. Treasury yield is higher (2.86% vs. 2.72%) while the 10-year German Bund yield is lower (0.36% vs. 0.70%). Although yields in both markets did climb to even higher levels - 3.12% and 0.78%, respectively - in February and March before pulling back to current levels. As we update the Checklist once again this week, we see that the backdrop is still conducive to rising bond yields in the U.S. and Europe, but with differing risks compared to six months ago (Table 1). Note that the Checklist was designed to assess if we should maintain our duration tilt, thus we apply a checkmark ("check") to any indicator that points to potentially higher bond yields, and an "x" to any element that could signal a bond market rally. Table 1The Message From Our Duration Checklist Is Still Bearish For Both USTs & Bunds Global growth momentum is decelerating. The OECD's global leading economic indicator (LEI) is in a clear downtrend, having fallen for five consecutive months (Chart 2). That weakening is broad based, as shown by the depressed level of our LEI diffusion index. The global ZEW index, measuring investor sentiment towards growth in the major developed economies, has been falling sharply since March of this year and now sits at the lowest level since January 2012. The Citigroup Global Data Surprise index peaked at the beginning of 2018 and has fallen steadily to below zero, although it may be in the process of bottoming out. Meanwhile, our global credit impulse - a reliable leading indicator of global growth - has noticeably slowed. We are giving an "x" to all these elements of our Duration Checklist, indicating that the current "soft patch" of global growth represents a risk to the performance of our below-benchmark duration stance. U.S. growth remains solid, but Europe is cooling a bit. The U.S. economy is firing on all cylinders at the moment (Chart 3). The ISM manufacturing index is near 60, while both consumer and business confidence are above the mid-2000s peak of the previous business cycle. Corporate profits are growing around 20% and our models suggest that this trend can continue over the rest of 2018. All these indicators earn a "check" on the U.S. side of our Duration Checklist. Chart 2Global Growth Indicators Are##BR##No Longer Bond Bearish Chart 3U.S. Growth##BR##Remains Strong The growth story is mixed in the euro area, however (Chart 4). The manufacturing PMI has been steadily falling since February of this year, but still remains well above the 50 line indicating an expanding economy. Consumer and business confidence are both at cyclical highs, but the upward momentum has stalled. Corporate profits are growing at a robust pace, but our models suggest that earnings should slow over the remainder of this year. In our Duration Checklist, the momentum of the growth indicators is the relevant measure and not the level. So we are now placing an "x" on the manufacturing PMI, which is giving a clear signal on slowing growth, while maintaining a "check" next to confidence and profit growth but with a question mark given that both may be in the process of rolling over. Inflation pressures are strengthening on both sides of the Atlantic. Back in January, the inflation elements of the Checklist were providing the most mixed signals. That is no longer the case (Charts 5 & 6). Oil prices are accelerating in both U.S. dollar and euro terms, which suggests upside risks on headline inflation in the U.S. and euro area. Unemployment rates are now below the OECD estimates of full employment, and wage inflation is accelerating, in both regions. Thus, all the inflation components of our Duration Checklist earn a "check". Chart 4Is Euro Area Growth Peaking? Or Just Cooling? Chart 5U.S. Inflation Backdrop Is Bond Bearish Chart 6Euro Area Inflation Backdrop Is Bond Bearish Both the Fed and European Central Bank (ECB) are biased to tighten monetary policy. The Fed continues to signal that additional rate hikes are coming given the underlying strength of the U.S. economy and rising trend in U.S. inflation. The ECB has announced that it will taper its net new bond purchases to zero by year-end in its asset purchase program, and has provided forward guidance on the timing of a first rate hike in 2019. Both policies are credible given falling unemployment and rising core inflation rates in both the U.S. and euro area. Thus, we are keeping the "check" on both sides of the policy portion of the Checklist. Investor risk appetite has grown more cautious. This element of our Checklist was a potential headwind to our below-benchmark duration stance back in January, but is much less of an impediment to higher yields now (Charts 7 & 8). Chart 7U.S. Investor Risk Appetite##BR##Has Cooled Off A Bit Chart 8European Investor Risk Appetite##BR##Has Also Cooled Off The cyclical advances of both the S&P 500 and EuroStoxx 600 have stalled, and both indices are now back close to their 200-day moving averages, suggesting that equity markets are not overstretched (and, therefore, ripe for a correction that could drive down bond yields in a risk-off move). The VIX and VStoxx volatility indices