Economy

Highlights Global Inflation has upside on a cyclical basis, but this narrative is well known and investors have already placed their bets accordingly, buying inflation protection in a wide swath of markets. However, global growth has not yet found its footing, suggesting a mini-deflation scare, at least relative to expectations, is likely this summer. The U.S. dollar will benefit in such a scenario, and NOK/SEK will depreciate. While GBP/USD has downside, the pound should rally versus the euro. Weakness in EUR/CAD has not yet fully played out; the recent bout of strength was only a countertrend move. Feature Inflation is coming back, and this will obviously have major consequences for both asset and currency markets. However, macro investing is not just about forecasting fundamentals correctly; often, just as importantly, it is about understanding how other investors have priced in these expected economic developments. Therein lies the problem. While we understand why inflation could pick up, so too have most investors, and they have positioned themselves accordingly. With global growth currently looking shaky, we believe a better entry point for long-inflation plays will emerge in the coming months. In the meanwhile, a defensive, pro-U.S. dollar posture still makes sense. Investors Are Long Inflation Bets We have long argued that inflation was likely to make a cyclical comeback, a return that would begin in the U.S. before spreading to the rest of the globe. This story is currently playing out. However, in response these developments, investors have placed their bets accordingly, and the story currently seems well baked in. Prices of assets traditionally levered to inflation have already moved to discount a significant pick-up in inflation. The most evident dynamics can be observed in the U.S. inflation breakevens. Both the 10-year breakevens as well as the 5-year/5-year forward breakevens just experienced some of their sharpest two-year changes of the past 20 years, notwithstanding the pricing out of a post-Lehman, depression-like outcome (Chart I-1). Breakevens are not alone. Other assets have displayed similar behavior. In the U.S., investors have aggressively sold their holdings of utilities stocks, which have been greatly outperformed by industrial stocks. Traditionally, investors lift the price of XLI relative to that of XLU when they anticipate global inflation to pick up (Chart I-2). Chart I-1Markets Are Positioning Themselves##br## For Higher Inflation Chart I-2U.S. Sectoral Performance Suggests Investors ##br##Have Already Bet On Higher Inflation... It is not just intra-equity market dynamics that support this assertion. The behavior of the U.S. stock market relative to Treasurys further buttresses the idea that investors have already aggressively discounted an upturn in global consumer prices (Chart I-3). Potentially, the best illustration of investors' preference for inflation protection is currently visible in EM assets. A seemingly paradoxical phenomenon has been puzzling us: How have EM equities managed to avoid the gravitational pull that has caused EM bonds to nearly flirt with the nadir of early 2016? After all, EM equities, EM currencies and EM bonds are normally closely correlated, driven by investors' wagers on the direction of global growth. A simple variable can explain this strange dichotomy: anticipated inflation. As Chart I-4 illustrates, the performance of a volatility adjusted long EM stocks / short EM bonds portfolio tends to anticipate fluctuations in global inflation. The current price action in this basket indicates that investors have made their bets, and they think inflation is going up. Chart I-3...So Does The Stock-To-Bond Ratio Chart I-4Inflation Bets Explain Why EM Stocks And EM Bond Prices Have Diverged Anecdotal evidence suggests that in recent quarters, pension plans have been aggressive buyers of commodities - a move that normally coincides with these long-term investors putting in place some inflation hedges. Moreover, positioning in the futures markets corroborates these stories: speculators are still very long commodities like copper and oil - commodities traditionally perceived as efficient protectors against inflation spikes (Chart I-5). Finally, despite the potentially deflationary risks created by Italy three weeks ago, speculators remain short U.S. Treasury futures, bond investors are underweight duration, and sentiment toward the bond market remains near its lowest levels of the past eight years (Chart I-6). Again, this behavior is consistent with investors being positioned for an inflationary environment. Chart I-5Money Has Flown Into Resources Chart I-6Bond Market Positioning Is Still Very Short Bottom Line: There is a well-defined case to be made that a global economy that was not so long ago defined by the presence of deflationary risks is now morphing into a world where inflation is on the upswing. However, based on inflation breakevens, sectoral relative performance, equities relative to bonds in both DM and EM as well as on the positioning of investors in commodity and bond markets, this changing state has been quickly discounted by investors. The Decks Are Stacked, But Where Does The Economic Risk Lie? The problem facing investors already long inflation protection every which way they can be is that the global economy is slowing, which normally elicits deflationary fears, not inflationary ones. This seems a recipe for disappointment, albeit one that is likely to help the dollar. Our global economic and financial A/D line, which tallies the proportion of key variables around the world moving in a growth-friendly fashion, has fallen precipitously. This normally heralds a slowdown in global economic activity (Chart I-7). Chart I-7Global Growth Is Losing Traction In similar vein, global leading economic indicators have also begun to roll over - a trend that could gain further vigor if the diffusion index of OECD economies experiencing rising versus contracting LEIs is to be believed (Chart I-8). The global liquidity picture has also deteriorated enough to warrant caution. Currency carry strategies - as approximated by the performance of EM carry trades funded in yen - have sagged violently. This tells us that funds are flowing out of EM economies and moving back to countries already replete with excess savings like Japan or Switzerland (Chart I-9). Historically, these kinds of negative developments for global liquidity have preceded industrial slowdowns, as EM now accounts for the lion's share of global IP growth. Finally, China doesn't yet look set to bail out the world's industrial sector. This month's money and credit numbers were weaker than anticipated, and our leading indicator for the Li-Keqiang index - our preferred gauge of industrial activity in the Middle Kingdom - points to further weakness (Chart I-10). This makes it unlikely that China's imports will rise, lifting global growth. Additionally, China has re-stocked in various commodities, suggesting it is front-running its own domestic demand, highlighting the risk that its commodities intake could become even weaker than what domestic growth implies. Chart I-8More Weakness In LEIs Chart I-9Global Liquidity Tightening Chart I-10China Not Yet Set To Bail Out The World With this kind of backdrop, we expect the current slowdown in global growth to run further before ebbing, probably in response to what will be a policy move out some kind from China to put a floor under growth. As a result, the current infatuation with inflation hedges among investors may wane for a bit as slower growth could shock inflation expectations downward, especially in a global context that has been defined by excess capacity since the late 1990s. An environment where global inflation expectations could be downgraded in response to slower growth is likely to be an environment where the dollar performs well, particularly as U.S. growth continues to outperform global growth (Chart I-11). This also confirms our analysis from two weeks ago that showed that when bonds rally the dollar tends to outperform most currencies, with the exception of the yen.1 Moreover, with the Federal Open Market Committee upgrading its path for interest rates by one additional hike in 2018, this reinforces the message from our previous work noting that once the fed funds rate moves in the vicinity of r-star, the dollar performs well, nearly eradicating the losses it incurred when the fed funds rate rises but is well below the neutral rate (Table I-1). This is especially true if vulnerability to higher rates rests outside - not inside - the U.S., as is currently the case.2 Chart I-11The Dollar Likes Lower Global Inflation Table I-1Fed And The Dollar: Where We Stand Matters As Much As The Direction Beyond the dollar, one particular currency cross has historically been a good correlate to investors betting on higher inflation: NOK/SEK. As Chart I-12 illustrates, when investors buy inflation hedges such as going long EM equities relative to EM bonds, this generates a rally in NOK/SEK. These dynamics played in our favor when we were long this cross earlier this year. However, not only are EM equities extended relative to EM bonds, the current economic environment portends a growing risk of investors curtailing these kinds of bets. The implication is bearish for NOK/SEK, and we recommend investors sell this cross at current levels. Chart I-12NOK/SEK Suffers If Inflation Bets Are Unwound Bottom Line: Investors have quickly and aggressively positioned themselves to protect their portfolios against upside inflation risks. However, the global economy is still slowing - a development that has further to run. As a result, this current anticipation of inflation could easily morph into a temporary fear of deflation, at least relative to lofty expectations. This would undo the dynamics previously seen in the market. This is historically an environment in which the dollar performs well, suggesting the greenback rally is not over. Moreover, NOK/SEK could suffer in this environment. The Bad News Is Baked Into The Pound There is no denying that the data flow out of the U.K. has been poor of late. In fact, despite what was already a low bar for expectations, the U.K. economy has managed to generate large negative surprises (Chart I-13). One of the direct drivers of this poor performance has been the complete meltdown in the British credit impulse (Chart I-14). Additionally, the slowdown in British manufacturing can be easily understood in the context of slowing global growth (Chart I-15). Chart I-13Anarchy In The U.K. Chart I-14The Credit Impulse Has Bitten Chart I-15U.K. Exports Are Slowing Because Of Global Growth But, the bad new seems well priced into the pound, especially when compared to the euro. Not only is the GBP trading at a discount to the EUR on our fundamental and Intermediate-term timing models, speculators have accumulated near-record short bets on the pound versus the euro (Chart I-16). This begs the question: Could any positive factor come in and surprise investors, resulting in a fall in EUR/GBP? We think the answer to this question is yes. First, despite the negatives already priced in, incremental bad news have had little traction in dragging the pound lower versus the euro in recent weeks, suggesting that EUR/GBP buying has become exhausted. Second, a falling EUR/USD tends to weigh on EUR/GBP, as the pound tends to act as a low-beta version of the euro (Chart I-17). Chart I-16Investors Are Well Aware Of Britain's Problems Chart I-17EUR/GBP Sags When EUR/USD Weakens Third, the economic outlook for the U.K. is improving. It is true that in the context of slowing global growth, the manufacturing and export sectors are unlikely to be a source of positive surprises for Great Britain. However, the domestic economy could well be. As Chart I-14 highlights, the credit impulse has collapsed, but the good news is that outside of the Great Financial Crisis it has never fallen much below current levels, suggesting that a reversion to the mean may be in offing. Additionally, U.K. inflation is peaking, which is lifting British real wages (Chart I-18). In response, depressed consumer confidence is picking up. This is crucial as consumer spending, which represents roughly 70% of the U.K.'s GDP, has been the key drag on growth since 2016. Any improvement on this front will lift the whole British economy, even if the manufacturing sector remains soft. Fourth, Brexit is progressing. This week's vote in the House of Commons was confusing, but it is important to note than an amendment that gives Westminster the right to force a renegotiation between the U.K. and the EU if no deal is reached in 2019 has been passed. This also decreases the risk of a completely economically catastrophic Brexit down the road, but increases the risk that PM Theresa May could be ousted over the next 12 months. Our positive view on the pound versus the euro (or negative EUR/GBP bias) is not mimicked in cable itself. Ultimately, despite the GBP/USD's beta to EUR/GBP being below one, it is nonetheless greater than zero. As such, it is unlikely that GBP/USD will be able to rally if the DXY rallies and the EUR/USD weakens (Chart I-19). Therefore, while we recommend selling EUR/GBP, we are not willing buyers of GBP/USD. Chart I-18A Crucial Support To Growth Chart I-19Cable Will Not Avoid The Downward Pull Of A Strong Dollar Bottom Line: The British economy has undergone a period of weakness, which is already reflected in the very negative positioning of investors in the GBP versus the EUR. However, the bad data points are losing their capacity to push EUR/GBP higher, and the British economy may begin to heal as consumer confidence is rebounding thanks to improving real wages. The low beta of GBP/USD to the euro also implies that a falling EUR/USD will weigh on EUR/GBP. However, while the pound has upside against the euro, it will continue to suffer against the dollar if EUR/USD experiences further downside. What To Do With EUR/CAD? One weeks ago, we were stopped out of our short EUR/CAD trade. Has EUR/CAD finished its fall, or was the recent rally a pause within a downward channel? We are inclined to think the latter. Heated rhetoric on trade has hit the CAD harder than the EUR, as exports to the U.S. represent a much larger share of Canada's GDP than of the euro area, forcing the pricing of a risk premium in the loonie. However, even after a rather explosive G7 meeting, we do believe that a compromise is still feasible and that NAFTA is not dead on arrival. A deal is still likely because, as Chart I-20 demonstrates, Canadian tariffs on U.S. imports are not only marginally in excess of U.S. tariffs on Canadian imports, they are also in line with international comparisons. This suggests only a small push is needed to arrive to a deal that salvages NAFTA, which ultimately is much more important to Canada than the dairy industry. Chart I-20Canada And The U.S. Can Find A Compromise Despite this reality, we cannot be too complacent, U.S. President Donald Trump is likely to be playing internal politics ahead of the upcoming mid-term elections. U.S. citizens are distrustful of free trade (Chart I-21), a trend especially pronounced among his base. However, a good result for the GOP in November is contingent on the Republican base showing up at the polls. Firing this base up with inflammatory trade rhetoric is a sure way to do so. This means that risks around NAFTA are still not nil. Chart I-21America Belongs To The Anti-Globalization Bloc However, EUR/CAD continues to trade at a substantial premium to fair-value on an intermediate-term horizon (Chart I-22). Moreover, as the last panel of the chart illustrates, speculators remain massively short the CAD against the EUR. This creates a cushion for the CAD versus the EUR if global growth slows. Moreover, technicals are still favorable of shorting EUR/CAD. Not only is EUR/CAD still overbought on a 52-week rate-of-change basis, it seems to be in the process of forming a five-wave downward pattern, with the fourth one - a countertrend wave - potentially ending (Chart I-23). Chart I-22EUR/CAD Is Still Vulnerable Chart I-23Wave Pattern Not Completed Finally, EUR/CAD tends to perform poorly when the USD strengthens, which fits with our current thematic for the remainder of 2018. Bottom Line: The headline risk surrounding NAFTA has weighed on the loonie against the euro, stopping us out of our short EUR/CAD trade with a small profit. However, the valuation, positioning and technical dynamics suggest the timing is ripe to short this cross once again. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Rome Is Burning: Is It The End?", dated June 1, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "This Time Is NOT Different", dated May 25, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was stellar: NFIB Business Optimism Index climbed to 107.8, outperforming expectations; the price changes and good times to expand components are also very strong; Headline and core PPI both outperformed expectations, auguring well for future consumer inflation; Headline and core retail sales grew by 0.8% and 0.9% in monthly terms, beating expectations; Both initial and continuing jobless claims also came out below expectations, highlighting that the labor market is still tightening, and wage growth could pick up further. The Fed raised interest rates this week to 2%, and added one additional rate hike to its guidance for 2018. FOMC members once again highlighted the "symmetric" target, suggesting that the Fed expects the economy to overheat slightly. An outperforming U.S. economy relative to the rest of the world is likely to propel the greenback this year. Report Links: This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Economic data was largely disappointing: Italian industrial output contracted by 1.2% on a monthly basis, and grew only by 1.9% on a yearly basis; The German ZEW Survey declined substantially across all metrics; European industrial production increased by 1.7% annually, less than the expected 2.8% increase; However, Spanish headline inflation spiked up from 1.1% to 2.1%. Yesterday, ECB President Mario Draghi announced the ECB's plan to taper asset purchases to EUR 15 bn a month in September, and phase them out completely by year-end. Moreover, Draghi highlighted that the ECB was not anticipating to implement its first hike until after the summer of 2019. Furthermore, the ECB President highlighted the current slowdown in global growth, as well as the rising protectionist risk from the U.S. potentially negatively impacting the European economy and the ECB's decisions going forward, suggesting that the plans are not set in stone. 2018 is likely to remain a volatile year for the euro. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Japanese data has been strong this week: Machine orders increased on a 9.6% annual basis, and a 10.1% monthly basis, in April, outperforming expectations by a large margin; The Domestic Corporate Goods Price Index also increased by 2.7% annually, higher than the expected 2.2% increase. As political and economic risks in Europe and South America having subsided for now, the yen has lost some of its glitter. However, with ongoing uncertainty on trade and populism across the globe, we maintain our tactically bullish stance on the yen, especially against commodity currencies and the euro. However, beyond the short-term horizon, the BoJ will remain determined to cap any excess appreciation in the yen, as a strong JPY tightens Japanese financial conditions, weighing on the BoJ's ability to hit its inflation target. This will ultimately limit the yen's upside on a cyclical basis. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Data from the U.K. was somewhat disappointing: Manufacturing and industrial production both increased less than expected, at 1.4% and 1.8%, respectively; The goods trade deficit widened to GBP 14.03bn from GBP 12bn, and the overall trade deficit widened to GBP 5.28bn from GBP 3.22bn; Average earnings grew by 2.8%, less than the expected 2.9%; However, headline inflation came in at 2.4%, less than the expected 2.5%, while retail price inflation also underperformed expectations. This means that the uptrend in real wages continues. Given the limited movement in the pound, it seems that a lot of the bad news was already priced in by last month's depreciation. However, Theresa May's ongoing blunders in parliament represent a continued source of risk for the pound. While the GBP has downside against the EUR, it is unlikely to see much upside against the greenback. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Do Not Get Flat-Footed By Politics - March 30, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was weak: NAB Business Confidence and Conditions surveys both declined, also underperforming expectations; Australian employment grew by 12,000, less than expected. Moreover, full-time employment contracted. While the unemployment rate dropped as a result, this was largely due to a fall in the participation rate. RBA's Governor Lowe, in a speech on Wednesday, announced that any increase in interest rates "still looks some time away" as the slack in the labor market does not seem to be diminishing. Annual wage growth has been constant at 2.1% for the past three quarters, and did not pick up despite an improvement in full-time employment earlier this year. We remain bearish on the AUD. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The NZD is likely to face significant downside against the greenback along with the other commodity currencies as global growth slows down. However, due to its weaker linkages to Chinese industrial demand, the kiwi is likely to see less downside than the AUD. Nevertheless, it is likely to weaken against the CAD and the NOK as the NZD is expensive against these oil currencies, and oil's is likely to continue to outperform other commodities will support this view. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 USD/CAD has been on an uptrend given the greenback generally strong performance since February year, a force magnified by the volatile rhetoric surrounding NAFTA negotiations. However, the Canadian economy has been accelerating this year, thanks to robust growth in the U.S., to a strong Quebecer economy, and to a pickup in Alberta. In addition, the Canadian labor market is tightening further and wage growth is above 3%. Furthermore, risks surrounding NAFTA seem already reflected in the CAD's behavior and valuation. There is more clarity on the CAD versus its crosses than on the CAD versus the USD. Outperforming U.S. and Canadian growth relative to the rest of the world mean that the CAD should outperform most other G10 currencies. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data out of Switzerland was decent: Industrial production increased by 9% in annual terms, albeit less than the previous 19.6% growth; Producer and import prices increased by 3.2% year on year, in line with expectations, however the monthly increase underperformed markets anticipations. With global trade tensions rising, and Germany having entered President Trump's line of sight, the CHF could experience additional upside against the euro in the coming months. However, the SNB is unlikely to deviate from its ultra-accommodative stance, which means that any downside in EUR/CHF will proved to be short lived. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Both headline and core inflation underperformed, coming in at 2.3% and 1.2%, respectively. However, the Regional Network Survey hinted at a pickup in capacity utilization as expectations for industrial output remained robust, as well as at an additional strength in employment. This led to a forecast of a resurgence in inflationary pressures. We expect the NOK to outperform the EUR. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish inflation rose from 1.7% to 1.9%, coming in line with expectations. Additionally, Prospera 1-year inflation expectations survey rose to 1.9% from 1.8% in the March survey. This is likely to provide the Riksbank with reasons to turn gradually more hawkish, which should support the very cheap krona. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The chaotic conclusion to last weekend's G7 summit in Charlevoix is a reminder that the specter of trade wars will not fade quietly into the night. A trade war would hurt the U.S., but would punish the rest of the world even more. The U.S. dollar typically strengthens when global trade slows. Despite President Trump's antics, the dollar is at little risk of losing its status as the world's premier reserve currency. Fiscal stimulus should keep U.S. growth above trend well into next year, allowing the Fed to maintain its once-per-quarter pace of rate hikes. We are currently overweight global equities, but we expect to shift to neutral before the end of the year. Feature Hit First, Ask Questions Later Donald's Trump's negotiating style - hit as hard as you can and then compromise - has worked well in dealing with tin-pot dictators, at least judging by the apparent outcome of this week's Singapore summit with Kim Jong-Un. It has also worked well throughout Trump's career as a real estate developer. However, as the breakdown of last weekend's G7 summit demonstrates, it is not clear if it is a winning strategy in the realm of international trade. Down-on-their-luck creditors may be willing to settle for twenty cents on the dollar when they had been promised one hundred, but governments have their citizens to answer to, and national pride often trumps (ahem) narrow financial interests in such matters. How Not To Fight A Trade War The U.S. is a fairly closed economy and hence a trade war probably would not have severe effects on growth. However, the way Trump is waging his war ensures that whatever impact it has on the domestic economy will be negative. This is not only because Trump's tariffs are certain to invite retaliation; it is also because Trump is targeting intermediate goods - goods that are used as inputs into production of final goods - for tariffs. Chart 1Rising Productivity In The Steel Sector ##br##Caused Employment To Decline Consider the case of steel. Today, the U.S. steel industry employs just 145,000 workers, down from 203,000 workers in 2000. In contrast, there are about two million workers employed in steel-consuming sectors of the economy.1 A reasonable rule-of-thumb from the international trade literature is that a one-percent increase in foreign prices causes domestic prices to rise by about half a percent. This is mainly because domestic producers end up capturing some of the gains from tariffs through higher profit margins. A 25% increase in steel tariffs would thus raise steel prices by around 12.5%. Higher steel prices will lead to higher prices for many American goods such as automobiles, some of which are exported abroad. It is actually quite conceivable that steel tariffs would reduce exports more than they would depress imports, leading to a wider trade deficit. Ironically, foreign competition probably explains only a small fraction of the decline in U.S. steel employment. The U.S. produces roughly as much steel now as it did in 2000 (Chart 1). What has changed is that output-per-worker in the steel industry has increased by a total of 43% since then. Blame technological progress, not trade. Trade Wars, The Fed, And The Dollar Chart 2The Dollar Tends To Strengthen ##br##When Global Trade Deteriorates Even if higher tariffs did produce a one-off increase in consumer and producer prices, slower GDP growth would likely prompt the Fed to moderate the pace of rate hikes. If the stock market declined in sympathy with slower growth and rising protectionist sentiment, the resulting tightening in financial conditions would further justify a go-slow approach to monetary normalization. All things equal, a more dovish-than-expected Fed would likely translate into a weaker dollar. All things are not equal, however. A trade war would probably hurt the rest of the world more than the U.S. This is partly because the rest of the world is more open to trade, but it is also because the rest of the world runs a trade surplus with the U.S., which makes it more vulnerable to a broad-based decline in trade volumes. Chart 2 shows that the dollar tends to strengthen when global trade is weakening. Reserve Currency Status In Jeopardy? An often-heard counterargument to the "protectionism is good for the dollar" view is that at some point, rising trade tensions could undermine the dollar's standing as the world's premier reserve currency. The U.S. has run a trade deficit almost continuously for 40 years, accumulating 40% of GDP in net liabilities to the rest of the world in the process (Chart 3). If foreign buyers decide to scale back their purchases of U.S. assets, the dollar could swoon. Chart 3U.S. External Deficit: 40 Years And Counting Trump's statement at the conclusion of the G7 summit that "We're like a piggy bank that everybody's robbing" seems to imply that he thinks that foreigners are living beyond their means by draining the U.S. of its wealth. The opposite is actually the case: The U.S. has been able to spend more than it earns for decades precisely because foreigners have been willing to deposit ever more money into the U.S. piggy bank. Fortunately for the greenback, America's status as the world's piggy bank of choice is unlikely to change any time soon. The euro area remains hopelessly divided. The Italian bond market - the biggest in Europe - has once again become the object of investor angst. Japan is drowning in a sea of government debt, with debt monetization probably the only viable solution. China would like to transform the renminbi into a global reserve currency, but opacity in government decision-making, and a still largely closed capital account, will limit any progress towards that goal for some time to come. China and other countries could try to "punish" the U.S. government by buying fewer Treasury bonds, but where would that get them? The average maturity of U.S. government debt is less than six years. The Fed, not China, largely sets rates at that portion of the yield curve. Granted, a decline in Treasury purchases would reduce the demand for dollars. However, that would just put upward pressure on the value of the renminbi. China does not want a stronger currency. For all the talk about how America's rivals are keen to reduce their dollar holdings, their share of global central bank reserves has actually climbed over the past two decades, largely because they have been gobbling up dollars to keep their own currencies from appreciating (Chart 4). Today, nearly two-thirds of global currency reserves are denominated in dollars, a higher proportion than when the Berlin Wall fell in 1989 (Chart 5). Chart 4Geopolitics Is Not Driving Demand For Treasurys Chart 5The Dollar Remains The Preferred Reserve Currency A Not So Exorbitant Privilege Chart 6The U.S. Term Premium Is ##br##Higher Than Elsewhere In any case, it's not clear how much the U.S. benefits from having a reserve currency. There is little evidence that U.S. long-term bond yields are lower than they would otherwise be because of foreign reserve accumulation. Chart 6 shows that the term premium - the difference between the yield on a long-term bond and the market's expectation of the average level of short-term rates over the life of the bond - is higher in the U.S. than in the rest of the world. If foreign central bank purchases were pushing down U.S. bond yields, one would expect to see the reverse pattern. The only tangible benefit the United States gets from having a reserve currency is that the U.S. Treasury can issue currency to foreigners who hold it as a store of value rather than spending it. This amounts to an interest-free loan to the U.S. government. This so-called "seigniorage revenue" is not trivial: Last year, foreigners increased their holdings of U.S. currency by $60 billion.2 However, this is still less than one-third of one percent of U.S. GDP. What Really Explains Why The U.S. Has A Current Account Deficit? It is often argued that the dollar's reserve currency status has allowed the U.S. to run large current account deficits. However, Australia has run even bigger current account deficits than the U.S., and it does not have a reserve currency. What matters in the end is whether people trust you to pay back your debts, not whether you have a reserve currency. The rate of return that a country offers investors is also important. As we explained in our weekly report on April 6th, an often-overlooked reason for why the U.S. and Australia run current account deficits is that both countries enjoy faster trend growth than most of their peers.3 Faster growth tends to push up the neutral real rate of interest, otherwise known as r-star. A country with a relatively low neutral rate needs to have an "undervalued" currency that is expected to appreciate over time in order to compensate investors for the subpar yield that its bonds provide. As sketched out in Chart 7, this results in current account surpluses for countries with low neutral rates, and current account deficits for countries with high neutral rates. Chart 7Interest Rates And Current Account Balances Commentators who claim that the euro is cheap are barking up the wrong tree. The euro needs to be cheap to entice investors into holding low-yielding German bunds and other safe-haven euro area bond markets. Indeed, one could argue that the euro is not cheap enough. Thirty-year U.S. Treasurys currently yield 3.07% while 30-year German bunds yield 1.16%, a difference of 191 basis points. Even if one allows for the fact that investors expect euro area inflation to be lower than in the U.S. over the next 30 years, EUR/USD would need to trade at a measly 84 cents today in order to compensate German bund holders for the inferior yield they will receive.4 The euro got a good clobbering yesterday following the release of the ECB's post-meeting statement, which established a timeline for ending asset purchases by the end of this year but promised no rate hikes for at least another 12 months. We continue to expect EUR/USD to hit 1.15, with a high likelihood that it goes even lower. Lessons From The Nixon Shock We are skeptical of the argument that threatening to raise tariffs is an effective tool for talking down one's currency. It is true that the Nixon Administration imposed an across-the-board 10% tariff in August 1971, which succeeded in forcing America's trading partners to revalue their currencies within the quasi-fixed exchange-rate Bretton Woods system that prevailed at that time. Such an arrangement would be difficult to orchestrate today. For one thing, the U.S. does not have the geopolitical sway that it once did. Moreover, when exchange rates are pegged, one can often revalue a currency to the upside while cutting interest rates (if investors expect a series of revaluations, they would be willing to hold government bonds even if they yielded less than those abroad). In today's world of flexible exchange rates, a country would need to be willing to tighten monetary policy to drive up its currency. Thus, it would get hit on two fronts: From a stronger currency and from higher interest rates. This additional cost to the economy lowers the odds that any country would voluntarily undertake such measures in the hope (probably futile anyway) of placating Trump. In any case, most of the dollar's weakness in the 1970s occurred after the December 1971 Smithsonian Agreement reversed Nixon's tariff hike. What followed was a period of trade liberalization on the back of successive GATT negotiation rounds. U.S. tariffs actually fell more in the 1970s than in the prior two decades (Chart 8). The fact that the dollar weakened during that period had more to do with the Fed, which permitted inflation to get out of hand by allowing real rates to remain in chronically negative territory. The dollar also suffered from the surge in oil prices, which produced a 35% deterioration in the U.S. terms of trade over the course of the decade (Chart 9). Chart 8Two Centuries Of U.S. Tarriffs Chart 9Dollar Weakness In the 1970s: Blame Deteriorating Terms Of Trade And A Dovish Fed It is possible that the Fed will repeat the mistakes of the 1970s, but this is more of a risk for the 2020s than a near-term concern. U.S. real yields have actually risen substantially relative to those abroad since last September (Chart 10). Chart 10The Dollar Is Once Again Responding ##br##To Real Rate Differentials The outcome of this week's FOMC meeting was on the hawkish side. The median number of dots in the newly released Summary of Economic Projections now point to four rate hikes this year, up from three hikes in the March projections. In addition, the Fed increased estimates for both growth and core inflation for this year. The decision to hold press conferences following every FOMC meeting will also give the Fed greater scope to expedite the pace of rate hikes. Investment Conclusions After panicking over every Trump tweet promising more protectionism earlier this year, markets have taken the recent news of escalating trade tensions in stride. Investors presumably think that Trump will water down his rhetoric, as he has periodically done over the past few months. Such a benign outcome is entirely possible. Trump left a fig leaf at the G7 summit in the form of a challenge to other members to eliminate their tariffs in exchange for the U.S. doing the same. Reaching such a deal would not be easy, but incremental progress towards this goal could be achieved. The overall level of tariff barriers within developed countries is already quite low. The U.S. actually stands at the top end of the spectrum -- average U.S. tariffs of 1.6% are double that of Canada, for example -- so the rest of the G7 would be wise to call Trump's bluff and agree to talks to further scale back trade barriers (Chart 11). This could give risk assets some breathing space for the next year or so. Yet, such a rosy outcome is far from guaranteed. Protectionism is popular among American voters, especially among Trump's base (Chart 12). Trump's obsession with the level of the stock market was a constraint on his protectionist rhetoric, but now that investors are content to look the other way, that constraint has loosened. Chart 11Tariffs: Who Is Robbing The U.S.? Chart 12Free Trade Is Not In Vogue In The U.S., And Is ##br##Especially Disliked Among Trump Supporters The fact that Trump's macroeconomic policies are completely at odds with his trade agenda does not help matters. Fiscal stimulus will boost aggregate demand, which will suck in more imports. An overheated economy will prompt the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. All this will result in a wider trade deficit. What will Trump tell voters two years from now when he is campaigning in Michigan and Ohio about why the trade deficit has widened rather than narrowed under his watch? Will he blame himself or America's trading partners? No trophy for getting that answer right. The effect of a trade war on the stock market would be grave. Multinational firms have large footprints abroad, the result of decades of investment in global supply chains. Equities represent a claim on the existing capital stock, not the capital stock that might emerge after a trade war has been fought. A trade war would result in a lot of stranded capital, forcing investors to mark down the value of the companies in their portfolios. In light of these risks, we expect to downgrade our recommendation on global equities from overweight to neutral before the end of the year. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Lydia Cox and Kadee Russ, "Will Steel Tariffs put U.S. Jobs at Risk?," EconoFact, February 26, 2018. Steel-consuming industries are defined as those that devote more than 5% of their total costs to steel. 2 Considering that 80% of U.S. currency in circulation consists of $100 bills, it is safe to say that much of this overseas stash of cash belongs to those who acquired it through ill-gotten means. 3 Please see Global Investment Strategy Weekly Report, "U.S.-China Trade Spat: Is R-Star To Blame?," dated April 6, 2018, available at gis.bcaresearch.com. 4 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The annual inflation differential of 0.4% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.49 after 30 years. If one assumes that the euro reaches that level by then, the common currency would need to trade at 1.49/(1.0191)^30=0.84 today. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Major and drawn-out financial market downturns usually occur in phases and often resemble a domino effect. There have been a number of noteworthy divergences in the EM space of late. They are probably part of a domino effect - some tiles have begun to drop, but other tiles down the chain still remain standing. The selloff in EM risk assets will broaden and intensify. A defensive positioning is warranted. India's relative equity performance has by and large been undermined by rising oil prices. A potential roll-over in crude prices will aid the Indian bourse's relative performance versus its EM peers. The South African rand remains on shaky foundation; stay short. Feature There have been a number of noteworthy divergences in financial markets of late, in particular between emerging markets (EM) and commodities, as well as between Chinese investable stocks trading outside the mainland and equity prices listed domestically. In our view, these divergences are part of a domino effect - some tiles have begun to drop, but other tiles down the chain still remain standing. In dominos, tiles do not all fall simultaneously. They fall one by one, and there is a time lag between the first domino and the last-standing domino to drop. Also, unlike in natural sciences, time lags and speed in economics and finance vary with each experiment - because they are contingent on complex human psychology and behavior, not on well defined natural phenomena such as gravity or motions of objects. Hence, they are impossible to forecast with much precision. A Message From Our Risky Versus Safe-Haven Currency Ratio Although U.S. share prices have lately been firm, EM stocks have broken below their 200-day moving average (Chart I-1, top panel). So has our risky versus safe-haven currencies ratio 1 (Chart I-1, bottom panel). Indeed, while having held up at its 200-day moving average several times in the past two years, the ratio has recently decisively broken below this technical support line. This indicator correlates extremely well with EM share prices, and its message is presently unambiguous: The rally in EM is over, and a bear market has likely commenced. Crucially, this ratio measures commodities currencies versus the average of the Japanese yen and Swiss franc - two defensive currencies - not against the U.S. dollar. Hence, it is not impacted by the greenback's trend. Given that all six risky currencies used in the numerator of this ratio - AUD, CAD, NZD, BRL, ZAR and CLP - are commodity currencies, it is not surprising that the ratio also correlates with commodities prices. In this context, it currently suggests the outlook for both industrial metals and oil is troublesome (Chart I-2). Chart I-1Beware Of These Breakdowns Chart I-2A Red Flag For Commodities Prices The common denominator that links all these financial variables is global growth. The risky versus safe-haven currencies ratio typically leads world trade cycles by several months, and it currently points to a notable slowdown in global export volumes (Chart I-3). Chart I-3Global Export Growth Is Set To Slow Further, commodities prices have exhibited a rare decoupling from the U.S. dollar. It is very unlikely that this divergence can be sustained for much longer. Our bias is that global trade will slow as China/EM demand weakens despite robust U.S. growth. Growth dynamics shifting in favor of the U.S. entails that the greenback will continue to appreciate. Consistently, EM/China growth disappointments and U.S. dollar's persisting strength suggest that commodities will reverse their current trend sooner rather than later. A relapse in commodities prices will reinforce EM currency depreciation, triggering more outflows from EM equities and fixed-income markets. Decoupling Or A Time Lag? Chart I-4Domino Effect In 2007-08 Major and drawn-out financial market downturns usually occur in phases and often resemble a domino effect. The EM crises in 1997-98 did not occur simultaneously across all EM countries. It began in July 1997 with Thailand, then it spread to Korea, Malaysia and Indonesia and finally, to the rest of Asia. In August 1998, Russian financial markets collapsed triggering the LTCM debacle. The last leg of this crisis appeared in Brazil and culminated in the real's devaluation in January 1999. Similarly, the U.S. financial/credit crisis commenced with the selloff in sub-prime securities in March 2007. Following that, corporate spreads began widening and bank share prices rolled over in June 2007. In the meantime, the S&P 500 and EM stocks peaked on October 9 and 29, 2007, respectively. Despite all of these developments, commodities prices and EM currencies continued rallying until summer of 2008 and then quickly collapsed in the second half of that year (Chart I-4). Finally the Lehman crash took place on September 29 of 2008. That marked the apogee of the crisis, causing a complete unravelling of financial markets and the global economy, and lasting until March of 2009. It seems some sort of domino effect is now taking hold of the EM universe. Initially, it started with Turkey and Argentina. Then, it spread to Indonesia, India and Brazil. The currency weakness across the wider EM universe has already led to EM credit spread widening. Yet, there are a few EM financial markets, particularly Chinese, Korean and Taiwanese, that are still holding up relatively well. Moreover, U.S. share prices and high-yield credit spreads have done quite well too. How should investors interpret these divergences? Our view has been, and remains, that EM risk assets will do poorly regardless of the direction of the S&P 500. In fact, an escalation in EM turmoil and a slowdown in developing economies are among the main risks to American share prices themselves. The primary link from EM financial markets to the S&P 500 is via the exchange rate - a strong dollar along with an EM/China growth slump will weigh on American multinationals' profits. The following three questions are presently vital for investors: 1. Can EM and U.S. risk assets de-couple from each other, and has a sustainable divergence happened in the past? Although short-term moves in U.S. and EM equity indexes often appear correlated, from a big-picture perspective there have been considerable divergences. The overall EM stock index is now at the same level it was in 2007 (Chart I-5). Meanwhile, the S&P 500 index is a hair below its all-time high. Chart I-5EM Share Prices And The S&P 500: A Long-Term Perspective The same is true for many EM currencies and the S&P 500. A substantial decoupling did occur in the not-so-distant past: EM currencies depreciated from 2011 to early 2016, while U.S. share prices rallied strongly from late 2011 until 2015 (Chart I-6). With respect to U.S. credit spreads, Chart I-7 illustrates that EM and U.S. credit spreads have had a much higher correlation than their respective equity indexes. During the 1997-'98 EM crises and the 2014 -'15 EM turmoil, U.S. high-yield corporate spreads widened. In brief, there has historically been little decoupling between U.S. and EM credit markets. Hence, the U.S. high-yield credit market's latest resilience in the face of widening in EM credit spreads is historically exceptional. Chart I-6EM Currencies And The S&P 500 Chart I-7EM Sovereign And U.S. Corporate Credit Spreads: A Long-Term Perspective As EM currencies continue to depreciate versus the U.S. dollar, EM sovereign and corporate credit spreads will widen. Given their past high correlation with U.S. credit markets, odds point to widening corporate credit spreads in the U.S. On the whole, if EM risk assets continue to sell off, which is our baseline scenario, the S&P 500 and U.S. credit markets could defy gravity for a while, but not forever. At some point, risks stemming from EM turbulence will cause a selloff in American stocks and corporate bonds. It is impossible to know when and by how much U.S. stocks will suffer. Our bias is that a U.S. equity selloff will likely be on par with the 2015-'16 episode. 2. Can North Asian equity markets such as China, Korea and Taiwan remain relatively resilient if the turbulence in other EM countries continues? Based on history, they can, but only for a short period of time. There have been a few episodes when emerging Asian and Latin American stocks de-coupled: In 1997-'98, the home-grown Asian crisis devastated regional markets, but Latin American stocks continued to rally until mid-1998 - at which point they began plummeting (Chart I-8, top panel). In 2007-'08, emerging Asian equities started tumbling along with the S&P 500 in late 2007, but Latin American bourses fared well until the middle of 2008 due to surging commodities prices (Chart I-8, middle panel). Finally, the bottom panel of Chart I-8 illustrates that in early 2015, Asian stocks performed well, supported by the inflating Chinese equity bubble. Meanwhile, Latin American stocks plunged. In all of these episodes, the de-coupling between Asia and Latin America proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside. Regarding Asia's business cycle conditions, the slowdown is already taking place and will likely intensify. Leading indicators of exports and manufacturing such as Korea's manufacturing shipments-to-inventory ratio and Taiwan's semiconductor shipments-to-inventory ratio herald further deceleration in their respective export sectors (Chart I-9). Chart I-8Asian And Latin American Equities: ##br##Unsustainable Divergences Chart I-9Asia's Export Slowdown Is In Making 3. Is there any other notable financial market decoupling that investors should be aware of? Chart I-10China: A Decoupling In Various Equity Segments Since early this year, there has been substantial decoupling between Chinese investable stocks and the onshore A-share market. First, the overall A-share index has dropped since early this year, but the MSCI Investable Chinese stock index has so far been resilient (Chart I-10). Second, while it might be tempting to explain this decoupling by discrepancies in the sectors' weights in these indexes, this has not been the case this time around. The fact remains that there has been considerable divergence between share prices of the same sectors. For example, onshore and offshore equity prices have diverged for the following sectors: real estate stocks, materials, industrials, technology, utilities and consumer discretionary (Chart I-11A and Chart I-11B). Only defensive sectors such as consumer staples and health care have done well in both universes. Share prices of financials and telecoms have dropped in both the onshore and offshore markets. Chart I-11AChinese Equity Sectors: Puzzling Decoupling Chart I-11BChinese Equity Sectors: Puzzling Decoupling Finally, a similar performance gap has appeared between Chinese small cap stocks trading onshore and in Hong Kong (Chart I-12). Chart I-12China's Small-Cap Stocks: A Perplexing Gap How do we explain these divergences? Our bias is that local investors in China are much more concerned about the mainland growth outlook than foreign investors. This is the opposite of what occurred in 2015. Back then, international investors were somewhat cautious on China - commodities prices and other China-related global financial market plays were in a bear market. Meanwhile, local investors were caught up in a full-fledged equity mania that ended with a crash. Given our downbeat outlook on China's capital spending and related plays in financial markets, we reckon that domestic investors in China will be proven right in the months ahead, while the international investment community will be left flat-footed. Importantly, there has been an unexplainable mismatch between monetary/credit tightening in China and complacency among international investors about the outlook for the mainland economy. Specifically, the cost of borrowing has gone up, and credit standards have tightened. Chart I-13 illustrates that both onshore and offshore corporate bond yields have risen to new cycle highs, Chinese banks' lending rates are rising, while banks' loan approvals are dropping. Consistently, money and credit growth have plunged. Importantly, this is occurring in an economy with immense credit excesses. Nevertheless, commodities prices have so far defied such a pronounced deceleration in money and credit aggregates in China (Chart I-14). Chart I-13China: Ongoing Credit Tightening Chart I-14China's Money/Credit And Commodities Prices All in all, we interpret these divergences by varying lead and lags rather than as a fundamental breakdown in the relationship between money/credit and the real economy. We continue to expect tightening liquidity and credit to escalate the growth slowdown in China. As a result, there continues to be considerable downside risks for Chinese investable stocks and commodities prices. Bottom Line: The dominos have begun to fall. We continue to recommend a defensive strategy and an underweight position in EM equities, credit and currencies versus their U.S./DM peers. High-yield local currency bonds that are a de-facto bet on the underlying currencies are vulnerable too. For investors willing to go short, it is not too late to short EM stocks and currencies. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Average of cad, aud, nzd, brl, clp & zar total return (including carry) indices relative to average of jpy & chf total returns. India's Equity Underperformance: Blame It On Oil Indian stocks have been underperforming their EM counterparts. Rising oil prices have created a toxic macro mix for India, triggering the equity underperformance (Chart II-1): Rising crude prices have led to widening current account and trade deficits. Oil price swings are often instrumental to trends in India's current account balance (Chart II-2). The deterioration in the nation's external accounts has been behind the rupee's poor performance. Chart II-1Higher Crude Oil Prices Hurt Indian Stocks Chart II-2Crude Oil And Current Account Deficit Given that India is a major oil importer, falling commodities prices - especially crude oil - will benefit India's stock market. The recent surge in oil prices has also reinforced inflation dynamics in India (Chart II-3). Chart II-3Higher Crude Oil Boosts Inflation The basis for the high correlation between core consumer price inflation (excluding energy and food) and oil prices is due to the fact that core inflation includes components that are heavily influenced by fluctuations in oil prices. For instance, the transportation and communication component of inflation is very sensitive to changes in oil prices. This component accounts for 18% of core consumer price index. Further, the personal care and effects component also correlates with crude oil. Personal care goods use petroleum products as an important input in their production process. This component accounts for 8% of core consumer price index. Together these components account for a non-trivial 26% of core consumer price index, and will likely subside as oil prices fall. On the inflation front, we highlighted in our April 19 Weekly Report that risks to inflation are tilted to the upside due to strong consumer and government spending in an otherwise under-invested economy.1 Domestic demand has been accelerating, providing tailwinds for higher inflation (Chart II-4). Higher inflation and currency weakness has led to a considerable rise in both government and corporates local currency bond yields (Chart II-5). Chart II-4Domestic Economy Is Strong Chart II-5Rising Borrowing Rates Given the very high equity valuations, share prices in India are especially sensitive to rising local borrowing costs. All in all, India's relative equity performance has by and large been undermined by rising oil prices. BCA's Emerging Markets Strategy team believes the risk-reward for oil prices is skewed to the downside due to the expected deterioration in EM/China oil demand, investors' extremely high net long positions in crude and appreciating dollar.2 That is why we are still reluctant to downgrade Indian stocks within the EM equity universe. It is vital to emphasize, however, that our overweight call is relevant to dedicated EM equity portfolios. We have been, and remain, negative on Indian share prices in absolute U.S. dollar terms. Bottom Line: Odds are that commodities prices will drop meaningfully in the months ahead and that will support India's relative equity performance versus the EM benchmark. EM dedicated investors should keep an overweight stance on Indian equities for now. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "Country Perspectives: India And Turkey," dated April 19, 2018, link available on page 21. 2 The Emerging Markets Strategy team's view on oil differs from BCA's house view which remains bullish. The South African Rand Remains On Shaky Foundations Although the rand has not been among the worse hit EM currencies, investors should remain cautious on it. The currency presently finds itself resting on very shaky foundations, raising odds of substantial depreciation for the remainder of the year: First, South Africa's external funding has solely been driven by portfolio inflows, leaving the exchange rate highly exposed to potential portfolio outflows. As illustrated in Chart III-1, net portfolio inflows reached all-time highs while net FDIs reached all-time lows at the end of 2017 (the latest available statistics). Meanwhile, foreign ownership of domestic bonds has reached new highs (Chart III-2). The total return in dollar terms on South Africa's local currency bond index1 has failed to break above its previous highs and has relapsed (Chart III-3). It seems this asset class has entered a new bear market. Further decline in the total return of bonds will spur more selling or hedging of currency risks by international bond investors. Chart III-1South Africa: Highly Exposed To Portfolio Flows Chart III-2Foreign Holdings Of South African Local Bonds Is Elevated Chart III-3South African Bonds Were Unable To Break Out Second, the country's trade balance is set to deteriorate. Despite continued episodes of currency weakness throughout last decade, there has been little to no import substitution in South Africa. Consequently, a reviving domestic demand will prompt higher imports. That, and a potential relapse in export (raw materials) prices, will lead to a widening trade balance. Chart III-4The Rand Is Not Cheap Finally, the rand is not cheap; its valuation is neutral (Chart III-4). When an exchange rate is close to its fair value, it can either appreciate or depreciate. In short, the rand's valuation is not extreme enough to be a major factor in driving the market right now. Bottom Line: Currency traders should stay short the ZAR versus both the USD and the MXN. Relative trade balance dynamics and valuations continue to play in favor of the Mexican peso relative to the South African rand. Predicated by our negative view on the rand, we recommend EM dedicated equity and fixed-income investors to maintain an underweight allocation to South Africa. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 JP Morgan GBI-EM Global Diversified Emerging Markets Government Bond Index for South Africa. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The following four investment themes are likely to play out over the next couple of years: The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. The 10% undervaluation of the trade-weighted euro - as assessed by the ECB itself - will eventually correct. As the euro area's structural over-competitiveness gradually adjusts, euro area sectors that are domestically-oriented, like travel and leisure, will structurally outperform those that are export-oriented, like autos. Swedish real estate and Swedish real estate equities, which are both very richly valued, will underperform. Feature What connects last Sunday's dysfunctional G7 Summit with this week's ECB policy meeting? The answer is the euro area's €450 billion export surplus. Specifically, the €300 billion export surplus in Germany which equals 8% of its GDP - an export surplus that is squarely in President Trump's cross-hairs (Chart of the Week). Chart of the WeekECB Policy Has Driven Up Germany's Export Surplus The interesting thing is that the euro area hasn't always run an export surplus. Before 2012, the euro area's trade with the rest of the world was more or less in balance. Even Germany's export surplus was half of its current size. To put it in Trumpian terms, fewer Mercedes were "rolling down New York's Fifth Avenue." What caused the imbalance to surge in recent years? Was it punitive tariffs or restrictive trade practices in Germany? No, the answer is much simpler than that. ECB Policy Has Driven Up Germany's Export Surplus The export surplus in the euro area and in Germany is just a mirror-image of the euro exchange rate (Chart I-2). As the euro became undervalued, it made euro area exports more competitive and foreign imports into the euro area less competitive. This assessment of euro area over-competitiveness comes straight from the horse's mouth. The ECB's own indicators show that the euro area remains over-competitive by around 10%, meaning the euro is still undervalued by about 10%.1 In turn, the euro's substantial undervaluation is a near perfect function of the yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts (Chart I-3). It follows that the ultimate cause of the euro area's glaring imbalance is ECB policy itself - specifically, the extreme experiment with bond buying and negative interest rates. Chart I-2ECB Policy Has Driven Up The ##br##Euro Area's Export Surplus Chart I-3The ECB's Expansive Monetary Policy Is ##br##Responsible For The Euro's Undervaluation As Germany's former Finance Minister, Wolfgang Schäuble, explained: "When ECB chief Mario Draghi embarked on the expansive monetary policy, I told him he would drive up Germany's export surplus... I promised then not to publicly criticise this policy. But then I don't want to be criticised for the consequences of this policy." The ECB counters that it targets neither the euro exchange rate nor the trade balance; it sets policy to achieve its mandate for price stability. It argues that it is further from its mandate for price stability compared with the Federal Reserve because, ostensibly, the euro area is at a different point in the economic cycle compared with the U.S. This requires the ECB to set an ultra-accommodative policy compared with other central banks. The undervalued euro and trade surplus are the unavoidable spill-overs of this relative monetary policy. ECB Spill-Overs Felt Far And Wide However, one important reason that euro area inflation is underperforming U.S. inflation has nothing to do with the economic cycle. Rather, it is because the official measures of inflation in the euro area and the U.S. are defined differently (Chart I-4 and Chart I-5). The euro area's Harmonized Index of Consumer Prices (HICP) omits the consumption costs of owner-occupied housing, whereas the U.S. consumer price basket includes them at a very substantial 25% weight. Homeowners will testify that the cost of maintaining their homes constitutes one of their largest expenses, and that these costs tend to rise faster than other prices. Using the U.S. as a guide, we estimate that a euro area inflation measure that correctly included home maintenance costs would be running higher than HICP inflation by an average of 0.5 percentage points a year (Chart I-6). Chart I-4Euro Area Inflation##br## Is Underperforming... Chart I-5...Because Euro Area Inflation Omits ##br##Owner-Occupied Housing Costs Chart I-6Including Owner-Occupied Housing ##br##Costs Adds 0.5% To Inflation Just because the statisticians do not measure owner-occupied housing costs in the euro area HICP, it doesn't mean that homeowners do not feel these costs. In Germany, measured inflation is now running at 2.3%, so the true inflation that households feel is running closer to 3%. Meanwhile, interest rates on savings accounts are stuck near zero, which means that German savers are seeing the real value of their savings erode by 3% every year. As Der Spiegel magazine put it to ECB Chief Economist, Peter Praet: "Can you understand why so many Germans regard the ECB as the greatest threat to their personal wealth?" Spill-overs from the ECB's ultra-accommodative policy have also been felt across the Baltic Sea. The Riksbank and the Norges Bank have had to shadow the ECB to prevent a sharp appreciation of their currencies versus the euro. The trouble is that ultra-low and negative interest rates have been absurdly inappropriate for the booming Scandinavian economies. So ECB policy may have generated spill-over housing bubbles in Sweden and Norway (Chart I-7 and Chart I-8). Chart I-7ECB Spill-Overs Felt In Scandinavia Chart I-8Scandinavian Real Estate Appears Richly Valued Hence, a seemingly innocuous 'definitional' difference between the consumer price baskets in the euro area vis-à-vis the U.S. explains: the bulk of the shortfall in euro area inflation; the ECB's justification for ultra-accommodation; the undervalued euro; the euro area's €450 billion trade surplus; deeply negative real interest rates in Germany; and putative housing bubbles in Sweden and Norway. The main argument we hear in the ECB's defence is that the central bank is at the mercy of its treaty. If the treaty demands ultra-accommodation then the ECB must deliver it. But this argument is wrong. The ECB treaty only asks that the central bank delivers "price stability", leaving the ECB with substantial flexibility in how it precisely defines price stability. With this in mind, the ECB - and other central banks - should use this definitional flexibility to minimize differences with other central banks. Because in a world of integrated capital markets, the spill-overs from seemingly innocuous definitional differences are felt far and wide, resulting in political backlashes and economic imbalances. Imbalances Must Correct In The Long Run Ultimately though, economic imbalances must correct, and the corrective mechanism is economic, financial, or political feedback loops, or some combination of these. On this basis, we reiterate four investment themes that are likely to play out over the next couple of years: The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. The 10% undervaluation of the trade-weighted euro - as assessed by the ECB itself - will eventually correct. As the euro area's structural over-competitiveness gradually adjusts, euro area sectors that are domestically-oriented, like travel and leisure, will structurally outperform those that are export-oriented, like autos (Chart I-9). Chart I-9As The Euro's Undervaluation Corrects, It Will Help Euro Area Domestics And Hurt Exporters Swedish real estate and Swedish real estate equities, which are both very richly valued, will underperform. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see https://www.ecb.europa.eu/stats/balance_of_payments_and_external/hci/html/index.en.html The ECB uses three metrics to assess the euro area's competitiveness versus its major trading partners: GDP deflators, CPIs, and unit labour costs. The average of the three metrics suggests that the euro is undervalued by around 10%.The assessment of euro undervaluation assumes that the major euro area economies entered the monetary union at a broadly correct level of competitiveness against each other and against their other major trading partners. This assumption seems valid, given that the net external position of these economies were all in equilibrium at the onset of monetary union. Fractal Trading Model We are pleased to report that our long SEK/GBP currency position hit its profit target of 3% and is now closed. This week we note that the relative performance of two classically cyclical sectors, oil and gas versus financials, is technically stretched and at a 65-day fractal dimension which has accurately predicted the last two major reversals. Hence, our recommended trade is short euro area oil and gas versus euro area financials. Set a profit target of 6% with a symmetric 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

Highlights China's ongoing industrial sector slowdown will not likely lead to a global growth shock, but investors should recognize that China's relative stability is supported by strong global demand. A negative surprise to export growth could materially shift global investor sentiment about the trajectory of China's economy, which would bode poorly for Chinese ex-tech stocks versus their global peers. Stay overweight for now, but with a short leash. The recent inclusion of Chinese A-shares in the MSCI Emerging Markets index may lead to heightened investor attention over the coming months, but we still recommend a neutral allocation. Within the domestic market, a factor approach suggests that financials are a good bet, and that real estate stocks have great potential as a contrarian trade if housing sales begin to durably trend higher. Index inclusion may also be a factor leading to increased global investor attention towards China's bond market over the coming two years. The comparatively high-yield and short duration of China's corporate bond market makes for an attractive investment opportunity, despite recent concerns about defaults. Stay long/overweight over the coming 6-12 months. Feature We have presented the following views about China's economy and its financial markets over the past several months: China's industrial sector is slowing, and is set to slow further based on our proprietary leading indicators for the Li Keqiang index. This will cause a further deceleration in Chinese nominal import growth and suggests that Chinese ex-tech earnings per share growth will soon peak. Residential investment has potential to provide a tailwind to domestic growth if home sales sustainably pick up, but there are no firm signs that this is occurring. Robust export growth will help China's economy from slowing sharply, but there are several risks to the external demand outlook that need to be monitored. Given the poor growth momentum in the industrial sector, fiscal or monetary stimulus will likely be required if China suffers a sudden export shock. China's consumer-oriented tech sector ostensibly stands out as a shelter from an old economy slowdown, but it is extremely expensive, earnings momentum is very stretched, and it may be adversely impacted by the U.S.' section 301 investigation. We have recommended avoiding exposure since mid-February. China's ex-tech equity market is comparatively cheap, high-beta vs the global benchmark, and technically robust. While the risks to the economic outlook are clear, investors should continue to overweight Chinese ex-tech stocks vs their global peers. For global investors who are perennially concerned that a slowdown in China's economy will culminate in a significant shock to the global economy, Chart 1 provides a helpful visual representation of our view. The chart depicts two scenarios: first, the ongoing industrial sector slowdown in China results in an outright subtraction from global growth momentum via a contraction in imports, despite positive growth impulses from the U.S. and euro area. In our view, Chinese import growth is likely to remain positive, but will largely be driven by strong demand in the developed world (scenario 2). Chart 1Two Different Scenarios Concerning China's Contribution To The Global Economy Chart 1 highlights that our view is more positive for the global economy than one might otherwise think, but it is important for investors to understand the nature of China's relative stability in the event that export growth surprises to the downside over the coming months. In fact, Chart 2 highlights that the most salient data development over the past two weeks has been a fairly significant deceleration in smoothed nominal export growth, which is our preferred method of analyzing Chinese trade data. Despite the relative stability of China's PMIs over the past few months, a 3-month moving average of US$ exports decelerated from 17.5% to 7% in May, or from 10% to -1% in RMB-terms. Sequentially, Chinese export growth improved in May (vs April's reading) in both US$ and RMB-terms, and both beat market expectations. As a result, we are sticking with the second scenario depicted in Chart 1 as the more likely of the two for the coming 6-12 months. However, the reliance on strong external demand to prop up China's import growth is somewhat of a "shaky ladder" for global investors to climb, given the clear risks from U.S. protectionist action, the headwinds to Chinese export competitiveness from a strong currency (or, alternatively, the punishing impact of translation effects on exporter revenue), and the potential for robust export growth to embolden Chinese policymakers to push forward with even more aggressive reforms over the coming year. Still, Chart 3 highlights that many investors are perfectly willing to climb this ladder, shaky or otherwise. The chart shows that the relative performance of Chinese ex-tech stocks versus their global peers remains firmly within the ascending trend channel that has been in place since early-2017, despite the ongoing slowdown in the industrial sector. As we noted in our May 30 report,1 this message is consistent with the view that any recent negative relative performance of Chinese ex-tech stocks has been in response to global rather than idiosyncratic, China-specific risk. Chart 2A Nontrivial Slowdown In Chinese Export Growth Chart 3Investors Are Fine Climbing A Shaky Ladder We remain nervous bulls concerning Chinese ex-tech stocks, and continue to recommend an overweight stance. But our reading of China's macro dynamics suggests that investors should not be dogmatic about their equity allocation to China, and should be prepared to cut exposure in response to a material shift in sentiment towards the Chinese economy. As a final point, while we have clearly presented our framework over the past several months for thinking about and analyzing China, investors attending BCA's Annual Investment Conference in September will get an opportunity to hear additional perspectives about the cyclical trajectory of its economy. Leland R. Miller, CEO of the China Beige Book, will be presenting his thoughts on the outlook for Chinese growth and risk assets. Based on his firm's unique insights into China's economic and financial market developments, Mr. Miller's panel will certainly be among those not to miss. Bottom Line: China's ongoing industrial sector slowdown will not likely lead to a shock to global demand, but investors should recognize that China's relative stability is supported by strong global demand. A negative surprise to export growth could materially shift global investor sentiment about the trajectory of China's economy, which would bode poorly for Chinese ex-tech stocks versus their global peers. Stay overweight for now, but with a short leash. A-Shares: EM Inclusion, Factor Analysis, And A Contrarian Shadow Trade The beginning of June marked a milestone for Chinese equities, as MSCI added over 226 large-cap A-shares to their Emerging Markets index. Box 1 provides some brief details about the inclusion, and also notes how it affects several of the trades in our trade book. Chart A1A-Share Inclusion Added 10% Market Cap ##br##To The MSCI China Index Box 1 The Inclusion Of Chinese A-Shares In The MSCI Emerging Markets Index On May 31 2018, 226 China large-cap RMB-denominated A-shares were included in the MSCI Emerging Markets Index. The change represented a 1.4% increase in the market capitalization of the MSCI Emerging Markets index, and 10% increase in the MSCI China Index (Chart A1). We have often referred to the MSCI China Index as the "investable" index in previous reports and in our trade table, but this index now includes some domestic stocks as a result of the recent inclusion. We plan to continue to use the MSCI China Index (or its ex-tech equivalent) as the main outlet for our investment recommendations, which means that the benchmark for five of our trades will be re-labeled in our trade table (from China investable to MSCI China Index). One exception is our trade favoring the MSCI China ESG Leaders Index, as MSCI has yet to publish an ESG rating index for Chinese domestic stocks. We last wrote about the outlook for A-shares in our March 14 Weekly Report,2 and noted that the significant underperformance of A-shares relative to global stocks over the past few years was due to the legacy effects of an enormous, policy-driven speculative bubble in 2014-2015. We highlighted that while domestic stocks have worked off some of this bubble and multiples are no longer extreme, that a neutral allocation was still warranted due to an uninspiring earnings outlook and, at best, a very modest valuation discount relative to global stocks. Chart 4 illustrates this latter point; based on all four trailing valuation ratios that we track, ex-tech onshore stocks are either on par or considerably more expensive than global ex-tech stocks. By contrast, the MSCI China Index (excluding technology) is cheaper than their global peers by all measures, in some cases considerably so. Nevertheless, while we continue to recommend that investors maintain a neutral stance towards A-shares within a global equity portfolio, the inclusion of A-shares in the EM index may force some investors to increase their exposure to domestic stocks beyond the level that they otherwise would have maintained. In order to provide some perspective of what domestic stocks to favor, we have taken a quantitative approach to analyzing A-shares that is loosely inspired by the Fama-French three-factor model. More precisely, we have examined the historical relative performance of three separate factor strategies for A-shares and global stocks, both relative to their respective broad market. The three factors tested are as follows: Return On Equity (ROE): Replacing market beta in the F&F model, we have built a historical portfolio for both Chinese domestic and global stocks that favors level 1 GICS sectors with above-median ROE. Within high-ROE sectors, the portfolio allocates to the sectors on a value-weighted basis to maximize the investability of the strategy. Sector Weight: Our second approach favors GICS sectors with a below-median sector weight, which conceptually mimics the firm size factor in the F&F model. In reality, this strategy is selecting among sectors made up of large cap firms, meaning that investors should regard the performance of this strategy as reflecting the success or failure of investing in potentially underowned or unloved sectors. Value: Our third factor is exactly in line with the F&F model, with portfolios using this approach favoring sectors with above-median dividend yields. We have chosen a cash flow-based valuation measure instead of the book value yield to assuage potential investor concerns about accrual quality. Chart 5 presents the cumulative returns of these strategies, for both global and Chinese domestic stocks. Several important observations are noteworthy: Chart 4A-Shares Are Not Cheap Vs##br## Global Stocks In Ex-Tech Terms Chart 5ROE, Sector Weight, and Value Are ##br##All Successful Factors In China's Domestic Market Favoring high-ROE sectors has been a more profitable strategy when allocating among global sectors than those of the domestic Chinese market, but we have seen similar returns from the strategy in both markets since early-2011. This is consistent with an important conclusion that we made in our March report: the perception among some global investors that domestic Chinese stocks are a "casino" market disconnected from fundamentals does not appear to be supported by the data over the past several years. A strategy of favoring sectors with a low market cap weight has fared better for Chinese A-shares than for the global market, albeit with considerable volatility. We suspect that the underperformance of smaller-than-average sectors at the global level has been affected over the past four years by the underperformance of resources, but the outperformance of the strategy in China also makes sense: underowned or unloved sectors should have more abnormal return potential in smaller, less scrutinized markets. Favoring cheap stocks has been an abysmally poor strategy at the global level over the past decade, due to the chronic underperformance of the financial sector. But cheaper sectors have outperformed China's domestic equity market at a modest pace over the past several years, which is good news for value-oriented investors. Chart 6 highlights where each of China's domestic equity sectors currently sits in the ROE/size/value spectrum. There are three sectors exhibiting two of the factors employed in our analysis: health care, financials, and real estate. For now, we would caution investors against buying domestic health care stocks, as Chart 7 shows that the sector has become heavily overbought over the past several months. Domestic financials would appear to be a better bet: despite underperforming financials in the MSCI China Index, domestic financials have outperformed the domestic broad market over the past year and have not broken materially below their trend line despite a recent selloff. Chart 6Health Care, Financials, And Real Estate Are At The Intersection Of Successful Factors Chart 7Financials Are A Better Bet Than Health Care; Watch For A Housing Catalyst To Buy Real Estate Finally, real estate stocks have the potential to become a fantastic contrarian trade if Chinese home sales do sustainably pick up. The sector is cheap, profitable, and highly unloved given the view among many investors that the Chinese government's structural reforms will weigh on performance for some time to come. But as we have noted in previous reports, the persistent gap between home sales and housing construction over the past few years may very well be over, implying that the latter may rise in lockstep with the former if sales begin to trend higher. Chart 7 shows that investors are not even remotely pricing in such a scenario, as domestic real estate companies have underperformed the domestic benchmark since early-2016 and remain in a relative downtrend. We would not recommend fighting negative investor sentiment towards the sector for now, but domestic real estate companies should clearly be on an investor's watch list, alongside the trend in residential sales volume. Bottom Line: The recent inclusion of Chinese A-shares in the MSCI Emerging Markets index may lead to heightened investor attention over the coming months, but we still recommend a neutral allocation. Within the domestic market, a factor approach suggests that financials are a good bet, and that real estate stocks have great potential as a contrarian trade if housing sales begin to durably trend higher. An Update On China's Corporate Bond Market China's equity market may not be the only financial market segment to garner more addition from increased index inclusion over the coming year: Bloomberg recently announced that it will add Chinese RMB-denominated government and policy bank bonds to the Bloomberg Barclays Global Aggregate Index over a 20-month period beginning in April 2019, conditional on the implementation of certain "operational enhancements" to the market by the PBOC and Ministry of Finance.3 China's total bond market (government and corporate) is the third-largest in the world, with a record of 79 trillion yuan ($12.7 trillion) outstanding. Yet foreign investors have little exposure to Chinese bonds, due to frictions concerning investability, a lack of transparency on issuers/index components, and concerns about the quality of domestically-issued credit ratings (95% of China's corporate bonds are rated AA- or higher). Chart 8The Recent Uptick In Yields Has Had A Paltry Impact On Total Returns While the proportion of foreign ownership of Chinese bonds may rise slowly over time, our sense is that it will indeed rise. First, there is a clear yield advantage for Chinese relative to global bonds, in a world where high long-term absolute return prospects are scarce. Second, Chinese policymakers continue to (slowly) open China's financial markets to the rest of the world, and global investors can now gain access to China's onshore bond market through four channels without quota: the qualified foreign institutional investors program (QFII), the renminbi qualified foreign institutional investor program (RQFII), the China interbank bond market (CIBM), and the Bond Connect program.4 Third, China's regulators allowed foreign-owned ratings agencies to set up shop in China last year, in an attempt to address the ratings quality issue. BCA's China Investment Strategy service initiated our long China onshore corporate bonds trade on June 22 last year, which has since earned a 3.7% return in spite of widening yield spreads and a spike in default concerns over the past several weeks. Indeed, Chart 8 highlights that the recent rise in corporate yields has had a minimal impact on the index total return profile. There is one critical factor driving this apparent discrepancy that is not well understood by global investors: compared with corporate issues in the developed world, China's corporate bond market has considerably shorter duration. Table 1 highlights that most of the corporate bonds issued in China have a maturity of three years or less, and the duration for the ChinaBond Company Credit Index, the benchmark that we have used for our corporate bond trade, is approximately 2.3 years. By contrast, U.S. investment- and speculative-grade bonds currently have an effective duration of 7.5 and 4 years, respectively. Chart 9 illustrates the 12-month breakeven spread for the Company Credit Index, unadjusted for default. The breakeven spread represents the rise in yields that would be required for investors to lose money over a 12-month horizon (i.e. the yield change that exactly erases the income return from the position), assuming no defaults. The chart shows that Chinese corporate bond yields would have to rise approximately 250 bps over the coming year before investors suffer a negative total return, which would be an enormous rise that is totally inconsistent the PBOC's monetary policy stance. Table 1Maturity Distribution Of China's Bond Market Chart 9A Compelling Cushion Against Potentially Higher Rates Another way to gauge the attractiveness of a corporate bond position is to look at the spread relative to comparable duration government bonds in order to calculate the default loss that would be required to erase the spread (which is also roughly 250 bps today). Using the relatively conservative assumption of a 35% recovery rate, a 2.5% default loss implies a default rate of close to 4%. We noted in our May 23 Special Report that recent corporate defaults in China amounted to only 0.1% of the outstanding corporate bond market,5 implying that the ultimate scope of corporate bond defaults in China would have to be 40 times larger than currently observed to wipe out the spread relative to Chinese government bonds of comparable duration. While we cannot rule such an event from occurring, there is no evidence to suggest that such a dramatic escalation in defaults is about to occur. Bottom Line: Index inclusion may also be a factor leading to increased global investor attention towards China's bond market over the coming two years. The comparatively high-yield and short duration of China's corporate bond market makes for an attractive investment opportunity, despite recent concerns about defaults. Stay long/overweight over the coming 6-12 months. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com 1 Pease see China Investment Strategy Weekly Report "11 Charts To Watch", dated May 30, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Weekly Report "A-Shares: Stay Neutral, For Now", dated March 14, 2018, available at cis.bcaresearch.com. 3 These enhancements include the implementation of delivery vs. payment settlement, the ability to allocate block trades across portfolios, and clarification on tax collection policies. 4 The first three programs have a clear statement that no quotas apply, whereas the bond connect program has no specific statement concerning quotas. 5 Pease see China Investment Strategy Special Report "Messages From BCA's China Industry Watch", dated May 23, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights Contagion risk from Italy to its European peers presents a buying opportunity; Italian policymakers are constrained by the bond market and avoiding brinkmanship; In a game of chicken between Berlin and Rome, Chancellor Angela Merkel is behind the wheel of a 2.5-ton SUV; Italy's ultimate constraint is its bifurcated economic system - staying in the EU helps manage this problem; Underweight Italian bonds in a global portfolio and short Italian bonds versus their Spanish equivalents. Feature Chart 1Is Contagion Warranted? On May 31, Italy formed the second overtly populist government in the Euro Area. The first was the short-lived SYRIZA government in Greece, which lasted from January to September 2015. Under the leadership of Prime Minister Alexis Tsipras and his colorful finance minister Yanis Varoufakis, Athens took Greece to the brink of Euro Area exit in the summer of 2015. Ultimately, Greek politicians blinked, folded, and re-ran the January election in September, transforming SYRIZA from an overtly euroskeptic party to a europhile party in just eight months. Investors are concerned that "this time will be different." We disagree. To use a poker analogy, Italian policymakers are better positioned to "bluff" their European counterparts as their chip stack is larger. But they are still holding a bad hand, and other players at the table still hold big stacks. The recent turbulence in Italian bond markets has spilled over into other Mediterranean countries (Chart 1). This contagion is unwarranted, as there has been much improvement across the region over the past few years, both politically and economically. As for Italy itself, it is positive that populists have come to power today, for several reasons. First, it will force them to actually run the country, a sobering process that often tempers anti-establishment zeal, as it did in Greece. Second, they will run the country at a time when popular support for the Euro Area and EU remains strong enough to deter an overt attempt to exit those institutions. Third, Italy remains massively constrained by material forces outside of their control, which will force compromises in negotiations with Brussels and fellow EU member states. There Will Be No Contagion From Italy Markets overreacted to the political risks emanating from Italy in recent weeks. Fundamentally, Italy's peripheral peers have emerged stronger from the Euro Area crisis. Since the onset of the Euro Area crisis, Greece, Portugal, Ireland, and Spain - the hardest-hit economies in 2010 - have seen their unit labor costs contract by an average of 8.7%. Over the same period, the rest of the Euro Area inflated its labor cost structure by around 10.9% (Chart 2). Italy remains saddled with a rigid, under-educated, and rather unproductive workforce that has seen no adjustment in labor costs.1 Meanwhile, its Mediterranean peers have practically closed their once-enormous unit labor-cost gap with Germany. Furthermore, all southern European countries now run primary surpluses, reducing the need for external funding (Chart 3). It is fair that the market should apply a fiscal premium to Italy, given the new government's plans to blow out the budget deficit. But no such fiscal plan is in the works in the rest of the Mediterranean. The cyclically-adjusted primary balance - for Italy, Spain, Portugal, and Greece - has gone from a deficit of 4.4% during the height of the debt crisis, to a surplus of 1.4% today. One can argue about whether such fiscal austerity was really necessary. The advantage, however, is that the improvement in structural budget balances has diminished the need for additional austerity measures and could also provide greater fiscal space during the next recession. Finally, household balance sheets have been on the mend for some time. Consumer debt levels as a percentage of disposable income in Spain, Portugal, and Ireland - the epicenter of the original Euro Area debt crisis - have now dipped below U.S. levels. In the case of Italy, importantly, the household sector was never over-indebted to begin with (Chart 4). Chart 2Italy Has Had No Labor-Cost Adjustment Chart 3Mediterranean Austerity Is Over Chart 4No Household Credit Bubble In Italy On the political front, Italians are clearly more euroskeptic than their Euro Area peers (Chart 5). Although only 30% of Italians oppose the common currency, in line with Greece, this is still considerably higher than in Spain and Portugal (Chart 6). Italians also feel less "European" than the Spanish or the Portuguese - i.e., they identify more exclusively with their unique nationality. Again this is in line with Greek sentiment (Chart 7). Italians were not always this way: in the early 1990s, they felt the most European. Chart 5Italy Lags In Support For The Euro... Chart 6...But Only 30% Of Italians Want Out Chart 7Italians Are Feeling More Italian In Portugal and Spain, parties across the political spectrum have responded to improving political and economic fundamentals. In Spain, the mildly euroskeptic Podemos is polling below its June 2016 election result. Its leadership has also abandoned any ambiguity on its support of the common currency, although it still campaigned in 2016 on restructuring Spain's foreign debt. The leading party in the Spanish polls is the centrist Ciudadanos (Chart 8), led by 38-year old Albert Rivera. Much like French President Emmanuel Macron, Rivera has a background in finance - he worked as a legal counsel at La Caixa - and presents a centrist vision for Europe, favoring more integration. The rise of Ciudadanos is important as Spain could have new elections soon. Conservative Prime Minister Mariano Rajoy resigned following a vote of no-confidence engineered by the Spanish Socialist Party (PSOE) leader Pedro Sánchez. However, PSOE only holds 84 seats of the 350-seat parliament. As such, it is unclear how the Socialist minority government will govern, particularly with the budget vote coming in early fall. But investors should welcome, not fear, early elections in Spain. With Ciudadanos set to join a governing coalition, it is clear that Spain's commitments to the Rajoy structural reforms will remain in place while no discussions of Spanish exit from European institutions is on any investment-relevant horizon. In Portugal, the minority government of Prime Minister António Costa has overseen a brisk economic recovery. Costa's center-left Socialist Party has received support in parliament from the far-left, euroskeptic Left Bloc, plus the Communists and Greens. Despite the involvement of the Left Bloc, the minority government has not initiated any euroskeptic policy. The latest polling suggests that Costa could win a majority in 2019. An election has to be held by October of that year, thus potentially strengthening the pro-European credentials of the Portuguese government (Chart 9). Finally, in Greece, the once overtly euroskeptic SYRIZA is polling well below their 2015 levels of support. Ardently europhile and centrist New Democracy (ND) is set to win the next election - which must be held by October 2019 - if polling remains stable (Chart 10). The fascist and euroskeptic Golden Dawn remains a feature of Greek politics, but has a support rate under 10%, as it has over the past decade. In fact, the rising player in Greek politics is the centrist and europhile Movement for Change, an alliance that includes the vestiges of the center-left PASOK, which polls around 10%. Chart 8There Is No Populism In Spain... Chart 9...Or Portugal... Chart 10...And Surprisingly None In Greece Bottom Line: Italy stands alone in the Mediterranean as a laggard on both economic and political fundamentals. Contagion risk from Italy to the rest of its European peers should be faded by investors. It represents a buying opportunity every time it manifests itself. What Car Is Italy Driving In This Game Of Chicken? The new ruling coalition in Rome has a democratic mandate for a confrontation with Brussels over fiscal spending. The coalition consists of the Five Star Movement (M5S) and the League (Lega), formerly known as the "Northern League." In his inaugural speech to the Italian Parliament, Prime Minister Guiseppe Conte emphasized that the mandate of the new coalition includes "reducing the public debt ... by increasing our wealth, not with austerity."2 So, the gloves are off! Not really. Almost immediately, Conte pointed out that "we are optimistic about the outcome of these discussions and confident of our negotiating power, because we are facing a situation in which Italy's interests... coincide with the general interests of Europe, with the aim of preventing its possible decline. Europe is our home." PM Conte subsequently focused in his speech on increasing social welfare payments to the poor, conditional on vocational training and job reintegration. Talk of a "flat tax" was replaced with an eponymous concept that is anything but a "flat tax."3 And there was no mention of overturning unpopular pension reforms, but merely "intervening in favor of retirees who do not have sufficient income to live in dignity."4 We may be reading too much into one speech. However, the time for brinkmanship is at the beginning of a government's mandate. And Conte's opening salvo suggests that the M5S-Lega coalition has already punted on three of its most populist promises: wholesale change to retirement reforms, a flat tax of 15%, and universal basic income. The back-of-the-envelope cost of these three proposals is €100bn, which would easily blow out Italy's budget deficit by 5% of GDP, putting the total at 7%. There was also no mention of issuing government IOUs that would create a sort of "parallel currency" in the country. Conte's relatively tame speech represents one of three concessions that Rome has made before it even engaged Brussels in brinkmanship. The two others were to replace the original economy minister designate - euroskeptic Paulo Savona - and to form a government in the first place. The latter is particularly telling. Polls have shown that the two populist parties would have an even stronger hand if they waited until the fall to re-run the election (Chart 11). In particular, Lega has seen its support rise by 9% since the election. It is politically illogical to form a governing coalition with less political capital when a new election would strengthen the hand of both populist parties. So why the concessions? Because Italian policymakers are not interested in brinkmanship. The populist campaign rhetoric and hints of euroskepticism were an act. And perhaps the act would have continued, but the bond market reaction was so quick and jarring (Chart 12) - including the largest day-to-day selloff since 1993 (Chart 13) - that it has disciplined Italy's policymakers almost immediately. Chart 11Lega Gave Up A Lot By Forming A Coalition Chart 12Bond Vigilantes Are... Chart 13...A Massive Constraint On Rome This is instructive for investors. In 2015, Greece decided to play the game of brinkmanship with Europe and ultimately lost. Our high-conviction view at the time was that Athens would back off from brinkmanship because it was massively constrained.5 Not only would an exit from the Euro Area mean a government default and the redenomination of all household saving into "monopoly money," but the level of euroskepticism in Greece was not high enough to support such a high-risk strategy. At the time, we pointed out that most investors - and practically all pundits - were wrong when they argued that brinkmanship between Greece and Brussels was "unpredictable." This conventional view was supported by an incorrect reading of game theory, particularly the "game of chicken." Game theory teaches us that a game of chicken is the most dangerous game because it can create an equilibrium in which all rational actors have an incentive to stick to their guns - to "keep driving" in the parlance of the game - despite the risks.6 In Diagram 1, we can see that continuing to drive carries the most risks, but it also carries the most reward, provided that your opponent swerves. Since all actors in a game of chicken assume the rationality of their opponents, they also expect them to eventually swerve. When this does not happen, the bottom-right quadrant emerges, one of chaos and deeply negative payouts for everyone involved in the crash. The problem with this analysis is that - as with most game theory - its parsimony belies deep complexity that often varies due to a number of factors. The first such factor is replayability. The decisions of Italian policymakers will be informed by the outcomes of the 2015 Greek episode, which did not go well for Athens. Another factor that obviously varies the payout matrix is the relative strength of each player; or, to stick with the analogy, the type of vehicle driven by each actor. Greece and its Euro Area peers were not driving the same car. The classic game of chicken only produces the payouts from Diagram 1 if all participants are driving the same vehicle. However, if Angela Merkel is behind the wheel of a Mercedes-Benz G-Class SUV, while Greek PM Alexis Tsipras is riding a tricycle, then the payouts are going to be much different in the case of a crash. In that case, the payouts should approximate something closer to Diagram 2. Diagram 1Regular Game Of Chicken Diagram 2Greece Versus Euro Area In 2015 So the crucial question for investors is what vehicle are Italian policymakers driving? We do not doubt that it is an actual car, unlike Tsipras's tricycle. But it is more likely to be a finely-crafted Italian sportscar, adept at hugging the twists and turns of Rome's policy, rather than an SUV capable of colliding with Merkel's ominous truck. Why doesn't Rome have more capability than Greece? Because of time horizons. An Italian exit from the Euro Area would undoubtedly shake the foundations of the common currency and the European integrationist project. But Rome actually has to exit in order to shake those foundations. As we have learned with Brexit, such an "exit" scenario could take months, if not years. In the process of trying to exit, the Italian banking system would become insolvent, turning household savings and retirements into linguini. This would occur immediately and would exert economic, financial, and - most importantly - political pressure on Italian policymakers instantaneously. Our colleague Dhaval Joshi, BCA's Chief European Strategist, has argued that a 4% Italian bond yield is the "line in the sand" regarding the survival of Italy's banks.7 As Dhaval points out, investors start to get nervous about a bank's solvency when equity capital no longer covers net non-performing loans (NPLs). Based on this rule, the largest Italian banks now have €165 billion of equity capital against €130 billion of net NPLs, implying excess capital of €35 billion (Chart 14). Although the net NPL figure has improved much from the peak in 2015, it remains large. It follows that there would be fresh doubts about Italian banks' mark-to-market solvency if their bond valuations sustained a drop of just a tenth from the recent peak. Dhaval estimates that this equates to the 10-year BTP yield breaching and remaining above 4% (Chart 15). Chart 14Italian Banks' Equity Capital ##br##Exceeds Net NPLs By Euro 35 Bn Chart 15Italian Banks' Solvency Would Be In ##br##Question If The 10-Year BTP Yield Breached 4% Additionally, while Italian support for the common currency is relatively low, there is still a majority of around 60% that support the euro. This is similar to the level of support for the euro in Greece in 2015. We would suspect that the support for the currency would rise - and that populist parties would decline in popularity - if Italian policymakers set off a bond market riot that caused the insolvency of Italian banks. Does this mean that the bond market is a permanent constraint on Italian exit from the Euro Area? No. At some point in the future, after a deep recession that raises unemployment levels substantively, popular support for the common currency could tank precipitously. But we are far from that point. In fact, Italy has enjoyed a relatively robust recovery over the past 18 months. As such, any economic crisis today will be blamed on the populist policymakers themselves, yet another reason for them to moderate and seek the path of calm negotiations with the EU. Bottom Line: With regards to any potential "game of chicken" negotiations with the rest of Europe, Italian policymakers are not riding a tricycle like their Greek counterparts were in 2015. Italians are behind the wheel of a finely-crafted, titanium-chassis, Italian roadster. Unfortunately, Chancellor Angela Merkel is still in a Mercedes SUV that weighs 2.5 tons. This is a high-conviction view based on the actions of Italian policymakers over the past month. Despite an improvement in polling, populists have backed off from calling for a new election (which would have been perfectly logical) and that would have been advantageous to them and have abandoned some of the most controversial - and expensive - platforms of their coalition agreement. Unlike their peers in Greece, Italian populists have proven to have little stomach for actual confrontation. The Ultimate Constraint: Risorgimento In a report published back in 2016, we argued that Italy's original sin was its unification in 1861.8 Risorgimento brought together the North and South in a political and economic union that made little sense. The North had developed a market economy during the Middle Ages (and gave the West its Renaissance!), while the South had remained under feudalism well into the early twentieth century. Given the limited resources, governance, and technology of the mid-nineteenth century, the scope, ambition, and yes, folly of uniting Italy were probably several orders of magnitude greater than the effort to forge a common currency union in Europe in the twenty-first century. To this day, Italy remains an economically bifurcated country. Map 1 shows that the four wealthiest and most-productive regions of Europe, outside of capital cities, are the German Rhineland, Bavaria, the Netherlands, and Northern Italy. Meanwhile, the Italian South - or Mezzogiorno - is as undeveloped as Greece and Eastern Europe. Map 1Core Europe Extends Well Into Northern Italy The units of analysis in Map 1 are the so-called EU "nomenclature of territorial units for statistics" (NUTS).9 These regions matter because Brussels uses them to determine how much "structural funding" - essentially development aid - each country receives from the EU. The EU "regional and cohesion" funding - totaling €351.8 billion for the 2014-2020 budget period - is not distributed based on the aggregate wealth of each country, since that would favor the new entrants into the union. The EU's discerning eye when it comes to distributing development funds is not accidental. It is a product of decades of lobbying by Italy (and Spain) to prevent a shift of structural funding to Eastern European member states. From Rome's perspective, the real European development project is not in Poland or Greece, but in the Mezzogiorno. Chart 16Italy Shares The Burden Of The Mezzogiorno With The EU To this day, Italy and Spain receive the second and third largest amount of EU development aid (Chart 16). Despite contributing, in gross terms, 13% to the EU's total revenues, Italy's net contribution per person is smaller than those of the Netherlands, Sweden, Denmark, Finland, and Austria (Chart 17). Given that Italy is a wealthy EU state, its net budget contribution of approximately €3 billion, 0.2% of GDP, essentially means that it gets the benefits of EU membership for free. Chart 17Italy Gets To Join The Club For Free And EU membership comes with many benefits. Membership in the Euro Area - combined with sharing the same "lender of last resort" with Germany, the European Central Bank - allows Italy to finance its budget deficits at low interest rates and to issue government debt in the world's second largest reserve currency (Chart 18). These financial benefits are even greater than the rebate it gets from Europe. Access to cheap financing allows Italy to carry the costs of Mezzogiorno on its own. Chart 18The Big Difference Between 2011 & Today It is somewhat ironic that Lega is today preaching populism and euroskepticism. In the early 1990s, its main target of angst was not the EU and Brussels, but Italy's South and profligate Rome, which funneled the North's taxes to the South. This early iteration of the party was quite pro-EU, as it saw Italy's North as genuinely European and worthy of membership in EU institutions. Some of its politicians and voters hoped that Northern Italy could meld into the EU, leaving the Mezzogiorno to fend for itself. Hence there is no deep, ideological euroskepticism in Lega's DNA. The party's evolution also illustrates how opportunistic and pragmatic Italian policymakers can be. The reality is that if Italy were to act on its threat of "exit," it would undoubtedly become far worse off economically. Not only would Northern Italy have to support the Mezzogiorno alone, but any structural reforms that could lift productivity and education in the South would become far less likely as anti-establishment forces took hold. Bottom Line: Our high-conviction view is now the same as it was in 2016. Italy is "bluffing." Leaving the EU or the Euro Area makes no sense given its economic bifurcation, which is the result of Risorgimento. Both policymakers and voters understand this. The real intention in the game of chicken between Brussels and Rome is to see an easing of austerity. We expect that Italian policymakers will ultimately succeed in getting leniency from Brussels on allowing deficit-widening fiscal stimulus, but the stimulus will be much smaller than their original plans that spooked the bond market laid out. To European and Italian politicians, Italy's economic bifurcation is well understood. Jean-Claude Juncker, the President of the European Commission, specifically referred to it when he said, "Italians have to take care of the poor regions of Italy." He was later forced to apologize for his comments, with leaders of M5S and Lega faking outrage. But given that the ideological roots of Lega are precisely in the same intellectual vein as Juncker's comments, investors should understand that politicians in Rome are well aware of their fundamental constraints. Juncker's comments were a dog whistle to Rome. The actual message was: we know you are bluffing. Investment Implications Our analysis suggests that the path of least resistance for the M5S-Lega coalition is to negotiate some austerity relief from the EU Commission, but to definitively pivot away from talk of "exit" from European institutions. PM Conte has reaffirmed that exiting the euro is off the table and that it was never on the table to begin with. The new economy minister, Giovanni Tria, followed this up with a comment that "the position of this government is clear and unanimous... there are no discussions taking place about any proposal to leave the euro." Meanwhile, Lega leader and new Italian interior minister Matteo Salvini has focused his early efforts and commentary on the party's promise to check illegal immigration to Italy. This will be a policy upon which Lega will test its populist credentials, not a fight with Brussels. Is the worst of the crisis therefore "over"? Is it time to buy Italian assets? Not yet. Both Italian bonds and equities rallied throughout 2017. Italian equities, for example, have a higher Shiller P/E ratio than both Spanish and Portuguese stocks (Chart 19). As such, a sell-off was long overdue. Chart 19Why Did Italian Equities Rally So Much? Chart 20Italy's Binary Future Furthermore, we do not expect Rome's negotiations with Brussels to proceed smoothly. It is very likely that the bond market will have to continue to play the role of disciplinarian. The government debt-to-GDP ratio could quickly become unsustainable if the current primary budget balance is thrown into a deficit (Chart 20). According to the IMF and BCA Research calculations, Italian long-term debt dynamics are stable even with real interest rates rising to 2% - from just 0.5% today - and real GDP growth remaining at a muted 1%. But this stability requires the country to continue to run a primary budget surplus of around 2% of GDP (Chart 21). Conversely, running a persistent primary deficit of 2% would result in an explosive increase in Italy's debt dynamics. Even if that stimulus produces real GDP growth of 3%, the "bond vigilantes" could protest the surge in debt and drive real interest rates to 3.5% or higher. As such, the country's fiscal space will ultimately be determined by the bond market. Rome can afford to lower its primary budget surplus, but only so far as the bond market does not riot. Our colleague Dhaval Joshi believes that the math behind an Italian fiscal stimulus would make sense if it provides enough of a sustainable boost to economic growth without blowing out the budget deficit.10 We suspect that the bond market will eventually agree, but only if Brussels and Berlin bless the ultimate fiscal package as well. While investors wait to see the outcome of Rome-Brussels budget talks, which will likely last well into Q4, we prefer to play Mediterranean politics by shorting Italian government bonds versus their Spanish equivalents. BCA's Global Fixed Income Strategy initiated such a trade on December 16, 2016, which has produced a total return of 5.8%. The original logic for the trade was based on an assessment that Italy's medium-term growth potential, sovereign-debt fundamentals, and political stability were all much worse than those of Spain (Chart 22). These differences were not reflected in relative bond prices. Chart 21Three Factors Will Influence Italy's Debt Trajectory Chart 22Spain Trumps Italy On All Fronts Ongoing political turmoil in Italy has justified sticking with the trade. Looking ahead, there is potential for additional spread widening between Italy and Spain in the coming months. Spain is enjoying better economic growth; the deficit outlook will invariably worsen for Italy with the new coalition government; and Spanish support for the euro and establishment policymakers remains far higher and more buoyant than in Italy. All these factors justify a wider risk premium for Italian debt over Spanish bonds (Chart 23). Chart 23Stay Short 5-Year Italy Vs. 5-Year Spain Chart 24Stay Underweight Italian Debt One final critical point - the timing of any budget related uncertainty could not be worse for Italy. Economic growth is slowing and leading indicators say that this trend will continue, which suggests that Italian government bonds should continue to underperform global peers (Chart 24). Our Global Fixed Income Strategy team has argued that government debt in the European "periphery" should be treated more like corporate credit rather than sovereign debt.11 Faster economic growth leads to fewer worries about debt sustainability and increased risk-taking behavior by investors, both of which lead to reduced credit risk premiums and eventually, stronger growth. In other words, think of Italian BTPs as a BBB-rated corporate bond rather than a "risk-free" Euro Area government bond. So as long as the Italian economy continues to lose momentum, an underweight stance on Italian government bonds is justified. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 2 Please see Repubblica, "Il discorso di Conte in Senato, la versione integrale," dated June 6, 2018, available at repubblica.it. 3 Conte's exact quote was "the objective is the 'flat tax,' that is a tax reform characterized by the introduction of rates that are fixed, with a system of deductions that can guarantee that the tax code remains progressive." This is our own translation from Italian and therefore we may be missing something. However, a "flat tax" that has a number of different rates and that remains progressive is, by definition, not a flat tax. 4 In fact, the speech could be read with an eye towards some genuine supply-side reforms, particularly in bringing the country's youth into the labor force, improving governance, reforming the judiciary, cracking down on corruption and privileges of the political class, and generally de-bureaucratizing Italy. If successful, these would all be welcome reforms. 5 Please see BCA Geopolitical Strategy Monthly Report, "After Greece," July 8, 2015, available at gps.bcaresearch.com. 6 The game derives its name from a test of manhood by which two drivers drive towards each other on a collision course, preferably behind the wheel of a 1950s American muscle car. Whoever swerves loses. Whoever keeps driving, wins and gets the girl. 7 Please see BCA European Investment Strategy Weekly Report, "Italy's 'Line In The Sand,'" dated May 31, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 9 The acronym stands for Nomenclature des Unités Statistiques. 10 Please see BCA European Investment Strategy Special Report, "Italy Vs. Brussel: Who's Right?" dated May 24, 2018, available at eis.bcaresearch.com. 11 Please see BCA Global Fixed Income Strategy Weekly Report, "Is It Partly Sunny Or Mostly Cloudy?" dated May 22, 2018, available at gfis.bcaresearch.com.

Special Report

Much has been made of preparing for the arrival of the Millennial generation, accompanied by well-worn stereotypes of general 'failure to launch' as they reach adulthood. However, the former is a misnomer as this age cohort is already the largest and the latter is simply untrue. In the report below, authored by guest editor Richard Dias, we explore these themes and conclude with our recommendations for a Millennials basket of stocks to capture the strength of this cohort as consumers. The Echo Boom Heard Round The World According to the U.S. Census Bureau, Millennials are the U.S.'s largest living generation. Millennials, (or Echo Boomers) defined as people aged 18 to 36 (born 1982 to 2000), now number more than +80mn and represent more than one quarter of the U.S.'s population - Baby Boomers (born 1946 to 1964) number about 75mn.1 Stealthily becoming the largest age group in the U.S. over the last few years, Millennials per-year-birth-rate peaked at 4.3mn in 1990. Surprisingly, the pace matched that of the post-war Baby Boom peak-per-year-birth-rate in 1957 - the per-year average over the period was higher for the Baby Boomers (Chart 1). Chart 1Echo Boom This gap is now set to grow rapidly as the death rate of Baby Boomers accelerates. What's more, with the largest one-year age cohort only 25 years old, Millennials will be the dominant generation for many years. How these "kids" will impact the market as they become the most important consumers, borrowers and, to a lesser degree, investors is unclear but make no mistake: this is a seismic shift in economic power and it is here to stay. Also of note is how much better the demographic picture is in the U.S. versus other developed markets (Chart 2) but this last point will not be the focus of this report. Rather, the focus will be on the Echo Boom's domestic implications touching on the labor market (wage growth), inflation, debt and housing, CAPEX and growth. Chart 2Labor Force Growth The Graduates Chart 3Educational Intensity Is Increasing Unabated Millennials have invested in "human capital" more than any previous generations. By 2014, more received a postsecondary degree (associates, bachelor's, or graduate degree) than any other generation (Chart 3). More higher education is a rational response to a labor market that pays college graduates much more than adults without a college degree.2 Millennials have also been much more likely to attend graduate school than previous generations - enrollment increased at an even faster rate than undergraduate enrollment, jumping from 2.8% in 1995 to 3.8% in 2010.3 Timing Is Everything Unfortunately Echo Boomers entered the workforce at the worst possible time (Chart 4). During recessions, enrollment increases along with duration of study. This reflects a lower opportunity cost of schooling, as well as a stronger incentive to improve one's skills in a tougher job market. This cyclical pattern was exacerbated by the severity of the Great Recession. A lot has also been made of the historically low youth labor participation rates (Chart 5) but this is partly explained by Millennials focusing on studies instead of combining school and work.4 A rise in educational intensity - more time devoted to schoolwork and other extracurricular activities5 - has also played a role. Difficultly finding employment and poor returns therein (low wages) has also coincided with the massive uptake in student loans - now much more readily available - and acting as a major income substitute (more on this below). Chart 4Recessions Mean More Higher Learning... Chart 5...And Lower Participation Rates Forever Young Another dubious narrative is that Millennials don't want to grow up. In reality, horrible early career economic conditions have meant large and lasting delays to adulthood. Entering the labor market during a recession can result in substantial earnings losses that persist, with negative effects lasting longer for college graduates.6 Poor job prospects and earnings are reflected in reduced labor mobility (not chasing jobs that are no longer available), lower marriage rates (living with parents longer) (Table 1) and home ownership7 rates that are much lower than for previous generations (partly a combination of the two). Table 1Marital Status Of The Adult Population Millennials continue to delay marriage (and leaving home) for several reasons8 but this does not mean they do not want to marry. Indeed over 80% of Millennials say that they "think that they will marry", more than Generation Xers and Baby Boomers did at similar ages. Similarly, they are more likely to believe that they will have kids. Once you control for some of the demographic trends9 that keep kids at home, 25 to 34 year olds continue to set up independent households at roughly the same rate as they always have and recently this household formation has accelerated. It is also worth remembering that major inflection points in homeownership rates have happened before; following a large increase pre-war, there was a sustained decline in the number of young people living at home in the 1940-50s. Another problem with this narrative is that campus housing is considered "living at home". So as enrollment increased, so did the number of young "living at home". Now, almost half of young people "living with their parents" are in college (campus housing) - even if they pay for the education with student loans or are on scholarship. Assessing the merit of these commonplace assertions is important as an unwind of the negative impulses caused by the recession, along with echo boomers coming of age, will influence the U.S. economy for many years. Back In The Saddle With the youngest of Millennials finally coming of age (the largest one-year age cohort is now 25) and the economic recovery complete, Millennials are finally joining the labor force (Chart 5). Participation rates that were justifiably depressed during Millennials' college-going years have since made a recovery, though, notably, educational intensity remains unchanged for the younger cohort of Millennials (17 to 24) (Chart 5). This significant increase in participation occurred as the size of this cohort expanded at its fastest rate in 20 years (Chart 6). The growing numbers finishing college in a less horrible economic environment are faced with a higher opportunity cost; over the last two years there has been a big jump in the real median income for these older Millennials (Chart 7). Chart 6Participation Is Recovering... Chart 7...So Are Earnings Millennials' economic force (population times wages or wage growth) is set to increase in size and as such its relative importance over the next decade. These demographics are positive for home buying, consumption and, ultimately, economic growth. House Prices & Consumption Set To Reaccelerate Americans are moving at the lowest rate on record10 but as we have argued above, this is set to change. Ownership rates for residential real estate have a distinct life cycle pattern; rates start low when households first reach adulthood and rise substantially by the time they reach their late 30s and early 40s. Chart 8Better Household Balance Sheets Supports House Price Gains With a huge number of Millennials entering this cycle relatively unburdened (see grey box below) and households in aggregate having de-levered (top panel, Chart 8) since the recession, we have a situation where both demand and supply (bottom panel, Chart 8) dynamics point to a highly supportive environment for housing over the short to medium term. But What About All That Student Debt Chart 9Student Loans Are Rising But##br## Other Categories Are Falling A lot has been made about the levels of student debt in the U.S. It is obviously large; the total amount of debt currently stands at 1.4Tn dollars and it has trebled in 10 years (top panel, Chart 9). And it is clear that delinquency rates are high, at about 11% (bottom panel, Chart 9). The reigning theory is that new or recent graduates, heavily burdened by debt, are unable or unwilling to take the next steps into adulthood. This misses the point. Lost in all of this is that while student loan burdens climbed, every other major debt category fell (credit cards, auto loans, mortgages and home equity loans). According to the NY Fed, Millennials now have less per capita debt overall than they did in 2003.11 Granted, the difference (between 2003 & 2015) is modest but when you consider the difference within the context of the wider point, it becomes important to keep in mind: the largest cohort in a generation is entering their (albeit delayed) prime borrowing (and spending) years on better financial footing that in 2003!12 The issue of payments has also been overlooked.13 Although loan balances have ballooned, the average payment has increased only 50%. And, not to belabor the point, a misunderstanding about the debt distribution compounds this false narrative. A small fraction of borrowers have huge payments while 50% of borrowers had payments of $200 or less, and another 25% had payments of $200 to $400. The top panel of Chart 10 highlights the jump in home ownership.14 This is of course due in part to the recovery but Millennials are also now a growing portion of this household formation. As they continue to create millions of new households (delayed by the recession but now accelerating), mortgage debt and house prices (with the help of underwhelming housing supply growth) will be biased higher (bottom panel, Chart 10). This household formation drives consumption (e.g white goods & services). And, as Millennials mature into their peak earning and spending years, this consumption is set to increase (Chart 11). Chart 10Homeownership Is Rising Again Chart 11Millennials Are Consumers Phillips Curve Gaining Traction It has been 15 years since we have had employment growth (of young people) of this magnitude (in percentage terms and absolute numbers). The Phillips curve tells us employment and inflation are linked. Hence Chart 12 should not surprise, as it simply suggests that a big jump in the key segment of the population - newly employed, forming households, and able to borrow and consume - help drive up the costs of consumer goods and services. We should expect protracted rises in inflation over the next few years as a function of Millennials flexing their economic might. Bringing It All Together; What Does This All Mean For Growth? The Echo Boom is a big, generational demographic wave. A difficult and painful delay has not tempered its looming importance. Finally here, this wave of echo-boomers is educated, relatively unburdened by debt, and as they inevitably "grow up", will soon begin to form new households (and have kids). They will borrow, spend, earn, but not necessarily save and invest. And this will be an important long-term theme going forward. Near term we might already be seeing signs of their arrival and firms have begun to pivot accordingly. Millennials will support household consumption. Employment growth will underpin much higher inflation. Private residential gross fixed capital formation - which has lagged - will pick up. Add to that a CAPEX cycle (largely independent) that is firing on all cylinders (Chart 13), and improving productivity growth which will follow stronger wage growth and it seems that real GDP growth reaccelerating is the odds-on likely scenario (Chart 14). Chart 12Demand Is Increasing Along With Employment Chart 13Capex Is Surging Chart 14GDP Growth Is Pointing Higher Admittedly this note paints a rosy picture of future growth (real and nominal) and takes a narrow view by focusing on demographics. And of course this is not without risks; Baby Boomer burdens (debt & health), corporate debt and a tighter monetary policy to name a few. But nominal GDP growth solves many of these and more. Investment Implications The report above does an excellent job underlining why Millennials will boost consumption spending but does not offer many insights on how that consumption will change. For example, healthcare currently makes up 17% of personal consumption expenditure in the U.S., roughly in line with housing and utilities. We would anticipate the natural attrition of the aging Baby Boomer generation to push down health care's share of the consumer's wallet (we currently have an underweight recommendation for the S&P health care index). At the same time, and as discussed in detail above, the positive implications of the relatively unburdened Millennial cohort entering prime home acquisition age factors into our sanguine home-related equities view (we currently have an overweight recommendation for the S&P home improvement retail index and recently upgraded S&P homebuilders to neutral).15 Further, Millennials consume differently from their parents; social media, online shopping and smart phones are not the consumption categories of the Baby Boomers. With this in mind, we have created a basket of ten stocks that we think will be driven over the long term by the demographic rise of the Millennial. We note that these stocks are heavily weighted to the technology and consumer discretionary sectors, which is logical as Millennial consumption habits tend to be discretionary-focused and technology-based. Beginning with consumer discretionary, we are highlighting AMZN, NFLX and SPOT as core holdings in our Millennials basket. AMZN's heft dwarfs consumer discretionary indexes but it could fall in several categories; the acquisition of Whole Foods makes it a Millennials-focused consumer staples retailer and its cloud computing web services segment is a tech leader. NFLX and SPOT represent the means by which Millennials consume media, by streaming movies and music, respectively, over the internet. The idea of owning physical media is rapidly becoming an anachronism. The home ownership themes noted in the report above lead us to add HD and LEN to the basket. Millennials are "doers" and are set to be the dominant DIYers in the next few years, making HD a logical choice. LEN, as the nation's largest home builder, should benefit from the Millennials coming of age into home buyers. We are also adding TSLA to our basket as a lone clean tech-oriented equity. TSLA capitalizes on the increasing shift to clean energy of Millennials (the key reason why no traditional energy companies have a spot in our basket). The technology stocks in our Millennials basket are AAPL, FB and MSFT, together representing more than 9% of the total value of the S&P 500. AAPL's inclusion in the list is predictable as the leading domestic purveyor of devices on which Millennials consume media content. FB too is a predictable holding, with more than half of all Americans being monthly active users, dominated by the Millennial cohort. Our inclusion of MSFT is based on its leadership in cloud computing, a rapidly growing industry we expect the connectivity and mobile computing demands of Millennials will accelerate. Chart 15BCA Millennial Basket It is worth noting at this point that at least some of the stocks noted above will be shifting out of both consumer discretionary and tech in September of this year. Stay tuned for our report on the to-be announced communications services sector later this summer. The last stock we are adding to our basket is also the only financial services equity. Though avid consumers, Millennials have shown an aversion to cash, preferring card payment systems, including both debit and credit-based. Accordingly, we are adding the leader in both of these, V, to our Millennials basket. Our basket is shown in Chart 15. To create the basket, we have imagined a $1M portfolio, invested $100,000 in each of our basket stocks at the date of publishing. While the resulting basket has obviously been an outstanding performer in the past year, meaning that it is not as attractive an entry point as it was in recent history, we think a long term view should support continued outperformance. With respect to stocks to avoid, we are believers that Environmental, Social and Governance (ESG) criteria will gain in importance as Millennials invest their newfound wealth in the stock market. Accordingly, we would tend to avoid 'sin stocks', including gambling, tobacco and alcohol; demand for their services is unlikely to decline but investment weightings should mean that share prices will underperform. Further, and as noted above, we think demographics and a clean energy shift will mean energy and health care will be long term underperformers. Bottom Line: Investors seeking long term exposure to stocks lifted by the supremacy of the Millennial generation should own our Millennial basket (AAPL, AMZN, FB, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). We would not hesitate to add other sharing economy stocks, including Airbnb and Uber, to this basket should they become investable. Richard Dias, CFA Guest Editor Chris Bowes Associate Editor chrisb@bcaresearch.com Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Millennials Outnumber Baby Boomers and Are Far More Diverse (June 2015) http://www.census.gov/newsroom/press-releases/2015/cb15-113.html 2 The Rising Cost of Not Going to College (Feb 2014) http://www.pewsocialtrends.org/2014/02/11/the-rising-cost-of-not-going-to-college/ 3 15 Economic Facts About Millennials (Oct 2014) https://obamawhitehouse.archives.gov/sites/default/files/docs/millennials_report.pdf 4 NEET (Youth not in employment, education or training) level for youth 19 to 29 increased by only 4% during the Great Recession and has since returned to pre-recession levels about 15%. 5 Labor force participation: what has happened since the peak? (Sep 2016) https://www.bls.gov/opub/mlr/2016/article/labor-force-participation-what-has-happened-since-the-peak.htm 6 The long-term labor market consequences of graduating from college in a bad economy (Apr 2010) http://www.sciencedirect.com/science/article/pii/S0927537109001018 7 Homeownership Rates Are Falling, And It's Not Just A Millennial Problem (May 2016) https://www.forbes.com/sites/shreyaagarwal/2016/05/06/homeownership-rates-are-falling-and-its-not-just-a-millennial-problem/#3df54894494a 8 Reasons Millennials (17 to 35) stay at home longer include; this generation is younger (more 17 to 24 that 25 to 35), more culturally diverse, societally more tolerant, more time in post-secondary education, and houses have gotten much bigger 9 Five-year age subgroup, marital status, presence of children, sex, race, ethnicity, nativity (i.e. native- or foreign-born), current school enrollment, and educational attainment (Nov 2015) - http://jedkolko.com/2015/11/23/why-millennials-still-live-with-their-parents/ 10 Americans Moving at Historically Low Rates, Census Bureau Reports https://www.census.gov/newsroom/press-releases/2016/cb16-189.html 11 This myth about millennials needs debunking (Mar 2016) https://www.weforum.org/agenda/2016/03/this-myth-about-millennials-need… 12 Also of note from this two charts (Chart 21 & 22) is that it is NOT young people that are increasing their borrowing but old people. A 2016 blog post from the NY Fed "The Greying of American Debt" - expands on this theme. http://libertystreeteconomics.newyorkfed.org/2016/02/the-graying-of-ame… 13 Is There a Student Loan Crisis? Not in Payments (May 2016) https://clevelandfed.org/newsroom-and-events/publications/forefront/ff-… 14 Demographics: Renting vs. Owning (Feb 2017) http://www.calculatedriskblog.com/2017/03/demographics-renting-vs-ownin… 15 Please see BCA U.S. Equity Strategy Weekly Report, "Seeing The Light," dated May 29, 2018, available at uses.bcaresearch.com.

Highlights Neither the weakness in emerging market economies nor political turmoil in Europe are likely to significantly affect the U.S. economy. Although the U.S. economy is increasingly service-oriented, financial markets have become more bound to the manufacturing economy in the past 30 years. The U.S.'s large trade surplus in services fosters faster job creation and better pay than in the goods-producing area where the U.S. has a trade deficit. Our energy strategists believe that the risks for oil prices remain biased to the upside, although we are less bullish in view of OPEC 2.0's possible production increases in the near future. Feature U.S. risk assets are rebounding amid solid economic news and rising hopes that another Eurozone financial crisis has been averted. Still, investors remain concerned about rising rates, protectionist trade policies, and the health of emerging market economies. In addition, market participants continue to scan the U.S. economic data in both the manufacturing and service sectors looking for signs that the late-cycle phase of the expansion is ending and that a recession is nigh. The NASDAQ and small cap U.S. stocks rallied past their February peaks last week, but the S&P 500 remains 3.7% below its early 2018 heights. Moreover, BCA's stock-to-bond ratio continues in an uptrend and we expect stocks to beat bonds in the next year. However, neither U.S. high-yield spreads nor the VIX have returned to their January lows. 10-year Treasury yields are 53 bps higher and the dollar is up by 5%. West Texas Intermediate oil prices peaked at $72.26/bbl on May 21. We discuss BCA's latest view on oil later in this report. U.S. economic growth remains solid. May's reading (58.6) on the ISM non-manufacturing index released last week is consistent with 3.5% real GDP growth. Moreover, the May sounding (58.7) on manufacturing indicates that the U.S. economy is growing near 5%. We discuss the signal from both the ISM's manufacturing and non-manufacturing indicators in the next section. In any case, U.S. economic activity in 1H 2018 will easily surpass the FOMC's view of both potential GDP growth (1.8%) and its estimate for actual growth in 2018 (2.7%) (Chart 1). The Fed will provide a new set of dot plots and economic forecasts this week. BCA expects the Fed to bump up rates this week and then gradually during the next year. The Fed and the market's view of the path of rates in the next 12 months is aligned (Chart 2). However, BCA's stance is that inflation will accelerate in 2019, which would elicit a more aggressive response from the central bank starting in the second half of 2019. Our view is that the Fed will stick to its gradual path unless economic growth is much weaker than expected or inflation spikes higher. Moreover, because inflation is at the Fed's 2% target and the economy is at full employment, the price at which the Fed's "policy put" gets exercised is much lower than earlier in the cycle. The implication is that neither the weakness in emerging market economies nor political turmoil in Europe are likely to significantly affect the U.S. economy. Still, a wider trade war is a risk to U.S. and global growth, and we address this issue in the service sector below. Chart 11H GDP Tracking Well Above##BR##Potential & Fed's Forecast Chart 2Fed And Market Aligned##BR##On Rate Path In Next 12 Months On The Same Page The ISM surveys - manufacturing and non-manufacturing - are aligned. The top panel of Chart 3 shows that both metrics have climbed since their troughs in late 2015 (manufacturing) and early 2016 (non-manufacturing). These lows occurred amid EM-related economic and market turbulence. The 2015 nadir in the manufacturing series was more pronounced, thus the rise outpaced the non-manufacturing indicator (panel 2). U.S. financial markets, and the stock market more specifically, are sensitive to the performance of the manufacturing sector. The service sector accounts for 62% of U.S. economic activity and 86% of private-sector employment (Chart 4). Charts 5 and 6 show the relationship between the year-over-year change in BCA's stock-to-bond ratio and the level of manufacturing (Chart 5) versus non-manufacturing (Chart 6) composites. The relationship (r-squared 0.56) between our stock-to-bond ratio and the manufacturing sector is more robust that the r-squared (0.43) between the stock-to-bond ratio and the non-manufacturing sector. Chart 3Manufacturing And Non-Manufacturing ISM Are Aligned, But That's Not Always The Case Chart 4U.S. Economy Is 60% Services... Although the U.S. economy is increasingly service-oriented, Charts 7 and 8 show that the financial markets have become more bound to the manufacturing economy in the past 30 years. Between 1958 and 1988, the r-squared between our stock-to-bond ratio and manufacturing data was 0.19 (Chart 7). That increased to 0.34 from 1988 to 2018 (Chart 8). Chart 5Tighter Relationship Between##BR##Stock-To-Bond Ratio And Manufacturing ISM... Chart 6... Than With##BR##Non Manufacturing ISM Chart 7ISM Manufacturing Vs.##BR##Stock-To-Bond Ratio 1958-1988... Chart 8... And##BR##1988-2018 Chart 9 shows that there have been six other periods when the manufacturing index recovered more quickly than non-manufacturing. Five of the intervals were associated with EM stress.1 Moreover, as is currently the case, the economy was at or below full employment in four of the six occasions when manufacturing outpaced the service sector. Furthermore, the Fed initiated rate hikes in four of the seven episodes, including the current one (Appendix Chart 1). EM stocks tend to outpace U.S. equities as the non-manufacturing index rises faster than the manufacturing index. In addition, when the U.S. manufacturing sector is accelerating relative to the service sector, China's growth prospects (as measured by the LI Keqiang Index) improve. Chart 9Performance Of EM Assets When Manufacturing ISM Outpaces Service Sector ISM The peak in our Relative ISM composite index is consistent with BCA's view that the economic expansion that began in 2009 is nearing an end. Our Relative ISM Composite dipped prior to the 2001 recession, but began to rise as the 2007-2009 downturn commenced. Both the manufacturing and non-manufacturing indices collapsed at the same pace prior to the 2007-2009 recession, because the breakdown of the banking system related to the housing crisis weighed on the non-manufacturing data. Unfortunately, the ISM non-manufacturing data only begins in 1997. However, using the goods and service-sector GDP as proxies for the ISM metrics, we find that the manufacturing sector tends to underperform the service sector in the late stages of an expansion (Chart 10). Our earlier work2 details the performance of U.S. financial assets in a late-cycle environment. Chart 10Manufacturing Sector Tends To Underperform The Service Sector In Late Cycle Environments Bottom Line: Last year's "global synchronized growth" story is showing signs of wear. While the U.S. economy will enjoy a strong rebound in the second quarter, leading economic indicators in most of the other major countries have rolled over. The advanced stage of the U.S. business cycle, heightened geopolitical risks and our bias for capital preservation keep us tactically cautious on risk assets again this month. Service Sector: An Update Even with the increasingly dominant role of the service sector (Chart 4 again), the majority of high frequency economic data measures activity in the manufacturing sector. However, the Quarterly Services Survey (QSS) initiated in 2003-2004 by the Bureau of Economic Analysis (BEA), measures the service sector which includes small- and medium-sized companies3 and produces timely revenue figures on a quarterly basis. The dataset is used primarily by the BEA to paint a more accurate picture of national accounts, notably personal consumption and the intellectual property segment of private-fixed investment. The survey is also essential for FOMC policymakers because it is very useful to track economic performance. Moreover, the QSS is an important source of revisions to real GDP because over 40% of the quarterly estimates of personal consumption expenditures (PCE) for services is based on the QSS. The "key services statistics" include information services, health care services, professional, scientific and technical services, administrative and support, and waste management and remediation services. The QSS for Q1 2018 found that total revenues for selected services fell by 1.2% over the previous quarter but rose 5.2% over the last four quarters (in nominal terms and only non-seasonally adjusted data available). Nominal GDP climbed 4.7% year-over-year in Q1 (Chart 11). Several areas of the service economy saw sales growth in Q1 outpace nominal GDP. Sales were strongest in finance and insurance (+7.8%) followed by information (+7%). Real estate and rental leasing sales increased by 4.7% in the past year while revenue in health care & social assistance rose +3.4%. Together, sales in finance & insurance and health care & social assistance make up about 50% of total revenues. Chart 11Many Areas Of Service Sector##BR##Advancing Faster Than Nominal GDP Chart 12Sales Growth In The Service Sector##BR##Is Broad Based However, revenue growth in several categories decelerated in Q1 and grew more slowly than nominal GDP. Arts, entertainment and recreation, administration support and waste management, and other services are in this category. Bottom Line: Given that the majority of service industries from the QSS sample survey continue to show upward momentum, perhaps we will see a similar revision to real consumer spending for services for the third estimate of Q1 real GDP in late June (Chart 12). We continue to expect U.S. GDP growth to match or exceed the Fed's modest target for 2018. This above-trend growth will continue to put downward pressure on the unemployment rate and push inflation higher, setting the stage for a more aggressive Fed next year and a recession in 2020. The Wrong Trade War? The large trade surplus in the U.S. service sector is a hidden source of strength for the economy and labor market (Chart 13). President Trump campaigned on his ability to create high-paying manufacturing jobs and he has focused his attention on the goods side of the U.S. trade deficit. Nonetheless, his America First rhetoric threatens jobs in the high-paying service sector. Since the mid-1970s, the U.S. has imported more than it has exported, acting as a drag on GDP growth. The trade gap reflects a large and persistent goods deficit, which more than offsets a growing trade surplus on the service side (Chart 14). U.S. imported goods exceeded exports by $807 billion in 2017. Service exports reached an all-time high of $798 billion in 2017 - $255 billion more than imports - up from $249 billion in 2016. It is too soon to tell if the smaller surplus in services is related to Trump's protectionist trade rhetoric. Exports of services have increased by 6% a year on average since 2000, which is nearly twice as fast as nominal GDP. Service exports expanded by just 4% in 2017 versus 2016, which is below the pace of nominal GDP (4.7%) The trade surplus in services subtracted 0.08% from real GDP in Q1 2018, but added 0.05% in 2017. Moreover, the trade surplus in services has consistently added to GDP growth over the past few decades, although the trade surplus in services is swamped by the large drag on GDP due to the trade deficit on goods. Industries where the U.S. enjoys a trade surplus have experienced job growth that is faster than in industries where the U.S. runs a deficit. In addition, median wages ($30.07 as of April 2018) among surplus-producing industries are more than 20% higher than in industries in the goods sector ($24.94) where there is a trade deficit. Moreover, wages in the trade-oriented service sector have escalated quicker than in the goods-producing sector in the past year (Chart 15). Chart 13The U.S. Runs Trade##BR##Surplus In Services... Chart 14...But It's Not Large Enough To Offset##BR##The Big Trade Deficit In Goods Chart 15Wages In Export-Led Service Industries##BR##21% Higher Than In Goods Sector Furthermore, exports in the U.S. service sector tend to compete on quality (not on price) and, therefore, will not be as affected as U.S. goods exports if the dollar meets BCA's forecast for a modest increase this year (Chart 16). That said, the Trump administration's trade policies threaten to reduce the U.S.'s global dominance in services. Chart 16Services Exports Compete On Quality, Not Price Table 1 shows that the U.S. has the largest trade surplus in travel ($82 billion surplus in 2016), intellectual property ($80 billion), financial services ($73 billion) and other business services ($43 billion), which includes legal, accounting, consulting and architectural services. The U.S. also runs a surplus in maintenance and repair services. Table 1Key Components Of U.S. Trade Surplus In Services Trump's trade and immigration policies put this trade surplus at risk. In 2016, foreigners spent $82 billion more to vacation in, travel to, and be educated in the U.S. than what U.S. citizens spent on those services overseas. Moreover, a recent U.N. report4 noted that "Global flows of foreign direct investment fell by 23 per cent in 2017. Cross-border investment in developed and transition economies dropped sharply, while growth was near zero in developing economies." If foreign governments continue to react to Trump's directives on trade and immigration, then the U.S. trade advantage in financial services ($73 billion), software services ($29 billion), TV and film rights ($12 billion), architectural services ($5 billion) and advertising ($10 billion) will also be at risk. Bottom Line: The U.S.'s large trade surplus in services fosters faster job creation and better pay than in the goods-producing area where the U.S. has a trade deficit. The Trump administration's rhetoric and actions on trade and globalism potentially risks America's dominance in the service sector. In theory, U.S. trade restrictions could add to U.S. GDP growth via increased manufacturing output and a smaller goods trade deficit. However, many U.S. trading partners have already announced tariffs on U.S. goods which will put the brakes on growth. Even so, any gains on the manufacturing trade front could be largely offset by damage to the U.S. surplus in services trade. BCA's Geopolitical Strategy service expects that trade-related uncertainty will persist at least until the midterm elections in November.5 On a related note, an increase in onshore oil production in the past 10 years reduced the U.S's large trade deficit in petroleum and petroleum products. BCA's energy strategists recently updated their oil price and production forecasts for this year and next. Still Bullish On Oil BCA's Commodity & Energy Strategy service remains bullish on oil, although two key elements of the outlook makes forecasting particularly difficult.6 Our base case forecast has been bullish for some time, based on our assumption that OPEC 2.0 would retain its previous output cuts, at least through the end of 2018. Venezuela's production has contracted sharply and we penciled in a further modest decline. Iranian exports will also shrink due to the re-imposition of U.S. sanctions. The only substantial growth on the production side is expected to come from U.S. shale producers. The supply/demand backdrop pointed toward higher prices with world demand projected to remain robust. We estimated that Brent could reach $90/bbl early next year. Chart 17Ensemble Forecast Accounts For##BR##Collapse In Venezuela's Exports However, some major oil consumers, including the U.S., are starting to complain. The U.S. has asked the OPEC 2.0 countries to increase output, which may remove further upward pressure on prices. OPEC 2.0's leadership has signaled that it will consider reversing the production cuts during the second half of this year. This could add an extra 870 b/d of production. The other major unknown is how much further Venezuelan production will slide. Our oil strategists have run alternative scenarios to gauge the risks to the base case. The optimistic case sees OPEC 2.0 retaining production cuts and Venezuelan production dipping by another 1m b/d. The pessimistic case sees OPEC 2.0 reversing the production cuts, while Venezuelan production erodes modestly compared with the base and optimistic cases. Chart 17 shows that Brent hits $100/bbl in 2019 in the optimistic case, but drops to $60 in the pessimistic scenario. The ensemble forecast, shown in red in Chart 17, is a weighted average of the three scenarios. It shows that the price of oil will be roughly flat over the next 18 months. Bottom Line: Our energy strategists believe that the risks for oil prices remain biased to the upside, although we are less bullish in view of OPEC 2.0's possible production increases in the near future. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com Appendix Appendix Chart 1Fed Policy And Labor Market Slack When Manufacturing ISM Outpaces Service Sector ISM 1 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Cleanup On Aisle Two", published June 4, 2018. Available at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," published October 16, 2017. Available at usis.bcaresearch.com. 3 https://www.census.gov/services/qss/about_the_survey.html 4 http://unctad.org/en/PublicationsLibrary/wir2018_overview_en.pdf 5 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," April 4, 2018. Available at gps.bcaresearch.com. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Guiding To Higher Output; Volatility Set To Rise ... Again", published May 31,2018. Available at ces.bcaresearch.com.

Special Report

Highlights Since the end of the Bretton Woods system in 1971 there have been five major episodes where U.S. dollar moves were not uniform across all currencies. These episodes share common features: a rallying broad trade-weighted U.S. dollar, desynchronized global growth and falling commodity prices. The above conditions will likely be met in the coming months, producing a period of global currency divergence. Commodity and EM currencies will weaken the most against the U.S. dollar, then against the yen, and finally depreciating the least against the euro. Feature It is often assumed that the dollar behaves like a monolith. However, this is not always the case: some currencies do manage to occasionally buck the dollar's general trend (Chart 1). Interestingly, the yen is most often the currency that manages to avoid the broad dollar's general directionality. Chart 1Episodes Of Currency Divergence ##br##Versus the Dollar Our view has been and remains that the broad trade-weighted U.S. dollar still has meaningful upside this year, and that the EM currency complex will be under heavy selling pressure in the coming months. That said, it is worth asking whether all other currencies will share the same fate against a rising broad trade-weighted U.S. dollar, or whether some could diverge from the general dollar trend. This is essentially akin to trying to understand the pecking order of currencies outside the USD. To address these challenges, we believe it is important to understand how global growth will evolve, how relative growth dynamics among regions will shift, and how commodity prices will perform over the coming six to 12 months. When The Dollar Wears Many Masks There have been five major periods of currency divergence versus the U.S. dollar. These have lasted anywhere from one to three years (Table 1). Table 1Summary Of Currency Divergence Episodes Interestingly, they share some common features, heeding important insights for global investors. These features are as follows: 1) Common feature #1: A Rising Broad Trade-Weighted Dollar With the exception of the 2005-2007 episode, all other episodes where some currencies diverged from the general trend in the USD occurred when the broad trade-weighted U.S. dollar was in a bull market. 2) Common feature #2: Desynchronized Global Growth All episodes of divergence in the FX market occurred when global growth was desynchronized. This underscores the importance of growth as a key driver of FX movements. During the 1991-1993 period, the yen was able to buck the dollar's strength (Chart 2) even though Japanese growth was falling quite fast relative to the U.S. Explaining this seeming inconsistency was the policy conducted by the Bank of Japan at the time. The BoJ was cutting rates, from 6% in 1991 to below 2% in 1993, but it was not doing so fast enough to alleviate budding deflationary pressures. As a result, Japanese real interest rates did not fall. This caused real rate differentials to move firmly in favor of the yen. In the final months of 1991, Japanese 2-year and 10-year real rate spreads versus the U.S. were 50 basis points and -75 basis points respectively, but by June 1993, these spreads became 145 basis points and 115 basis points. In the 1995-1996 episode, all the economic blocks experienced a slowdown in growth relative to the U.S. While this time the yen plunged versus the dollar, commodity currencies managed to appreciate against the dollar. This was because commodity prices rose during this timeframe, creating a positive terms-of-trade tailwind that lifted these currencies (Chart 3). Chart 2Episode 1: The Yen Diverges Chart 3Commodity Currencies Diverge In 1997 and 1998, the euro was the currency that managed to remain stable versus the U.S dollar, while the yen and commodity currencies sagged meaningfully (Chart 4).The euro was able to defy the gravity of a strong dollar because the euro area's relative growth differential versus the U.S. remained stable. Essentially, in the late '90s, as the euro area periphery was enjoying the full dividend of convergence toward the living standards of core Europe, European domestic demand was left unaffected by the Asian crisis. Meanwhile, commodity producers and Japan - two groups with much deeper links with EM economies - were experiencing deeper repercussions from the EM economic contraction. The 2005-2007 period of de-synchronized currency action against the dollar is somewhat of an outlier (Chart 5). First, this particular episode of currency divergence materialized in an environment where the dollar was weak. Chart 4Episode 3: The Euro Diverges Chart 5Episode 4: The Yen Diverges Again Second, the outlier was the yen, which managed to depreciate against the dollar while all other currencies were strengthening against the greenback. Chart 6Episode 5: The Euro Diverges again Third, while Japanese growth was below that of the U.S. it was not falling versus the U.S. However, this still caused Japan to be the odd man out in terms of growth performance, as other economic blocs delivered better growth than the U.S. Moreover, Japan was not experiencing the same growth dividend from China's miraculous boom as emerging Asian or commodity producers were. Adding fuel to the fire was the endemic implementation of carry trades. The low FX and rate volatility of that era was an invitation to engage in this kind of strategy.1 But Japan's deflation, along with its sub-par economic performance when compared to non-U.S. economies, re-assured investors that the BoJ would keep rates at rock-bottom levels for the foreseeable future. This was an invitation to investors to sell the yen to fund these carry trades in EM and commodity currencies as well as the euro. Finally, during the 2012-2013 episode the euro area was the global growth laggard. However, the euro was the currency that was able to strengthen against the dollar, defying the greenback's broad appreciation (Chart 6). It is true that euro area domestic demand growth was slightly improving versus the U.S. More importantly though, this was the time period that followed European Central Bank President Mario Draghi's "whatever it takes" speech. These soothing words caused the break-up risk premia across euro area member states to collapse, lifting the euro in the process. 3) Common feature #3: Commodity Prices Were Falling In three out of five episodes, commodity prices were falling, which is consistent with the fact that four out of the five episodes were periods of broad trade-weighted U.S. dollar strength. The only exceptions were the 1995-1996 and 2005-2007 episodes, where commodities rallied. The latter period was further marked by a weak broad trade-weighted U.S. dollar. Bottom Line: Looking back at history, there have been five episodes where some major currencies diverged from the U.S. dollar's broad trend. In the majority of these episodes, the broad trade-weighted U.S dollar was rising, global growth was desynchronized, and commodity prices were falling. When Is The Next Episode On The Air? The aforementioned three common features can be thought of as pre-conditions for some currency divergence to transpire. So, when can investors expect the next episode to hit the proverbial airwaves? In our view, this scenario is most likely to materialize over the coming six to 12 months. Our main macro themes have been and remain2 that the global macro landscape over the coming months will be shaped by two tectonic shifts: on the one hand, America's fiscal stimulus will sustain robust U.S. growth, and on the other hand, the continued slowdown in money and credit in China will culminate in a relapse in capital spending. The Chinese leg of the scenario will depress commodity prices and consequently emerging market economies; meanwhile, thanks to considerable fiscal stimulus, easy financial conditions and relative economic insularity, U.S. growth will remain steady, leaving it as the global growth outperformer. These dynamics are bullish for the broad trade-weighted U.S. dollar: The U.S. economy is growing robustly despite rising interest rates. In fact, interest rate-sensitive sectors are showing no signs of slowing down, confirming the resilience of the economy at this stage of the cycle. Both the housing market and commercial lending standards are not flagging growth risks (Chart 7). Chart 8 demonstrates that BCA's broad money measure (M3) for China leads import volumes and industrial metals prices by about six months. Based on the indicator's track record, odds are that industrial commodity prices will fall meaningfully over the coming months. Chart 7U.S. Economy Is Weathering##br## Rising Interest Rates Chart 8China's Money/Credit Is Bearish ##br##For Industrial Metals While oil prices could hold out for longer due to supply dynamics and geopolitics, positioning remains extremely elevated. As such, we are not ruling out a meaningful pullback in crude as traders head for the exits - all in the context of slowing global demand. Bottom Line: Pieces are falling in place to create the conditions necessary for some currency decoupling: global growth is set to become desynchronized, and commodity prices are likely to weaken - all in the context of a rising broad trade-weighted U.S. dollar. A Reverse Currency Pecking Order Slowing global trade as well as a growth deceleration in China's capital spending and demand for commodities will have the biggest repercussions for commodity and EM Asian currencies (Chart 9). This leaves the euro and the yen as the two most likely candidates to potentially diverge from the broad U.S. dollar in this coming episode. In our view, we think the yen could win this title. First, while the euro area economy is less leveraged to a slowdown in China/EM than Japan, it is still extremely vulnerable. Investors are still very long the euro, and therefore are vulnerable to negative surprises. Euro area industrial production could be the impulse to continue generating underwhelming economic numbers, as it is very much leveraged to China (Chart 10), mainly due to Germany's own deep trade links with EM and China. Notably, the German IFO index for business expectations in German manufacturing - a good leading indicator for global trade - is pointing to a further slowdown in global exports (Chart 11, top panel). Furthermore, German manufacturing new orders from non-euro area countries are starting to roll over, suggesting German exports will weaken imminently (Chart 11, middle panel). Lastly, the Swiss KOF leading indicator has come in below 100 (Chart 11, bottom pane Chart 9EM Asia & Commodity Currencies To Remain Weak Chart 10When China Decelerates, So Does Europe Chart 11Global Trade Is Slowing Down Second, it seems that historically the yen has a greater ability to rally than the euro when commodity prices are falling or when the broad trade-weighted U.S. dollar is in a bull market, highlighting the counter-cyclical nature of the Japanese currency. This happened in the early to mid-'90s and in 2008 (Chart 12). The only exception was in 1998, when the euro was able to rally amid a selloff in commodity prices and a strengthening dollar because domestic growth was so resilient. Today, euro area domestic growth is healthier than it was in 2012-2013, but it is still much weaker than is the case in the U.S., especially as the latter is receiving a shot in the arm thanks to a large dose of late-cycle stimulus. Chart 12The Yen Has Counter Cyclical Attributes Chart 13Euro Long Positioning Is Higher Than For The Yen As such, we believe the euro has more downside than the yen against the U.S. dollar in this coming episode. Furthermore, speculators remain too long the euro versus the yen (Chart 13). Third, the yen is a crucial funding currency in global carry trades, while the euro has not been used by traders for this purpose over the past 18 months.3 As such, a selloff in EM and commodity currencies, which is our base case, could spur a rush to the exits for short yen positions, while the euro is not likely to benefit from a similar short squeeze. Additionally, Japan sports a large positive net international investment position of US$3.1 trillion, while Europe's stands at -US$0.6 trillion. Consequently, Japanese investors have proportionally more funds held abroad than European investors to repatriate home in the event of an upsurge in global/EM market volatility, adding a further impetus for the yen to buck the dollar trend. One of the best currency valuation metrics is the real effective exchange rate based on unit labor costs, because it takes into account both wages and productivity. Unfortunately, this data set does not exist for all countries. On this metric, the U.S. dollar is not expensive (Chart 14, top panel). Adding credence to our view that the yen will be more resilient than the euro this year, according to the unit labor costs-based measures, the JPY appears to be cheap in trade-weighted terms and relative to the EUR (Chart 14, bottom panel). Chart 14The Yen Is Cheaper Than the Euro,##br## Dollar Is Fairly Valued Chart 15The Korean Won##br## Is Expensive Chart 16Commodity Currencies ##br##Are Not Cheap The Korean won - the only emerging Asian currency for which this measure is available - seems to be expensive (Chart 15). Chart 16 demonstrates that commodity currencies including those of Australia, New Zealand and Chile are on the expensive side, while the Canadian dollar and the Colombian peso are fairly valued. Bottom Line: Putting all the pieces together, our reverse pecking order for global investors from the weakest to strongest currency against the U.S. dollar is as follows: commodity currencies, non-commodities EM currencies (primarily Asian), the euro, and the yen. Investment Conclusions We recommend the following strategy to best navigate the coming global currency divergence episode over the coming six to 12 months: Global asset allocators should underweight the following currencies, from most to least, in the following order: First, the extremely vulnerable commodity currencies (BRL, IDR, ZAR, CLP, COP, AUD, NZD, NOK, and CAD); second, the EM Asian currencies (KRW, MYR, SGD, TWD, and PHP); third, the euro; and lastly, the yen. Currency traders stand to benefit the most in this coming episode by going short commodity and EM Asian currencies versus the U.S. dollar. That said, Japanese and European investors also stand to benefit by selling or underweighting commodity and EM currencies. The yen and the euro will depreciate significantly less than commodity and EM currencies, with the yen potentially ending flat versus the U.S. dollar. To capture these dynamics we suggest a new currency trade: long JPY / short SGD. The rationale behind this trade is that the Monetary Authority of Singapore (MAS) manages the Singapore dollar against a basket of currencies of its major trading partners. Consequently, if as we anticipate the Japanese yen strengthens versus all other currencies with the exception of the greenback, the MAS will likely have to depreciate the Singapore dollar versus the yen. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com 2 Please see Emerging Markets Strategy Weekly Report, titled "Two Tectonic Macro Shifts", dated January 31, 2018, available at ems.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Euro: Risk On Or Risk Off?", dated November 17, 2017, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades