Equities

Highlights We have been cautious on asset allocation on a tactical (3-month) horizon for two months. The backdrop has deteriorated enough that we believe that caution is now warranted beyond a tactical horizon. Trim exposure to global stocks to benchmark and place the proceeds in cash on a cyclical (6-12 month) horizon. Government bonds remain at underweight. Our growth and earnings indicators are not flashing any warning signs. Indeed, while economic growth is peaking at the global level, it remains impressive in the U.S. Nonetheless, given the advanced stage of the economic cycle and the fact that a lot of good news is discounted in risk assets, we believe that it is better to be early and leave some money on the table than to be late. There are several risks that loom large enough to justify caution. First, the clash between monetary policy and the markets that we have been expecting is drawing closer. The FOMC may soon be forced to more aggressively tighten the monetary screws. The ECB signaled that it will push ahead with tapering. Perhaps even more important are escalating trade tensions, which could turn into a full-scale trade war with possible military implications. China has eased monetary policy slightly, but the broad thrust of past policy tightening will continue to weigh on growth. The RMB may be used to partially shield the economy from rising tariffs. Global bonds remain vulnerable. In the U.S., rate expectations in 2019 and beyond are still well below the path implied by a "gradual" tightening pace. In the Eurozone, there is also room for the discounted path of interest rates beyond the next year to move higher. Lighten up on both U.S. IG and HY corporate bonds, placing the proceeds at the short-end of the Treasury and Municipal bond curves. Duration should be kept short. We would consider upgrading if there is a meaningful correction in risk assets. More likely, however, we will shift to an outright bearish stance later this year or in early 2019 in anticipation of a global recession in 2020. Diverging growth momentum, along with the ongoing trade row, will continue to place upward pressure on the dollar. Shift to an overweight position in U.S. equities versus the other major markets on an unhedged basis. The risk of an oil price spike to the upside is rising. Feature The time to reduce risk-asset exposure on a cyclical horizon has arrived. Escalating risks and our assessment that equities and corporate bonds offered a poor risk/reward balance caused us to trim our tactical (3-month) allocation to risk assets to neutral two months ago. We left the 6-12 month cyclical view at overweight, because we expected to shed our near-term caution once the global slowdown ran its course, geopolitical risk calmed down a little, and EM assets stabilized. Nonetheless, the backdrop for global financial markets has deteriorated enough that we believe that caution is now warranted beyond a tactical horizon. It is not that there have been drastic changes in any particular area. Indeed, while profit growth is peaking at the global level, 12-month forward earnings continue to rise smartly in the major markets (Chart I-1). In the U.S., our corporate pricing power indicator is still climbing, forward earnings estimates have "gone vertical", and the net earnings revisions ratio is elevated (Chart I-2). The negative impact of this year's dollar strength on corporate profits will be trounced by robust sales activity. The U.S. economy is firing on all cylinders and growth appears likely to remain well above-trend in the second half of the year. Chart I-1Forward EPS Estimates Still Rising Chart I-2Some Mixed Signals For Stocks This economic and profit backdrop might make the timing of our downgrade seem odd at first glance. Nevertheless, valuations and the advanced stage of the economic and profit cycle mean that it is prudent to focus on capital preservation and be quicker to take profits than would be the case early in the cycle. BCA has recommended above-benchmark allocations to equities and corporate bonds for most of the time since mid-2009. There are several risks that loom large enough to justify taking some money off the table. One of our main themes for the year, set out in the 2018 BCA Outlook, is that markets are on a collision course with policy. This is particularly the case in the U.S. Real interest rates and monetary conditions still appear to be supportive by historical norms, but this cycle has been anything but normal and the level of real interest rates that constitute "neutral" today is highly uncertain. The fact that broad money growth has slowed in absolute terms and relative to nominal GDP is a worrying sign (Chart I-3). Dollar-based global liquidity is waning based on our proxy measure, which is particularly ominous for EM assets (bottom panel). Chart I-3Liquidity Conditions Are Deteriorating Moreover, our Equity Scorecard remained at 'two' in June, which is below a level that is consistent with positive excess returns in the equity market (please see the Overview section of the May 2018 Bank Credit Analyst). Our U.S. Willingness-to-Pay indicator reveals that investment flows are no longer favoring stocks over bonds in the U.S. (Chart I-2). Perhaps even more importantly for the near term are the escalating trade tensions, which could turn into a full trade war with possible military implications (see below). These and other risks suggest to us that the period of "prudent caution" may extend well into the 6-12 month cyclical horizon. For those investors not already at neutral on equities and corporate bonds, we recommend trimming exposure and placing the proceeds in cash rather than bonds. Fixed-income remains at underweight. There are risks on both sides for government bonds, but we believe that it is more likely that yields rise than fall. Trade Woes: Not Yet At Peak Pessimism The Trump Administration upped the ante in June by announcing plans to impose tariffs on another $200 billion of Chinese exports to the U.S., as well as to restrict Chinese investment in the U.S. We would expect China to retaliate if this is implemented but, at that point, China's proportionate response would cover more goods than the entire range of U.S. imports. Retaliation will therefore have to occur elsewhere. Tariffs are bad enough, but our geopolitical team flags the risk that trade tensions spill over into the South China Sea and other areas of strategic disagreement. The South China Sea or Taiwan could produce market-moving "black swan" geopolitical events this year or next.1 The Trump Administration has also launched an investigation into the auto industry, and has threatened to tear up the North American Free Trade Agreement (NAFTA). Congress will likely push hard to save the agreement because it is important for so many U.S. companies, especially those with supply chains that criss-cross the borders with Canada and Mexico. Still, Trump has the option of triggering the six-month withdrawal period as a negotiating tactic to increase the pressure on the two trading partners. This would really rattle equity markets. Many believe that Trump will back away from his aggressive negotiating tactics if the U.S. stock market begins to feel pain. We would not bet on that. The President's popularity is high, and has not been overly correlated with the stock market. Moreover, blue collar workers, Trump's main support base, do not own many stocks. The implication is that the President will be willing to take risks with the equity market in order to score points with his base heading into the mid-term elections. The bottom line is that we do not believe that investors have seen "peak pessimism" on the trade front. A trade war would result in a lot of stranded capital, forcing investors to mark down the value of the companies in their portfolios. Can Trump Reduce The Trade Gap? One of the Administration's stated goals is to reduce the U.S. trade deficit. It is certainly fair to ask China to pay for the intellectual property it takes from other countries. Broadly speaking, rectifying unfair trade practices is always a good idea. However, erecting a higher tariff wall alone is unlikely to either shrink the trade gap or boost U.S. economic growth, especially given that other countries are retaliating in kind. During the 2016 election campaign, then-candidate Trump proposed a 35% and 45% across-the-board tariff on Mexican and Chinese imports, respectively. We estimated at the time that, with full retaliation, this policy would reduce U.S. real GDP by 1.2% over two years, not including any knock-on effects to global business confidence.2 Cancelling NAFTA would be much worse. The bottom line is that nobody wins a trade war. Moreover, the trade deficit is more likely to swell than deflate in the coming years, irrespective of U.S. trade policy action. The flip side of the U.S. external deficit is an excess of domestic investment over domestic savings. The latter is set to shrivel given the pending federal budget deficit blowout and the fact that the household savings rate continues to decline and is close to all-time lows. This, together with an expected acceleration in business capital spending, pretty much guarantees that the U.S. external deficit will swell in the next few years. This month's Special Report, beginning on page 18, discusses the consequences of the deteriorating long-term fiscal outlook and the associated "twin deficits" problem. We conclude that a market riot point will be required to change current trends. But even if disaster is avoided for a few more years, the dollar will ultimately be a casualty. In the near term, however, trade friction and the decoupling of U.S. from global growth should continue to support the dollar. We highlighted the divergence in growth momentum in last month's Overview. Fiscal policy is pumping up the U.S. economy, while trade woes are souring confidence abroad. Coincident and leading economic indicators confirm that the divergence will continue for at least the near term (Chart I-4). Policy Puts We do not believe that the current 'soft patch' in the Eurozone and Japanese economies will turn into anything worse over the next year. We are much more concerned with the Chinese economy. May data on industrial production, retail sales, and fixed asset investment all disappointed. Property prices in tier 1 cities are down year-over-year. Our leading indicator for the Li Keqiang index, a widely followed measure of economic activity, is in a clear downtrend (Chart I-5). Chart I-4Growth Divergence To Continue Chart I-5China's Growth Slowdown The authorities will likely provide fresh stimulus if the trade war intensifies. Indeed, recent statements from the Ministry of Finance suggest that planned fiscal spending for the year will be accelerated/brought forward, and the PBOC has already made a targeted cut to the reserve requirement ratio and reduced the relending rate for small company loans. Chart I-6U.S. Small Business Is Ecstatic However, the bar for a fresh round of material policy stimulus is higher today than it was in the past; elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities can respond with monetary or fiscal stimulus. The most effective way for China to retaliate to rising U.S. tariffs is to weaken the RMB, but this too could be quite disruptive for financial markets and, thus, provides another reason for global investors to scale back on risk. Similarly, the bar is also rising in terms of the Fed's willingness to come to the rescue. Policymakers have signaled that they will not mind an overshoot of the inflation target. Nonetheless, the facts that core PCE inflation is closing in on 2% and that unemployment rate is well below the Fed's estimate of full employment, mean that the FOMC will be slower to jump to stock market's defense were there to be a market swoon. Small business owners are particularly bullish at the moment because of Trump's regulatory, fiscal and tax policies. The NFIB survey revealed that confidence soared to the second highest level in the survey's 45-year history (Chart I-6). Expansion plans are also the most robust in survey history. With the output gap effectively closed, increasing pressure on resource utilization should translate into faster wage gains and higher inflation. This was also quite apparent in the latest NFIB survey. Reports of higher compensation hit an all-time high as firms struggle to find qualified workers, and a growing proportion of small businesses plan to increase selling prices. Despite the signs of a very tight labor market, the FOMC's inconsistent macro projection remained in place in June. Policymakers expect continued above-trend growth for 2018-2020, but they forecast a flat jobless rate and core inflation at 3.5% and 2.1%, respectively. If the Fed is right on growth, then the overshoot of inflation will surely be larger than officials are currently expecting. Risk assets will come under downward pressure when the Fed is forced to shift into a higher gear and actively target slower economic growth. We expect the Fed to hike more aggressively next year than is discounted, and lift the consensus 'dot' for the neutral Fed funds rate from the current 2¾-3% range. Bonds remain vulnerable to this shift because rate expectations in 2019 and beyond are still well below the path implied by a "gradual" quarter-point-per-meeting tightening pace (Chart I-7). Chart I-7Market Expectations For Fed Funds Are Below A ''Gradual'' Pace At a minimum, rising inflation pressures have narrowed the Fed's room to maneuver, which means that the "Fed Put" is less of a market support. Italy Backs Away From The Brink Last month we flagged Italy as a reason to avoid risk in financial markets, but we are less concerned today. We believe that Italy will eventually cause more volatility in global financial markets, but for the short-term it appears that this risk has faded. The reason is 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 to 7% of GDP. There was also no mention of issuing government IOUs that would create a sort of "parallel currency" in the country. If this is wrong and there is another blowout in Italian government spreads, investors should fade any resulting contagion to the peripheral countries. Greece, Portugal, Ireland and Spain - the hardest-hit economies in 2010 - have undertaken significant fiscal adjustment and, unlike Italy, have closed a lot of the competitiveness gap relative to Germany. Spread widening in these countries related to troubles in Italy should be considered a buying opportunity.3 ECB: Tapering To Continue The ECB looked through the recent Italian political turmoil and struck a confident tone in the June press conference. President Draghi described the first quarter cooling of the euro area economy as a soft patch driven mainly by external demand. We agree with the ECB President; in last month's Overview we highlighted several factors that had provided extra lift to the Eurozone economy last year. These tailwinds are now fading, but we believe that growth is simply returning to a more sustainable, but still above-trend, pace. That said, rising trade tensions are a wildcard to the economic outlook, especially because of Europe's elevated trade sensitivity. Draghi provided greater clarity on the outlook for asset purchases and interest rates. The pace of monthly purchases will slow from the current €30bn to €15bn in the final three months of year and then come to a complete end (Chart I-8). On interest rates, the ECB expects rates to remain at current levels "at least through the summer of 2019". This means that September 2019 could be the earliest timing for the ECB to deliver the first rate hike. Chart I-8ECB Balance Sheet Will Soon Stop Growing We agree with this assessment on the timing of the first rate increase. It will likely take that long for inflation to move into the 1½-2% range, and for long-term inflation expectations to surpass 2%. These thresholds are consistent with the ECB's previous rate hike cycles. Still, there is room for the discounted path of interest rates beyond the next year to move higher as Eurozone economic slack is absorbed. The number of months to the first rate hike discounted in the market has also moved too far out (24 months). Thus, we expect that bunds will contribute to upward pressure on global yields. Bond investors should be underweight the Eurozone within global fixed income portfolios. In contrast, we recommend overweight positions in U.K. gilts because market expectations for the Bank of England (BoE) are too hawkish. Investors should fade the central bank's assertion that policymakers now have a lower interest rate threshold for beginning to shrink the balance sheet. The knee-jerk rally in the pound and gilt selloff in June will not last. First, the OECD's leading economic indicator remains in a downtrend, warning that the U.K. economy faces downside risks (Chart I-9). Second, Brexit uncertainty will only increase into the March 2019 deadline. Prime Minister May managed to win a key parliamentary vote on the Withdrawal Bill in late June, but the Tories will face more tests ahead, including a vote on the Trade and Customs Bill. The fault lines between the hard and soft Brexiteers within the Tory party could bring an early end to May's government. Either May could be replaced with a hard Brexit prime minister, such as Brexit Secretary David Davis, or the U.K. could face a new general election. The latter implies the prospect of a Labour-led government. Admittedly, this will ensure a soft Brexit, but Jeremy Corbyn would almost surely herald far-left economic policies that will dampen business sentiment. As a result, we believe that the BoE is sidelined for the remainder of the year, which will keep a lid on gilt yields and sterling. Corporate Bonds: Poor Value And Rising Leverage Our newfound caution for equities on a 6-12 month investment horizon carries over to the corporate bond space. Corporate balance sheets have been deteriorating since 2015 Q1 based on our Corporate Health Monitor (CHM). The first quarter's improvement in the CHM simply reflected the tax cuts and thus does not represent a change in trend (Chart I-10). Chart I-9Fade BoE Hawkish Talk Chart I-10Q1 Improvement In Corporate ##br##Health To Reverse The improvement was concentrated in the components of the Monitor that use after-tax cash flows, and as such they were influenced by the sharp decline in the corporate tax rate. Profit margins, for example, increased from 25.8% to 26.4% on an after-tax basis in Q1 (Chart I-10, panel 2), but would have fallen to 25.5% if the effective corporate tax rate had remained the same as in 2017 Q4. As the effective corporate tax rate levels-off around its new lower level (bottom panel), last quarter's improvement in the Corporate Health Monitor will start to unwind. More importantly, the corporate sector has been leveraging aggressively, as we highlighted in our special reports that analysed company-level data from the U.S. and the Eurozone.4 We highlighted that investors and rating agencies are not too concerned about leverage at the moment, but that will change when growth slows. Interest- and debt-coverage ratios are likely to plunge to new historic lows (Charts I-11A and I-11B). Chart I-11ACorporate Leverage Will Come ##br##Back To Haunt Bondholders Chart I-11BCorporate Leverage Will Come ##br##Back To Haunt Bondholders Both U.S. investment grade (IG) and high-yield (HY) corporates are expensive, but not at an extreme, based on the 12-month breakeven spread.5 However, both IG and HY are actually extremely overvalued once we adjust for gross leverage (Chart I-12). Chart I-12U.S. Leverage - Adjusted ##br##Corporate Bond Valuation We have highlighted several other indicators to watch to time the exit from corporate bonds. These include long-term inflation expectations (when the 10-year TIPS inflation breakeven reaches the 2.3-2.5% range), bank lending standards for C&I loans, the slope of the yield curve, and real short-term interest rates or monetary conditions. While monetary conditions have tightened, the overall message from these indicators as a group is that it is still somewhat early to expect rising corporate defaults and sustained spread widening. That said, we have also emphasized that it is very late in the credit cycle and return expectations are quite low. Excess returns historically have been modest when the U.S. 3-month/10-year yield curve slope has been in the 0-50 basis point range. Similar to our logic behind trimming our equity exposure, the expected excess return from corporate bonds no longer justifies the risk. We recommend lightening up on both U.S. IG and HY corporate bonds, moving to benchmark and placing the proceeds at the short-end of the Treasury and Municipal bond curves. Duration should be kept short. Also downgrade EM hard currency sovereign and corporate debt to maximum underweight. We are already underweight on Eurozone corporates within European fixed-income portfolios due to the pending end to the ECB QE program. Conclusions The political situation in Italy and tensions vis-à-vis North Korea appear to be less of a potential landmine for investors, at least for the next year. Nonetheless, the risks have not diminished overall - they have simply rotated into other areas such as international trade. It is also worrying that the FOMC will have to become more aggressive in toning down the labor market. What makes the asset allocation decision especially difficult is that the economic and earnings backdrop in the U.S. is currently constructive for risk assets. Nonetheless, recessions and bear markets are always difficult to spot in real time. Given the advanced stage of the economic cycle and the fact that a lot of good news is discounted in risk assets, we believe that it is better to be early and leave some money on the table than to be late and go over the cliff. This does not mean that we will recommend a neutral allocation to risk assets for the remainder of the economic expansion. We would consider upgrading if there is a meaningful correction in equity and corporate bond prices at a time when our growth indicators remain positive. More likely, however, we will shift to an outright bearish stance on risk assets later this year or in early 2019 in anticipation of global recession in 2020. The divergence in growth momentum between the U.S. and the rest of the major economies, along with the ongoing trade row, will continue to place upward pressure on the dollar. We envision the following pecking order from weakest to strongest currency versus the greenback: dollar bloc and EM commodity currencies, non-commodity sensitive EM currencies, the euro and yen. The Canadian dollar is an exception; we are bullish versus the U.S. dollar beyond a short-term horizon due to expected Bank of Canada rate hikes. Tightening financial conditions are likely to culminate in a crisis in one or more EM countries; as a share of GDP, exports and international reserves, U.S. dollar debt is at levels not seen in over 15 years. Slowing Chinese growth and trade tensions just add to the risk in this space. The recent upturn in base metal prices will likely reverse if we are correct on the Chinese growth outlook. Oil is a different story, despite our bullish dollar view. OPEC 2.0 - the oil-producer coalition led by Saudi Arabia and Russia - agreed in June to raise oil output by 1 million bpd. The coalition aims to increase production to compensate for an over-compliance of previous deals to trim output, as well as production losses due to lack of investment and maintenance (Chart I-13). The bulk of the losses reflect the free-fall in Venezuela's output. Our oil experts believe that OPEC 2.0 does not have much spare capacity to lift output. Meanwhile, the trend decline in production by non-OPEC 2.0 states is being magnified by unplanned outages in places like Nigeria, Libya and Canada. While U.S. shale producers can be expected to grow their output, infrastructure constraints - chiefly insufficient pipeline capacity to take all of the crude that can be produced in the Permian Basin to market - will continue to limit growth in the short-term. In the face of robust demand, the risk to oil prices thus remains to the upside. A stronger dollar will somewhat undermine the profits of U.S. multinationals. U.S. equities also appear a little expensive versus Europe and Japan based on our composite valuation indicators (Chart I-14). Nonetheless, the sector composition of the U.S. stock market is more defensive than it is elsewhere and relative economic growth will favor the U.S. market. On balance, we no longer believe that euro area and Japanese equities will outperform the U.S. in local currency terms. Overweight the U.S. market on an unhedged basis. Chart I-13Oil Production Outlook Chart I-14Composite Equity Valuation Indicators Consistent with our shift in broad asset allocation this month, we have adjusted our global equity sector allocation to be more defensive. Materials and Industrials were downgraded to underweight, while Healthcare and Telecoms were upgraded (Consumer Staples was already overweight). Financials was downgraded to benchmark because the flattening term structure is expected to pressure net interest margins. Mark McClellan Senior Vice President The Bank Credit Analyst June 28, 2018 Next Report: July 26, 2018 1 Please see Geopolitical Strategy Special Reports, "The South China Sea: Smooth Sailing?," March 28, 2017 and "Taiwan Is A Potential Black Swan," March 30, 2018, available at gps.bcaresearch.com. 2 Please see The Bank Credit Analyst Overview, dated December 2016, Box I-1. 3 Please see Geopolitical Strategy Special Report, "Mediterranean Europe: Contagion Risk Or Bear Trap?," June 13, 2018, available at gps.bcaresearch.com. 4 Please see The Bank Credit Analyst, March 2018 and June 2018, available at bca.bcaresearch.com. 5 The breakeven spread is the amount of spread widening that would have to occur over 12 months for corporates to underperform Treasurys. We focus on the breakeven spread to adjust for changes in the average duration of the index over time. II. U.S. Fiscal Policy: An Unprecedented Macro Experiment Congress is conducting a major economic experiment that has never been attempted in the U.S. outside of wartime; substantial fiscal stimulus when the economy is already at full employment. The budget deficit is on track to surpass 6% of GDP in a few years. It would likely peak above 8% in the case of a recession. The alarming long-term U.S. fiscal outlook is well known, but it has just become far worse. The combination of rising life expectancy and a decline in the ratio of taxpayers to retirees will place growing financial strains on the Social Security and Medicare systems. The federal government will be spilling far more red ink over the next decade than during any economic expansion phase since the 1940s. The debt/GDP ratio could surpass the previous peak set during WWII within 12 years. Shockingly large budget deficits in the past have sparked some attempt in Congress to limit the damage. Unfortunately, there will be little appetite to tighten the fiscal purse strings for the next decade. Voters have shifted to the left and politicians are following along. Factors that explain the political shift include disappointing income growth, income inequality, and rising political clout for Millennials, Hispanics and the elderly. Fiscal conservatism is out of fashion and this is unlikely to change over the next decade, no matter which party is in power. This means that a market riot will be required to shake voters and the political establishment into making the tough decisions necessary. While the U.S. is not at imminent risk of a market riot over the deteriorating fiscal trends, there are costs: in the long-term, the dollar will be weaker, borrowing rates will be higher and living standards will be lower than otherwise would be the case. Profligacy: (Noun) Unconstrained by convention or morality. Congress is conducting a major economic experiment that has never been attempted before in the U.S. outside of wartime; substantial fiscal stimulus at a time when the economy is already at full employment. Investors are celebrating the growth-positive aspects of the new fiscal tailwind at the moment, but it may wind up generating a party that is followed by a hangover as the Fed is forced to lean hard against the resulting inflationary pressures. Moreover, even in the absence of a recession, the federal government will likely be spilling far more red ink than during any economic expansion since the 1940s (Chart II-1). What are the long-term implications of this macro experiment? Will the U.S. continue to easily fund large and sustained budget deficits? Chart II-1U.S. Deficits Will Be Extremely Large For A Non-Recessionary Period Historically, shockingly large budget deficits sparked some attempt by Congress to limit the damage. Unfortunately, we argue in this Special Report that there will be little appetite to tighten the fiscal purse strings for the next decade. Voters have shifted to the left and politicians are following along. While the U.S. is not at imminent risk of a market riot over the deteriorating fiscal trends, the dollar will be weaker, borrowing rates will be higher and living standards will be lower than otherwise would be the case. On The Bright Side The Trump tax cuts, the immediate expensing of capital spending and a lighter regulatory touch have stirred animal spirits in the U.S. The Administration's trade policies are a source of concern, but CEO confidence is generally high. The NFIB survey highlights that small business owners are almost euphoric regarding the outlook. The IMF estimates that the tax cuts and less restrictive spending caps will provide a direct fiscal thrust of 0.8% in 2018 and 0.9% in 2019 (Chart II-2). The overall impact on the economy over the next 12-18 months could be larger to the extent that business leaders follow through on their newfound bullishness and ramp up capital spending. Chart II-2Lots Of Fiscal Stimulus In 2018 And 2019 Fiscal policy is a clear positive for stocks and other risk assets in the near term, as long as inflation is slow to respond. In addition to the near-term boost, there will be longer-term benefits from the 2017 tax act. Various provisions of the act affect the long-run productive potential of the U.S. economy, by promoting increases in investment and labor supply. Corporate tax cuts and the full expensing of business capital outlays should permanently increase the nation's capital stock relative to what it otherwise would be, leading to a slightly faster trend pace of productivity growth. Similarly, lower income taxes are projected to encourage more people to enter the workforce or to work longer hours. The CBO estimates that the tax act will boost the level of potential real GDP by 0.9% by the middle of the next decade. This may not sound like much, but it translates into almost a million extra jobs. The supply-side benefits of the 2017 tax act are therefore meaningful. Unfortunately, given the lack of offsetting spending cuts, it comes at the cost of a dramatically worse medium- and long-term outlook for government debt. The CBO estimates that the recent changes in fiscal policy will cumulatively add $1.7 trillion to the federal government's debt pile, relative to the previous baseline (Chart II-3). The annual deficit is projected to surpass $1 trillion in 2020, and peak as a share of GDP at 5.4% in 2022. Federal government debt held by the private sector will rise from 76% this year to 96% in 2028 in this scenario. Chart II-3Comparing To The Reagan Era The budget situation begins to look better after 2020 in the CBO's baseline forecast because a raft of "temporary provisions" are assumed to sunset as per current law, including some of the personal tax cuts and deductions included in the 2017 tax package. As is usually the case, the vast majority of these provisions are likely to be extended. The CBO performed an alternative scenario in which it extends the temporary provisions and grows the spending caps at the rate of inflation after 2020. In this more realistic scenario, the deficit reaches 7% of GDP by 2028 and the federal debt-to-GDP ratio hits 105% (Chart II-3). Moreover, there will undoubtedly be a recession sometime in the next five years. Even a mild downturn, on par with the early 1990s, could inflate the budget deficit to 8% or more of GDP. The Demographic Time Bomb Chart II-4The Withering Support Ratio The pressure that the aging population will place on federal coffers over the medium term is well known, but it is worth reviewing in light of Washington's new attitude toward deficit financing. The combination of rising life expectancy and a decline in the ratio of taxpayers to retirees will place growing financial strains on the Social Security and Medicare systems. In 1970, there were 5.4 people between the ages of 20 and 64 for every person 65 or older. That ratio has since dropped to 4 and will be down to 2.6 within the next 20 years (Chart II-4). Spending on entitlements (Social Security, Medicare, Medicaid, Income Security and government pensions) is on an unsustainable trajectory (Charts II-5 and II-6). In fiscal 2017, these programs absorbed 76% of federal revenues and the CBO estimates that this will rise to almost 100% by 2028, absent any change in law. If we also include net interest costs, total mandatory spending1 is projected to exceed total federal government revenues as early as next year, meaning that deficit financing will be required for all discretionary spending. Chart II-5Entitlements Will Explode ##br##Mandatory Spending Chart II-6All Discretionary Spending ##br##To Be Deficit Financed? The CBO last published a multi-decade outlook in 2017 (Chart II-7). The Federal debt/GDP ratio was projected to reach 150% by 2047. If we adjust this for the new (higher) starting point in 2028 provided by the CBO's alternative scenario, the debt/GDP ratio would top 164% in 2047. Chart II-7An Unsustainable Debt Accumulation To put this into perspective, the demands of WWII swelled the federal debt/GDP ratio to 106% in 1946, the highest on record going back to the early 1700s (Chart II-8). The debt ratio could rocket past that level before 2030, even in the absence of a recession. Chart II-8U.S. Debt In Historical Context These extremely long-term projections are only meant to be suggestive. A lot of things can happen in the coming years that could make the trajectory better or even worse. But the point is that current levels of taxation are insufficient to fund entitlements in their current form in the long run. Chart II-9 shows that outlays as a share of GDP have persistently exceeded revenues since the mid-1970s, except for a brief period during the Clinton Administration. The gap is set to widen over the coming decade. Something will have to give. Chart II-9U.S. Outlays And Revenues Forget Starving The Beast "Starve the Beast" refers to the idea that the size of government can be restrained through a low-tax regime that spurs growth and pressures Congress to cut spending and control the budget deficit. It has been the mantra of Republicans since the Reagan era. The 1981 Reagan tax cuts included an across-the-board reduction in marginal tax rates, taking the top rate down from 70% to 50%. Corporate taxes were slashed by $150 billion over a 5-year period and tax rates were indexed for inflation, among other changes. It was not surprising that the budget deficit subsequently ballooned. Outrage grew among fiscal conservatives, but Congress spent the next few years passing laws to reverse the loss of revenues, rather than aggressively attacking the spending side. Today, Congressional fiscal hawks are in retreat and the Republican Party under President Donald Trump is not as fiscally conservative as it once was. This trend reflects the pull toward the center of the economic policy spectrum in response to a shift to the left among voters. BCA's political strategists have highlighted that this is the "median voter theory" (MVT) in action.2 The MVT posits that parties and politicians will approximate the policy choices of the median voter in order to win an election or stay in power. Every U.S. presidential election involves candidates making a mad dash to the most popularly appealing positions. President Trump exhibited this process when he ran in the Republican primary on a platform of increased infrastructure spending and zero cuts to "entitlement" spending. The Great Financial Crisis, disappointingly slow growth, stagnating middle class incomes and the widening income distribution have resulted in a leftward shift among voters on economic issues. Adding to the shift is the rising political clout of the Millennial generation, which generally favors more government involvement in the economy and will become the major voting block as it ages in the 2020s. There also are important changes underway in the ethnic composition of the electorate. The rising proportion of Hispanic voters will on balance favor the Democrats, according to voting trends (Chart II-10). A previous Special Report by Peter Berezin, BCA's Chief Global Strategist, predicted that Texas will become a swing state in as little as a decade and a solid Democrat state by 2030.3 Chart II-10The Proportion Of Minority Voters Set To Grow President Trump's shift to the left on economic policy helped him to out-flank Clinton in the election, particularly in the Rust Belt, where his protectionist and anti-austerity message resonated. Even his anti-immigration appeal is mostly based on economic reasoning - i.e. jobs, rather than cultural factors. Trump has admitted that he is not all that concerned about taking the country deeper into hock. The Republican rank-and-file has generally gone along with Trump's agenda because he has delivered traditional Republican tax cuts and continues to rate highly among his supporters (his approval is around 90% among Republicans). Fiscal hawks within the GOP have been forced to the sidelines while Trump and moderate Republicans have passed bipartisan spending increases with Democratic assistance. Where's The Outrage? Chart II-11Entitlements Are Popular* The implication is that, unlike the Reagan years, we do not expect there will be a strong political force capable of leading a fight against budget deficits. After a decade of disappointing income growth, voters are in no mood for tax hikes. On the spending side, health care and pensions are still politically untouchable. A recent study by the Pew Research Center confirms that only a very small percentage of Americans of either political stripe would agree with cuts to spending on education, Medicare, Social Security, defense, infrastructure, veterans or anti-terrorism efforts (Chart II-11). It is therefore no surprise that a populist such as Trump has promised to defend entitlement programs. Moreover, the graying of America will make it increasingly difficult for politicians to tame the entitlement beast. An aging population might generally favor the GOP, but it will also solidify opposition towards cutting Medicare and Social Security. As for defense, U.S. military spending was 3.3% of GDP and almost 15% of total spending in 2017 (Chart II-12). Congress recently lifted the spending cap for defense expenditures, but it is still projected to fall as a share of total government spending and GDP in the coming years. It is conceivable that Congress could eventually trim the defense budget even faster, but spending is already low by historical standards and it is hard to see any future Congress gutting the military at a time when the global challenge from China and Russia is rising. Indeed, given the geopolitical atmosphere of great power competition, defense spending is more likely to rise. Chart II-12What's Left To Cut? So, what is left to cut? If entitlements and defense are off the table, that leaves non-defense discretionary spending as the sacrificial lamb. This category includes spending by the Departments of Agriculture, Education, Energy, Homeland Security, Health and Human Services, Justice, State and Veteran Affairs. Such spending has already declined sharply during the past several decades (Chart II-12). Non-defense discretionary spending amounted to $610 billion in 2017, which is only 15.3% of total federal spending. To put this into perspective, cutting every last cent of non-defense discretionary spending by 2022 would still leave a budget deficit of about 2½% of GDP. And it would be political suicide. The Departments of Education, Health and Human Services, Homeland Security, Justice and Veterans Affairs account for more than half of non-defense discretionary spending. But these programs are very popular among voters. And, at only 1.3% of total spending, eliminating all foreign aid won't make much difference. Either President Trump or Vice-President Mike Pence will be the GOP presidential candidate in 2020. Pence could be more fiscally conservative than Trump, but Congress is unlikely to remain GOP-controlled through 2024. Similarly, it is difficult to see the Democrats making more than a token effort to rein in the deficit if the party is in charge after 2020. Perhaps they will raise taxes on the rich and push the corporate rate back up a bit, but voters will probably not favor a full reversal of the Trump tax cuts. Democrats will not tackle entitlements either. In other words, we can forget about "starving the beast" as a viable option no matter which party is in power. There will be little appetite for fiscal austerity in the U.S. through to the mid-2020s at a minimum. International Comparison This all places the U.S. out of sync with other major industrialized countries, where structural budget deficits have been tamed in most cases and are expected to remain so according to the IMF's latest projections (Chart II-13). The U.S. cyclically-adjusted budget deficit is projected to be almost 7% of GDP in 2019, by far the highest among other industrialized countries except for Norway. Spain and Italy are expected to have relatively small structural deficits of 2½% and 0.8%, respectively, next year. Greece is running a small structural surplus! Including all levels of government, the IMF estimates that the U.S. general government gross debt/GDP ratio is projected to be well above that of the U.K., France, Germany, Spain and Portugal in 2023 (Chart II-14). It is expected to be on par with Italy at that time, although the newly-installed populist government there is likely to negotiate a loosening of the fiscal rules with Brussels, leading to higher debt levels than the IMF currently expects. The implication is that the U.S. government appears destined to become one of the most indebted in the developed world. Chart II-13U.S. Budget Deficit Stands Out Chart II-14International Debt Comparison The Fiscal Tipping Point Investors are not yet worried about the path of U.S. fiscal policy; the yield curve is quite flat, CDS spreads on U.S. Treasurys have not moved and the dollar is still overvalued by most traditional measures. The challenge is timing when a fiscally-induced crisis might occur. A warning bell does not ring when government debt or deficits reach certain levels. Fiscal trends generally do not suddenly spiral out of control - it is a gradual and insidious process reflected in multi-year deficits and slowly accumulating debt burdens. Eventually, a tipping point is reached where the only solution is drastic policy shifts or in extreme cases, default. Along the way, there are a number of signs that fiscal trends are entering dangerous territory. The relevance of the various signs will be different for each country, reflecting, among other things, the depth and structure of the financial system, the soundness of the economy, the dependence on foreign capital, and the asset preferences of domestic investors. Some key signs of building fiscal stress are given in Box II-1. None of the factors in Box II-1 appear to be a threat at the moment for the U.S. Moreover, comparisons with other countries that have hit the debt wall in the past are not that helpful because the U.S. is a special case. It has a huge economy and has political and military clout. The dollar is the world's main reserve currency and the country is able to borrow in its own currency. This suggests that the U.S. will be able to "get away with" its borrowing habit for longer than other countries have in the past. At the same time, financial markets are fickle and, even with hindsight, it not always clear why investors switch from acceptance to bearishness about a particular state of affairs. BOX II-1 Traditional Signs Of An Approaching Debt Crisis Government deficits absorb a rising share of net private savings, leaving little for new investment. Interest payments account for an increasingly large share of government revenues, squeezing out discretionary spending and requiring tough budget action merely to stop the deficit from rising. The government exhausts its ability to raise tax burdens. Traditional sources of debt finance dry up, requiring alternative funding strategies. Fears of inflation and/or default lead to a rising risk premium on interest rates and/ or a falling exchange rate. Political shifts occur as governments get blamed for eroding living standards, high taxes, and continued pressure to cut spending. The Costs Of Fiscal Profligacy Even if the U.S. is not near a fiscal tipping point, this does not mean that massive debt accumulation is costless: Interest Costs: Spending 3% of GDP on servicing the federal government's debt load over the next decade is not a disaster. Nonetheless, it does reduce the tax dollars available to fund entitlements or investing in infrastructure. Counter-Cyclical Fiscal Policy: Lawmakers would have less flexibility to use tax and spending policies to respond to unexpected events, such as natural disasters or recessions. As noted above, a recession in 2020 could generate a federal deficit of more than 8% of GDP. In that case, Congress may feel constrained in supporting the economy with even temporary fiscal stimulus. National Savings: Because government borrowing reduces national savings, then either capital spending must assume a smaller share of the economy or the U.S. must borrow more from abroad. Most likely it will be some combination of both. Crowding Out: If global savings are not in plentiful supply, then the additional U.S. debt issuance will place upward pressure on domestic interest rates and thereby "crowd out" business capital spending. This would reduce the nation's capital stock, leading to lower growth in productivity and living standards than would otherwise be the case. The CBO estimates that the positive impact on the capital stock from the changes to the corporate tax structure will overwhelm the negative impact from higher interest rates over the next decade. Nonetheless, the crowding out effect may dominate over a longer-time horizon. Academic studies suggest that every percentage point rise in the government's debt-to-GDP ratio adds 2-3 basis points to the equilibrium level of bond yields. If this is correct, then a rise in the U.S. ratio of 25 percentage points over the next decade in the CBO's baseline would lift equilibrium long-term bond yields by a meaningful 50-75 basis points. Much depends, however, on global savings backdrop at the time. External Trade Gap: If global savings are plentiful, then it may not take much of a rise in U.S. interest rates to attract the necessary foreign inflows to fund both the higher U.S. federal deficit and the private sector's borrowing requirements. Of course, this implies a larger current account deficit and a faster accumulation of foreign IO Us. Twin Deficits The U.S. has run a current account deficit for most of the past 40 years, which has cumulated into a rising stock of foreign-owned debt. The Net International Investment Position (NIIP) is the difference between the stock of foreign assets held by U.S. residents and the stock of U.S. assets held by foreign investors. The NIIP has fallen increasingly into the red over the past few decades, reaching 40% of GDP today (Chart II-15). The current account deficit was 2.4% at the end of 2017, matching the post-Lehman average. Nonetheless, this deficit is set to worsen as increased domestic demand related to the fiscal stimulus is partly satisfied via higher imports. Chart II-15Scenarios For The U.S. Net International Investment Position We estimate that a two percentage point rise in the budget deficit relative to the baseline could add a percentage point or more to the current account deficit, taking it up close to 4% of GDP. Upward pressure on the external deficit will also be accentuated in the next few years to the extent that the U.S. business sector ramps up capital spending. The implication is that the NIIP will fall deeper into negative territory at an even faster pace. A 2% current account deficit would be roughly consistent with stabilization in the NIIP/GDP ratio. But a 4% deficit would cause the NIIP to deteriorate to almost 80% of GDP by 2040 (Chart II-15). The sustainability of the U.S. twin deficits has been an area of intense debate among academics and market practitioners for many years. The U.S. has been able to get away with the twin deficits for so long in part because of the dollar's status as the world's premier reserve currency. The critical role of the dollar in international transactions underpins global demand for the currency. This has allowed the U.S. to issue most of its debt obligations in U.S. dollars, forcing the currency risk onto foreign investors. The worry is that foreign investors will at some point begin to question the desirability of an oversized exposure to U.S. assets within their global portfolios. We argued in our April 2018 Special Report 4 that the U.S. situation is not that dire that the U.S. dollar and Treasury bond prices are about to fall off a cliff because of sudden concerns about the unsustainability of the current account deficit. Even though the NIIP/GDP ratio will continue to deteriorate in the coming years, it does not appear that the U.S. is close to the point where foreign investors would begin to seriously question America's ability or willingness to service its debt. That said, the "twin deficits" and the downward trend in U.S. productivity relative to the rest of the world will ensure that the underlying long-term trend in the dollar will remain down (Chart II-16).5 Chart II-16Structural Drivers Of The U.S. Dollar Conclusions The long-term U.S. fiscal outlook was dire even before the Great Recession and the associated shift to the political left in America. Fiscal conservatism is out of fashion and this is unlikely to change before the mid-2020s, no matter which party is in power. This means that a market riot will be required to shake voters and the political establishment into making the tough decisions. Given demographic trends, it appears more likely that taxes will rise than entitlements cut. We do not foresee a crisis occurring in the next few years. Nonetheless, arguing that the U.S. fiscal situation is sustainable for the foreseeable future does not mean that it is desirable. There will be costs associated with current fiscal trends, even on a relatively short 5-10 year horizon. Interest costs will mushroom, potentially crowding out government spending in other areas. U.S. government debt has already been downgraded by S&P to AA+ in 2013, and the other two main rating agencies are likely to follow suit during the next recession as the deficit balloons to 8% or more. Investors may begin to demand a risk premium in order to entice them to continually raise their exposure to U.S. government bonds in their portfolios. Taxes will eventually have to rise to service the government debt, and some capital spending will be crowded out, both of which will undermine the economy's growth potential. Finally, the dollar will also be weaker than it otherwise would be in the long-term, representing an erosion in America's standard of living because everything imported is more expensive. Could Japan offer a roadmap for the U.S.? The Bank of Japan has effectively monetized 43% of the JGB market and has control over yields, at least out to the 10-year maturity. Moreover, Japan has enjoyed a "free lunch" so far because monetization has not resulted in inflation. The reason that Japan has enjoyed a free lunch is that it has suffered from a chronic lack of demand and excess savings in the private sector. The government has persistently run a deficit and fiscally stimulated the economy in order to offset insufficient demand in the private sector. The Bank of Japan purchased bonds and drove short-term interest rates down to zero. These policies have made very slow progress in eradicating lingering deflationary economic forces. However, if animal spirits in the business sector perk up, then inflation could make a comeback unless the policy stimulus is dialed down in a timely manner. In other words, the BoJ-financed fiscal "free lunch" should disappear at some point. The U.S. is in a very different situation. There is no lack of aggregate demand or excessive savings in the private sector. The economy is at full employment, and thus persistent budget deficits should turn into inflation much more quickly than was the case in Japan. In other words, the U.S. is unlikely to enjoy much of a "free lunch", whether the Fed monetizes the debt or not. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Mandatory spending refers to entitlements; that is, government expenditure programs that are required by current law. These include Social Security, Medicare, Medicaid, government pensions and other smaller programs. 2 Please see Geopolitical Strategy Monthly Report, "Introducing The Median Voter Theory," June 8, 2016, available at gps.bcaresearch.com. 3 Please see The Bank Credit Analyst, "America's Fiscal Fortune: Leave Your Wallet On The Way Out," June 2011, available at bca.bcaresearch.com. 4 Please see The Bank Credit Analyst Special Report, "U.S. Twin Deficits: Is The Dollar Doomed?," April, 2018, available at bca.bcaresearch.com. 5 In the near term, fiscal stimulus and increased business capital spending will likely boost the dollar. But this effect on the dollar will reverse in the long-term. III. Indicators And Reference Charts The divergence between the U.S. corporate earnings data and our equity-related indicators continued in June. Forward earnings estimates continue to climb at an impressive pace. The U.S. net revisions ratio pulled back a little, but remains well above the zero line. Moreover, positive earnings surprises continue to trounce negative surprises. That said, the earnings upgrades are partly due to the Trump tax cuts, which are still being reflected in analysts' estimates. Second, some of our indicators are warning that there are clouds on the horizon. Our Monetary Indicator has fallen to levels that are low by historical standards, which is a negative sign for risk assets. This partly reflects the slowdown in growth in the monetary aggregates (see the Overview section). Our Equity Technical Indicator is threatening to dip below the zero line, which would be a clear 'sell' signal. Our Equity Valuation Indicator is flirting with our threshold of overvaluation, at +1 standard deviations. This is not bearish on its own, but valuation does provide information on the downside risks when the correction finally occurs. Our Willingness-to-Pay (WTP) indicator for the U.S. has rolled over, although this hasn't yet occurred for Japan and the Eurozone. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. This indicator suggests that flows into the U.S. stock market are waning. Finally, our Revealed Preference Indicator (RPI) for stocks remained on a 'sell' signal in June. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. The U.S. 10-year Treasury is slightly on the inexpensive side and our Composite Technical Indicator suggests that the bond has still not worked off oversold conditions. This suggests that the consolidation period has further to run, although we still expect yields to move higher over the remainder of the year. The dollar is expensive on a PPP basis, but is not yet overbought. The long-term outlook for the dollar is down, but it has more upside in the next 6-12 months. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Underweight We moved to a large over small cap preference last month, based on the exploding balance sheets of small cap equities. Our thesis was that the rapid increase in leverage would find its way into higher risk premia for small cap equities, necessitating a valuation derating. Small caps have since been outperforming owing to their inherent trade war insulation (top panel), implying the opposite has happened and risk premia have, in fact, decreased. The middle panel of the chart shows the cyclically adjusted relative price to earnings (CAPE) ratio. While on a forward earnings basis, small caps are trading at an elevated (but still within the realm of normal) 13% premium to large caps, on a cyclically adjusted basis, the premium has exploded near all-time highs, approaching 50%, well above the historical mean. This lofty relative CAPE multiple leaves small caps increasingly vulnerable to profit and debt related shocks and we reiterate our large cap bias.

Highlights Wage inflation in the EU28 is running at exactly the same rate as in the U.S. In the euro area, it is only modestly lower. As the current business cycle completes, the euro area versus U.S. bond yield spread will narrow, one way or the other. European equities are structurally handicapped by their substantial underexposure to technology, their substantial overexposure to financials, and the structurally undervalued currency. Still, there will be phases in which financials outperform technology and therefore in which European equities outperform. We anticipate that the next such phase to overweight European equities will occur later this year. In the near term, one European stock market that could outperform is Switzerland's SMI. Feature Largely unnoticed and without great fanfare, Europe has just overtaken the U.S. on a very important labour market measure. For the first time in living memory, the percentage of the working age (15-64) population that is in the labour force is higher in Europe than it is in the U.S., for both men and women (Chart of the Week). Chart of the WeekMale Labour Force Participation Is Now Higher In Europe Than In The U.S. One putative explanation is that as U.S. baby boomers have aged, people older than 64 have chosen to remain in the labour force, which has indirectly weighed on the U.S. 15-64 participation rate. But the phenomenon of baby boomers staying in the workforce is common to both Europe and the U.S. and cannot explain the extent of outperformance in European labour participation - a ten percentage point catch-up since the start of this millennium (Chart I-2). Chart I-2Labour Force Participation Is Now Higher ##br##In Europe Than In The U.S. The true explanation is that the European female participation rate has been in a major structural uptrend (Chart I-3) while the U.S. male participation rate has been in a major structural downtrend (Chart I-4). Chart I-3European Female Labour Force Participation##br## Is In A Structural Uptrend Chart I-4U.S. Male Labour Force Participation##br## Is In A Structural Downtrend Misleading Comparison 1: The Unemployment Rate In Europe Vs The U.S. This week, our purpose is not to discuss the reasons behind these labour participation trends - as we covered these in our recent report How Women Are Powering The European Economy.1 Rather, we want to point out one important repercussion: when the participation rate is changing, the unemployment rate is a misleading measure of labour market slack. When labour participation is rising, a seemingly high unemployment rate overstates true slack; conversely, when labour participation is falling, a seemingly low unemployment rate understates true slack. To understand why, consider a population in which the numbers employed, unemployed, and officially inactive stand at 95:5:25. The unemployment rate is 5%. But let's assume that ten officially inactive people could, with some mild encouragement, participate in the formal labour market. This means the true slack is fifteen people, or 14%.2 Now imagine that five of the officially inactive people join the formal labour force, albeit with a slightly higher unemployment rate given their inexperience in the formal labour force. Under these circumstances, the numbers employed, unemployed, and officially inactive might reasonably change to 99:6:20. The unemployment rate has increased to 5.7%, suggesting slack has increased. But the truth is that slack has actually decreased to eleven people, or 10%.3 Clearly, the process also works the other way. If somebody leaves the formal labour force, it might depress the unemployment rate, giving the impression of a tight labour market. But the impression would be misleading. As a recent paper from the Federal Reserve Bank of Boston pointed out:4 "Informal work arrangements, such as gig economy jobs... embodies an economically significant amount of labour market slack that is not captured in the U-3 unemployment rate and other standard estimates of slack... Informal work can be viewed as slack because most informal work participants would drop informal work for formal work, (thereby) adding potential labour supply to the formal market that could reduce pressure on measured wages" Is there any direct evidence for this thesis? Yes, the evidence is compelling. Standard measures of slack, such as the unemployment rate, suggest that the labour market has substantially more slack in Europe than in the U.S. (Chart I-5). Yet wage inflation is running at exactly the same rate in the EU28 as in the U.S. (Chart I-6). And in the euro area, it is only modestly lower (Chart I-7). Chart I-5The Unemployment Rate Suggests Much More ##br##Slack In Europe Than In The U.S. ... Chart I-6...But Wage Inflation ##br##Is Identical! Chart I-7Euro Area Wage Inflation##br## Is Not Far Behind This brings us to a glaring structural anomaly which must eventually correct. The gulf in monetary policy between the ECB and the Fed - reflected in the bond yield spread - has become unsustainably stretched relative to the economic fundamentals, specifically the difference in wage inflation which in reality is very modest (Chart I-8). As the current business cycle completes, we expect this bond yield spread to narrow, one way or the other. Chart I-8The U.S.-Euro Area Bond Yield Spread Is Stretched ##br##Relative To The Wage Inflation Differential Misleading Comparison 2: Equity Valuations In Europe Vs The U.S. Staying on the theme of Europe versus U.S. comparisons which are highly misleading, let's share one of the most common questions we get: are European equities relatively cheap, as their headline valuation suggests? The answer is an emphatic no. Compared with currencies and bonds, mainstream stock markets have little connection with the economies of their countries or regions of domicile. Mainstream stock markets are just collections of multinational companies, with each stock market defined by its own unique sector fingerprint. Sectors with vastly different structural growth prospects - say, financials and technology - must necessarily trade on vastly different valuations. So the sector with the lower headline valuation is not necessarily the cheaper sector. By extension, the stock market with the lower headline valuation because of its sector fingerprint is not necessarily the cheaper stock market. This means that a head-to-head comparison of European stock market valuations either with each other or with non-European stock markets is highly misleading. To which, a frequent follow-up question is: within the same sector, are European companies cheaper than their counterparts elsewhere in the world? The answer is, not necessarily. To understand why, consider the international cruise company Carnival which has a dual listing, one in London, one in New York. The London listing has recently traded at a substantial discount to the New York listing (Chart I-9 and Chart I-10). Does this mean that the London listing is cheap? Of course not. If it were, the markets would arbitrage away this valuation anomaly instantaneously! Chart I-9Carnival Can Trade On A Different Valuation##br## In London And New York... Chart I-10...Because Of The Currency##br## Translation Effect On the face of it, the valuations of Carnival's two listings should be the same because the underlying company is the same. However, the London and New York valuations can deviate substantially because of the so-called 'currency translation effect'. An international company like Carnival will intentionally receive its sales and profits across multiple global currencies - say, dollars and pounds, but a stock market listing is denominated in just one currency. If investors anticipate the dollar ultimately to weaken versus the pound - because they see that the pound is structurally cheap today - they might downgrade Carnival's multi-currency profit growth expectations in pound terms. Thereby, the London listing will trade at a discount to the New York listing. But the discount is a false impression. Allowing for the anticipated decline in the dollar versus the pound, the London listing is not cheap. It follows that any multinational listed in Europe will give a false impression of cheapness if investors see European currencies as structurally undervalued. European Equity Relative Performance Has Little Connection With European Economic Relative Performance Given the large distortions to stock market valuations from sector effects and currency translation effects, picking markets on the basis of relative valuation is a very dangerous way to invest. The correct and safe way to invest is to pick stock markets on the basis of the sector and currency biases you wish to express. This creates a paradox. The overall economic fundamentals in Europe, correctly measured, are not inferior to those in the United States. Yet European stock market relative performance has very little to do with Europe's relative economic performance. European equities are structurally handicapped by their substantial underexposure to technology, their substantial overexposure to financials, and the structurally undervalued currency. Unfortunately, this will necessarily weigh on their long-term relative performance prospects. Still, there will be phases in which financials outperform technology and therefore in which European equities outperform other major markets. We anticipate that the next such phase to overweight European equities will occur later this year. In the near term, one European stock market that could outperform is Switzerland's SMI. Given its overweighting to healthcare - Novartis and Roche - and healthcare's outperformance this year, the SMI should have fared well in the first half. However, this tailwind was countered by a stronger headwind - the SMI has a huge underweight to oil and gas, which is the one cyclical sector that has outperformed. But as we pointed out last week, the performance of oil and gas equities is technically stretched, and will require strong momentum in the crude price to extend further. Therefore, we like the combination of overweight healthcare, underweight oil and gas - which is precisely what Switzerland's SMI offers (Chart I-11). Chart I-11Switzerland = Long Healthcare, Short Energy Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report, 'How Women Are Powering The European Economy' dated June 7, 2018 available at eis.bcaresearch.com 2 5/(95+5) = 5%, (5+10)/(95+5+10) = 14% 3 6/(99+6) =5.7%, (6+5)/(99+6+5) = 10% 4 The Federal Reserve Bank of Boston Current Policy Perspectives No. 18-2 'Wage Inflation and Informal Work' by Anat Bracha and Mary A. Burke, October 2017. Fractal Trading Model This week we note that the outperformance of consumer services versus consumer goods is technically stretched. The 65-day fractal dimension is at a limit that has reliably signalled reversals. The recommended trade is short global consumer services versus consumer goods. Set a profit target of 2.5% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 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

NOTE: There will be a few minor scheduling changes to BCA's China Investment Strategy service in July. We will publishing next week's report and the report scheduled on July 25 one day late, on Thursday, July 5 and 26, respectively. There will also be no report on Wednesday, July 18 due to our regular summer break. Highlights In response to the sharp spike in the risk of a full-blown U.S./China trade war, many market participants have concluded that significant fiscal and/or monetary policy stimulus is forthcoming. But for now, a depreciation in the RMB is the only clear and significant policy response to the imposition of U.S. import tariffs that we can currently observe, and we would still classify it as just a remedial measure. While a falling RMB will improve the financial position of China's exporters, it also increases the risk that the U.S. will follow through with the worst of their threats. Despite two conceivable upside scenarios for the equity market, we recommend a neutral stance towards Chinese stocks within a global equity portfolio and currently view the risks as largely to the downside. We are closing our long China / short Taiwan trade for a considerable profit, and recommend that investors go long low-beta sectors within the MSCI China index. Feature Chart 1A Decisive Technical Breakdown In ##br##Ex-Tech Stocks Vs Global In a Special Alert last week, we recommended that investors downgrade Chinese ex-tech stocks versus their global peers to neutral from overweight,1 after having placed them on downgrade watch at the end of March.2 Our recommendation was made in response to the ongoing slowdown in China's industrial sector, a significant escalation in the imposition of import tariffs between the U.S. and China, and an unfavorable shift in the risk/reward balance of global risky asset prices.3 It was also timely, as Chinese ex-tech stock prices have now decisively broken below their 200-day moving average (Chart 1). Following our shift in stance, the question facing BCA's China team, as well as global investors, is straightforward: Now what? Stimulus Watch The answer to this question among many market participants is that fiscal and/or monetary policy stimulus is forthcoming. We have no doubt that China will announce some remedial or compensatory measures in response to protectionist action from the U.S. Indeed, recent statements from the Ministry of Finance (MOF) suggest that planned fiscal spending for the year will be accelerated/brought forward, and the PBOC has already made a targeted cut to the reserve requirement ratio and reduced the relending rate for small company loans. However, we have argued that the bar for a fresh round of material stimulus is higher today than it was in the past, and we continue to hold this view. Elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities can respond with the usual barrage of infrastructure spending and increased bank lending. The economy likely needs to feel more pain before policymakers come to its aid with enough magnitude to potentially spark another upswing in economic activity. Below we outline a few perspectives on the potential for stimulus, and how investors can gauge whether policymakers are deploying enough stimulus to materially impact China's economic outlook: Fiscal Stimulus The MOF's statement reflects the first fiscal policy action that China would likely take to combat any economic weakness, which is to speed up spending that has already been approved but was planned to occur later in the year. But from the perspective of whether a policy action is likely to materially boost economic activity, frontloading pre-approved spending would qualify, at best, as a remedial measure. In our view, tracking China's budgetary government finance data represents the best method for investors to determine whether policymakers are truly stimulating via the fiscal channel. While it is true that China's shadow budget deficit is much larger than the official data show (Chart 2), there is a crucial aspect of China's recent mini-cycle that is not well understood by many investors: almost all of the expansion of China's fiscal stance from 2014-16 was from on-budget rather than off-budget spending. Given that China has been trying to limit off-budget spending as part of its structural reform program, our sense is that this time won't be different if China decides that significant fiscal stimulus is required. This is good news for investors, given that on-budget spending is easier to observe in real-time, and Chart 3 presents two simple measures that we are using to monitor China's fiscal stance, alongside their year-over-year changes: on-budget expenditure and the on-budget balance, both as a % of GDP. Based on these measures there are no signs yet that the fiscal stance is easing (in fact, the opposite has occurred over the past year), but we will watching Chart 3 closely over the coming months for any indication of a change. Chart 2China's Shadow Budget Deficit Is Large... Chart 3...But If China Stimulates It Will Likely Be On-Budget Monetary Stimulus In our judgement, the recent cut to the reserve requirement ratio is not likely to be effective at stimulating the domestic economy. Investors should note that the initial reaction of many market participants to the April 17 reserve requirement ratio cut of 1% was that it represented a shift in the PBOC's policy stance towards easing, which ultimately proved to be a false narrative. Chart 4 shows China's 3-month interbank repo rate (China's de-facto policy rate which leads average lending rates), and highlights the timing of two specific events: March 28, when news broke that the PBOC would extend the deadline for the implementation of new regulatory standards for asset management products, and April 17, when the PBOC announced its targeted reserve requirement ratio cut. The chart makes it clear that the decline in the repo rate was in response to the deadline extension rather than the repo rate cut. This is entirely consistent with the findings of our February 22 Special Report,4 particularly the fact that 75% of the monetary tightening that has occurred since late-2016 has been regulatory in nature. We have previously argued that the dip in the repo rate in response to the deadline extension would probably be temporary,5 and Chart 4 shows that the rate has indeed increased over that past two months. In short, there is no evidence that the April 17 reserve ratio cut had any measurable effect on the stance of monetary policy in China. Given this, there are two key points for investors. The first is that small cuts to the reserve requirement ratio should be viewed, at best, as remedial measures that may help blunt the impact of shock to the export sector, but they are unlikely to alter the downward trajectory of the "old economy" (the portion of China's economy that is most relevant to global investors). The second is that if cuts to the reserve requirement ratio or any other monetary policy action stimulates the provision of credit via easier lending standards (rather than by reducing the cost of borrowing), their effect should result in a pickup in broad measures of credit growth rather than a reduction in interest rates. Chart 5 highlights that, for now, no such pickup has occurred; adjusted total social financing, which excludes equity issuance but includes municipal bonds, remains in a downtrend. This series, along with its impulse equivalent, are both included in the BCA Li Keqiang Leading Indicator which is at the core of our efforts to monitor the cyclical condition of China's business cycle. Chart 4No Evidence That April RRR Cut Eased Interest Rates Chart 5No Evidence That April RRR Cut Eased Lending Standards The Exchange Rate BCA's Geopolitical Strategy team has recently argued that China is likely to retaliate to a potential tariff imposition by weakening CNY/USD. This would have the effect of improving the competitiveness of exports priced in RMB, or would bolster the revenue of exporters selling goods priced in U.S. dollars (by way of receiving more RMB after converting the dollars received). Evidence has emerged over the past week to suggest that the PBOC is indeed allowing China's currency to depreciate against the U.S. dollar. Chart 6 shows the actual CNY/USD exchange rate alongside the value that would be predicted based on its relationship with the dollar over the year prior to its early-April peak. The chart suggests that the decline in CNY/USD appears to have, until very recently, reflected the strength in the U.S. dollar. However, the chart shows that CNY/USD has fallen over the past few days by magnitude in excess of what would be expected given movements in the U.S. dollar, implying that the very recent weakness is likely policy-driven. Chart 6The PBOC Is Letting CNY/USD Depreciate We agree that depreciating the currency versus the U.S. dollar will improve the financial condition of domestic exporters, but we would also caution investors against looking at a deep depreciation in CNY/USD in an encouraging light. We have noted in previous reports that such a development would be a clear sign of an outright, full-scale trade war between the U.S. and China, and in this context currency deprecation should still be classified as just a remedial measure (i.e. it is unlikely to lead to a renewed upswing in Chinese economic activity). Bottom Line: A depreciation in the RMB is the only clear and significant policy response to the imposition of U.S. import tariffs that we can currently observe, and we would still classify it as just a remedial measure. While a falling RMB will improve the financial position of China's exporters, it may also invite even further protectionist action from the U.S. Investment Recommendations Our recommendation to cut Chinese ex-tech stocks to neutral means that investors should be looking both for upside and downside risks when judging when to make their next allocation shift. For now, our discussion above underscores that we view the risks largely to the downside. The scenario that would cause us to further downgrade Chinese stocks to underweight within a global equity portfolio is not difficult to imagine: the worst outcome in the U.S. / China trade dispute materializes, the global economy slows meaningfully, and the inertia from the ongoing structural reform program causes Chinese policymakers to limit their stimulus to compensatory, remedial measures until a painful slowdown emerges in the domestic economy. We are not yet past the "point of no return" on the way to this outcome, but the events of the past two weeks have clearly moved us further along the path. Conversely, there are two scenarios that we can envision that could cause us to upgrade Chinese stocks back to overweight: Chart 7Keep Monitoring Floor Space Sold A protectionist exchange occurs between China and the U.S. but fails to devolve to the most damaging outcome. China's remedial measures are successful at easing the pain from tariffs on domestic producers, and the economic outlook stabilizes. In this scenario the most acute risk would be removed, but the gradual underlying downtrend in China's "old economy" would be intact. In this case we would be more comfortable upgrading Chinese stocks if there was an additional reflationary tailwind, such as a boost from fiscal spending or some reversal of the monetary tightening that has occurred since late-2016. But a significant, exogenous acceleration in economic activity from some other sector of China's economy would also fit the bill, and we have argued in past reports that housing appears to be the best candidate. Chart 7 highlights that residential sales volume may now be in a gradual uptrend, which could translate into stronger construction in the months ahead. The second scenario that would cause us to upgrade Chinese stocks is straightforward: Chinese policymakers determine that the risks to growth from an export shock are unacceptably large given the existing slowdown in the industrial sector, and decide to temporarily reverse course on the structural reform path by opting for "big bang" fiscal and/or monetary stimulus. A significant and highly investment-relevant mini-cycle upswing occurred in China the last time that the authorities strongly prioritized growth, and we will watching closely for real indications of a shift in attitude in this direction. For now our judgement is that policymakers have a higher pain threshold than in the past, suggesting that this is outcome is not yet probable. Related to our decision to downgrade Chinese ex-tech stocks to neutral within a global equity portfolio, we have three updates to our trade book: We are closing our long MSCI China / short MSCI Taiwan position and upgrading our Taiwanese cyclical stance to neutral: Despite being massively overweight technology stocks, Chart 8 highlights that Taiwan is a comparatively low-beta equity market versus China. Our trade has generated a 21% return since we initiated it in February 2017, and we believe it is time to book profits. Given Taiwan's small size it is actually possible that its economy and/or equity market will suffer disproportionately if the worst U.S. / China trade outcome materializes, which could cause us to revisit the trade. But for now our judgement is that a neutral position is warranted. We are sticking with our long China onshore corporate bond trade: We would certainly expect credit spreads on Chinese corporate bonds to flare in response to a deteriorating economic outlook, but we highlighted in our June 13 Weekly Report how high the bar is for investors to lose money on these bonds.6 In short, China's corporate bond market already offers a margin of safety given its high yield and a comparatively short duration, and we do not see recent developments on the trade front as a sufficiently compelling reason to exit the trade. We are initiating a new trade - within the MSCI China index, long low-beta sectors / short benchmark: Chart 9 presents the relative US$ stock price return of a portfolio of low-beta level 1 GICS sectors within the MSCI China index, relative to the index itself. Our methodology in calculating the portfolio is the same as that employed in the A-share factor analysis that we presented in our June 13 report; namely it is a value-weighted portfolio of sectors with below-median rolling 1-year market beta.7 The chart shows that the portfolio has outperformed over time, but sold off quite substantially last year as the high-flying tech sector boosted the performance of the overall index. The relative performance trend for low-beta has recently strengthened and crossed above its 200-day moving average, which we regard as a supportive technical signal to initiate the trade. Chart 8Taiwan's Equity Market Is Low Beta Vs China's Chart 9Go Long Low-Beta Sectors Vs The Broad Market Bottom Line: Despite two potential upside scenarios, we recommend a neutral stance towards Chinese stocks within a global equity portfolio and currently view the risks as largely to the downside. We are closing our long China / short Taiwan for a considerable profit, and recommend that investors go long low-beta sectors within the MSCI China index. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see China Investment Strategy Special Alert "Downgrade Chinese Stocks To Neutral", dated June 20, 2018, available at gis.bcaresearch.com. 2 Please see China Investment Strategy Special Report, "Chinese Stocks: Trade Frictions Make For A Tenuous Overweight," dated March 28, 2018, available at cis.bcaresearch.com. 3 Pease see Global Investment Strategy Special Report "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 19, 2018, available at gis.bcaresearch.com. 4 Pease see China Investment Strategy Special Report "Seven Questions About Chinese Monetary Policy", dated February 22, 2018, available at cis.bcaresearch.com. 5 Pease see China Investment Strategy Weekly Report "China: A Low-Conviction Overweight", dated May 2, 2018, available at cis.bcaresearch.com. 6 Pease see China Investment Strategy Weekly Report "A Shaky Ladder", dated June 13, 2018, available at cis.bcaresearch.com. 7 The current sector weights of the portfolio are: 26% telecom services, 24% industrials, 19% health care, 16% utilities, and 14% consumer staples. Cyclical Investment Stance Equity Sector Recommendations

Highlights We have downgraded our 12-month recommendation on global equities and credit from overweight to neutral. If macro developments evolve as expected, then we will shift to an outright bearish stance on risk assets later this year or early 2019 in anticipation of a global recession in 2020. BCA has identified ten periods since 1950 when U.S. equities moved sideways for at least five months in a narrow range; when the economy is at full employment, stocks are more likely to sell off after these sideways periods than if there is still some slack in the labor market. Feature The outlook for global risk assets will likely be more challenging in the coming months. With that in mind, we have downgraded our 12-month recommendation on global equities and credit from overweight to neutral. BCA still expects that the U.S. stock-to-bond ratio will grind higher in the next 12 months, as U.S. stocks move sideways and Treasury yields climb (Chart 1A and 1B). We recommend that investors put the proceeds from the sale of equity positions into cash. Chart 1AScenarios For Stock-To-Bond Ratio ##br##If 10-Year Treasury Hits 3.80% Chart 1BScenarios For Stock-To-Bond Ratio ##br##If 10-Year Treasury Hits 3.29% Within a fixed-income only portfolio, we are selling credit and putting the proceeds into Treasuries. We maintain our underweight duration stance given our view of the Fed and the 10-year Treasury. At 2.91%, the 10-year is still below BCA's view of fair value (3.29%). Moreover, BCA's position is that the Fed's gradual path of rate hikes is consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%, well above current levels.1 On the credit side, we note that late in the cycle the yield curve is moderately flat, between 0 and 50 bps. Work by our U.S. Bond Strategy team2 shows that periods when the curve is flat are consistent with much lower excess returns than when the slope is above 50 bps (Chart 2). Given the low potential reward, a neutral posture on credit makes the most sense. Investors will not give up too much by starting to downgrade early. Tomorrow's U.S. Bond Strategy report will provide more details on the corporates versus Treasuries allocation. Chart 2Corporate Bond Performance And The Yield Curve BCA has recommended overweight positions in U.S. risk assets since spring 2009 when equities became attractive from a risk/reward perspective. At that time, the U.S. economy was weak, the Fed was easing, equity valuations were depressed and forward earnings estimates were dismal (Chart 3). In contrast, the risk/reward for risk assets today is much less attractive. The economy is in the late stages of an expansion and is running beyond full employment. The central bank is raising rates. Moreover, equity valuations are elevated and forward earnings estimates are at their most optimistic in 20 years (Chart 3 again). This means that good news is already priced into the equity market. When the Shiller PE, a measure of the market's valuation, is between 30 and 40, 1-year returns are tepid at best (Chart 4). Chart 3Five-Year Bottom-Up EPS Growth Estimates Are Impossibly High Chart 4Expected Returns Given Starting Point Shiller P/E We are not trimming exposure to risk assets because we are more concerned about the economic outlook. BCA's view is that odds of a U.S. recession in the next 12 months remain low. Furthermore, the traditional recession signals that we track do not suggest a recession is nigh (Chart 5). For example, the 2/10 yield curve is still positive at 34 basis points (panel 2). Upward movement in long-dated breakevens will offset some of the upward pressure at the front-end from further Fed rate hikes, limiting the amount of curve flattening during the next few months. Once long-dated breakevens get back to a range between 2.3% and 2.5% then flattening could proceed more rapidly.3 Panel 3 shows that the LEI crosses below zero when a recession is imminent. The May LEI rose by 6% year-over-year. Initial claims for unemployment insurance in the week ending June 16 were 24K below their mid-December 2017 reading. Panel 4 shows that a 6-month increase in unemployment claims of between 75,000 and 100,000 is associated with a recession. The bottom line is that we are not concerned about a recession. Nonetheless, BCA's Equity Scorecard has dropped to 2, below the critical value of three that has been consistent in the past with positive equity returns (not shown). Table 1 updates our Exit Checklist of items that are important for the equity allocation call. Three of the nine are now giving a 'sell' signal and they suggest that prudence is necessary, despite the constructive economic outlook. Chart 5No Recession Signal Here Table 1Exit Checklist For Risk Assets Furthermore, several technical indicators that we monitor signal caution. The National Association of Active Investment Managers (NAAIM) says that active managers have increased equity risk since the start of the year (Chart 6). At 89%, the average equity exposure of institutional investors is close to the cycle high reached in March 2017, which was the highest since 2007, just before the S&P 500 peak in October 2007. Furthermore, BCA's Equity Speculation Index remains elevated. At slightly under 2, it is at a position where bear markets began in 2000 and 2007, and it is well above the level seen just before the 2015 bear market (Chart 7, panel 1). That said, not all technical indicators are flashing red. Chart 8 shows that BCA's Technical Indicator is not at an extreme (panel 1). Moreover, BCA's Equity Sentiment Composite Index is neutral (panel 2); panel 3 shows that the U.S. large cap equities remain in the middle of their 2009-2018 recovery channel, albeit in the top half of the channel. Note that the S&P 500 tested the top end of the channel (near 2850) in January 2018. Chart 6Active Managers Have Increased ##br##Equity Exposure This Year Chart 7Equity Speculation Is Elevated Chart 8Not All Technical Indicators Are Bearish The risk to our neutral stance on equities is that credit and equities will rally to fresh highs before the cycle is done. However, given our bias for capital preservation and views on the late stage of the business cycle, it is not advisable to reach for the last few drops of return. With equity valuations stretched, we would rather be early and judicious and miss out on the last few basis points of outperformance rather than be late and underperform as risk assets sell off. BCA's view is that the next recession will be sparked by the Fed overtightening in 2019 and 2020 when it finds itself behind the curve on inflation. Moreover, because inflation is at the Fed's 2% target and the economy is beyond 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 the Fed will be reluctant to deviate from its tightening path even in the face of more turmoil in the EM space or in Europe. This supports our guarded view on equities and our decision to move into cash instead of Treasuries. Geopolitical risk is another reason to be cautious. Chart 9 shows that globalization, a tailwind for risk assets, is stalling. Moreover, there is an increased threat of a breakup in the Eurozone, led by political uncertainty in Italy (Chart 10). In addition, tensions with Iran are mounting. Nonetheless, our Geopolitical Strategy service notes that the U.S.'s relationship with China is the primary source of geopolitical peril (Chart 11).4 Although we are not adjusting our view on the dollar,5 a stronger greenback would bolster our case for caution on risk assets. A higher dollar would hurt the profits of U.S. multinationals and could lead to instability in the emerging markets, raising the odds of a policy misstep. Chart 9Globalization Has Reached Its Zenith Chart 10Risk Of Eurozone Breakup Is Rising Chart 11BCA's Geopolitical Power Index Illustrates A Multipolar World Equity volatility will accelerate through year end, as is often the case late in equity bull markets. Bottom Line: If macro developments evolve as expected, then we will shift to an outright bearish stance on risk assets later this year or early 2019 in anticipation of a global recession in 2020. Absent a recession, we would move to underweight stocks if a wider trade war develops. We would consider temporarily shifting our 12-month recommendation back to overweight if global equities sell off by more than 15% in the next few months, especially if our economic indicators remain constructive and the Fed either cuts rates or signals that it is on hold. Treading Water BCA has identified ten periods since 1950 when U.S. equities moved sideways for at least five months in a narrow range (See Appendix Charts 1 and 2).6 We excluded bear markets and recessions from our analysis because our view is that neither condition will occur in the next 12 months. Table 2 shows that these sideways episodes lasted an average of eight months. At the end of six of the ten intervals, U.S. large cap equities rallied (1986, 1988, 1992, 1997-1998, 2004, and 2015); after two phases, stocks recovered briefly and then sold off (1951-52 and 1972). At the conclusion of the 1991 episode, stocks rallied and then resumed moving sideways. Stocks sold off after the eight-month sideways phase in 1976. Table 2What Happens After Stocks Move Sideways? Four (1951-52, 1972, 1988, 1997-98) of the ten sideways periods occurred after the U.S. economy reached full employment. The 10 year Treasury yield increased as stocks moved sideways in 1972 and in 1988, but fell in the 1997-98 episode. The S&P 500 PE ratio increased in two sideways phases (1972 and 1997-98) and contracted in 1988. S&P 500 EPS growth accelerated in 1972, 1988 and 1997-98 phases. The S&P 500 rallied after the sideways episodes in 1988 and 1997-98, but sold off after the 1951-52 and 1972 sideways phases that occurred after the economy hit full employment (Chart 12). Chart 12S&P 500 Valuations, EPS Growth, Margins And The 10-Year Treasury Yield When Stocks Move Sideways As the S&P 500 moved sideways when the economy was not yet at full employment (1976, 1986, 1991, 1992, 2004 and 2015), 10-year Treasury yields fell four times (1976, 1986, 1991 and 1992) and rose in two (2004 and 2015). The forward PE ratio for the S&P 500 expanded in 1986 and 1992, but contracted in 1991, 2004 and 2015. EPS growth during sideways episodes for stocks when the economy was not yet at full employment is mixed. EPS growth accelerated in 1976, 1992 and 2004, but slowed in 1986, 1991 and 2015 as oil prices fell. U.S. large cap equities rallied after four of the sideways periods when the economy was not yet at full employment (1986, 1992, 2004 and 2015) but sold off after the 1976 sideways move (Chart 12 again). We intend to further examine the macro backdrop during sideways periods for U.S. equities in future Weekly Reports. Bottom Line: BCA expects bond yields to rise in the next 12 months and S&P 500 profit growth will peak. Stocks are more likely to move higher after a period of sideways price action if the economy is not at full employment. Rising PE ratios as stocks move sideways most often lead to equity rallies after the sideways phases end. With valuations already elevated, PEs are unlikely to expand much further in this cycle. Moreover, the U.S. economy reached full employment in early 2017, making it less likely that the Fed will hit the pause button on its rate hike regime. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's U.S. Bond Strategy Weekly Report, "Bond Bear Still In Tact," published June 5, 2018. Available at usbs.bcaresearch.com. 2 Please see BCA's U.S. Bond Strategy Weekly Report, "As Good as It Gets For Corporate Debt," published April 24, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA's U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty," published June 19, 2018. Available at usbs.bcaresearch.com. 4 Please see BCA's Geopolitical Strategy "Are You Sick of Winning Yet," published June 20, 2018. Available at gps.bcaresearch.com. 5 Please see BCA Research's Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," published June 20, 2018. Available at gis.bcaresearch.com. 6 There are well-established periods for bull and bear markets for U.S. equities, however not for "sideways" episodes for stocks. We have defined "sideways" as a period of range-bound equity price movements that have lasted for at least five months outside of recessions and bear markets. Readers may have other definitions of "sideways". APPENDIX CHARTS Chart 1Sideways Epsisodes For Stocks 1950-1980... Chart 2..And 1980-2018

Highlights Portfolio Strategy Selling in the S&P cable & satellite index is overdone. Recession type valuations fully reflect the acquirer discount heavyweight CMCSA is still commanding. Lift exposure to neutral. Content providers' assets are highly coveted, and these firms remain in play as media is undergoing a tectonic shift. The industry's demand backdrop is also on the rise, signaling that it no longer pays to underweight the S&P movies & entertainment index. Increasing construction expenditures, ballooning balance sheets, soft relative selling prices and a rising U.S. dollar all suggest that restaurant profits will underwhelm. Downgrade to underweight. Recent Changes Raise the S&P cable & satellite index to neutral today. Lift the S&P movies & entertainment index to a benchmark allocation today. Act on the downgrade alert and trim the S&P restaurants index to underweight today. Table 1 Feature Geopolitical risks held equities hostage last week as President Trump toughened his tariff rhetoric toward China. While the risk of a global trade spat remains acute, the market is becoming desensitized to daily trade-related headlines and remains resilient. Given the plethora of political risks and upcoming midterm elections, I look forward to hearing Greg Valliere's keynote speech in BCA's Toronto Investment Conference on September 24-25. Importantly, last week rising protectionism along with "Three Policy Puts Going Kaput" compelled BCA's Global Investment Strategy service to turn more cautious toward global risk assets over its 6 to 12 month cyclical horizon, prompting them to downgrade global equities from overweight to a neutral stance.1 We have sympathy for this view and acknowledge that the risks to our still sanguine U.S. equity market view, which we have been flagging in recent publications, have increased a notch. We are especially worried about the greenback's appreciation and increasing potential to infiltrate SPX EPS in calendar 2019 (please see Chart 2 and Chart 4 from the June 4th Weekly Report). Given that technology has the highest foreign sales exposure (58% of total sales) among GICS1 sectors, and a 26% market cap weight, we are closely monitoring leading indicators for tech profits. Indeed, for calendar 2019 the S&P tech sector's contribution to S&P 500 profit growth is the highest at 21%, with financials right on its tail at 20% (Chart 1). Energy sector EPS base effects are filtered out in 2019, but industrials, that have a 37% foreign sales exposure and are at the epicenter of President Trump's tariff rhetoric, also explain 13% of SPX EPS growth in calendar 2019 (Chart 1). Chart 1Contribution To S&P 500 2019 EPS Growth In fact, over a structural (2-3 year) time horizon we are aligned with BCA's more bearish equity outlook. We have been advocating this longer term thesis in our travels visiting BCA clients (please download our latest marketing slide deck here that highlights our bearish secular equity market view). Importantly, the three signposts we are monitoring to help us time the end of the business cycle, and thus equity bull market, are: a yield curve inversion (leading indicator), doubling in year-over-year oil prices based on monthly dataset (coincident indicator) and a mega-merger announcement either in tech or biotech space (confirming anecdotal indicator). There are currently no ticks in any of these three boxes, and we conclude that the S&P 500 has yet to peak for the cycle (Chart 2). Crucially, the Fed is inflating a massive bubble by staying too easy for too long. It is rather obvious to us that the U.S. economy is firing on all cylinders with real non-residential investment growing near 10% in Q1, but the real fed funds rate is still near the zero line (Chart 3). In addition, recent Fed minutes signaled that the Fed is willing to take some inflation risk, which will further push equity markets into steeper disequilibrium. It would be unprecedented for the cycle to end with the real fed funds rate glued to zero (Chart 3). Chart 2Recession Indicators Chart 3Real Fed Funds Rate Is Still Zero! Moreover, the U.S. economy just received a two year fiscal stimulus injection which is rare in both duration and magnitude during the late stages of the expansion and thus inherently inflationary. Worrisomely, the last time this happened was in the mid-to-late 1960s that led to the inflationary 1970s (please see Chart 1 and Table 2 from our October 9th "Can Easy Fiscal Offset Tighter Monetary Policy?" Weekly Report). Tack on the starting point of a World War-like debt-to-GDP ratio and the only regulatory mechanism for government profligacy is the bond market (Chart 4). Chart 4Interest Rates Have Nowhere To Go But Up Another way to make the debt arithmetic work is if one believes the White House's real GDP projections of 3%+ as far as the eye can see, which stand in marked contrast to the IMF's, the CBO's and the Fed's own projections (Chart 5). Therefore, the path of least resistance for interest rates is higher as a way to slow down the economy and also rein in debt excesses. Typically, this overheating late in the cycle is synonymous with a blow off phase in equities (Chart 6), before the bottom falls out. Chart 5Don't Believe The White House Chart 6Blow Off Phase In sum, while BCA downgraded global equities to neutral last week on a cyclical time horizon, we are deviating from the BCA House View and still believe that the S&P 500 will make new all-time highs in absolute terms before the next recession hits. This week we are making a few subsurface changes to the S&P consumer discretionary sector, but we maintain an underweight allocation to this interest rate-sensitive sector. New Media Landscape: (Pipelines Vs. Content Providers) Vs. Netflix At last count Netflix broke into the top 25 largest companies (market cap based) in the S&P 500, and if it keeps up its frenetic pace it is on track to surpass Boeing. While legacy media giants had a chance to scoop up Netflix in the past few years, its current stratospheric valuation makes it uneconomical and nonsensical. Instead, the specter of Netflix, as well as other tech giants circling the space, has accelerated an inter- and intra-industry consolidation (bottom panel, Chart 7). Why? Because Netflix not only went straight to the consumer on a new medium, the internet, and sped up cord cutting, but also blurred industry lines by becoming a content provider producing its own original content in addition to offering third party content. The media landscape is thus still trying to adjust to the Netflix induced "creative destruction" and media executives are scrambling to compete with/protect legacy franchises from Netflix. The recently cleared AT&T/Time Warner merger has intensified the bidding war of remaining crown jewel assets in the legacy content media world. We were well positioned for this shake up in the space as we went underweight the media complex in early March.2 But now, we deem that the easy money has been made and most of the negative narrative is reflected in bombed out relative valuations despite depressed relative profit and sales growth estimates (second & third panels, Chart 7). As a result we recommend lifting exposure back to benchmark in the broad S&P media index. Beyond these industry related intricacies, the macro backdrop is starting to turn in favor of media outfits, warning that it no longer pays to be bearish. Chart 8 shows that relative consumer outlays on media have spiked recently. The implication is that industry revenue growth has more upside. BCA's ad spending indicator also corroborates this firming top line growth message, as does the latest ISM services survey that remains squarely above the 50 boom/bust line on a broad array of measures. Unsurprisingly, this budding demand recovery has translated into a pick up in industry pricing power with our media selling price gauge even surpassing overall inflation. The implication is that media profits could surprise to the upside. Chart 7M&A Frenzy Continues Chart 8Overlooked Demand Recovery While our sense is that pipelines (S&P cable & satellite index) are the likely losers and content providers (S&P movies & entertainment) are the likely winners from the ongoing broad media deck reshuffling, the way we are executing the S&P media upgrade to neutral is by lifting both the S&P cable & satellite and S&P movies & entertainment sub-indexes to neutral. On the cable front, M&A activity is weighing heavily on relative share prices as index heavyweight Comcast is a possible acquirer of the Murdoch empire assets. However, this bellwether company is not a pure pipeline play and were it to win the FOX-related assets bidding war, it would further diversify its cash flow. Monetizing those assets involves execution risk, especially as the legacy cable business is wrestling with decelerating selling prices and still has to contend with cord cutting (top & middle panels, Chart 9). Encouragingly, the bottom panel of Chart 9 shows that likely all the negative news flow is already baked into compelling relative valuations. With regard to the content providers, not only are some of these assets currently caught up in a bidding war, but every remaining independent content provider is now in play, and deal hungry investment bankers are aggressively pitching M&A to media (and likely other industry) CEOs. Macro headwinds are also morphing into tailwinds for the S&P movies & entertainment group. Consumer confidence is pushing multi decade highs and given the fact that the economy is at full employment any increase in discretionary consumer incomes will likely further boost recreation outlays (Chart 10). Industry pricing power is also expanding at a healthy clip at a time when industry executives are showing labor restraint (Chart 11). If selling prices stay firm on the back of improving demand as we expect, then movies & entertainment profit margins will enter an expansion phase (middle panel, Chart 10). Chart 9Cable's Blues Are ##br##Well Discounted Chart 10Firming ##br##Recreation Outlays... Chart 11And Recovering Operating Metrics##br## Remain Underappreciated None of this rosy outlook is reflected in cyclically low S&P movies & entertainment relative valuations (bottom panel, Chart 10). Bottom Line: Book relative profits of 13.5% in the S&P cable & satellite index since inception and lift to neutral. Boost the S&P movies & entertainment index to a benchmark allocation for a relative loss of 8.3% since the early March inception. As a result the broad S&P media index also commands a neutral weighting. The ticker symbols for the stocks in the S&P cable & satellite and S&P movies & entertainment indexes are: BLBG: S5CBST - CMCSA, CHTR, DISH and BLBG: S5MOVI - DIS, FOXA, FOX, VIAB, respectively. Portion Control In Restaurants Restauranteurs are eternal optimists; at least that is the lesson we take from the National Restaurant Association's Restaurant Performance Index (RPI) which only rarely dips below the expansion line (Chart 12, second panel). However, changes in this overly optimistic sentiment survey are useful as they closely lead the S&P restaurants index's relative performance. This indicator has recently rolled over and we think the timing is right to turn negative on restaurants (Chart 12, bottom panel). The recent evaporation of industry pricing power echoes the RPI's early indications of a downturn (Chart 13, second panel). In view of how tightly it moves with relative industry sales, the growth outlook for restaurants has darkened considerably. The underlying driver of weakening pricing power is the industry's collapsing share of the consumer's wallet over the past two years, which has been at least as destructive to industry growth as the Great Recession (Chart 13, bottom panel). While both relative consumption and sales, which move in lockstep, have been staging a recovery in 2018, they both remain firmly in deflationary territory. Meanwhile, industry wages - the largest input cost - have been expanding above trend for the better part of the past four years (Chart 14, second panel). Though restaurant wage growth has recently slowed considerably it has not been enough to bring our margin proxy out of negative territory, implying sliding relative earnings growth is set to continue (Chart 14, bottom panel). Chart 12Optimism Reigns In Restaurants Chart 13Falling Pricing Should Weigh On Sales Chart 14Labor Costs Are A Profit Headwind A rising U.S. dollar is an additional profit headwind for this heavily internationally-geared consumer discretionary sub-index. Despite dollar strength offering an input cost tailwind via lower food commodity costs, declining translation of foreign profits will likely swamp those gains. McDonald's and Starbucks, which together represent 80% of the weight of the S&P restaurants index, had 62% and 49%, respectively, of their locations outside the U.S. at the end of last year. To compensate for a tough profit outlook, restaurants have embarked on a construction spending spree that shows no signs of abating (Chart 15, second panel). The predictable result has been a near-doubling of leverage ratios over the past three years (Chart 15, bottom panel). A weak profit backdrop signals that relief from these levels will be hard to find. Chart 15Restaurants Are Binging On Debt Chart 16Valuations Do Not Reflect Risks Valuations have been treading water at above-normal levels for several years (Chart 16, second and third panels). Perky valuations seem poised for a fall given the cloudy profit outlook and the higher risk premium that recently geared up balance sheets typically command. Bottom Line: Still-high valuations are not supported by falling returns in an increasingly capital intensive industry. Accordingly, we are pulling the trigger on last month's downgrade alert on the S&P restaurants index and moving to an underweight allocation. The ticker symbols for the stocks in this index are: BLBG: S5REST - MCD, SBUX, YUM, DRI, CMG. What Does All This Mean For The S&P Consumer Discretionary Index? Chart 17Stay Underweight Consumer Discretionary Despite the S&P media's heavy weighting in the broad consumer discretionary sector, our S&P restaurants downgrade sustains the below benchmark allocation in the S&P consumer discretionary sector. Importantly, the three key factors weighing on this early-cyclical sector we identified in early March remain intact: rising fed funds rate, quantitative tightening and higher prices at the pump (Chart 17). Meanwhile, were we to exclude AMZN from the day the S&P included it in the SPX and the S&P 500 consumer discretionary index (November 21st, 2005), then the vast majority of consumer discretionary stocks are actually following the typical historical relationship with the Fed's tightening cycle (middle panel, Chart 17). Put differently, the equal weighted S&P consumer discretionary relative share price ratio is indeed following the Fed's historical tightening path (bottom panel, Chart 17). Bottom Line: Earnings underperformance will eventually result in relative share price underperformance. Stay underweight the S&P consumer discretionary index. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 19, 2018, available at gis.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Short oil and gas versus financials. Stick with underweights in the classically cyclical sectors. Downgrade the FTSE100 to neutral. Overweight France, Ireland, Switzerland and Denmark. Underweight Italy, Spain, Sweden and Norway. European equities will struggle to make much headway versus the technology-dominated S&P500 and MSCI Emerging Markets. Overall market direction will be range-bound through the summer. Feature Two market oddities stood out in the first half of the year. The first oddity was the abrupt decoupling of bank equity performance from bond yields (Chart I-2). For many years, bank equity performance and bond yields have been joined at the hip (Chart I-3). The faithful relationship exists because higher bond yields tend to signal stronger economic growth, either real or nominal. Stronger growth should be good for banks as it is associated with both accelerating credit growth and lower provisions for non-performing loans. Chart of the WeekWhen Technology Outperforms, European Equities Struggle Versus Emerging Market Equities Chart I-2Oddity 1: Banks Abruptly Decoupled##br## From Bond Yields Chart I-3Banks And Bond Yields Have Been ##br##Joined At The Hip For Years The second oddity was the abrupt decoupling of crude oil from industrial metal prices (Chart I-4). It is rare for crude oil to outperform copper by 30% in the space of just six months (Chart I-5). Chart I-4Oddity 2: The Crude Oil Price Abruptly ##br##Decoupled From Metal Prices Chart I-5It Is Rare For Crude Oil To Outperform ##br##Copper By 30% In Six Months Explaining The Oddities In The 1st Half The underperformance of banks is consistent with similar underperformances in the other classically growth-sensitive sectors - industrials, and basic materials (Chart I-6). Furthermore, the underperformances of these cyclicals is closely tracking the downswing in the global 6-month credit impulse (Chart I-7). Chart I-6The Odd Man Out: ##br##Oil And Gas Chart I-7The Underperformance Of Cyclicals Is Closely ##br##Tracking The Global 6-Month Credit Impulse Note also that these underperformances started well before any inkling of a trade spat. Hence, the recent escalation in the trade skirmishes is reinforcing a change of trend that was already in place. Taken together, this evidence would strongly suggest that global growth is not accelerating; it is decelerating. Oil is the odd man out because its supply dynamics, rather than demand dynamics, have been dominating its price action, lifting its year-on-year inflation rate to 60%. However, a large part of this surge in year-on-year inflation is also to do with the 'base effect', the dip in the oil price to $45 a year ago. The base effect is a statistical quirk, and shouldn't really bother markets. After all, most people do not consciously compare today's price with that exactly a year ago. Unfortunately, central banks' inflation targets are based on year-on-year comparisons, and this could explain why bond yields have decoupled from growth. If oil price inflation is running at 60% it will underpin headline CPI inflation, central bank reaction functions, and thereby bond yields. So here's the explanation for the oddities in the first half. Banks, industrials, and the other classically cyclical sectors are taking their cue from global growth and industrial activity, which does appear to be losing momentum. In contrast, bond yields are taking their cue from the oil price, given its major impact on headline inflation and on central bank reaction functions. Spotting An Opportunity In The 2nd Half Chart I-8Crude Oil's 12-Month Inflation Rate Is 60% Ultimately, an oil price spike based on supply dynamics without support from stronger demand is unsustainable - because the higher price eventually leads to demand destruction (Chart I-8). On the other hand, if global demand growth does reaccelerate, it is the beaten-down bank equity prices that have the recovery potential. Either way, this leads us to a compelling intra-cyclical trade: short oil and gas versus financials. In aggregate though, we expect cyclical sectors to continue underperforming defensives through the summer. Based on previous credit impulse mini-cycles, we can confidently say that mini-deceleration phases last at least six to eight months and that the typical release valve is a decline in bond yields. In this regard, the apparent disconnect between decelerating growth and slow-to-budge bond yields risks protracting this mini-deceleration phase. Therefore, through the summer, it is appropriate to stick with underweights in the classically cyclical sectors. The strategy has worked well since we initiated it at the start of the year, and it is too early to take profits. Likewise, the portfolio of high-quality government 30-year bonds which we bought in early May is performing well, and we expect it to continue doing so for the time being. Don't Over-Complicate The Investment Process! To reiterate, stick with an underweight to the classical cyclicals versus defensives; and within the cyclicals, short oil and gas versus financials. These sector stances then have a very strong bearing on regional and country equity allocation. This is because up to a quarter of the market capitalisation of each major stock market is in one dominant sector, and this dominant sector gives each equity index its defining fingerprint (Table I-1): for the FTSE100, it is oil and gas; for the Eurostoxx50 it is financials; for the Nikkei225 it is industrials. So all three of these regional indexes are dominated by classical cyclicals. Table I-1Each Major Stock Market Has A Defining Sector Fingerprint For the S&P500 and MSCI Emerging Markets indexes, the dominant sector is technology. Although the technology sector is not strictly speaking defensive, it is much less sensitive to growth accelerations and decelerations than the classical cyclicals. There is another important factor to consider: the currency. The FTSE100 oil and gas stock, BP, receives its revenue and incurs its costs in multiple major currencies, such as euros and dollars. In this sense, BP's global business is currency neutral. But BP's stock price is quoted in London in pounds. This means that if the pound strengthens, the company's multi-currency profits will decline relative to the stock price and weigh it down. Conversely, if the pound weakens, it will lift the BP stock price. So the currency is the channel through which the domestic economy can impact its stock market, albeit it is an inverse relationship: a strong currency hinders the stock market; a weak currency helps it. The upshot is that the defining sector fingerprints for the major indexes turn out to be: FTSE100 = global oil and gas shares expressed in pounds. Eurostoxx50 = global banks expressed in euros. Nikkei225 = global industrials expressed in yen. S&P500 = global technology expressed in dollars. MSCI Emerging Markets = global technology expressed in emerging market currencies. Professional investors might argue that this trivializes an investment process on which they spend a lot of time, resource, research, and ultimately money. But we would flip this argument around. To justify the large amounts of time and resource spent on the investment process, professional investors are often guilty of over-complicating it! We fully admit that many factors influence the financial markets, but these factors follow the Pareto Principle, also known as the 80:20 rule. A small number of causes explain the majority of effects. And the 20% that explains 80% of a stock market's relative performance is its defining sector fingerprint. The Chart of the Week and Chart I-9-Chart I-12 should dispel any lingering doubts that readers might have. Chart I-9FTSE 100 Vs. S&P 500 = Global Oil And Gas##br## In Pounds Vs. Global Tech In Dollars Chart I-10FTSE 100 Vs. Nikkei 225 = Global Oil And Gas ##br##In Pounds Vs. Global Industrials In Yen Chart I-11FTSE 100 Vs. Euro Stoxx 50 = Global Oil And Gas ##br##In Pounds Vs. Global Banks In Euros Chart I-12Euro Stoxx 50 Vs. S&P 500 = Global Banks ##br##In Euros Vs. Global Tech In Dollars So what does all of this mean for investors right now? A stance that is short oil and gas versus financials necessarily implies that the FTSE100 will struggle versus the Eurostoxx50, given the FTSE100's oil and gas fingerprint and the Eurostoxx50's banks fingerprint. Hence, today we are taking profits in our overweight to the FTSE100, and downgrading this position to neutral. This leaves us with overweight positions to France, Ireland, Switzerland and Denmark, and underweight positions to Italy, Spain, Sweden and Norway. Meanwhile, a stance that is underweight the classical cyclicals necessarily implies that European equities will struggle to make much headway versus the technology-dominated S&P500 and MSCI Emerging Markets. Finally, in terms of overall market direction, we expect the range-bound pattern established in the first half of the year to hold through the summer. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* There are no new trades this week. However, we reiterate that the outperformance of oil and gas versus financials is technically very stretched, which reinforces the fundamental arguments in the main body of this report to go short oil and gas versus financials. 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-13 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

Special Report

Three macro "policy puts" are in jeopardy of disappearing or, at the very least, being repriced. Fed Put: Rising inflation has made the Fed more reluctant to back off from rate hikes at the first hint of slower growth or falling asset prices. China Put: Worries about high debt levels, overcapacity, and pollution all mean that the bar for fresh Chinese stimulus is higher than in the past. Draghi Put: Bailing out Italy was a no-brainer in 2012 when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. These factors, along with additional risks such as mounting protectionism, warrant a more cautious 12-month stance towards global equities and other risk assets. The fact that valuations are stretched across most asset classes only adds to our concern. A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase over the balance of the year, with the next big move for global equities probably being to the downside. Buckle Up One of BCA's key ongoing themes is that policy and markets are on a collision course. We are starting to see this impending crash play out across the world. Higher Inflation Is Tying The Fed's Hands A slowdown in global growth caused the Fed to abort its tightening plans for 12 months starting in December 2015. Global growth is faltering again, but this time around the Fed is less eager to hit the pause button. In contrast to 2015, the U.S. economy has run out of spare capacity. The unemployment rate fell to a 48-year low of 3.75% in May. For the first time in the history of the Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS), there are more job vacancies than unemployed workers (Chart 1). Average hourly earnings surprised on the upside in May, while the Employment Cost Index for private-sector workers - the cleanest and most reliable measure of U.S. wage growth - rose at a robust 4% annualized pace in the first quarter. Labor market surveys, which generally lead wage growth by three-to-six months, are pointing to a further acceleration in wages (Chart 2). Chart 1There Are Now More ##br##Vacancies Than Jobseekers Chart 2U.S. Wage Growth Is Set To Accelerate The Dollar Rally Can Keep Going Rising wages will put more income into workers' pockets, who will then spend it. Stronger demand can be partly satisfied by imports, but it will take a change in relative prices for that to happen. U.S. imports account for only 16% of GDP. Unless the prices of foreign-made goods decline in relation to the prices of domestically-produced goods, the bulk of any additional household income will be spent on goods produced in the U.S. This means that the dollar needs to strengthen. The Fed's broad trade-weighted dollar index is up 8% since the start of February. While we are not as bullish on the dollar as we were a few months ago, we still believe that the path of least resistance for the greenback is up. Our long DXY trade recommendation has gained 12.1% inclusive of carry since we initiated it. We are raising the target price from 96 to 98. A stronger dollar can help deflect some additional spending towards imports, but this won't be enough to fully cool the economy. Services, which generally cannot be imported, account for nearly two-thirds of GDP. Since it takes time to shift resources from goods-producing sectors to service sectors, any rising aggregate demand will boost service prices. Outside of housing, service-sector inflation is already running at 2.4%, a number that is likely to rise further over the coming year (Chart 3). This will keep the Fed on edge. Hard Times For Emerging Markets The combination of rising U.S. rates and a stronger dollar is bad news for emerging markets. Eighty percent of EM foreign-currency debt is denominated in dollars. Outside of China, EM dollar debt is now back to late-1990s levels both as a share of GDP and exports (Chart 4). Chart 3Faster Wage Growth Will Push ##br##Up Service Inflation Chart 4EM Dollar Debt Back To Late-1990s Levels The wave of EM local-currency debt issued in recent years only complicates matters. If EM central banks raise rates to defend their currencies, this could imperil economic growth and make it difficult for local-currency borrowers to pay back their loans. Rather than hiking rates, some EM central banks may simply choose to inflate away debt. Consider the case of Brazil. Ninety percent of Brazilian sovereign debt is denominated in reais. The Brazilian government won't default on its debt per se. However, if push comes to shove, Brazil's central bank can always step in to buy government bonds, effectively monetizing the fiscal deficit. The specter of trade wars only adds to the risks facing emerging markets. A larger U.S. budget deficit will drain national savings, leading to a bigger trade deficit. Rather than blaming his own macroeconomic policies, President Trump will blame America's trading partners. Global trade has already been flatlining for over a decade (Chart 5). Trump's trade agenda will further undermine the global trading system. Emerging markets will bear the brunt of that development. Chart 5Global Trade Has Crested Chinese Stimulus To The Rescue? When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive new stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. Today, Chinese growth is slowing again. May data on industrial production, retail sales, and fixed asset investment all disappointed. Property prices in tier 1 cities are down year-over-year. Our leading indicator for the Li Keqiang index, a widely followed measure of economic activity, is in a clear downtrend (Chart 6). So far, the policy response has been fairly muted. Reserve requirements have been cut and some administrative controls loosened, but the combined credit and fiscal impulse has plunged (Chart 7). Onshore and offshore corporate bond yields have increased to multi-year highs. Bank lending rates are rising, while loan approvals are dropping (Chart 8). Chart 6Chinese Growth Is Slowing Anew Chart 7China: Policy Response To Slowdown ##br##Has Been Muted So Far Chart 8China: Credit Tightening We have no doubt that China will stimulate again if the economy appears to be heading for a deep slowdown. However, the bar for a fresh round of stimulus is higher today than it was in the past. Elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities can respond with the usual barrage of infrastructure spending and increased bank lending. The economy needs to feel more pain before policymakers come to its aid. Draghi's Dilemma The Italian economy was showing signs of weakness even before bond yields exploded higher. Domestic demand slowed to a mere 0.3% qoq in Q1. The PMIs, consumer confidence, and the Bank of Italy's Ita-Coin cyclical indicator all decelerated (Chart 9). Italy would benefit from a more competitive cost structure, but the political will to undertake the sort of reforms Germany implemented in the late 1990s, and that Spain implemented after the Great Recession, has been sorely lacking (Chart 10). Unwilling to take tough actions to improve competitiveness, the Five Star-Lega coalition government has proposed loosening fiscal policy to support demand. Chart 9Italy's Economy Is Weakening... Again Chart 10Italy: More Work Needs To Be Done On ##br##The Labor Competitiveness Front Italy's shift towards populism is arriving at the same time that the ECB is looking to wind down its asset purchase program. This means that a key buyer of Italian debt is stepping back just when it may be needed the most. Getting the ECB to bail out Italy will not be as straightforward this time around. Recall that Mario Draghi and Jean-Claude Trichet penned a letter to the Italian government in 2011 outlining a series of reforms they wanted to see enacted as a condition of ongoing ECB support. The contents of the letter were so explosive that they precipitated the resignation of then-PM Silvio Berlusconi when they were leaked to the public. One of the reforms that Mario Draghi demanded - and the subsequent government led by Mario Monti ultimately undertook - was the extension of the retirement age. Italy's current government has explicitly promised to reverse that decision much to the consternation of the ECB and the European Commission. It was one thing for Mario Draghi to promise to do "whatever it takes" to protect Italy when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. Investment Conclusions The outlook for global risk assets is likely to be more challenging over the coming months. With that in mind, we are downgrading our 12-month recommendation on global equities and credit from overweight to neutral. A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase again over the balance of the year, with the next big move for global equities probably being to the downside. Although Treasurys could rally in the near term, higher U.S. inflation will push bond yields up over a 12-month horizon. Given that yields are positively correlated across international bond markets, rising U.S. yields will put upward pressure on yields in the rest of the world. As such, we recommend shifting equity allocations towards cash rather than long-duration bonds. We would also reduce credit exposure. Within the commodity complex, the backdrop for crude remains more favorable than for economically-sensitive metals. Investors should underweight EM equities, credit, and currencies relative to their developed market peers. The Fed needs to tighten U.S. financial conditions to prevent the economy from overheating. Chart 11 shows that EM equities almost always fall when that is happening. Chart 11Tighter U.S. Financial Conditions Do Not Bode Well For EM Stocks A stronger dollar will hurt the profits of U.S. multinationals. That said, the sector composition of the U.S. stock market is a bit more defensive than it is elsewhere. On balance, we no longer have a strong view that euro area and Japanese equities will outperform the U.S. in local-currency terms, and hence we are closing our trade recommendation to this effect for a loss of 5.4%. If macro developments evolve as we expect, we will shift to an outright bearish stance on risk assets later this year or in early 2019 in anticipation of a global recession in 2020. That said, we would consider moving our 12-month recommendation temporarily back to overweight if global equities were to sell off by more than 15% over the next few months or the policy environment becomes markedly more market friendly. But at current prices, the risk-reward trade-off no longer justifies a high degree of bullishness. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Feature In a Global Investment Strategy service Special Report sent to all BCA clients yesterday,1 we recommended downgrading global equities to neutral (from overweight) over the coming year. For BCA's China Investment Strategy service, the most immediate implication of this change in recommendation is that an overweight stance towards Chinese stocks within a global portfolio is no longer justified. Consequently, we are closing two open positions in our trade book: 1) long MSCI China ex-technology / short MSCI All Country World ex-technology, and 2) long MSCI China value / short MSCI All Country World value. The rationale behind our downgrade of global equities is rooted in the view that there has been an unfavorable shift in the risk/reward balance for risky assets. A potential slowdown in global growth, fueled by protectionist action in the U.S. and dollar-driven weakness in emerging markets, could be met by intransigent policy, particularly in the U.S. In this scenario, financial markets would be set up for a collision course with global policymakers, which could precipitate a material selloff in risky asset prices before a sufficiently large policy response could be deployed. In the case of China, we have argued many times over the past several months that a slowdown in its industrial sector raised the risk of eventual underperformance of ex-tech "old economy" stocks versus their global peers. Chart 1 highlights that our leading indicator for the Li Keqiang index suggests that the index itself is set to decelerate further over the coming months, and we have highlighted that this poor domestic growth momentum means that fiscal or monetary stimulus will likely be required if China suffers a sudden export shock. This week's sharp escalation of protectionist action between the U.S. and China clearly raises the risk of such a shock. In addition, we showed in a January Special Report that China has become a high-beta equity market versus the global benchmark (in common currency terms) over the past few years,2 and Chart 2 shows that this is true even for ex-tech stock prices. In our judgement, the combination of an ongoing slowdown in China's industrial sector, a significant escalation in the imposition of import tariffs between the U.S. and China, and an unfavorable shift in the risk/reward balance of global risky asset prices is a compelling reason to reduce pro-cyclical exposure to China. Chart 1China's Old Economy Will Continue To Slow Chart 2Chinese Stocks Are High Beta, Even Excluding Technology Bottom Line: We are closing two pro-cyclical positions in our trade book, and recommend that investors downgrade Chinese stocks to neutral within a global equity portfolio. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see Global Investment Strategy Special Report "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 19, 2018, available at gis.bcaresearch.com. 2 Pease see China Investment Strategy Special Report "China: No Longer A Low-Beta Market", dated January 11, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Special Report

Three macro "policy puts" are in jeopardy of disappearing or, at the very least, being repriced. Fed Put: Rising inflation has made the Fed more reluctant to back off from rate hikes at the first hint of slower growth or falling asset prices. China Put: Worries about high debt levels, overcapacity, and pollution all mean that the bar for fresh Chinese stimulus is higher than in the past. Draghi Put: Bailing out Italy was a no-brainer in 2012 when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. These factors, along with additional risks such as mounting protectionism, warrant a more cautious 12-month stance towards global equities and other risk assets. The fact that valuations are stretched across most asset classes only adds to our concern. A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase over the balance of the year, with the next big move for global equities probably being to the downside. Buckle Up One of BCA's key ongoing themes is that policy and markets are on a collision course. We are starting to see this impending crash play out across the world. Higher Inflation Is Tying The Fed's Hands A slowdown in global growth caused the Fed to abort its tightening plans for 12 months starting in December 2015. Global growth is faltering again, but this time around the Fed is less eager to hit the pause button. In contrast to 2015, the U.S. economy has run out of spare capacity. The unemployment rate fell to a 48-year low of 3.75% in May. For the first time in the history of the Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS), there are more job vacancies than unemployed workers (Chart 1). Average hourly earnings surprised on the upside in May, while the Employment Cost Index for private-sector workers - the cleanest and most reliable measure of U.S. wage growth - rose at a robust 4% annualized pace in the first quarter. Labor market surveys, which generally lead wage growth by three-to-six months, are pointing to a further acceleration in wages (Chart 2). Chart 1There Are Now More ##br##Vacancies Than Jobseekers Chart 2U.S. Wage Growth Is Set To Accelerate The Dollar Rally Can Keep Going Rising wages will put more income into workers' pockets, who will then spend it. Stronger demand can be partly satisfied by imports, but it will take a change in relative prices for that to happen. U.S. imports account for only 16% of GDP. Unless the prices of foreign-made goods decline in relation to the prices of domestically-produced goods, the bulk of any additional household income will be spent on goods produced in the U.S. This means that the dollar needs to strengthen. The Fed's broad trade-weighted dollar index is up 8% since the start of February. While we are not as bullish on the dollar as we were a few months ago, we still believe that the path of least resistance for the greenback is up. Our long DXY trade recommendation has gained 12.1% inclusive of carry since we initiated it. We are raising the target price from 96 to 98. A stronger dollar can help deflect some additional spending towards imports, but this won't be enough to fully cool the economy. Services, which generally cannot be imported, account for nearly two-thirds of GDP. Since it takes time to shift resources from goods-producing sectors to service sectors, any rising aggregate demand will boost service prices. Outside of housing, service-sector inflation is already running at 2.4%, a number that is likely to rise further over the coming year (Chart 3). This will keep the Fed on edge. Hard Times For Emerging Markets The combination of rising U.S. rates and a stronger dollar is bad news for emerging markets. Eighty percent of EM foreign-currency debt is denominated in dollars. Outside of China, EM dollar debt is now back to late-1990s levels both as a share of GDP and exports (Chart 4). Chart 3Faster Wage Growth Will ##br##Push Up Service Inflation Chart 4EM Dollar Debt Back To Late-1990s Levels The wave of EM local-currency debt issued in recent years only complicates matters. If EM central banks raise rates to defend their currencies, this could imperil economic growth and make it difficult for local-currency borrowers to pay back their loans. Rather than hiking rates, some EM central banks may simply choose to inflate away debt. Consider the case of Brazil. Ninety percent of Brazilian sovereign debt is denominated in reais. The Brazilian government won't default on its debt per se. However, if push comes to shove, Brazil's central bank can always step in to buy government bonds, effectively monetizing the fiscal deficit. The specter of trade wars only adds to the risks facing emerging markets. A larger U.S. budget deficit will drain national savings, leading to a bigger trade deficit. Rather than blaming his own macroeconomic policies, President Trump will blame America's trading partners. Global trade has already been flatlining for over a decade (Chart 5). Trump's trade agenda will further undermine the global trading system. Emerging markets will bear the brunt of that development. Chart 5Global Trade Has Crested Chinese Stimulus To The Rescue? When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive new stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. Today, Chinese growth is slowing again. May data on industrial production, retail sales, and fixed asset investment all disappointed. Property prices in tier 1 cities are down year-over-year. Our leading indicator for the Li Keqiang index, a widely followed measure of economic activity, is in a clear downtrend (Chart 6). So far, the policy response has been fairly muted. Reserve requirements have been cut and some administrative controls loosened, but the combined credit and fiscal impulse has plunged (Chart 7). Onshore and offshore corporate bond yields have increased to multi-year highs. Bank lending rates are rising, while loan approvals are dropping (Chart 8). Chart 6Chinese Growth Is Slowing Anew Chart 7China: Policy Response To Slowdown ##br##Has Been Muted So Far Chart 8China: Credit Tightening We have no doubt that China will stimulate again if the economy appears to be heading for a deep slowdown. However, the bar for a fresh round of stimulus is higher today than it was in the past. Elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities can respond with the usual barrage of infrastructure spending and increased bank lending. The economy needs to feel more pain before policymakers come to its aid. Draghi's Dilemma The Italian economy was showing signs of weakness even before bond yields exploded higher. Domestic demand slowed to a mere 0.3% qoq in Q1. The PMIs, consumer confidence, and the Bank of Italy's Ita-Coin cyclical indicator all decelerated (Chart 9). Italy would benefit from a more competitive cost structure, but the political will to undertake the sort of reforms Germany implemented in the late 1990s, and that Spain implemented after the Great Recession, has been sorely lacking (Chart 10). Unwilling to take tough actions to improve competitiveness, the Five Star-Lega coalition government has proposed loosening fiscal policy to support demand. Chart 9Italy's Economy Is Weakening... Again Chart 10Italy: More Work Needs To Be Done On ##br##The Labor Competitiveness Front Italy's shift towards populism is arriving at the same time that the ECB is looking to wind down its asset purchase program. This means that a key buyer of Italian debt is stepping back just when it may be needed the most. Getting the ECB to bail out Italy will not be as straightforward this time around. Recall that Mario Draghi and Jean-Claude Trichet penned a letter to the Italian government in 2011 outlining a series of reforms they wanted to see enacted as a condition of ongoing ECB support. The contents of the letter were so explosive that they precipitated the resignation of then-PM Silvio Berlusconi when they were leaked to the public. One of the reforms that Mario Draghi demanded - and the subsequent government led by Mario Monti ultimately undertook - was the extension of the retirement age. Italy's current government has explicitly promised to reverse that decision much to the consternation of the ECB and the European Commission. It was one thing for Mario Draghi to promise to do "whatever it takes" to protect Italy when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. Investment Conclusions The outlook for global risk assets is likely to be more challenging over the coming months. With that in mind, we are downgrading our 12-month recommendation on global equities and credit from overweight to neutral. A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase again over the balance of the year, with the next big move for global equities probably being to the downside. Although Treasurys could rally in the near term, higher U.S. inflation will push bond yields up over a 12-month horizon. Given that yields are positively correlated across international bond markets, rising U.S. yields will put upward pressure on yields in the rest of the world. As such, we recommend shifting equity allocations towards cash rather than long-duration bonds. We would also reduce credit exposure. Within the commodity complex, the backdrop for crude remains more favorable than for economically-sensitive metals. Investors should underweight EM equities, credit, and currencies relative to their developed market peers. The Fed needs to tighten U.S. financial conditions to prevent the economy from overheating. Chart 11 shows that EM equities almost always fall when that is happening. Chart 11Tighter U.S. Financial Conditions Do Not Bode Well For EM Stocks A stronger dollar will hurt the profits of U.S. multinationals. That said, the sector composition of the U.S. stock market is a bit more defensive than it is elsewhere. On balance, we no longer have a strong view that euro area and Japanese equities will outperform the U.S. in local-currency terms, and hence we are closing our trade recommendation to this effect for a loss of 5.4%. If macro developments evolve as we expect, we will shift to an outright bearish stance on risk assets later this year or in early 2019 in anticipation of a global recession in 2020. That said, we would consider moving our 12-month recommendation temporarily back to overweight if global equities were to sell off by more than 15% over the next few months or the policy environment becomes markedly more market friendly. But at current prices, the risk-reward trade-off no longer justifies a high degree of bullishness. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com