remain at low levels, even after the spike that occurred in early February and the more modest volatility shock in the aftermath of the Italian election in May. This implies that investors still prefer owning risky assets over risk-free government bonds. These elements warrant a "check" on both sides of our Duration Checklist. Corporate bond spreads, however, have widened over the past few months, suggesting that investors are pricing in some increased uncertainty over future creditworthiness. While the overall level of spreads is still historically low, the rising trend justifies an "x" in our Checklist as a possible headwind to rising Treasury and Bund yields from waning investor risk appetite. Treasuries and Bunds are not as oversold compared to January, but large short positions remain an issue. The 10-year U.S. Treasury yield is now trading just above its 200-day moving average, while the deeply oversold price momentum seen earlier in the year has eased up a bit but remains negative (Chart 9). The combined signal is a neutral one but, in our Checklist framework, neither of these measures is stretched enough to suggest that yields cannot move higher. Thus, we are giving a weak "check" to both momentum elements on the U.S. side. There is still a large short position in 10-year Treasury futures according to the CFTC data, however, and this remains an impediment to higher Treasury yields - we are keeping the "x" for this piece of the Checklist. For Bunds, yields are now trading just below the 200-day moving average while price momentum has turned slightly positive (Chart 10). While neither indicator is stretched from an historical perspective, they are not sending a message that Bunds are oversold. Thus, we are giving a weak "check" to both technical elements on the European side of our Checklist (note that due to a lack of available data, we exclude investor positioning when evaluating the technical backdrop for Bunds). Chart 9USTs Not Oversold,##BR##But Large Short Positions Remain Chart 10Bund Technicals##BR##Are Neutral The majority of indicators in our Duration Checklist continue to point to upward pressure on U.S. Treasury and German Bund yields. Thus, we conclude that a continued below-benchmark duration stance is warranted for both markets. Not all of the news is bond bearish, however. The cooling of global growth indicators, the euro area manufacturing PMI, the widening of corporate credit spreads and the persistent short position in the Treasury market remain potential headwinds to a renewed period of rising bond yields. Yet without evidence that U.S. or European capacity constraints are loosening up, triggering a dovish shift from the Fed and ECB, the upward trend in inflation will prevent any meaningful decline in yields from current levels. Bottom Line: An update of our medium-term Duration Checklist highlights that the strategic backdrop for global government bonds remains bearish. A continued below-benchmark overall portfolio duration stance is warranted - even after our recent move to downgrade spread product exposure. Canada Delivers Another Rate Hike, With More To Follow Chart 11The BoC & The Fed: Follow The Leader The Bank of Canada (BoC) hiked its policy rate last week by 25bps to 1.5%, once again delivering a tightening in lagged response to U.S. rate increases over the past year. The hike was not a surprise, as the Canadian economy is operating at full capacity and core inflation is at the midpoint of the BoC's 1-3% target band. Overnight Index Swap (OIS) markets are now pricing that both the BoC and the Fed will raise rates by another 75bps over the next twelve months, and we see the potential for even more increases than that - even with the Canadian economy cooling from the very rapid growth seen last year (Chart 11). The current spread between 2-year government bond yields in the U.S. and Canada is the widest since 2008, which is weighing on the level of the Canadian dollar versus the greenback (3rd panel). The latter is helping to ease financial conditions in Canada (bottom panel), especially at a time when the country is benefitting from the positive terms of trade impact of strong oil prices. The loonie is also being impacted by worries about future U.S. trade policy. The Trump administration has already imposed tariffs on Canadian steel and aluminum exports and is demanding serious concessions in the renegotiation of the North American Free Trade Agreement (NAFTA). In their latest Monetary Policy Review (MPR) that was released after the BoC policy meeting last week, the central bank provided an estimate of the impact of the steel and aluminum tariffs that went into effect on June 1st. The conclusion was that the 25% tariff on U.S. imports of Canadian steel, and 10% levy on U.S. aluminum imports, would have little net impact on the Canadian economy once the Canadian response was factored in. The BoC concluded that the level of total real Canadian exports would be reduced by -0.6% by year-end, but that Canadian real imports would also decline by a similar amount as the Canadian government slapped its own tariffs on U.S. exports of steel, aluminum and various consumer products. This neutral view on U.S.-Canada trade tensions appeared throughout the BoC's updated economic forecasts, as its projections on the growth of Canadian exports, imports and U.S. real GDP growth (the critical driver of Canadian trade) were all increased from the previous MPR published in April. That may be an overly optimistic assessment of the potential impact of a trade dispute with the U.S. Yet the BoC did admit that it can only estimate the impact of tariffs once the precise details are known, thus it cannot adjust its forecasts based on what might happen in the NAFTA negotiations. The BoC can only base its forecasts on what they can observe now, which is that Canada's overall economy remains in decent shape, even though the composition of growth is shifting. The BoC's latest Business Outlook Survey indicates that Canadian firms continue to see robust demand and are facing increasing capacity constraints. This is boosting hiring plans and keeping capital spending intentions reasonably firm even with the uncertainties over NAFTA that is causing some firms to delay investment (Chart 12). The BoC is projecting that overall Canadian real GDP will only grow by 2% in 2018, even with a smaller contribution to growth from consumer spending and housing. The year-over-year rate of change in retail sales volumes has already dipped into negative territory and is now at the lowest since the end of 2009 (Chart 13). The BoC has attributed this to some slowing in interest-sensitive spending in response to tighter BoC monetary policy. At the same time, household debt growth has been slowing and house price inflation has plunged over the past year (although most of this decline occurred in the overheated Toronto market). The BoC is not concerned about the impact of its rate hikes on the interest burden for households, despite the high level of household debt, given the accelerating pace of wages and income growth. The BoC is likely happy to see a shift away from overheating consumption fueled by speculative increases in house prices, but there is a risk that additional rate hikes could finally trigger the long-awaited bursting of the Canadian housing bubble. Chart 12Canadian Businesses Are Optimistic,##BR##Even With Trade Worries Chart 13Higher BoC Rates##BR##Do Have An Impact (On a related note - the topic of housing bubbles will be discussed at the upcoming BCA Investment Conference in Toronto on September 23-25 by Hilliard Macbeth of Richardson GMP, who has written several books on the topic of global asset bubbles and has some particularly strong views to share on Canadian housing.) Yet the BoC will have to take the risk that additional rate increases could cause a bigger shakeout in the Canadian housing market, given that Canadian inflation is trending higher. Headline CPI inflation is now above the midpoint of the BoC's 1-3% target band, while all the various measures of core inflation that the BoC monitors are hovering around 2% (Chart 14). The BoC estimates that the output gap in Canada is now closed, and that the tight labor market will continue to boost inflation. Chart 14Inflation On The Rise In Canada Chart 15Market Is Underpricing The BoC Already, the average hourly earnings measure of wage inflation is growing close to 4% on a year-over-year basis, although the BoC has noted in recent research that other measures of labor costs are not growing as fast.3 Nonetheless, with 10-year inflation expectations in the Canadian inflation-linked government bond market now trading just below the BoC's 2% target (bottom panel), and with a high number of Canadian businesses reporting increasing difficulties in sourcing quality labor, the inflationary message sent by the surging rate of average hourly earnings growth will likely prove to be correct. Even though the Canadian OIS curve is now discounting another 75bps of rate hikes over the next year, that would only take the BoC policy rate to 2.25% - still below the central bank's estimate of the neutral policy rate, which is between 2.5-3% (Chart 15). Given the likely need for the BoC to eventually move to a restrictive stance to cool off an overheating economy and keep inflation around the 2% target, we see more potential upside for Canadian bond yields, especially with very little increase currently priced in the forwards. Stay underweight Canada in hedged global bond portfolios. Bottom Line: The Bank of Canada hiked rates again last week, and additional increases are likely given growing capacity constraints and accelerating Canadian inflation. Stay underweight Canadian government bonds. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15th, 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Some Thoughts On The Treasury-Bund Spread", dated January 30th, 2018, available at gfis.bcaresearch.com. 3 https://www.bankofcanada.ca/wp-content/uploads/2018/01/san2018-2.pdf Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy Firming crude oil prices and recovering capex budgets suggest that energy E&P stocks are in a sweet spot and primed for outperformance. Decreasing refining margins, a deteriorating supply/demand backdrop and extended relative valuations suggest that refiners are a sell. Recent Changes Lift the S&P oil & gas exploration & production index to overweight today. Downgrade the S&P oil & gas refining & marketing index to underweight today. Table 1 Feature Equities broke out of their recent trading range last week on the eve of earnings season despite protectionist rhetoric. While Q2/2018 EPS euphoria may serve as a catalyst to catapult the SPX to fresh all-time highs in the coming months, especially given the collapse in stock correlations (CBOE implied correlation index shown inverted, Chart 1), sell-side analysts have now revised down Q1/2019 EPS growth estimates by 300bps to 7%. We view Q1/2019 earnings as critically important, as they will give us the first clean read on trend EPS growth. By that time the one-off impact of tax reform will be filtered out of the data. At present, Q1/2019 EPS estimates are likely suffering for two reasons: delayed P&L FX translation effects from a year-to-date rise in the U.S. dollar and difficult year-over-year comparisons with a blowout Q1/2018 quarter. In recent research, we have been flagging the currency as the single biggest risk to our sanguine equity market view. In other words, a sustainable breakout in equities requires a sideways-to-lower move in the greenback (trade-weighted U.S. dollar shown inverted, Chart 2). Chart 1All-Time Highs Ahead... Chart 2...But Watch The Greenback Drilling beneath the surface, Charts 3 & 4 show net earnings revisions (NER) per sector as a four week average and Chart 5 summarizes the latest data points for an easier comparison. Industrials NER have taken a hit on the back of Trump's tariff rhetoric and recent implementation. Nevertheless, the tech sector shows no signs of infiltration either from a rising currency or Trump's protectionist actions. As a reminder, the IT sector garners 60% of its sales from abroad and remains the most important sector to monitor for any broad market EPS inflection points.1 Chart 3Sector... Chart 4...Net EPS Revisions On the economic front, a softening U.S. dollar would be synonymous with a reacceleration in global growth. We are currently in the seventh month of the economic soft patch and there are high odds that by early fall the tide will turn. The global non-manufacturing PMI is already signaling that a pick up in growth is forthcoming. Historically, the global services PMI has been an excellent leading indicator of its sibling, the global manufacturing PMI, and the current message is to expect an end to the global growth deceleration sometime in the autumn (Chart 6). Chart 5Watch Tech Stocks Chart 6Longest Uninterrupted Payrolls Expansion On Record!!! In the U.S., the ISM manufacturing survey reaccelerated last month despite Trump's protectionist rhetoric with both trade subcomponents of the survey - new export orders and imports - rising smartly. Even the latest employment report came in above expectations, and confirmed that the U.S. economy is firing on all cylinders and remains a key global growth engine. Importantly, non-farm payrolls have been expanding on a month-over-month basis for the longest period on record hitting 93 consecutive months as of June (Chart 7). Similarly, the yield curve has remained positively sloped for a record 134 straight months (please see Chart 2 from our April 16th Special Report titled 'Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening'). Tack on China's recent easing in monetary conditions, as evidenced by both a depreciating currency (steepest month-over-month depreciation since 1994) and falling interest rates (Chart 8), and the likelihood of additional easing measures in the pipeline, and the world's two largest economies will likely lead global growth out of its recent mini-slump. Chart 7Can Services Pull Up Manufacturing? Chart 8China Is Easing Monetary Conditions This week we are refining our energy sector sub-surface positioning that sustains the broad energy complex in the overweight column, and we reiterate its high-conviction status. E&P Is Flaring Up... Exploration & production (E&P) stocks have significantly trailed crude oil prices since the latter broke out roughly a year ago (Chart 9). There are high odds that a catch up phase looms and we recommend to boost exposure to this late-cyclical energy sub-index to overweight. Disbelief in the longevity of the increase in oil prices is the likely culprit weighing on E&P stocks along with a bottleneck-induced steep shale oil price discount to WTI. Keep in mind that as oil prices were collapsing during the global manufacturing recession of late-2015/early-2016, the U.S. E&P industry went through a clean-up phase where a plunge in free cash flow (FCF) caused a spike in bankruptcies on the back of extreme balance sheet degradation (Chart 10). Chart 9Most Vulnerable Gap Has To Be Filled Chart 10Balance Sheets Getting Repaired Chart 11No Longer Stressed In more detail, E&P FCF got squashed, dropping by 66% from peak to trough as net debt ballooned by 30% during the same time frame. And, in response, independent energy producers' junk bond spreads skyrocketed to over 20%, surpassing even the Great Recession peak (Chart 11). Nevertheless, the steep recovery in underlying commodity prices along with the forgiving debt and equity markets that lent a helping hand to this extremely fragmented industry, has restored some semblance of normality in the E&P space. The second panel of Chart 9 shows that shale oil production is rising at a healthy clip following a long bottoming phase on the heels of reaccelerating WTI crude oil prices. Not only is OPEC 2.0 supporting oil price gains, but sustained domestic inventory draws are also underpinning crude prices. BCA's Commodity & Energy Strategy service remains positive on the oil price backdrop with oil price risks skewed to the upside. The upshot is that the recovery in E&P cash flow growth will continue in the coming months (second & third panels, Chart 10). Similar to the broad energy complex that integrateds dominate, oil & gas E&P producers are a capital expenditure upcycle play, which remains a key BCA theme for the year (middle panel, Chart 12). Rising oil prices are conducive to additional energy-related investments (bottom panel, Chart 9). Importantly, there is a sizable divergence between the oil & gas rig count and relative share prices that will likely narrow via a catch up phase in the latter (top panel, Chart 12). National data confirm the Baker Hughes weekly rig count that has been in a V-shaped recovery. Energy related investment has doubled from the depths of the manufacturing recession (bottom panel, Chart 12), and if oil prices even stand pat at current levels, additional drilling will most likely take place in the biggest shale plays (Permian, Eagle Ford, Marcellus and Bakken) where breakeven costs are roughly 30% lower. All of this suggests that U.S. producers will continue to pump oil at a brisk pace, and earnings will likely overwhelm. Sell side analysts have taken notice and relative EPS estimates are following crude oil prices higher. Similarly, S&P oil & gas E&P net EPS revisions are also in positive territory (Chart 13). Chart 12Capex Upcycle Beneficiary Chart 13Following Oil Higher Adding it up, there are high odds that E&P stocks will continue to outpace the broad energy complex and the SPX on the back of firming capex budgets and sustained oil inflation. Bottom Line: We are boosting the S&P oil & gas E&P index to an overweight stance. The ticker symbols for the stocks in this index are: BLBG: S5OILP - COP, EOG, APC, PXD, DVN, CXO, MRO, APA, HES, NBL, EQT, COG, XEC and NFX. ...But Refiners Are Flaming Out While we are warming up to the S&P oil & gas E&P index, the opposite is true for the pure play S&P oil & gas refining & marketing index, and recommend to trim exposure below benchmark. Refiners have taken it to the chin over the past six weeks underperforming both the SPX and the broad energy complex, and deteriorating industry fundamentals signal that more pain lies ahead. The middle panel of Chart 14 shows that crack spreads have given way recently, and as the Brent/WTI crude oil spread closes in on the zero line, refining margins will remain under intense downward pressure. Already, margins are contracting on a six-month rate of change basis and that will continue to weigh on relative share prices (bottom panel, Chart 14). This is an ominous sign for relative profits that will likely follow crack spreads lower. The refining supply/demand backdrop is also waning. Refined products consumption has sunk recently, and the year-to-date steep momentum reversal of 13 percentage points suggests that relative profits will underwhelm (top & middle panels, Chart 15). Not only is demand faltering, but the news is equally grim on refining inventories. In fact, there is no apparent supply side offset: gasoline stocks are rising (gasoline inventories shown inverted, bottom panel, Chart 15). This supply/demand backdrop will weigh on industry profitability. Worrisomely, the sell side's analyst community is extremely optimistic with regard to 12-month forward relative EPS growth estimates (north of 20%, not shown). On a 5-year forward relative EPS basis Wall Street's exuberance is unprecedented: analysts expect refiners to double the SPX's 16% long-term EPS growth rate (Chart 16). We would lean against these great expectations. Chart 14Refiners Rally Has Cracked Chart 15Mind The Supply/Demand Backdrop Chart 16Too Much Optimism Adding insult to injury, relative valuations do not offer any cushion in case of any profit mishaps as they are hovering near previous cyclical peaks and significantly higher than the historical mean (bottom panel, Chart 16). Netting it out, decreasing refining margins, a deteriorating supply/demand backdrop and extended relative valuations suggest that refiners are a sell. Bottom Line: Trim the S&P oil & gas refining & marketing index to underweight. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC, ANDV and HFC. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Unwavering," dated June 4, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps