Bear/Bull Market

Highlights Duration: The market is only priced for a fed funds rate of 2.83% by the end of 2019. This is well below the range of 3.25% to 3.5% that will prevail if the Fed sticks to its current 25 basis points per quarter rate hike pace. Maintain below-benchmark portfolio duration. The Neutral Rate: Our indicators of the neutral (or equilibrium) fed funds rate are sending conflicting signals. The economic data suggest that the neutral rate might be above 3%, but this is contradicted by weakness in the price of gold. TIPS: Long-dated TIPS breakeven inflation rates remain slightly below target levels, but appear to be increasingly taking their cues from the realized inflation data rather than swings in global growth and commodity prices. Remain overweight TIPS versus nominal Treasuries. Feature In February we published a report that outlined how we expect the cyclical bear market in bonds to evolve. Essentially, we view the bear market as consisting of two stages.1 The first stage is characterized by the re-anchoring of inflation expectations and the second stage deals with determining the neutral (or equilibrium) federal funds rate. In this week's report we track how the two-stage Treasury bear market has progressed since February and consider the implications for portfolio strategy. The First Stage Is Nearly Complete Long-maturity TIPS breakeven inflation rates are slightly higher than when we published our February report, but they are still not at levels we would consider "well anchored". We showed in our February report that prior periods when core inflation was close to the Fed's 2% target coincided with both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates in a range between 2.3% and 2.5%. At present, the 10-year TIPS breakeven inflation rate is 2.10% and the 5-year/5-year forward is 2.19%. As long as TIPS breakeven inflation rates remain below the 2.3% - 2.5% target range, nominal Treasury yields have further cyclical upside due to the re-anchoring of inflation expectations. This re-anchoring will play out as the core inflation data are released and investors come to realize that inflation is no longer consistently undershooting the Fed's target. When that re-anchoring occurs and both the 10-year and 5-year/5-year forward breakevens cross above 2.3%, the first stage of the bond bear market will be complete. One recent development is that TIPS breakevens have risen even as commodity prices have declined (Chart 1). In fact, while breakevens are somewhat higher than when we published our February report, commodity prices - as measured by the CRB Raw Industrials index - are lower. While this shift in correlation is so far only tentative, it could signal that TIPS investors are increasingly influenced by the actual core inflation data and not swings in the global growth outlook. We would not be surprised to see this correlation continue to weaken going forward, especially considering that core inflation looks more and more consistent with the Fed's 2% target. Core CPI for July came in at 2.33% on both a trailing 12-month and 3-month basis, annualized (Chart 2). This is more or less consistent with the pre-crisis period when the Fed's preferred PCE inflation measure was close to the 2% target. Alternative measures of CPI send a similar message (Chart 2, panel 2) and our diffusion index shows that more individual items have accelerated in price than have decelerated in each of the past three months (Chart 2, bottom panel). Taken together, the signals point to further near-term price acceleration. Chart 1Inflation Date Sinking In Inflation Date Sinking In Inflation Date Sinking In Chart 2Inflation Picking Up Steam Inflation Picking Up Steam Inflation Picking Up Steam Digging deeper, we see that the outlook for higher inflation pervades each of the main components of core CPI (Chart 3). The reading from our shelter inflation model has stabilized, core goods inflation continues to track non-oil import prices higher, and the rebound in core services inflation is consistent with rising wage growth. Eventually, we would expect the strengthening dollar to exert a drag on import prices (Chart 4), but it will be some time before this is reflected in the CPI data. Another important development is that, after appearing to have turned a corner in 2016, the residential vacancy rate has dipped back down (Chart 4, bottom panel). Such a low vacancy rate will continue to support strong shelter inflation. Chart 3The Components Of Core CPI The Components Of Core CPI The Components Of Core CPI Chart 4A Headwind And A Tailwind For Inflation Headwing & Tailwind For Inflation Headwing & Tailwind For Inflation Bottom Line: Long-dated TIPS breakeven inflation rates remain slightly below target levels, but appear to be increasingly taking their cues from the realized inflation data rather than swings in global growth and commodity prices. Nominal Treasury yields have further upside at least until both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach a range between 2.3% and 2.5%. We also continue to recommend an overweight position in TIPS relative to nominal Treasury securities. We will remove this recommendation when breakeven rates reach our target range and stage one of the bond bear market is complete. Stage 2 Update: Conflicting Evidence On The Neutral Rate Once inflation expectations are well-anchored at levels consistent with the Fed's target, the cyclical bond bear market will transition into its second stage. How much further Treasury yields rise during this stage will depend on how high the Fed is able to lift interest rates before the economy starts to slow. In other words, the cyclical peak in Treasury yields will be determined by the neutral (or equilibrium) fed funds rate - the level of interest rates where monetary policy is neither accommodative nor restrictive, and which is also consistent with stable inflation near the Fed's 2% target. Unfortunately, the neutral rate can only be known with certainty in hindsight. But in a recent report we presented three factors that investors can track in real time that have forewarned of the shift from accommodative to restrictive monetary policy in the past.2 We review the recent trends in each of these signals below. Signal 1: Nominal GDP Growth Vs The Fed Funds Rate Chart 5The Message From Nominal GDP Growth The Message From Nominal GDP Growth The Message From Nominal GDP Growth A fed funds rate that is above the year-over-year growth rate in nominal GDP is typically a signal (though often a lagging one) that monetary policy has turned restrictive (Chart 5). An intuition that is confirmed by the fact that the spread between nominal GDP growth and the fed funds rate correlates positively with the slope of the yield curve. But while the flattening yield curve has caused some to worry that the Fed is tightening too quickly, the message from nominal GDP growth is that monetary policy is actually becoming more accommodative (Chart 5, bottom panel). If the Fed continues to lift rates at its current pace of 25 basis points per quarter, the fed funds rate will be between 3.25% and 3.5% by the end of 2019. Nominal GDP would have to decelerate fairly substantially from its current 5.4% growth rate to signal restrictive monetary policy by then. Signal 2: Cyclical Spending Another indicator that has historically coincided with restrictive monetary policy and the cyclical peak in bond yields is when growth in the most interest-rate sensitive sectors of the economy (aka the cyclical sectors) slows as a proportion of overall growth (Chart 6). This is especially true for consumer spending on durable goods. Not only is it well below pre-crisis levels as a percent of GDP, but recent data revisions revealed that the personal savings rate is much higher than previously thought. The savings rate looks especially elevated relative to household wealth, which leaves room for spending to accelerate as it falls to more normal levels (Chart 7). Extremely high consumer confidence supports the view that the savings rate will decline (Chart 7, panel 2), and despite recent increases in interest rates and the price of gasoline, consumer spending on essentials is not yet excessive relative to income (Chart 7, bottom panel). Chart 6Signal 2: Cyclical Spending Signal 2: Cyclical Spending Signal 2: Cyclical Spending Chart 7The Outlook For Consumer Spending The Outlook For Consumer Spending The Outlook For Consumer Spending Cyclical spending - which includes consumer spending on durable goods, residential investment and nonresidential investment in equipment & software - is currently rising only slowly as a proportion of GDP, but it remains well below average historical levels. This suggests that further catch-up is likely. Much like consumer spending, residential investment also has a lot of room to play catch-up relative to pre-crisis levels (Chart 6, panel 3). However, growth in residential investment has waned in recent months (Chart 8). The slowdown is likely the result of the housing market coming to grips with higher mortgage rates. But while higher rates have definitely impaired affordability, housing remains quite cheap compared to history (Chart 8, panel 2). A further support for housing is that homebuilders are extraordinarily confident in the outlook (Chart 8, panel 3). This is for good reason. The outstanding housing supply is historically low and continues to contract relative to demand as increases in building permits fail to keep pace with household formation (Chart 8, bottom panel). Unlike consumer spending on durables and residential investment, nonresidential investment in equipment & software is roughly consistent with its average historical level as a proportion of GDP (Chart 6, bottom panel). But so far leading indicators are not pointing to a slowdown. On the contrary, surveys of new orders, capital expenditure plans and CEO confidence suggest that investment growth will stay strong for the next few quarters (Chart 9). At some point, given its higher level relative to GDP, investment could be the cyclical sector that first shows some evidence of weakness. But so far this is not the case. Chart 8The Outlook For Residential Investment The Outlook For Residential Investment The Outlook For Residential Investment Chart 9The Outlook For Non-Residential Investment The Outlook For Non-Residential Investment The Outlook For Non-Residential Investment Signal 3: Gold Chart 10Signal 3: Gold Signal 3: Gold Signal 3: Gold The final signal of restrictive monetary policy we consider is the price of gold. The widely accepted perception of gold as a long-run store of value makes it the ideal "anti-central bank" asset. In other words, gold tends to perform well when monetary policy is perceived to be turning more accommodative relative to its neutral level, and it tends to sell off when policy is perceived to be turning restrictive. Gold is also a useful addition to our suite of indicators because it is a price that is set in financial markets. Compared to our other two indicators which are based on economic data, financial market indicators can provide more of a leading signal. The trade-off, however, is that false signals are far more frequent. Most interestingly, we observe that fluctuations in the price of gold have preceded revisions to the Fed's estimate of the neutral fed funds rate in the post-crisis period (Chart 10). This seems entirely logical. The falling gold price in 2014/15 suggested that the market viewed Fed policy as becoming increasingly restrictive, but market expectations for the near-term path of rate hikes were roughly flat during this period (Chart 10, bottom panel). The only explanation is that investors were revising down their estimates of the neutral fed funds rate during this time, resulting in a de-facto policy tightening. Similarly, around the same time that gold put in a bottom in early 2016, neutral rate estimates from both investors and the Fed started to level-off around the 3% level, where they remain today. Going forward, the implication is that if gold were to break out of its trading range to the upside, it would send a strong signal that the Fed is perceived to be falling behind the curve. Such a price movement would make upward revisions to the neutral fed funds rate, and a higher cyclical peak in Treasury yields, more likely. Conversely, if gold continues its recent slide, it could signal that policy is turning restrictive more quickly than many expect. Bottom Line: Trends in our neutral rate indicators since February are sending conflicting signals. The economic data - nominal GDP growth and cyclical spending - have improved and suggest that we should think about a neutral fed funds rate above the current market consensus of 3%. On the other hand, the weakness in the price of gold suggests that investors view monetary policy as becoming increasingly restrictive. Investment Strategy How best to square these conflicting signals when formulating a portfolio strategy? For the time being we strongly advise investors to maintain below-benchmark duration on a cyclical (6-12 month) horizon. For one thing, the bond bear market remains in its first stage and the market is still not fully convinced that inflation will re-anchor itself around the Fed's 2% target. This alone argues for maintaining below-benchmark duration and an overweight allocation to TIPS versus nominal Treasuries, at least until long-dated TIPS breakevens reach our target range. Beyond that, while the true neutral fed funds rate remains uncertain, the market is only priced for a fed funds rate of 2.83% by the end of 2019. This is well below the range of 3.25% to 3.5% that will prevail if the Fed sticks to its current 25 basis points per quarter rate hike pace, and is consistent with a neutral rate that is well below 3% (Chart 11). Chart 11The Market Not Buying Into The Fed's Current Rate Hike Pace The Market Not Buying Into The Fed's Current Rate Hike Pace The Market Not Buying Into The Fed's Current Rate Hike Pace In other words, current market pricing tilts the risk/reward trade-off firmly in favor of below-benchmark duration, but we will keep a close eye on our neutral rate signals in the coming quarters to see if a more consistent message emerges. Stay tuned. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Valuation measures and technical indicators are widely followed market gauges, but neither set of metrics dependably warns of impending bear markets. Recessions might, however, as they almost always overlap with bear markets. A simple indicator using just three inputs - the yield curve, the index of leading economic indicators ("LEI") and the state of monetary policy - has correctly called all seven recessions of the last fifty years. Our recession indicator is timely as well as accurate. It turns red an average of six months ahead of a recession, aligning closely with the S&P 500's average cyclical peak. Our indicator is currently giving the all-clear signal, and we do not expect it will sound the alarm for at least another year. We do not foresee downgrading equities to underweight before then unless trade tensions take a turn for the worse, the S&P 500 rises parabolically, or the Fed moves its hiking timetable forward. Feature Investors who get the biggest macro questions right will generally find themselves on the right side of their performance benchmarks. The biggest question right now is how much longer the equity bull market will last. Trying to call a market top is folly, but "close enough" counts for recognizing the beginning of bear markets, and we are confident that our recession indicator gets close enough to provide a practical asset-allocation guide. While our indicator has moved closer to sounding the alarm over the last year, it is not yet signaling any immediate trouble.1 Can We Call Bear Markets? Neither we nor any other investor can consistently call market tops or bottoms with any degree of accuracy. The core problem is that doing so requires pinpointing the moment when a firmly established trend reverses for good - after all, a bear market begins the day a bull market concludes, and vice versa. As our colleague Martin Barnes has pointed out, there are no foolproof guides to identifying these inflection points in real time.2 The most popular rules of thumb - valuation measures, technical indicators and the calendar - are of no help at all in forecasting equity bear markets. Equities are surely more vulnerable when they trade at high multiples than when they trade at low multiples, but conventional valuation measures have been all over the map ahead of the eight bear markets that have occurred over the last 50 years (Box 1). The late-'80-to-early-'82 and 1990 bear markets occurred despite P/E, Shiller P/E and P/B multiples that were all comfortably below their long-run medians (Chart 1, second, third and fourth panels). The dot-com-bubble bear market occurred when every valuation metric was at an all-time high, to be sure, but our composite valuation indicator had spent three solid years in extremely overvalued territory (Chart 1, bottom panel) before the bear finally arrived. BOX 1 50 Years Of U.S. Equity Bear Markets For the purposes of this Special Report, we adhere to the classic definition of a bear market - a peak-to-trough closing price decline of at least 20% - and we confine our analysis to the last 50 years. The result is eight bear markets, as shown in Table 1 (we round the 1990 bear up to 20% from 19.9% but leave out the 1998 and 2011 corrections of 19.3% and 19.4%, respectively). Chart 3 shows the S&P 500, in log scale, with NBER-defined recessions shaded in gray and bear markets shaded in light red. The shaded chart brings two key observations to the fore: recessions and bear markets nearly always travel together (gray and light red only failed to overlap in the opening leg of the double-dip Volcker recessions and 1987's Black Monday), and bull markets (the white space in the chart) are more or less the S&P 500's default condition. The bear markets can be nasty, however, and a process that could help a manager sidestep even a portion of their declines could lead to significant outperformance over time. Technical indicators don't provide consistently reliable advance signals, either. Nearly all of the most overheated technical environments of the last 50 years (Chart 2, bottom panel) worked themselves off without tipping into full-fledged bear-market declines. Our composite technical indicator looks much more like a coincident indicator than a leading one. The calendar is of no help at all; since 1968, bull markets have lasted anywhere from two to nine years, and the current one, within two weeks and a percentage point of becoming the longest of the postwar era, may make it to ten. Chart 1Valuation Is A Poor Guide To Bear Markets ... Valuation Is A Poor Guide To Bear Markets ... Valuation Is A Poor Guide To Bear Markets ... Chart 2... And Technicals Aren't Much Better ... And Technicals Aren't Much Better ... And Technicals Aren't Much Better Table 1U.S. Equity Bear Markets, 1968 -2018 How Much Longer Can The Bull Market Last? How Much Longer Can The Bull Market Last? Chart 350 Years Of Recessions And Bear Markets 50 Years Of Recessions And Bear Markets 50 Years Of Recessions And Bear Markets Can We Call Recessions? Given the mingling of gray and red in Chart 3, a reliable recession indicator would be nearly as good as an equity bear market indicator. As noted above, only one recession (January to July 1980) passed without an accompanying bear market. Only the fall 1987 bear market occurred outside of a recession, though the two 19% corrections over our sample period also occurred ex-recessions. We submit that these three declines, accompanied by Black Monday's 20% one-day crash, the Russian crisis and the implosion of Long-Term Capital Management, and the U.S. debt-ceiling showdown and the euro crisis, were sparked by exogenous events that nearly defied prediction. Economists have a deservedly poor reputation for foretelling recessions. As the late economist John Kenneth Galbraith put it, "The only function of economic forecasting is to make astrology look respectable." Perhaps the Ph.Ds have overcomplicated matters by trying to pack too many variables into convoluted models. We have found that just three simple measures, in combination, have called all of the recessions in our 50-year sample without a single false positive. Our Recession Indicators Our first recession indicator is the orientation of the yield curve, defined as the sign of the difference between the 10-year Treasury bond yield and the 3-month T-bill rate.3 When the 3-month's rate exceeds the 10-year's yield, the curve is inverted and a recession typically follows. In our 50-year sample period, the yield curve has successfully called all seven recessions with just one false positive (Chart 4). As a standalone indicator, however, it tends to be overly eager, prematurely signaling the onset of a recession by an average of nearly twelve months (Table 2). Chart 4The Yield Curve Has Called 8 Of The Last 7 Recessions... The Yield Curve Has Called 8 Of The Last 7 Recessions... The Yield Curve Has Called 8 Of The Last 7 Recessions... Table 2Inverted Yield Curves, 1968 - 2018 How Much Longer Can The Bull Market Last? How Much Longer Can The Bull Market Last? Our second recession indicator is the sign of the year-over-year change in the index of the leading economic indicators ("LEI"). When the LEI contracts on a year-over-year basis, a recession typically ensues. As with the inverted yield curve, year-over-year contractions in the LEI have successfully called all of the recessions in our sample with just one false positive (Chart 5). The LEI signal tends to flip to red in a more timely fashion than the perpetually early yield curve, leading recessions by an average of six-plus months (Table 3). Chart 5...And So Have Leading Economic Indicators ...And So Have Leading Economic Indicators ...And So Have Leading Economic Indicators Table 3LEI Contractions, 1968 - 2018 How Much Longer Can The Bull Market Last? How Much Longer Can The Bull Market Last? The false positives go away once we combine the yield curve and the LEI into a single signal. To confirm that signal and make it more robust, we also consider the monetary policy backdrop. Over the nearly 60 years for which BCA's model calculates an estimate of the equilibrium fed funds rate, every recession has occurred when the fed funds rate has exceeded our estimate of equilibrium (Chart 6). In other words, recessions only occur when monetary policy settings are restrictive. In this case, the old market wisdom really is wise: expansions don't die of old age, they die because the Fed murders them. Chart 6Tight Policy Is A Necessary, But Not Sufficient, Recession Ingredient Tight Policy Is A Necessary, But Not Sufficient, Recession Ingredient Tight Policy Is A Necessary, But Not Sufficient, Recession Ingredient From Recession Indicator To Portfolio Strategy Tool Relative asset-class performance in previous bear markets, as detailed in the initial version of this study, published last summer by our Global ETF Strategy service,4 clearly argues for portfolio de-risking ahead of a recession. Investors would have benefited handsomely from overweighting bonds and cash at the expense of equities, overweighting countercyclical stocks and underweighting cyclicals, and overweighting Treasuries while underweighting high-yield corporates. Timing those defensive shifts is hardly clear-cut, however. The lead times between yield curve inversion, LEI contraction, the onset of restrictive monetary policy and the beginning of a recession vary from cycle to cycle. Fortunately for investors, waiting until all of the indicator components are in agreement dampens much of the variability in lead times. As Table 4 shows, the LEI signal is much less hasty than either the yield curve or the policy signals. It typically is the last component to flip, guiding the composite indicator to issue its recession signal just one week ahead of the S&P 500's average pre-recession peak. Sample averages mask in-sample variability, and the composite indicator does not march in lockstep with the S&P 500, but it is timely enough to have managed to catch about three-fourths of every bear market that coincided with a recession (Table 5). Table 4Lead Times For Indicator Components And Bear Markets How Much Longer Can The Bull Market Last? How Much Longer Can The Bull Market Last? Table 5Share Of Bear Markets Captured By Recession Indicator How Much Longer Can The Bull Market Last? How Much Longer Can The Bull Market Last? Why Bother? Some of our colleagues, duly noting forecasting's inherent difficulties, argue that there's little to be gained from attempting to narrow down the potential range of bear-market start dates. Fearful of the consequences of flying too close to the sun, they suggest that investors de-risk when enough common-sense-defying signs of a peak accumulate, and not worry about leaving some performance on the table. Such an approach has the benefits of being flexible and intuitive, but is difficult to apply consistently. Even proponents of former Supreme Court Justice Potter Stewart's legendary I-know-it-when-I-see-it obscenity standard have to concede that its parameters are arbitrary. It is also a concern that licking one's finger and holding it aloft is likely to put one squarely in the midst of the herd. The practicality of Justice Stewart's standard hinges on broad agreement: only if the distribution of opinions within the consensus is very narrow will a good deal of the community be satisfied with decisions based on it. Comity is the enemy of alpha, however, and an investor whose common sense is too common will wind up exiting the market too early and getting back into it too late, underperforming on both sides of the inflection point. The empirical record suggests that there's much to be lost from leaving too early. Bull markets tend to end with a bang, not a whimper (Chart 7 and Table 6). It is unlikely that investors who are willing to forego some returns in the name of security on the way up have the temperament to get back in at the beginning stages of the next rally. Factor in our view that public-market returns will be thin gruel over the next five to ten years compared to what investors have enjoyed since 1982, and one can make a case for trying to capture as much of the current bull market's gains as possible. Chart 7Sprinting To The Finish Line Sprinting To The Finish Line Sprinting To The Finish Line Table 6Finishing In Style How Much Longer Can The Bull Market Last? How Much Longer Can The Bull Market Last? Investment Implications Our composite recession indicator has done an excellent job of flagging recessions in advance. As recessions and equity bear markets are such steadfast companions, the composite recession indicator holds considerable promise as a tool to help investors capture a greater share of bull-market gains while helping them skirt some bear-market losses. Given a flattening but still positively-sloped yield curve, booming year-on-year growth in the LEI, and a policy rate that looks to be at least a year from becoming restrictive, we see no recession on the horizon. Unless trade negotiations fall apart, the S&P 500 melts up, or the Fed's rate-hiking guidance gets much more aggressive, we do not expect that investors will have cause to put their recession/bear market game plan into place for at least another year. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 This Special Report is adapted from the August 16, 2017 Global ETF Strategy Special Report, "A Guide To Spotting And Weathering Bear Markets," available at etf.bcaresearch.com. 2 Please see BCA Research Special Reports, "Timing The Next Equity Bear Market," and "Timing Equity Bear Markets," published January 24, 2014 and April 6, 2011, respectively, available at www.bcaresearch.com. 3 We use the 3-month/10-year segment instead of the more common 2-year/10-year because the 3-month bill is a cleaner proxy for short rates than the 2-year note, which incorporates estimates of the Fed's future actions. 2s/10s also fail to measure up empirically, inverting even earlier than the habitually premature 3-month/10-year. 4 August 16, 2017 Global ETF Strategy Special Report, "A Guide To Spotting And Weathering Bear Markets."

Highlights Chart 1Corporate Health: Improving Everywhere, ##br##Down In The U.S. Corporate Health: Improving Everywhere, Down In The U.S. Corporate Health: Improving Everywhere, Down In The U.S. Dollar bull markets are often accompanied by positive returns for the S&P 500. While a strong dollar hurts the earnings outlook for the S&P 500, it supports an expansion of multiples by putting downward pressure on rates and elongating the U.S. business cycle. The dollar and stocks are most positively correlated when the U.S. yield curve slope is between zero and 50-basis points, and flattening. Today's environment fits this bill. BCA is neutral on U.S. in a balanced portfolio. While the USD's strength should be associated with rising U.S. equity prices, the quality of U.S. stock returns is deteriorating. This warrants a certain degree of de-risking relative to our former overweight stance. Feature For the past two weeks, we have warned investors that the dollar rally was over-extended, and that a correction was likely to ensue. However, we also argued that this correction was likely to prove a countertrend move, and that the dollar was likely to end the year at higher levels. BCA has a neutral stance on equities on both a cyclical and tactical horizon. BCA is also neutral on U.S. equities within a global equity portfolio. For investors, it becomes important to understand whether a stronger dollar constitutes an additional downside risk for stocks. This is especially relevant in the U.S., where equity valuations are comparatively elevated, and where corporate health is deteriorating relative to the rest of the world (Chart 1). In this report, we built on the research of our colleague Anastasios Avgeriou, who spearheads BCA's U.S. Equity Sector Strategy service, who has shown that the dollar and the S&P often do rise in unison.1 Ultimately, while the dollar can have an impact on the relative performance of the U.S., it is generally not a strong determinant of the trend in the S&P 500. Strong Dollar And The S&P: Good Friends Indeed A picture is worth a thousand words. As Chart 2 illustrates, a strong dollar has never really been enough to slay a bull run in the S&P 500. Between late 1978 and early 1985, the real trade-weighted dollar rallied by 45%, yet the S&P 500 was able to advance by 102%. Between 1995 and 2002, the real trade-weighted dollar increased by 33% but rallied by nearly 92%. If one were to confine their observations to 1995 to August 2000 window, the dollar would have been up 16.5% and the S&P an outstanding 223%. Finally, from its most recent cyclical bottom in 2011 to the end of 2016, the trade-weighted dollar rallied by 22%, but the S&P 500 managed to rise by another impressive 68%. It is true that the magnitude of the strength of U.S. equities in the face of a strong dollar has decreased over time. This essentially reflects the fact that in the early 1980s, 20% of S&P 500 revenues were garnered outside the U.S. versus roughly 40% today, which in turn has increased the drag on earnings created by a stronger dollar. This problem is illustrated by the negative relationship present between the dollar and U.S. earnings revisions (Chart 3). Chart 2Strong Dollar, No Problem Strong Dollar, No Problem Strong Dollar, No Problem Chart 3Dollar Is Dangerous For The Earnings Outlook Dollar Is Dangerous For The Earnings Outlook Dollar Is Dangerous For The Earnings Outlook Yet, despite this negative link between earnings revisions and the dollar, the S&P can still rise when the dollar increases. What explains this seeming paradox? The answer is almost tautological: It is multiples. A strong dollar tends to be associated with a rising P/E ratio. This is because a strong dollar has a dampening impact on inflation. As a result, when the dollar rises, the Federal Reserve can keep interest rates lower than would otherwise be the case, fomenting periods of declining bond yields (Chart 4). Thanks to lower bond yields, not only do multiples get a boost, but additionally the domestically driven U.S. economic cycle also gets elongated. This further helps stocks in the process. Another more international dimension helps explain the positive correlation between stocks and the dollar. The dollar tends to experience its strongest rallies when U.S. growth is superior to that of the rest of the G-10. As Chart 5 illustrates, the bulk of the early 1980s dollar rally, of the late 1990s rally, and of the 2011 to early 2017 rally materialized when U.S. economic activity was outperforming. In all these instances, the relative strength of the U.S. economy attracted funds from abroad. This also meant that foreign funds flowing into the U.S. economy bolstered liquidity in the U.S. economy. Not only did this liquidity support economic activity, thereby counterbalancing the drag created by a stronger dollar, these funds also found their way into asset markets, generating higher multiples in the U.S. in the process. Chart 4Strong Dollar Hurts Yields Strong Dollar Hurts Yields Strong Dollar Hurts Yields Chart 5Growth Differentials Matter For The Dollar Growth Differentials Matter For The Dollar Growth Differentials Matter For The Dollar Bottom Line: A strong dollar in and of itself has never been enough to derail a bull market in the S&P 500. While a strong dollar creates a hurdle for foreign earnings accruing to U.S. firms, higher multiples often compensate for this negative. Essentially, a higher dollar causes downside to bond yields, warranting lower hurdle rates and higher valuations. Moreover, a stronger dollar diminishes inflationary pressures in the U.S., warranting easier Fed policy than would otherwise be the case. Since the U.S. economy is domestically driven, this elongates the business cycle, helping stocks in the process. Correlation And The Yield Curve Slope While a strong dollar does not seem to be a death threat for the equity market, are there environments when the dollar and the S&P 500 are more correlated than others? Table 1Dollar Versus S&P 500 Correlation: ##br##A Function Of The Yield Curve The S&P Doesn't Abhor A Strong Dollar The S&P Doesn't Abhor A Strong Dollar The answer to this question is yes. As Table 1 illustrates, the correlation between the dollar and the S&P 500 fluctuates significantly based on both the slope of the yield curve and whether the yield curve is flattening or not. Interestingly, when the yield curve is steep (defined as greater than a 50-basis-point spread between 10-year and 2-year Treasury yields), the dollar and U.S. stock prices tend to move in opposite directions. However, when the yield curve is flatter but before it has yet to invert (a yield curve slope of between zero and 50 basis points), the correlation between the dollar and the S&P 500 changes: it becomes positive. In fact, the time at which the correlation between stocks and the dollar is the highest is when the yield curve slope is in that zone and is also flattening. This is surprising, but at the same time it makes sense. We know that when the yield curve is flat but not inverted, the stock market tends to still rally (Chart 6). However, this flattening yield curve indicates that monetary conditions are not as accommodative as they once were. Interestingly, while the dollar performs poorly in the early innings of a monetary tightening campaign, it performs much better when monetary conditions are not so easy anymore that they juice up global growth, but they are not yet tight enough to cause an imminent recession in the U.S.2 This corresponds to a an environment with a flatter yield curve that has yet to invert, such as the one in place today. In light of these observations, the close correlation between the S&P 500 and the dollar in this environment should not be very surprising. Chart 6Flat And Flattening: No Problem For Stocks Flat And Flattening: No Problem For Stocks Flat And Flattening: No Problem For Stocks Bottom Line: The dollar and the stock market are not always positively correlated. However, when the U.S. yield curve slope stands between zero and 50 basis points and is flattening, the positive correlation between the S&P 500 and the dollar is at its strongest. This defines today's environment. Investment Implications BCA thinks the U.S. dollar has ample downside on a long-term basis. After all, the U.S. dollar trades at a significant premium to its PPP fair value, and this kind of overvaluation historically indicates significant downside for the greenback on a multi-year time horizon (Chart 7). Moreover, the Trump administration's fiscal policy is likely to result in a widening of both the fiscal and current account deficits. While a twin deficit rarely impacts the dollar negatively, so long as U.S. real rates rise relative to the rest of the world, it nonetheless often ends up being a harbinger of long-term weakness in the greenback.3 It is hard to make any inference for the S&P 500 based on a bearish long-term dollar view as historically, during a structural dollar bear market, the relationship between the greenback and the S&P has been rather ambiguous. However, BCA also thinks the 2018 dollar rally is not over. As Chart 8 shows, when U.S. rates are in the top of the distribution of interest rates among G-10 economies, the dollar tends to perform well. The U.S.'s status as the global high-yielder is currently unchallenged. This suggests the dollar has a natural advantage over other currencies through the remainder of the year. Chart 7Long-Term Downside For The Dollar... Long-Term Downside For The Dollar... Long-Term Downside For The Dollar... Chart 8...But 2018 Rally Is Not Over ...But 2018 Rally Is Not Over ...But 2018 Rally Is Not Over Moreover, as the U.S. economy is less exposed to the global industrial cycle than the rest of the world is, the U.S. dollar will benefit from the softening global economic environment. This is even truer, given that the U.S. economy was already set to outperform other G-10 economies even before the soft patch in global trade began. As a result, long-term flows into the U.S. are strong, which is generating a basic balance-of-payments surplus (Chart 9). American investors are not blind to this reality; the higher expected rate of returns on U.S. projects along with U.S. corporations bringing earnings back home to take advantage of the Trump tax cuts is generating outsized repatriation flows into the country, historically a good correlate of a strong dollar (Chart 10). This phenomenon is likely to remain alive through the remainder of the year. Chart 9Money Is Making Its Way Into The U.S. Money Is Making Its Way Into The U.S. Money Is Making Its Way Into The U.S. Chart 10Americans Like Their Dollar Americans Like Their Dollar Americans Like Their Dollar Since the U.S. yield curve slope currently stands between zero and 50 basis points while it is flattening in response to the Fed's interest rate hikes, we are in the part of the cycle where the dollar and stocks are positively correlated, and where they in fact often rise together. This suggests the S&P 500 has more upside ahead for the rest of the year as well. It is important to note that the tech sector is now the most at risk from the dollar strength as it has the largest percentage of foreign sales (Chart 11). However, BCA is neutral on stocks on a cyclical horizon. This is not because stocks will not be able to eke out some positive returns; it is because we are acutely aware that we stand close to the end of the bull market. Moreover, the end of an equity bull market is often marked by a pick-up in volatility. Accordingly, risk-adjusted returns for U.S. equities are declining. Hence, while an underweight stance on stocks is not yet warranted, a neutral stance is appropriate as we believe that it is better to be early and leave some money on the table than to be late.4 There remains a big risk that could cause the dollar to rally and stocks to fall, despite where we stand in the cycle: trade disputes. As Chart 12 illustrates, since May, tariff announcements and protectionist pronouncements have buoyed the dollar. However, the same announcements ultimately represent a real risk to profits as they create a real danger for global supply chains and imply higher cost of goods sold by U.S. corporations. Investors should monitor these risks closely. Chart 11S&P 500: Aggregate Sector International Revenue Exposure (%) The S&P Doesn't Abhor A Strong Dollar The S&P Doesn't Abhor A Strong Dollar Chart 12While Tariffs Can Help The Dollar, ##br##They Will Not Help Stocks While Tariffs Can Help The Dollar, They Will Not Help Stocks While Tariffs Can Help The Dollar, They Will Not Help Stocks Bottom Line: BCA anticipates the dollar to be able to rise over the course of the next six to nine months, as U.S. rates are in favor of the greenback and domestic growth outperformance will continue to favor inflows into the U.S. This bullish view on the U.S. dollar currently does not constitute a reason to downgrade stocks to underweight. In fact, at this stage of the cycle, U.S. stocks and the dollar tend to rise in unison. However, since the quality of the equity gains is likely to deteriorate as equity volatility is on an uptrend, BCA prefers to maintain a neutral cyclical stance on equities within a balanced portfolio rather than an overweight stance. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see U.S. Equity Sector Strategy Insight Report, titled "Can the S&P 500 Continue Rising Alongside the U.S. Dollar?", dated October 13, 2016, available at uses.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "This Time Is NOT Different," dated May 25 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Twin Deficits: Bearish Or Not, The Fed Holds The Trump Card," dated February 23 2018, available at fes.bcaresearch.com 4 Please see The Bank Credit Analyst Special Report, titled "U.S. Fiscal Policy: An Unprecedented Macro Experiment," dated June 28, 2018 available at bcaresearch.com. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

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

Highlights Macro Outlook: Global growth is decelerating and the composition of that growth is shifting back towards the United States. Policy backdrop: The specter of trade wars represents a real and immediate threat to risk assets. Meanwhile, many of the "policy puts" that investors have relied on have been marked down to a lower strike price. Global equities: We downgraded global equities from overweight to neutral on June 19th. Investors should favor developed market equities over their EM counterparts. Defensive stocks will outperform deep cyclicals, at least until the dollar peaks early next year. Government bonds: Treasury yields may dip in the near term, but will rise over a 12-month horizon. Overweight Japan, Australia, New Zealand, and the U.K. relative to the U.S., Canada, and the euro area. Credit: The current level of spreads points to subpar returns over the next 12 months. We have a modest preference for U.S. over European corporate bonds. Currencies: EUR/USD will fall into the $1.10-to-1.15 range during the next few months. The downside risks for the pound and the yen are limited. Avoid EM and commodity currencies. The risk of a large depreciation in the Chinese yuan is rising. Commodities: Favor oil over metals. Gold will do well over the long haul. Feature I. Macro Outlook Back To The USA The global economy experienced a synchronized expansion in 2017. Global real GDP growth accelerated to 3.8% from 3.2% in 2016. The euro area, Japan, and most emerging markets moved from laggards to leaders in the global growth horse race. The opposite pattern has prevailed in 2018. Global growth has slowed, a trend that is likely to continue over the next few quarters judging by a variety of leading economic indicators (LEIs) (Chart 1). The U.S. has once again jumped ahead of its peers: It is the only major economy where the LEI is still rising (Chart 2). The latest tracking data suggest that U.S. real GDP growth could reach 4% in the second quarter, more than double most estimates of trend growth. Chart 1Global Growth Is Slowing Again Global Growth Is Slowing Again Global Growth Is Slowing Again Chart 2U.S. Is Outshining Its Peers U.S. Is Outshining Its Peers U.S. Is Outshining Its Peers Such a lofty pace of growth cannot be sustained. For the first time in over a decade, the U.S. economy has reached full employment. The unemployment rate stands at a 48-year low of 3.75%. The number of people outside the labor force who want a job, as a percentage of the total working-age population, is back to pre-recession lows (Chart 3). 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 4). Chart 3U.S. Is Back To Full Employment U.S. Is Back To Full Employment U.S. Is Back To Full Employment Chart 4There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers Mainstream economic theory states that governments should tighten fiscal policy as the economy begins to overheat in order to accumulate a war chest for the next inevitable downturn. The Trump administration is doing the exact opposite. The budget deficit is set to widen to 4.6% of GDP next year on the back of massive tax cuts and big increases in government spending (Chart 5). Chart 5The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The Fed In Tightening Mode As the labor market overheats, wages will accelerate further. Average hourly earnings surprised to the upside in May. The Employment Cost Index for private-sector workers - one of the cleanest and most reliable measures of wage growth - rose at a 4% annualized pace in the first quarter. The U.S. labor market has finally moved onto the 'steep' side of the Phillips curve (Chart 6). Rising wages will put more income into workers' pockets who will then spend it. As aggregate demand increases beyond the economy's productive capacity, inflation will rise. The New York Fed's Underlying Inflation Gauge, which leads core CPI inflation by 18 months, has already leaped to over 3% (Chart 7). The prices paid components of the ISM and regional Fed purchasing manager surveys have also surged (Chart 8). Chart 6Wage Inflation Will Accelerate Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Chart 7U.S. Inflation: Upside Risks (Part I) U.S. Inflation: Upside Risks (Part I) U.S. Inflation: Upside Risks (Part I) Chart 8U.S. Inflation: Upside Risks (Part II) U.S. Inflation: Upside Risks (Part II) U.S. Inflation: Upside Risks (Part II) The Fed has a symmetric inflation target. Hence, a temporary increase in core PCE inflation to around 2.2%-to-2.3% would not worry the FOMC very much. However, a sustained move above 2.5% would likely prompt an aggressive response. The fact that the unemployment rate has fallen 0.7 percentage points below the Fed's estimate of full employment may seem like a cause for celebration, but this development has a dark side. There has never been a case in the post-war era where the unemployment rate has risen by more than one-third of a percentage point without this coinciding with a recession (Chart 9). The Fed wants to avoid a situation where the unemployment rate has fallen so much that it has nowhere to go but up. Chart 9Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle As such, we think that the bar for the Fed to abandon its once-per-quarter pace of rate hikes is quite high. If anything, the risk is that the Fed expedites monetary tightening in order to keep real rates on an upward trajectory. Jay Powell's announcement that he will hold a press conference at the conclusion of every FOMC meeting opens the door for the Fed to move back to its historic pattern of hiking rates once every six weeks. Housing And The Monetary Transmission Mechanism Economists often talk about the "monetary transmission mechanism." As Ed Leamer pointed out in his 2007 Jackson Hole symposium paper succinctly entitled, "Housing Is The Business Cycle," housing has historically been the main conduit through which changes in monetary policy affect the real economy.1 A house will last a long time, and the land on which it sits - which in many cases is worth more than the house itself - will last forever. Thus, changes in real interest rates tend to have a large impact on the capitalized value of one's home. Today, the U.S. housing market is in pretty good shape (Chart 10). Construction activity was slow to increase in the aftermath of the Great Recession. As a result, the vacancy rate stands at ultra-low levels. Home prices have been rising briskly, but are still 13% below their 2005 peak once adjusted for inflation. On both a price-to-rent and price-to-income basis, home prices do not appear overly stretched. Mortgage-servicing costs, expressed as a share of disposable income, are near all-time lows. The homeownership rate has also been trending higher, thanks to faster household formation and an improving labor market. Lenders remain circumspect (Chart 11). The ratio of mortgage debt-to-disposable income has barely increased during the recovery, and is still 31 percentage points below 2007 levels. The average FICO score for new mortgages stands at a healthy 761, well above pre-recession standards. Chart 10U.S. Housing Is In Pretty Good Shape U.S. Housing Is In Pretty Good Shape U.S. Housing Is In Pretty Good Shape Chart 11Mortgage Lenders Remain Circumspect Mortgage Lenders Remain Circumspect Mortgage Lenders Remain Circumspect The Urban Institute Housing Credit Availability Index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, is nowhere close to dangerous levels. This is particularly the case for private-label mortgages, whose default risk has hovered at just over 2% during the past few years, down from a peak of 22% in 2006. If Not Housing, Then What? Since the U.S. housing sector is in reasonably good shape, the Fed may need to slow the economy through other means. Here's the rub though: Other sectors of the economy are not particularly sensitive to changes in interest rates. Decades of empirical data have clearly shown that business investment is only weakly correlated with the cost of capital. Unlike a house, most business investment is fairly short-lived. A computer might be ready for the recycling heap in just a few years. The Bureau of Economic Analysis estimates that the depreciation rate for nonresidential assets is nearly four times higher than for residential property (Chart 12). During the early 1980s, when the effective fed funds rate reached 19%, residential investment collapsed but business investment was barely affected (Chart 13). Chart 12U.S.: Depreciation Rate For Business ##br##Investment Is Much Larger Than For Residential Property U.S.: Depreciation Rate For Business Investment Is Much Larger Than For Residential Property U.S.: Depreciation Rate For Business Investment Is Much Larger Than For Residential Property Chart 13Residential Investment Collapsed In ##br##Response To Higher Interest Rates In The Early 80s... While Business Investment Was Barely Affected Residential Investment Collapsed In Response To Higher Interest Rates In The Early 80s... While Business Investment Was Barely Affected Residential Investment Collapsed In Response To Higher Interest Rates In The Early 80s... While Business Investment Was Barely Affected Rising rates could make it difficult for corporate borrowers to pay back loans, which could indirectly lead to lower business investment. That said, a fairly pronounced increase in rates may be necessary to generate significant distress in the corporate sector, given that interest payments are close to record-lows as a share of cash flows (Chart 14). In addition, corporate bonds now represent 60% of total corporate liabilities. Bonds tend to have much longer maturities than bank loans, which provides a buffer against default risk. A stronger dollar would cool the economy by diverting some spending towards imports. However, imports account for only 16% of GDP. Thus, even large swings in the dollar's value tend to have only modest effects on the economy. Likewise, higher interest rates could hurt equity prices, but the wealthiest ten percent of households own 93% of all stocks. Hence, it would take a sizable drop in the stock market to significantly slow GDP growth. The conventional wisdom is that the Fed will need to hit the pause button at some point next year. The market is pricing in only 85 basis points in rate hikes between now and the end of 2020 (Chart 15). That assumption may be faulty, considering that housing is in good shape and other sectors of the economy are not especially sensitive to changes in interest rates. Rates may need to go quite a bit higher before the U.S. economy slows materially. Chart 14U.S. Corporate Sector Interest Payments ##br##At Near Record-Low Levels As A Share Of Cash Flows U.S. Corporate Sector Interest Payments At Near Record-Low Levels As A Share Of Cash Flows U.S. Corporate Sector Interest Payments At Near Record-Low Levels As A Share Of Cash Flows Chart 15Market Expectations Versus The Fed Dots Market Expectations Versus The Fed Dots Market Expectations Versus The Fed Dots Global Contagion Investors and policymakers talk a lot about the neutral rate of interest. Unfortunately, the discussion is usually very parochial in nature, inasmuch as it focuses on the interest rate that is consistent with full employment and stable inflation in the United States. But the U.S. is not an island unto itself. Even if a bit outdated, the old adage that says that when the U.S. sneezes the rest of the world catches a cold still rings true. What if there is a lower "shadow" neutral rate which, if breached, causes pain outside the U.S. before it causes pain within the U.S. itself? Eighty per cent of EM foreign-currency debt is denominated in U.S. dollars. Outside of China, EM dollar debt is now back to late-1990s levels both as a share of GDP and exports (Chart 16). Just like in that era, a vicious cycle could erupt where a stronger dollar makes it difficult for EM borrowers to pay back their loans, leading to capital outflows from emerging markets, and an even stronger dollar. The wave of EM local-currency debt issued in recent years only complicates matters (Chart 17). If EM central banks raise rates, this could help prevent their currencies from plunging. However, higher domestic rates will make it difficult for local-currency borrowers to pay back their loans. Damned if you do, damned if you don't. Chart 16EM Dollar Debt Is High EM Dollar Debt Is High EM Dollar Debt Is High Chart 17EM Borrowers Like Local Credit Too EM Borrowers Like Local Credit Too EM Borrowers Like Local Credit Too China To The Rescue? Don't Count On It 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. Our leading indicator for the Li Keqiang index, a widely followed measure of economic activity, is in a clear downtrend (Chart 18). Property prices in tier one cities are down year-over-year. Construction tends to follow prices. So far, the policy response has been muted. Reserve requirements have been cut and some administrative controls loosened, but the combined credit and fiscal impulse has plunged (Chart 19). Onshore and offshore corporate bond yields have increased to multi-year highs. Bank lending rates are rising, while loan approval rates are dropping (Chart 20). Chart 18Chinese Growth Is Slowing Anew Chinese Growth Is Slowing Anew Chinese Growth Is Slowing Anew Chart 19China: Policy Response To Slowdown ##br##Has Been Muted So Far China: Policy Response To Slowdown Has Been Muted So Far China: Policy Response To Slowdown Has Been Muted So Far Chart 20China: Credit Tightening China: Credit Tightening China: Credit Tightening There is 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 will be willing to 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. Rising Risk Of Another RMB Devaluation Chart 21China: Currency Wars Are Good And ##br##Easy To Win China: Currency Wars Are Good And Easy To Win China: Currency Wars Are Good And Easy To Win Even if China does stimulate the economy, it may try to do so by weakening the currency rather than loosening fiscal and credit policies. Chart 21 shows that the yuan has fallen much more over the past week than one would have expected based on the broad dollar's trend. The timing of the CNY's recent descent coincides with President Trump's announcement of additional tariffs on $200 billion of Chinese goods. Global financial markets went into a tizzy the last time China devalued the yuan in August 2015. The devaluation triggered significant capital outflows, arguably only compounding China's problems. This has led commentators to conclude that the authorities would not make the same mistake again. But what if the real mistake was not that China devalued its currency, but that it did not devalue it by enough? Standard economic theory says that a country should always devalue its currency by a sufficient amount to flush out expectations of a further decline. China was too timid, and paid the price. Capital controls are tighter in China today than they were in 2015. This gives the authorities more room for maneuver. China is also waging a geopolitical war with the United States. The U.S. exported only $188 billion of goods and services to China, a small fraction of the $524 billion in goods and services that China exported to the United States. China simply cannot win a tit-for-tat trade war with the United States. In contrast, a currency war from China's perspective may be, to quote Donald Trump, "good and easy to win." The Chinese simply need to step up their purchases of U.S. Treasurys, which would drive up the value of the dollar. Trump And Trade Needless to say, any effort by the Chinese to devalue their currency would invite a backlash from the Trump administration. However, since China is already on the receiving end of punitive U.S. trade actions, it is not clear that the marginal cost to China would outweigh the benefits of having a more competitive currency. The truth is that there may be little that China can do to fend off a trade war. Protectionism is popular among American voters, especially among Trump's base (Chart 22). Donald Trump ran on a protectionist platform, and he is now trying to deliver on his promise of a smaller trade deficit. Whether he succeeds is another story. Trump's macroeconomic policies are completely at odds with his trade agenda. Fiscal stimulus will boost aggregate demand, which will suck in more imports. An overheated economy will prompt the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. All of this will result in a wider trade deficit. What will Trump tell voters two years from now when he is campaigning in Michigan and Ohio about why the trade deficit has widened under his watch? Will he blame himself or America's trading partners? No trophy for getting that answer right. Trump seems to equate countries with companies: Exports are revenues and imports are costs. If a country is exporting less than it is importing, it must be losing money. This is deeply flawed reasoning. I run a current account deficit with the place where I eat lunch and they run a capital account deficit with me - they give me food and I give them cash - but I don't go around complaining that they are ripping me off. A trade war would be much more damaging to Wall Street than Main Street. While trade is a fairly small part of the U.S. economy, it represents a large share of the activities of the multinational companies that comprise the S&P 500. Trade these days is dominated by intermediate goods (Chart 23). The exchange of goods and services takes place within the context of a massive global supply chain, where such phrases as "outsourcing," "vertical integration" and "just-in-time inventory management" have entered the popular vernacular. Chart 22Free Trade Is Not In Vogue In The U.S. Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Chart 23Trade In Intermediate Goods Dominates Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End This arrangement has many advantages, but it also harbors numerous fragilities. A small fire at a factory in Japan that manufactured 60 per cent of the epoxy resin used in chip casings led to a major spike in RAM prices in 1993. Flooding in Thailand in 2011 wreaked havoc on the global auto industry. The global supply chain is highly vulnerable to even small shocks. Now scale that up by a factor of 100. That is what a global trade war would look like. The Euro Area: Back In The Slow Lane Euro area growth peaked late last year. Real final demand grew by 0.8% in Q4 of 2017 but only 0.2% in Q1 of 2018. The weakening trend was partly a function of slower growth in China and other emerging markets - net exports contributed 0.41 percentage points to euro area growth in Q4 but subtracted 0.14 points in Q1. Domestic factors also played a role. Most notably, the euro area credit impulse rolled over late last year, taking GDP growth down with it (Chart 24).2 It is too early to expect euro area growth to reaccelerate. German exports contracted in April. Export expectations in the Ifo survey sank in June to the lowest level since January 2017, while the export component of the PMI swooned to a two-year low. We also have yet to see the full effect of the Italian imbroglio on euro area growth. Italian bond yields have come down since spiking in April, but the 10-year yield is still more than 100 basis points higher than before the selloff (Chart 25). This amounts to a fairly substantial tightening in financial conditions in the euro area's third largest economy. And this does not even take into account the deleterious effect on Italian business confidence. Chart 24Peak In Euro Area Credit Impulse Last Year##br## Means Slower Growth This Year Peak In Euro Area Credit Impulse Last Year Means Slower Growth This Year Peak In Euro Area Credit Impulse Last Year Means Slower Growth This Year Chart 25Uh Oh Spaghetti-O Uh Oh Spaghetti-O Uh Oh Spaghetti-O If You Are Gonna Do The Time, You Might As Well Do The Crime At this point, investors are basically punishing Italy for a crime - defaulting and possibly jettisoning the euro - that it has not committed. If you are going to get reprimanded for something you have not done, you are more likely to do it. Such a predicament can easily create a vicious circle where rising yields make default more likely, leading to falling demand for Italian debt and even higher yields (Chart 26). The fact that Italian real GDP per capita is no higher now than when the country adopted the euro in 1999, and Italian public support for euro area membership is lower than elsewhere, has only added fuel to investor concerns (Chart 27). Chart 26When A Lender Of Last Resort Is Absent, Multiple Equilibria Are Possible Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Chart 27Italy: Neither Divine Nor A Comedy Italy: Neither Divine Nor A Comedy Italy: Neither Divine Nor A Comedy The ECB could short-circuit this vicious circle by promising to backstop Italian debt no matter what. But it can't make such unconditional promises. Recall that prior to delivering his "whatever it takes" speech in 2012, Mario Draghi and his predecessor Jean-Claude Trichet penned a letter to Silvio Berlusconi 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 Berlusconi's resignation after they were leaked to the public. One of the reforms that Draghi and Trichet demanded - and the subsequent government led by Mario Monti ultimately undertook - was the extension of the retirement age. Italy's current leaders promised to reverse that decision during the election campaign. While they have softened their stance since then, they will still try to deliver on much of their populist agenda over the coming months, 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. Italy's Macro Constraints Much has been written about what Italy should be doing, but the fact is that there are no simple solutions. Italy suffers from an aging population that is trying to save more for retirement. Italian companies do not want to invest in new capacity because the working-age population is shrinking, which limits future domestic demand growth. Thus, the private sector is a chronic net saver, constantly wanting to spend less than it earns (Chart 28). Italy is not unique in facing an excess of private-sector savings. However, Italy is unique in that the solutions available to most other countries to deal with this predicament are not available to it. Broadly speaking, there are two ways you can deal with excess private-sector savings. Call it the Japanese solution and the German solution. The Japanese solution is to have the government absorb excess private-sector savings with its own dissavings. This is tantamount to running large, sustained fiscal deficits. Italy's populist coalition Five Star-Lega government tried to pursue this strategy, only to have the bond vigilantes shoot it down. The German solution is to ship excess savings out of the country through a large current account surplus (in Germany's case, 8% of GDP). However, for Italy to avail itself of this solution, it would need to have a hypercompetitive economy, which it does not. Unlike Spain, Italy's unit labor costs have barely declined over the past six years relative to the rest of the euro area, leaving it with an export base that is struggling to compete abroad (Chart 29). Chart 28The Italian Private Sector Wants To Save The Italian Private Sector Wants To Save The Italian Private Sector Wants To Save Chart 29Italy: More Work Needs To Be Done On The Labor Competitiveness Front Italy: More Work Needs To Be Done On The Labor Competitiveness Front Italy: More Work Needs To Be Done On The Labor Competitiveness Front Since there is little that can be done in the near term that would improve Italy's competitiveness vis-à-vis the rest of the euro area, the only thing the ECB can do is try to improve Italy's competitiveness vis-à-vis the rest of the world. This means keeping monetary policy very loose and hoping that this translates into a weak euro. II. Financial Markets Downgrade Global Risk Assets From Overweight To Neutral Investors are accustomed to thinking that there is a "Fed put" out there - that the Fed will stop raising rates if growth slows and equity prices fall. This was a sensible assumption a few years ago: The Fed hiked rates in December 2015 and then stood pat for 12 months as the global economic backdrop darkened. These days, however, the Fed wants slower growth. And if weaker asset prices are the ticket to slower growth, so be it. The "Fed put" may still be around, but the strike price has been marked down to a lower level. Likewise, worries about growing financial and economic imbalances will limit the efficacy of the "China stimulus put" - the tendency for the Chinese government to ease fiscal and credit policy at the first hint of slower growth. The same goes for the "Draghi put." The ECB is hoping, perhaps unrealistically so, to wind down its asset purchase program later this year. This means that a key buyer of Italian debt is stepping back just when it may be needed the most. The loss of these three policy puts, along with additional risks such as rising protectionism, means that the outlook for global risk assets is likely to be more challenging over the coming months. With that in mind, we downgraded our 12-month recommendation on global risk assets from overweight to neutral last week. Fixed-Income: Stay Underweight Chart 30U.S. Corporate Bonds: Leverage-Adjusted Value U.S. Corporate Bonds: Leverage-Adjusted Value U.S. Corporate Bonds: Leverage-Adjusted Value A less constructive stance towards equities would normally imply a more constructive stance towards bonds. Global bond yields could certainly fall in the near term, as EM stress triggers capital flows into safe-haven government bond markets. However, if we are really in an environment where an overheated U.S. economy and rising inflation force the Fed to raise rates more than the market expects, long-term bond yields are likely to rise over a 12-month horizon. As such, asset allocators should move the proceeds from equity sales into cash. The U.S. yield curve might still flatten in this environment, but it would be a bear flattening - one where long-term yields rise less than short-term rates. Bond yields are strongly correlated across the world. Thus, an increase in U.S. Treasury yields over the next 12 months would likely put upward pressure on bond yields abroad, even if inflation remains contained outside the United States. BCA's Global Fixed Income Strategy service favors Japan, Australia, New Zealand, and the U.K. over the U.S., Canada, and euro area bond markets. Investors should also pare back their exposure to spread product. Our increasing caution towards equities extends to the corporate bond space. BCA's U.S. Corporate Health Monitor (CHM) remains in deteriorating territory. With profits still high and bank lending standards continuing to ease, a recession-inducing corporate credit crunch is unlikely over the next 12 months. Nevertheless, our models suggest that both investment grade and high yield credit are overvalued (Chart 30). In relative terms, our fixed-income specialists have a modest preference for U.S. over European credit. The near-term growth outlook is more challenging in Europe. The ECB is also about to wind down its bond buying program, having purchased nearly 20% of all corporate bonds in the euro area over the course of only three years. Currencies: King Dollar Is Back The U.S. dollar is a counter-cyclical currency, meaning that it tends to do well when the global economy is decelerating (Chart 31). If the Chinese economy continues to weaken, global growth will remain under pressure. Emerging market currencies will suffer in this environment especially if, as discussed above, the Chinese authorities engineer a devaluation of the yuan. Momentum is moving back in the dollar's favor. Chart 32 shows that a simple trading rule - which goes long the dollar whenever it is above its moving average and shorts it when it is below - has performed very well over time. The dollar is now trading above most key trend lines. Chart 31Decelerating Global Growth Tends To Be##br## Bullish For The Dollar Decelerating Global Growth Tends To Be Bullish For The Dollar Decelerating Global Growth Tends To Be Bullish For The Dollar Chart 32The Dollar Trades On Momentum The Dollar Trades On Momentum The Dollar Trades On Momentum Some commentators have argued that a larger U.S. budget deficit will put downward pressure on the dollar. However, this would only happen if the Fed let inflation expectations rise more quickly than nominal rates, an outcome which would produce lower real rates. So far, that has not happened: U.S. real rates have risen across the entire yield curve since Treasury yields bottomed last September (Chart 33). As a result, real rate differentials between the U.S. and its peers have increased (Chart 34). Chart 33U.S. Real Rates Have Risen Across ##br##The Entire Yield Curve U.S. Real Rates Have Risen Across The Entire Yield Curve U.S. Real Rates Have Risen Across The Entire Yield Curve Chart 34Real Rate Differentials Have Widened ##br##Between The U.S. And Its DM Peers Real Rate Differentials Have Widened Between The U.S. And Its DM Peers Real Rate Differentials Have Widened Between The U.S. And Its DM Peers Historically, the dollar has moved in line with changes in real rate differentials (Chart 35). The past few months have been no exception. If the Fed finds itself in a position where it can raise rates more than the market anticipates, the greenback should continue to strengthen. Chart 35Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials True, the dollar is no longer a cheap currency. However, if long-term interest rate differentials stay anywhere close to where they are today, the greenback can appreciate quite a bit from current levels. For example, consider the dollar's value versus the euro. Thirty-year U.S. Treasurys currently yield 2.98% while 30-year German bunds yield 1.04%, a difference of 194 basis points. Even if one allows for the fact that investors expect euro area inflation to be lower than in the U.S. over the next 30 years, EUR/USD would need to trade at a measly 84 cents today in order to compensate German bund holders for the inferior yield they will receive.3 We do not expect EUR/USD to get down to that level, but a descent into the $1.10-to-$1.15 range over the next few months certainly seems achievable. Brexit worries will continue to weigh on the British pound. Nevertheless, we are reluctant to get too bearish on the pound. The currency is extremely cheap (Chart 36). Inflation has come down from a 5-year high of 3.1% in November, but still clocked in at 2.4% in April. Real wages are picking up, consumer confidence has strengthened, and the CBI retail survey has improved. In a surprise decision, Andy Haldane, the Bank of England's Chief Economist, joined two other Monetary Policy Committee members in voting for an immediate 25 basis-point increase in the Bank Rate in June. Perhaps most importantly, Brexit remains far from a sure thing. Most polls suggest that if a referendum were held again, the "Bremain" side would prevail (Chart 37). Rules are made to be broken. It is the will of the people, rather than legal mumbo-jumbo, that ultimately matters. In the end, the U.K. will stay in the EU. The yen is likely to weaken somewhat against the dollar over the next 12 months as interest rate differentials continue to move in the dollar's favor. That said, as with the pound, we think the downside for the yen is limited (Chart 38). The yen real exchange rate remains at multi-year lows. Japan's current account surplus has grown to nearly 4% of GDP and its net international investment position - the difference between its foreign assets and liabilities - stands at an impressive 60% of GDP. If financial market volatility rises, as we expect, some of those overseas assets will be repatriated back home, potentially boosting the value of the yen in the process. Chart 36The Pound Is Cheap The Pound Is Cheap The Pound Is Cheap Chart 37When Bremorse Sets In When Bremorse Sets In When Bremorse Sets In Chart 38The Yen's Long-Term Outlook Is Bullish The Yen's Long-Term Outlook Is Bullish The Yen's Long-Term Outlook Is Bullish Commodities: Better Outlook For Oil Than Metals The combination of slower global growth and a resurgent dollar is likely to hurt commodity prices. Industrial metals are more vulnerable than oil. China consumes around half of all the copper, nickel, aluminum, zinc, and iron ore produced around the world (Chart 39). In contrast, China represents less than 15% of global oil demand. The supply backdrop for oil is also more favorable than for metals. While Saudi Arabia is likely to increase production over the remainder of the year, this may not be enough to fully offset lower crude output from Venezuela, Iran, Libya, and Nigeria, as well as potential constraints to U.S. production growth due to pipeline bottlenecks. Additionally, a recent power outage has knocked about 350,000 b/d of Syncrude's Canadian oil sands production offline at least through July. The superior outlook for oil over metals means we prefer the Canadian dollar relative to the Aussie dollar. Chart 40 shows that the AUD is expensive compared to the CAD based on a Purchasing Power Parity calculation. Although the Canadian dollar deserves some penalty due to NAFTA risks, the current discount seems excessive to us. Accordingly, as of today, we are going tactically short AUD/CAD. Chart 39China Is A More Dominant Consumer ##br##Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil Chart 40The Canadian Dollar Is Undervalued ##br##Relative To The Aussie Dollar The Canadian Dollar Is Undervalued Relative To The Aussie Dollar The Canadian Dollar Is Undervalued Relative To The Aussie Dollar The prospect of higher inflation down the road is good news for gold. However, with real rates still rising and the dollar strengthening, it is too early to pile into bullion and other precious metals. Wait until early 2020, by which time the Fed is likely to stop raising rates. Equities: Prefer DM Over EM One can believe that emerging market stocks will go up; one can also believe that the Fed will do its job and tighten financial conditions in order to prevent the U.S. economy from overheating. But one cannot believe that both of these things will happen at the same time. As Chart 41 clearly shows, EM equities almost always fall when U.S. financial conditions are tightening. Chart 41Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Our overriding view is that U.S. financial conditions will tighten over the coming months. As discussed above, the adverse effects of rising U.S. rates and a strengthening dollar are likely to be felt first and foremost in emerging markets. Our EM strategists believe that Turkey, Brazil, Argentina, South Africa, Malaysia, and Indonesia are most vulnerable. We no longer have a strong 12-month view on regional equity allocation within the G3 economies, at least not in local-currency terms. The sector composition of the euro area and Japanese bourses is more heavily tilted towards deep cyclicals than the United States. However, a weaker euro, and to a lesser extent, a weaker yen will cushion the blow from a softening global economy. In dollar terms, the U.S. stock market should outperform its peers. Getting Ready For The Next Equity Bear Market 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. We predicted last week that the next "big move" in stocks will be to the downside. We would consider moving our 12-month recommendation temporarily back to overweight if global equities were to sell off by more than 15% during the next few months or if the policy environment becomes more market-friendly. Similar to what happened in 1998, when the S&P 500 fell by 22% between the late summer and early fall, a significant correction today could set the scene for a blow-off rally. In such a rally, EM stocks would probably rebound and cyclicals would outperform defensives. However, absent such fireworks, we will probably downgrade global equities in early 2019 in anticipation of a global recession in 2020. The U.S. fiscal impulse is set to fall sharply in 2020, as the full effects of the tax cuts and spending hikes make their way through the system (Chart 42).4 Real GDP will probably be growing at a trend-like pace of 1.7%-to-1.8% by the end of next year because the U.S. will have run out of surplus labor at that point. A falling fiscal impulse could take GDP growth down to 1% in 2020, a level often associated with "stall speed." Investors should further reduce exposure to stocks before this happens. The next recession will not be especially severe in purely economic terms. However, as was the case in 2001, even a mild recession could lead to a very painful equity bear market if the starting point for valuations is high enough. Valuations today are not as extreme as they were back then, but they are still near the upper end of their historic range (Chart 43). A composite valuation measure incorporating both the trailing and forward PE ratio, price-to-book, price-to-cash flow, price-to-sales, market cap-to-GDP, dividend yield, and Tobin's Q points to real average annual total returns of 1.8% for U.S. stocks over the next decade. Global equities will fare slightly better, but returns will still be below their historic norm. Long-term equity investors looking for more upside should consider steering their portfolios towards value stocks, which have massively underperformed growth stocks over the past 11 years (Chart 44). Chart 42U.S. Fiscal Impulse Set To Drop In 2020 U.S. Fiscal Impulse Set To Drop In 2020 U.S. Fiscal Impulse Set To Drop In 2020 Chart 43U.S. Stocks Are Pricey U.S. Stocks Are Pricey U.S. Stocks Are Pricey Chart 44Value Stocks: An Attractive Proposition Value Stocks: An Attractive Proposition Value Stocks: An Attractive Proposition Appendix A depicts some key valuation indicators for global equities. Appendix B provides illustrative projections based on the discussion above of where all the major asset classes are heading over the next ten years. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Edward E. Leamer, "Housing Is The Business Cycle," Proceedings, Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, (2007). 2 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. Euro area private-sector credit growth accelerated from -2.6% in May 2014 to 3.1% in March 2017, but has been broadly flat ever since. Hence, the credit impulse has dropped. 3 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The annual inflation differential of 0.4% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.49 after 30 years. If one assumes that the euro reaches that level by then, the common currency would need to trade at 1.49/(1.0194)^30=0.84 today. 4 We are not saying that fiscal policy will be tightened in 2020. Rather, we are saying that the structural budget deficit will stop increasing as the full effects of the tax cuts make their way through the system and higher budgetary appropriations are reflected in increased government spending (there is often a lag between when spending is authorized and when it takes place). It is the change in the fiscal impulse that matters for GDP growth. Recall that Y=C+I+G+X-M. If the government permanently raises G, this will permanently raise Y but will only temporarily raise GDP growth (the change in Y). In other words, as G stops rising in 2020, GDP growth will come back down. Appendix A Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Appendix A Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Appendix B Appendix B Chart 1Market Outlook: Bonds Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Appendix B Chart 2Market Outlook: Equities Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Appendix B Chart 3Market Outlook: Currencies Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Appendix B Chart 4Market Outlook: Commodities Third Quarter 2018: The Beginning Of The End Third Quarter 2018: The Beginning Of The End Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

As with all bull markets, the question on investors' minds has never been if it would end but when it will end as the former is a certainty and the latter is the source of alpha. We have previously noted that by almost all measures, this is the longest bull market in history and, with its age starting to show, it is time to focus on late-cycle dynamics. With that in mind, we have examined the relationships between the peak of the ISM manufacturing composite index, the peak of the S&P 500 and the beginning of the recession. Our cycle-on-cycle analysis is presented below and yields an important insight: Typically, the S&P 500 falls modestly after the ISM peaks but then delivers one last hurrah, before the end of the cycle, yielding the fattest returns of the bull market. We have overlaid this cycle-on-cycle chart with the S&P 500, indexed to 0 at the most recent ISM peak in March of this year, underlining our thesis that, despite being past the peak of the ISM, the S&P 500 has not yet seen its best days. Please see this week's Special Report for more details, including an analysis of the durations of each phase of the late cycle as well as sector winners & losers as the cycle draws to a close. Portfolio Positioning For A Late Cycle Surge Portfolio Positioning For A Late Cycle Surge

Highlights Bond Bear Market: TIPS breakeven inflation rates are still below target, and this gives us high conviction that Treasury yields will increase on a cyclical horizon. If we assume that the equilibrium fed funds rate is approximately 3%, then the cyclical peak for the 10-year Treasury yield will likely occur between 3.35% and 3.52%. Interest Sensitive Spending: The robust performance of the cyclical sectors of the economy suggests that monetary policy remains accommodative. When growth in these interest rate-sensitive sectors starts to slow it will be a good signal that we are approaching the cyclical peak in Treasury yields. Bond Yields & Gold: A breakout to a significantly higher gold price could signal that the equilibrium fed funds rate needs to be revised up, suggesting a much higher cyclical peak for Treasury yields. Feature Chart 1The Bear Is Back The Bear Is Back The Bear Is Back After a brief pause in March, the cyclical bond bear market has resumed. The 10-year Treasury yield even briefly broke above 3% last week, with its 27 basis point rise off the early-April lows evenly split between the compensation for inflation protection and the 10-year real yield (Chart 1). To mark the occasion of the 10-year Treasury yield breaking above 3% for the first time since early 2014, this week we update our roadmap for the Two-Stage Cyclical Bond Bear Market, which we first outlined in late February.1 Specifically, we consider the questions of where the 10-year Treasury yield might be by the end of this year, and where it might ultimately peak for the cycle. On the second question we think bond investors can glean important information from trends in the price of gold. Tracking The Two-Stage Bear Market In our report from February we described how the cyclical Treasury bear market will proceed in two stages. The first stage is characterized by the re-anchoring of inflation expectations. Stage 1: The Re-Anchoring Of Inflation Expectations The 10-year TIPS breakeven inflation rate and the 5-year/5-year forward TIPS breakeven inflation rate currently sit at 2.17% and 2.25%, respectively. Historically, when core inflation is well anchored around the Fed's target, both of those breakeven rates have traded in a range between 2.3% and 2.5% (Chart 2). This means that nominal Treasury yields still have room to rise as the market prices in a more realistic outlook for inflation. That could happen sooner rather than later. Core PCE inflation increased 0.15% in March, causing the 12-month rate of change to jump from 1.57% to 1.88% (Chart 2, bottom panel). Meanwhile, the annualized 3-month and 6-month rates of change remain well above the Fed's 2% target. Looking further out, we see inflationary pressures continuing to build in the U.S. economy. The employment data now clearly show very little slack in the labor market, and this appears to be finally filtering through to wages. The Employment Cost Index for Wages & Salaries rose 0.9% in the first quarter, its largest quarterly increase since 2007. The year-over-year growth rate in the index moved up to 2.7%, from 2.6% in Q4, and is right in line with its predicted value based on the prime age employment-to-population ratio (Chart 3).2 Chart 2Stage 1 Almost Complete Stage 1 Almost Complete Stage 1 Almost Complete Chart 3Faster Wage Growth Ahead A Signal From Gold? A Signal From Gold? As long as TIPS breakeven inflation rates remain below our target range we have high conviction that Treasury yields will increase, driven by a re-anchoring of inflation expectations. Once our TIPS breakeven target is met, the cyclical bond bear market will transition to stage two. Stage 2: The Terminal Fed Funds Rate After inflation expectations are re-anchored around the Fed's target, the most important question for bond investors becomes: How high will the Fed need to lift the policy rate to keep inflation from moving well above target? Or alternatively: What is the terminal (or peak) fed funds rate for this cycle (see Box)? Box: The Terminal Fed Funds Rate & The Equilibrium Fed Funds Rate Please note that in this report we refer to two separate, though related, concepts. We define the terminal fed funds rate as the peak fed funds rate for the business cycle. We also define the equilibrium fed funds rate as the fed funds rate that is consistent with neither an accommodative nor a restrictive monetary policy. The terminal fed funds rate is almost certainly higher than the equilibrium fed funds rate because monetary policy will likely turn restrictive before the end of the economic cycle. Chart 4Treasury Yield Models Treasury Yield Models Treasury Yield Models We can show why this question is so important using a simple model of Treasury yields based on expectations for changes in the fed funds rate and the MOVE index of implied rate volatility. The latter is a proxy for the term premium embedded in Treasury yields (Chart 4). For example, if we assume that the equilibrium fed funds rate - the rate consistent with neither accommodative nor restrictive monetary policy - is approximately 3%, and that by the end of this year the yield curve will price in a return to neutral monetary policy by the end of 2019. That would be consistent with a 10-year Treasury yield between 3.03% and 3.19% by the end of this year, assuming also that the MOVE index ranges between its current level and its historical low. This result can be seen in Table 1 by looking at the rows consistent with three rate hikes in 2018 and a 12-month discounter of 75 bps by year end. We could also assume that the equilibrium fed funds rate is 3%, but that the market will start to price in a restrictive monetary policy by the end of 2019 - i.e. a fed funds rate above its equilibrium level. That result would be consistent with a 10-year Treasury yield between 3.35% and 3.52% by the end of this year, once again assuming that the MOVE index ranges between its current level and its historical low. The bottom line is that with TIPS breakeven inflation rates still below target, we have high conviction that yields will increase on a cyclical horizon. Beyond that, if we assume that a 3% fed funds rate is roughly consistent with a neutral monetary policy stance, then we should expect the cyclical peak in the 10-year Treasury yield to be in a range between 3.35% and 3.52%. Tracking The Equilibrium Fed Funds Rate Using Nominal GDP And Gold It's worth pointing out that both examples in the prior section assumed that the MOVE index will either stay flat or decline. The reason for that assumption is that both examples assume a relatively low equilibrium fed funds rate of 3%. In other words, both examples assume that monetary policy will turn restrictive once the fed funds rate moves above 3%, causing economic growth to slow. If that assumption proves to be correct, and with the 10-year Treasury yield already close to 3%, the yield curve will undoubtedly flatten as the fed funds rate is raised. A flatter yield curve is highly correlated with lower implied rate volatility. In order for implied rate volatility to move meaningfully higher, and for us to see a much higher 10-year Treasury yield (as is shown in the bottom third of Table 1), the market will need to start discounting a higher equilibrium fed funds rate. Put differently, investors would have to believe that the fed funds rate necessary to slow economic growth and inflation is much higher than 3%. It is only in that scenario that the cyclical peak for the 10-year Treasury yield will significantly exceed the 3.35% to 3.52% range posited in the prior section. Table 1Treasury Yield Projections Under Different Scenarios A Signal From Gold? A Signal From Gold? But how can we decide whether or not the equilibrium fed funds rate is higher than 3%? One imperfect way is to simply track economic growth and look for signs that it is about to slow. Cyclical Nominal GDP Growth Chart 5 shows that one good signal of a recession is when nominal GDP growth falls below the fed funds rate. While this is a fairly reliable recession indicator, it is not always a good method for determining when monetary policy turns restrictive. For example, prior to the last recession nominal GDP growth started to wane when it was still far above the level of the fed funds rate. If we had been waiting for the fed funds rate to exceed nominal GDP growth we would have missed the inflection point toward slower growth. The method worked better prior to the 1990 recession when the fed funds rate was lifted above the pace of nominal GDP growth while the latter was still accelerating. That configuration gave a much clearer real-time signal of restrictive monetary policy. Chart 5Cyclical Spending Suggests That Monetary Policy Remains Accommodative Cyclical Spending Suggests That Monetary Policy Remains Accommodative Cyclical Spending Suggests That Monetary Policy Remains Accommodative A more refined version of this approach is to track only the cyclical sectors of the economy - those sectors that are most sensitive to interest rates. Growth in those sectors - consumer spending on durable goods, residential investment and nonresidential investment for equipment and software - tends to deteriorate prior to major downturns in overall nominal GDP (Chart 5, bottom panel). This method gives us a slightly earlier warning that monetary policy has turned restrictive. On that note, we observe that while cyclical spending as a percent of overall GDP is still in an uptrend, its rate of increase has declined during the past few quarters (Chart 6). This is mostly due to somewhat weaker consumer spending on durables. But we doubt that cyclical spending is in danger of rolling over any time soon. Chart 7 shows that the fundamentals underpinning the key cyclical sectors of the economy remain robust: Consumer sentiment is elevated compared to history, and income growth has started to move higher (Chart 7, top panel). The latter will be helped along by recently enacted tax cuts during the next few months. New orders for core durable goods already display solid growth, and survey indicators give no signal of imminent deterioration (Chart 7, panel 2). On residential investment, homebuilder confidence is near historical highs (Chart 7, panel 3), while mortgage purchase applications so far seem immune from the effects of higher interest rates (Chart 7, bottom panel). Chart 6Cyclical Spending Still Rising... Cyclical Spending Still Rising... Cyclical Spending Still Rising... Chart 7...And Fundamentals Remain Sound ...And Fundamentals Remain Sound ...And Fundamentals Remain Sound At the moment, this analysis tells us that monetary policy is probably still accommodative. Once the cyclical sectors of the economy start to slow, that will give us a signal that monetary policy is restrictive and that we are probably near the cyclical peak in Treasury yields. Inflation, Uncertainty And The Price Of Gold But is there another method we can use to track the equilibrium fed funds rate and the stance of monetary policy in real time? We think there is, and it relates to investors' perceptions of inflationary pressures in the economy. First, we recognize that when inflationary pressures are higher, the equilibrium fed funds rate is also higher. In other words, the Fed needs to lift rates further before monetary policy becomes restrictive and inflation starts to flag. This intuition is confirmed by the historical relationship between long-run inflation forecasts and the short-term interest rate (Chart 8). More interestingly, we also observe that uncertainty about the long-run inflation forecast is positively related to implied interest rate volatility, the slope of the yield curve and the price of gold (Chart 9). Once again, this is intuitive. If investors are more uncertain about the long-run inflation outlook they will demand a greater risk premium to bear inflation risk in the long-run, thus driving long-dated bond yields higher. Chart 8Inflation Forecasts &##br## Interest Rates Inflation Forecasts & Interest Rates Inflation Forecasts & Interest Rates Chart 9Inflation Uncertainty Drives##br## The Term Premium Inflation Uncertainty Drives The Term Premium Inflation Uncertainty Drives The Term Premium The gold price is positively correlated with inflation uncertainty because gold is in many ways the "anti-Fed" asset. Since it is perceived to be a long-run store of value, investors will bid up the gold price whenever there is a heightened risk that the Fed might "fall behind the curve" allowing inflation to overshoot its target. Conversely, the gold price tends to fall when the perception is that the Fed is "ahead of the curve" and is maintaining an overly restrictive monetary policy. Chart 10Gold Has Led The Fed Gold Has Led The Fed Gold Has Led The Fed This is why bond investors would be wise to heed the signal from gold. A sharply rising gold price signals that the fed funds rate is running further below its equilibrium level. This could occur because the Fed is cutting rates to levels that the market deems too low. Or, it could occur because the market now believes that the equilibrium fed funds rate is higher. A sharply falling gold price gives the exact opposite signal. It tells us that either the Fed is lifting the funds rate too far above equilibrium, or that the market is revising down its assessment of the equilibrium rate. This chain of events played out before our eyes during the past few years. The gold price started to fall sharply in early 2013, and continued its decline until late 2015 (Chart 10). A signal that investors were discounting a more restrictive monetary policy stance during that timeframe. But the Fed was not lifting rates during that period. In fact, with hindsight it now seems obvious that the gold price was falling because the market was revising down its assessment of the equilibrium fed funds rate. Investors should also note that the falling gold price signaled a lower equilibrium fed funds rate well before the Fed started to revise down its median forecast for the interest rate that is expected to prevail in the "longer run".3 Tracking the price of gold would have given us a much timelier signal than waiting for the Fed. Chart 10 also shows that the gold price has rebounded since early 2016, but has been confined to a trading range during the past few months. Not coincidentally, this rebound has coincided with the Fed ceasing the downward revisions to its estimate of the equilibrium fed funds rate. Going forward, we think that bond investors would be wise to closely track the price of gold. A significant move higher in the gold price would be a strong signal that the Fed is not tightening policy quickly enough to contain inflationary pressures. In other words, it would signal that the equilibrium fed funds rate should be revised higher. This would drive up implied interest rate volatility, apply steepening pressure to the yield curve, and lead to a higher end-of-cycle target for the 10-year Treasury yield. Bottom Line: The robust performance of the cyclical sectors of the economy suggests that monetary policy remains accommodative. When growth in these interest rate-sensitive sectors starts to slow it will be a good signal that we are approaching the cyclical peak in Treasury yields. Bond investors should also track the price of gold. A breakout to a significantly higher gold price could signal that the equilibrium fed funds rate needs to be revised up, suggesting a much higher cyclical peak for Treasury yields. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 208, available at usbs.bcaresearch.com 2 In a recent report we showed that nonfarm payrolls need to increase by 110k or more per month to drive the prime age employment-to-population rate higher, leading to faster wage growth. For further details please see U.S. Bond Strategy Weekly Report, "Risk Review", dated April 10, 018, available at usbs.bcaresearch.com 3 The Fed's projection of the interest rate expected to prevail in the "longer run" is essentially its estimate of the equilibrium fed funds rate. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Global equities are poised for a "blow-off" rally over the next 12-to-18 months. Long-term return prospects, however, are poor. The final innings of the 1991-2001 economic expansion saw a violent rotation in favor of value stocks and euro area equities. We expect history to repeat itself. After sagging by as much as 7% in the second half of 1998 and going nowhere in 1999, the dollar rose by 13% between January 2000 and February 2002. The greenback today is similarly ripe for a second wind. The correlation between the dollar and oil prices was fairly weak in the late 1990s. The correlation is likely to weaken again now that U.S. crude imports have fallen by about 70% from their 2006 highs thanks to the shale boom. The U.S. 10-year Treasury yield peaked at 6.79% in January 2000. Thus far, there is scant evidence that the recent increase in bond yields is having a major effect on either U.S. capital spending or housing demand. This suggests yields can go higher before they enter restrictive territory. Feature Learning From The Past The theme of this year's BCA annual Investment Conference - which will be held in Toronto in September and will feature a keynote address by Janet L. Yellen - is, appropriately enough, entitled "Investing In A Late-Cycle Economy."1 In the spirit of our conference, this week's report looks back at the market environment at the tail end of the 1991-2001 expansion in order to distill some lessons for today. The mid-to-late 1990s was a tale of contrasts. The U.S. was thriving, spurred on by accelerating productivity growth, falling inflation, and a massive corporate capex boom. Southern Europe was also doing well, aided by falling interest rates and optimism about the coming introduction of the euro. On the flipside, Germany - dubbed by many pundits at the time as the sick man of Europe - was still coping with the hangover from reunification. Japan was mired in deflation. Emerging markets were melting down, starting with the Mexican peso crisis in late 1994, followed by the Asian crisis, and finally the Russian default. In the financial world, the following points are worth highlighting (Chart 1): Chart 1AFinancial Markets In The Late 1990s (I) Financial Markets In The Late 1990s (I) Financial Markets In The Late 1990s (I) Chart 1BFinancial Markets In The Late 1990s (II) Financial Markets In The Late 1990s (II) Financial Markets In The Late 1990s (II) Russia's default and the implosion of Long-term Capital Management (LTCM) led to a gut-wrenching 22% decline in the S&P 500 in the late summer and early fall of 1998. This was followed by a colossal 68% blow-off rally over the subsequent 18 months. The collapse of LTCM marked the low point for EM assets for the cycle. The combination of cheap currencies, rising commodity prices, and a newfound resolve to enact structural reforms paved the way for a major EM boom over the following decade. The VIX and credit spreads trended upwards during the late 1990s, even as U.S. stocks climbed higher. Rising equity volatility and wider spreads were partly a reaction to problems abroad. However, they also reflected the deterioration in U.S. corporate health and heightened fears that stock market valuations had reached unsustainable levels. The U.S. stock market peaked in March 2000. However, that was only because the tech bubble burst. Outside of the technology sector, the S&P 500 actually increased by 9.2% between March 2000 and May 2001. Value stocks finally began to outperform growth stocks in 2000, joining small caps, which had begun to outperform a year earlier. European equities also surged towards the end of the bull market, outpacing the U.S. by 34% in local-currency terms and 21% in dollar terms between July 1999 and March 2000. The strong U.S. economy during the late 1990s ushered in a prolonged period of dollar appreciation that lasted until February 2002. That said, the greenback did not rise in a straight line. The dollar fell by as much as 7% in the second half of 1998 as the Fed cut rates in response to the LTCM crisis. It went sideways in 1999 before resuming its upward trend in early 2000. The correlation between the dollar and oil prices was much weaker in the 1990s compared to the first 15 years of the new millennium. After falling from a high of 6.98% in April 1997 to 4.16% in October 1998, the 10-year U.S. Treasury yield rose to 6.79% in January 2000. The Fed would keep raising rates until May of that year. The recession began in March 2001. Now And Then Just as in the tail end of the 1990s expansion, the global economy is doing reasonably well these days. Growth has cooled over the past few months, but should remain comfortably above trend for the remainder of the year. After struggling in 2014-16, Emerging Markets are on the mend, thanks in part to the rebound in commodity prices. During the 1990s cycle, the U.S. was the first major economy to reach full employment. The same is true today. The headline unemployment rate has fallen to 4.1%, just shy of the 2000 low of 3.8%. The share of the working-age population out of the labor market but wanting a job is back to pre-recession levels. The same goes for the share of unemployed workers who have quit - rather than lost - their jobs (Chart 2). One key difference concerns fiscal policy. The U.S. federal budget was in great shape in 2000. The same cannot be said today. Chart 3 shows that the fiscal deficit currently stands at 3.5% of GDP. The deficit is on track to deteriorate to 4.9% of GDP in 2021 even if growth remains strong. Federal government debt held by the public is also set to rise to 83.1% of GDP in 2021, up from 33.6% of GDP in 2000. Unlike in the past, the U.S. government will have less scope to ease fiscal policy when the next recession rolls around. Chart 2An Economy At Full Employment An Economy At Full Employment An Economy At Full Employment Chart 3The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Further Upside For Global Bond Yields Deleveraging headwinds, excess spare capacity, slow potential GDP growth, and chronically low inflation have all conspired to keep a lid on global bond yields. That is starting to change. Credit growth has accelerated, while output gaps have shrunk. The structural outlook for productivity growth is weaker than it was in the 1990s, but a cyclical pickup is likely given the recent recovery in capital spending. Chart 4 shows that there is a reasonably strong correlation between business capex and productivity growth. On the inflation side, the 3-month annualized change in U.S. core CPI and core PCE has reached 2.9% and 2.8%, respectively. The prices paid component of the ISM manufacturing index hit a seven-year high in March. The New York Fed's Underlying Inflation Gauge has zoomed to 3.1% (Chart 5). The market has been slow to price in the prospect of higher U.S. inflation (Chart 6). The TIPS 10-year breakeven rate is still roughly 20 bps below where it traded in the pre-recession period, even though the unemployment rate is lower now than at any point during that cycle. As long-term inflation expectations reset higher, bond yields will rise. Higher inflation expectations will also push up the term premium, which remains in negative territory. Chart 4Pickup In Capex Brightens ##br##The Cyclical Productivity Outlook Pickup In Capex Brightens The Cyclical Productivity Outlook Pickup In Capex Brightens The Cyclical Productivity Outlook Chart 5Inflation##br## Is Coming... Inflation Is Coming... Inflation Is Coming... Inflation Is Coming... Inflation Is Coming... Chart 6...Which Could Take ##br##Bond Yields Higher ...Which Could Take Bond Yields Higher ...Which Could Take Bond Yields Higher The upward pressure on yields could be amplified if the market revises up its assessment of the terminal real rate. Perhaps in a nod to what is to come, the Fed revised its terminal fed funds projection from 2.8% to 2.9% in the March 2018 Summary of Economic Projections. However, this is still well below the median estimate of 4.3% shown in the inaugural dot plot in January 2012. The U.S. Economy Is Not Yet Succumbing To Higher Rates For now, there is little evidence that higher rates are having a major negative effect on the economy. Business capital spending has decelerated recently, but that appears to be a global phenomenon. Capex has weakened even more in Japan, where yields have barely moved. In any case, the slowdown in U.S. investment spending has been fairly modest. Core capital goods orders disappointed in March, but are still up 7% year-over-year. Likewise, while our capex intention survey indicator has ticked lower, it remains well above its historic average. And despite elevated corporate debt levels, high-yield credit spreads are subdued and banks continue to ease lending standards for commercial and industrial loans (Chart 7). In the household realm, delinquency rates are rising and lending standards are tightening for auto and credit card loans. However, this has more to do with excessively strong lending growth over the preceding few years than with higher interest rates. Particularly in the case of credit card lending, even large movements in the fed funds rate tend to translate into only modest percent changes in debt service payments because of the large spreads that lenders charge on unsecured loans. The financial obligation ratio - a measure of the debt service burden for the average household - is rising but is still close to the lowest levels in three decades. Mortgage debt, which accounts for about two-thirds of all household credit, is near a 16-year low as a share of disposable income (Chart 8). As Ed Leamer perceptively argued in his 2007 Jackson Hole address entitled "Housing Is The Business Cycle," housing is the main avenue by which monetary policy affects the real economy.2 Similar to business capital spending, while the housing data has leveled off to some extent, it still looks pretty good: Building permits and housing starts continue to rise. New and existing home sales rebounded in March. Home prices have accelerated. The S&P/Case Shiller Home Price Index saw its strongest month-over-month gain in February since 2005. The MBA Mortgage Applications Purchase Index is up 11% year-over-year. The percentage of households looking to buy a home in the next six months is at a cycle high. Homebuilder sentiment has dipped slightly, but it remains at rock-solid levels (Chart 9). Chart 7Capital Spending ##br##Still Quite Robust Capital Spending Still Quite Robust Capital Spending Still Quite Robust Chart 8Household Debt Load And Financial Obligations##br## Are At Pre-Housing Bubble Levels Household Debt Load And Financial Obligations Are At Pre-Housing Bubble Levels Household Debt Load And Financial Obligations Are At Pre-Housing Bubble Levels Chart 9The Housing Sector##br## Is Doing Fine The Housing Sector Is Doing Fine The Housing Sector Is Doing Fine Fixed-Income: Hedged Or Unhedged? Bond positioning is quite short, so a temporary dip in yields is probable. However, investors should expect bond yields to rise more than is currently discounted over the next 12 months. BCA's fixed income strategists favor cyclically underweighting the U.S., Canada, and core Europe, while overweighting Australia, the U.K., and Japan in currency-hedged terms. Table 1 shows that the hedged yield on U.S. 10-year Treasurys is only 20 bps in EUR terms, and 38 bps in yen terms. Table 1Global Bond Yields: Hedged And Unhedged Investing In A Late-Cycle Economy: Lessons From The 1990s Investing In A Late-Cycle Economy: Lessons From The 1990s The low level of hedged U.S. yields today means that Treasurys are unlikely to enjoy the same inflows as in the past from overseas investors. This could push yields higher than they otherwise would go. To gain the significant yield advantage that U.S. government debt now commands, investors would need to go long Treasurys on a currency-unhedged basis. For long-term investors, this is a tantalizing investment. The current spread between 30-year Treasurys and German bunds stands at 192 bps. The euro would have to appreciate to 2.15 against the dollar for buy-and-hold investors to lose money by going long Treasurys relative to bunds.3 Such an overshoot of the euro is unlikely to occur, especially since the structural problems haunting Europe are no less daunting than those facing the United States. A Pop In The Dollar? Admittedly, the near-term success of a strategy that buys Treasurys, currency-unhedged, will hinge on what happens to the dollar. As occurred at the turn of the millennium, the dollar could find a bid as the Fed is forced to raise rates more aggressively than the market is pricing in. In this regard, large-scale U.S. fiscal stimulus, while arguably bearish for the dollar over the long haul, could be bullish for the dollar in the near term. My colleague Jennifer Lacombe has observed that flows into U.S.-listed European equity ETFs, such as those offered by iShares (EZU) and Vanguard (VGK), have reliably led the euro-dollar exchange rate by about six months (Chart 10).4 Recent outflows from these funds augur poorly for the euro. Rising hedging costs could also prompt more investors to buy U.S. fixed-income assets currency-unhedged, which would raise the demand for dollars (Chart 11).5 Chart 10ETF Flows Point To Lower EUR/USD ETF Flows Point To Lower EUR/USD ETF Flows Point To Lower EUR/USD Chart 11The Dollar Could Bounce The Dollar Could Bounce The Dollar Could Bounce The Oil-Dollar Correlation May Be Weakening Investors are accustomed to thinking that the dollar tends to be inversely correlated with oil prices. That relationship has not always been in place. Brent bottomed at just over $9/bbl in December 1998. Crude prices tripled over the subsequent 20 months. The broad trade-weighted dollar actually rose by 5% over that period. The dollar has strengthened by 2.8% since hitting a low on September 8, 2017, while Brent has gained 37% over this period. This breakdown in the dollar-oil correlation harkens back to late 2016: Brent rose by 26% between the U.S. presidential election and the end of that year. The dollar appreciated by 4% during those months. We are not ready to abandon the view that a stronger dollar is generally bad news for oil prices. However, the relationship between the two variables seems to be fading. Chart 12 shows that the two-year rolling correlation coefficient of monthly returns for Brent crude and the broad trade-weighted dollar has weakened in recent years. Chart 12The Negative Dollar-Oil Correlation Has Weakened The Negative Dollar-Oil Correlation Has Weakened The Negative Dollar-Oil Correlation Has Weakened This is not too surprising. Thanks to the shale boom, U.S. oil imports have fallen by about 70% since 2006 (Chart 13). This has made the U.S. trade balance less sensitive to changes in oil prices. The recent surge in oil prices has also been strengthened by OPEC 2.0's decision to reduce the supply of crude hitting the market, ongoing turmoil in Venezuela, and the possibility that Iranian sanctions could take 0.3-0.8 million barrels a day off the market. A reduction in oil supply is bad for global growth at the margin. However, weaker global growth is good for the dollar (Chart 14). OPEC's production cuts also increase the scope for U.S. shale producers to gain global market share over the long haul, which should help the greenback. As such, while a modestly strong dollar over the remainder of the year will be a headwind for oil, it may not be a strong enough impediment to prevent Brent from rising another $6/bbl to reach $80/bbl, as per our commodity team's projections. Chart 13U.S. Oil Imports ##br##Have Collapsed U.S. Oil Imports Have Collapsed U.S. Oil Imports Have Collapsed Chart 14Slowing Global Growth Tends##br## To Be Bullish For The Dollar Slowing Global Growth Tends To Be Bullish For The Dollar Slowing Global Growth Tends To Be Bullish For The Dollar The Outlook For Equities Following the script of the late 1990s, stock market volatility has risen this year, as investors have begun to fret about the durability of the nine year-old equity bull market. Valuations are not as extreme as they were in 2000, but they are far from cheap. The Shiller P/E for U.S. stocks stands at 31, consistent with total nominal returns of only 4% over the next decade (Chart 15). On a price-to-sales basis, U.S. stocks have surpassed their 2000 peak (Chart 16). Such a rich multiple to sales can be justified if profit margins stay elevated, but that is far from a sure thing. Yes, the composition of the stock market has shifted towards sectors such as technology, which have traditionally enjoyed high margins. The explosion of winner-take-all markets has also allowed the most successful companies to dominate the stock market indices, while second-tier companies get pushed to the sidelines (Chart 17). Chart 15Long-Term Investors, Take Note Long-Term Investors, Take Note Long-Term Investors, Take Note Chart 16U.S. Stocks Are Pricey U.S. Stocks Are Pricey U.S. Stocks Are Pricey Chart 17Only The Best Investing In A Late-Cycle Economy: Lessons From The 1990s Investing In A Late-Cycle Economy: Lessons From The 1990s Nevertheless, there continues to be a strong relationship between economy-wide profits and the ratio of selling prices-to-unit labor costs (Chart 18). The latest data suggest that U.S. wage growth has picked up in the first quarter (Table 2). Low-skilled workers, whose wages tend to be better correlated with economic slack than those of high-skilled workers, are finally seeing sizable gains. Chart 18U.S. Profit Margins Could Resume Mean-Reverting... U.S. Profit Margins Could Resume Mean-Reverting... U.S. Profit Margins Could Resume Mean-Reverting... Table 2...If Wage Growth Continues Accelerating Investing In A Late-Cycle Economy: Lessons From The 1990s Investing In A Late-Cycle Economy: Lessons From The 1990s Even if productivity growth accelerates, unit labor costs are likely to rise faster than prices, pushing profit margins for many companies lower. Bottom-up analysts expect annual EPS growth to average more than 15% over the next five years, a level of optimism not seen since 1998 (Chart 19). The bar for positive surprises on the earnings front is getting increasingly high. Go For Value Historically, stocks tend not to peak until about six months before the start of a recession. Given our expectation that the next recession will occur in 2020, global equities could still enjoy a blow-off rally after the current shakeout exhausts itself. But when the music stops, the stock market is heading for a mighty fall. Given today's lofty valuations and the uncertainty about the precise timing of the next recession, we would certainly not fault long-term investors for taking some money off the table. For those who feel compelled to stay fully invested, our advice is to shift allocations towards cheaper alternatives. Value stocks have massively underperformed growth stocks for the past 11 years (Chart 20). Today, value trades at a greater-than-normal discount to growth. Earnings revisions are moving in favor of value names. Just like at the turn of the millennium, it may be value's turn to shine. Chart 19The Bar For Positive Earnings Surprises Has Risen The Bar For Positive Earnings Surprises Has Risen The Bar For Positive Earnings Surprises Has Risen Chart 20Value Stocks: An Attractive Proposition Value Stocks: An Attractive Proposition Value Stocks: An Attractive Proposition Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For more information about our Investment Conference, please click here or contact your account manager. 2 Edward E. Leamer, "Housing Is The Business Cycle," Proceedings, Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, (2007). 3 To arrive at this number, we multiply the current exchange rate by the degree to which EUR/USD would have to strengthen, on average, every year for the next 30 years in order to nullify the carry advantage of holding Treasurys over bunds. Thus, 1.217*(1.0192)^30=2.15. Granted, investors expect inflation to be about 45 bps lower in the euro area than in the U.S. over the next three decades. However, this would only lift the Purchasing Power Parity (PPP) value of EUR/USD from its current level of 1.32 to 1.51. This would still leave the euro 42% overvalued. 4 Please see Global ETF Strategy Special Report, "Do ETF Flows Lead Currencies?" dated April 18, 2018. 5 When a foreign investor buys U.S. bonds currency-hedged, this entails two transactions. First, the investor must purchase the bond, and second, the investor must sell the dollar forward (which is similar to shorting it). The former transaction increases the demand for dollars, while the latter increases the supply of dollars. Thus, as far as the value of the dollar is concerned, it is a wash. In contrast, if foreign investors buy bonds currency-unhedged, there is no offsetting increase in the supply of dollars, and hence the dollar will tend to strengthen. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Dear Client, Alongside this week's report we are also sending you a fascinating short Special Report written by Jennifer Lacombe of our Global ETF Strategy sister service. The report, which demonstrates the use of ETF flows as a leading indicator of FX trends, points to downside for the EUR/USD and GBP/USD this year. I trust you find the piece informative. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights A debate over slack is raging within the ECB. We tend to side with President Draghi, and believe there is more labor market slack in the euro area than suggested by the OECD's measures. Arguing in favor of this case is the presence of hidden labor market slack, the paucity of wage gains, even in Germany, and the potential for NAIRU to decline in many large economies. With global and European growth slowing, this will limit how hawkish the ECB can be in the short term, and thus limits the euro's gains in 2018. However, on a long-term basis, the presence of slack today argues that the euro area's potential GDP is higher than if there were no slack, and therefore policy rates and the euro have more long-term upside. Feature The recent release of the European Central Bank's account of its March policy meeting was very revealing. The ECB is currently torn between two camps: one believing there is little slack in the euro area labor market, and the other, led by ECB President Mario Draghi and chief economist Peter Praet, arguing that the continent's job market is still replete with excess capacity. This debate has enormous implications for the path of the euro. If there is no slack left in the euro area, this would point to an immediate need for higher rates and a higher euro, but it would also suggest the scope for the terminal policy rate in Europe to rise is limited. The long-term upside in the euro would therefore also be small. If there is still a large amount of slack in the euro area labor market, this implies that policy rates do not have much scope to rise over the next 18 months, and that the euro will find it difficult to appreciate much over this time frame. However, it also suggests that the potential growth rate of the euro area is higher than would otherwise be the case and that terminal policy rates can rise more in the long-run - implying that on a long-term basis the euro still has meaningful upside. We side in the latter camp. Chart I-1No Slack In Europe? No Slack In Europe? No Slack In Europe? Hidden Labor Market Slack... The question of slack in the euro area has been ignited by a simple reality: both the OECD's measure of the European output gap and the difference between the official unemployment rate and the equilibrium unemployment rate calculated by the OECD (NAIRU) are close to zero (Chart I-1). This observation would vindicate the desire of some ECB members to increase rates sooner than later, since the absence of an unemployment gap should lead to both higher wages and higher inflation. But before making too prompt a judgment, the U.S.'s recent experience is illuminating. Only now that the unemployment rate is 0.5% below NAIRU are U.S. wages and core inflation showing some signs of life (Chart I-2). In the U.S., we observed that while the headline unemployment rate has been consistent with accelerating wages as early as in 2015, discouraged workers back then represented 0.4% of the working age population, and were in fact willing participants in the job market. Only now that this number has fallen back to 0.27% - levels associated with full-employment in the previous business cycle - are employment costs perking up. There is little reason to believe that the eurozone economy is very different from the U.S. in this respect. In fact, the euro area suffered a double-dip recession, the second leg of which ended only in 2013, suggesting Europe suffered a severe enough shock to also fall victim to the symptoms of hidden labor market slack. A simple comparison helps illustrates that Europe is likely to still be experiencing labor market slack. Chart I-3 shows various measures of total and hidden labor market slack in the U.S. and the euro area. To begin with, despite a sharp rise in the female participation rate, the euro area's employment-to-population ratio for prime-age workers is not only well below the level that currently prevails in the U.S., it is also below its 2008 peak by a greater extent than is the case on the other side of the Atlantic. This suggests there is greater total labor market slack in Europe than in the U.S. Additionally, discouraged workers and long-term unemployment remain much closer to post-crisis highs in the euro area than in the U.S. In the latter, these ratios have mostly normalized close to levels consistent with full employment. Chart I-2The U.S. Experience WIth##br## Hidden Labor Market Slack The U.S. Experience WIth Hidden Labor Market Slack The U.S. Experience WIth Hidden Labor Market Slack Chart I-3The Euro Area Still Has ##br##Plenty Hidden Slack The Euro Area Still Has Plenty Hidden Slack The Euro Area Still Has Plenty Hidden Slack Looking at some euro area-specific variables also dispels the idea that the European job market is near full employment and about to generate inflation: The ECB's labor underutilization measure1 still shows a high level of slack, especially in the European periphery (Chart I-4). Another problem for Europe is irregular work contracts. Europe, like Japan, is plagued with a dual labor market. On one hand, permanent employees are still protected by generous employment laws. On the other hand, employees under temporary work contracts are not. In Japan, this same disparity has been blamed for keeping wages down, as temporary employees are often willing to switch to positions offering the protection of regular job contracts for no wage increases. These workers are a form of hidden labor-market slack. Temporary employment in Europe remains at elevated levels, and contract work represents a record share of employment in Italy and France (Chart I-5), suggesting the same disease present in Japan also lingers in vast swaths of the European economy. Chart I-4The ECB's Metrics Also Show ##br##Elevated Labor Underutilization The ECB's Metrics Also Show Elevated Labor Underutilization The ECB's Metrics Also Show Elevated Labor Underutilization Chart I-5A Dual Labor Market Weighs ##br##On Wage Growth A Dual Labor Market Weighs On Wage Growth A Dual Labor Market Weighs On Wage Growth Labor reforms could also be creating labor market slack in Europe. As Chart I-6 shows, after Germany implemented its Hartz IV labor reforms in 2004, NAIRU collapsed. Spain, which has implemented equally draconian measures, could also witness its own equilibrium unemployment rate trend sharply lower over the coming years (Chart I-6, bottom panel). In France, timid reforms were implemented during the Hollande presidency, but President Macron is pushing an agenda of deep job market reforms. While Italy remains a laggard and its current political miasma offers little hope, the reality remains that much of Europe could also be experiencing a decline in NAIRU like Germany did last decade. Even Germany shows limited signs of an overheating labor market, despite an unemployment rate of 5.3%, the lowest reading ever in re-unified Germany: not only have German wages been unable to advance at a faster pace than the experience of the past 15 years, recent quarters have seen a slowdown in wage growth (Chart I-7). The presence of slack in the rest of Europe therefore appears to be limiting wage pressures even in that booming economy. Chart I-6The Impact Of Labor Reforms##br## On Full Employment The Impact Of Labor Reforms On Full Employment The Impact Of Labor Reforms On Full Employment Chart I-7No Wage Growth##br## In Germany No Wage Growth In Germany No Wage Growth In Germany Bottom Line: The euro area is likely to be under the same spell as the U.S. was a few years ago. Traditional metrics portend a labor market at full employment, but broader measures in fact highlight that there is still plentiful slack. Additionally, the implementation of labor market reforms in key European economies in recent years could imply that Europe's NAIRU is lower than the OECD's estimate and may further decline in coming years. ... And Slowing Global Growth It is one thing for Europe to be experiencing hidden labor market slack, but if growth is set to accelerate further, this would mean that this slack could nonetheless dissipate fast enough to allow for a more hawkish ECB in the short run. However, this is not the case. The European economy is very sensitive to global growth gyrations, and signs are accumulating that the global synchronized boom is petering out. As we have already highlighted, the diffusion index of the OECD global leading economic indicator has plummeted well below the boom/bust line, pointing to a sharp slowdown in the LEI itself (Chart I-8, top panel). EM carry trades have been underperforming, which normally leads a slowdown in global industrial activity (Chart I-8, middle panel). Additionally, Japanese export growth is decelerating sharply (Chart I-8, bottom panel). In a previous report we attributed major responsibility for this slowdown to monetary, fiscal and regulatory tightening in China. Europe is not immune to this malaise. European exports growth and foreign orders are all slowing sharply, but interestingly domestic factors are also at play. As the top panel of Chart I-9 illustrates, the European credit impulse is now contracting, suggesting domestic demand is set to slow. In fact, this has already begun as the growth of German domestic manufacturing orders is in negative territory (Chart 9, bottom panel). Chart I-8Global Growth Is Slowing Clouds##br## Hanging Over Global Growth Global Growth Is Slowing Clouds Hanging Over Global Growth Global Growth Is Slowing Clouds Hanging Over Global Growth Chart I-9Euro Area Domestic##br## Growth Is Flagging Euro Area Domestic Growth Is Flagging Euro Area Domestic Growth Is Flagging No matter the source, the end result for Europe is the same: the torrid pace of European growth is set to slow, not accelerate. Not only have European economic surprises fallen precipitously (Chart I-10, top panel), but the Ifo survey - a key bellwether of German activity - has also peaked. Moreover, the Sentix survey points to a sharp slowdown in the manufacturing PMIs (Chart I-10, bottom panel). Because there is slack in the European economy and growth is set to slow, there is a good reason for the Draghi-led ECB to remain very cautious in the coming quarters before sounding hawkish. As a result, the euro faces strong headwinds over the next six months or so, especially as the Federal Reserve faces milder handicaps than the ECB: U.S. economic slack has dissipated and U.S. inflation is rising. These inflationary pressures could even intensify thanks to U.S. President Donald Trump's late-cycle fiscal stimulus. Relative growth dynamics also support the dollar this year as euro area industrial production is already lagging behind the U.S. (Chart I-11). This trend is set to continue for the coming quarters because the U.S. economy is less exposed to a global growth slowdown and U.S. households' are experiencing sharply accelerating disposable income growth, a support for domestic demand. Chart I-10Weakening European ##br##Growth Outlook Weakening European Growth Outlook Weakening European Growth Outlook Chart I-11European Growth Will ##br##Underperform The U.S. Further European Growth Will Underform The U.S. Further European Growth Will Underform The U.S. Further Bottom Line: Not only is there still slack in the euro area labor market, global growth is showing signs of a slowdown. This is likely to have a deleterious impact on European growth as the eurozone credit impulse is already contracting. As a result, European growth is likely to lag that of the U.S., an economy where there is no more slack, and where inflation is perking up. This combination represents a potent headwind for the euro over the next six months or so. The Euro Cyclical Bull Market Is Far From Over The combination of slowing global growth and labor market slack in the euro area suggests the euro may depreciate by six to eight cents over the next six months, but it does not sound the death knell of the euro's cyclical rally. To the contrary, the presence of slack in Europe suggests the euro still has significant cyclical upside. Historically, the euro performs well when the U.S. business cycle enters the last two years of expansion (Chart I-12). This is because European growth begins to outperform U.S. growth in the late stages of the economic cycle, allowing investors to upgrade their assessment of the path of long-term monetary policy in the euro area relative to the U.S. This time an additional impetus could emerge. If there is more slack in the euro area than traditional unemployment metrics imply, the euro area's potential GDP is also higher than these traditional metrics would submit - i.e. trend growth in Europe could be higher than once thought. The impact of labor market reforms in France and Spain further bolster this possibility. A consequence of a higher trend growth rate would also be a higher than originally assessed level for euro area neutral interest rates, or the so-called r-star. The European five-year forward 1-month OIS could therefore have significant upside from current levels (Chart I-13, top panel). This would also imply that expected rates in Europe have room to increase versus the U.S., lifting the euro in the process (Chart I-13, bottom panel). Chart I-12The Euro Rallies Late##br## In The Business Cycle The Euro Rallies Late In The Business Cycle The Euro Rallies Late In The Business Cycle Chart I-13European Slack Today Means ##br##Higher Rates Tomorrow European Slack Today Means European Slack Today Means European Slack Today Means European Slack Today Means Bottom Line: The presence of slack in Europe suggests that its potential GDP is higher than once thought. Hence, Europe could still have a few more years of robust growth in front of her. The following paradox ensues: if the presence of slack limits the upside for European interest rates today, it also suggests that European policy rates can rise much more in the future than if there was no slack today. Therefore, while this limits the capacity of the euro to rise further this year, the euro cyclical bull market has much more upside than if there was no slack in Europe today. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 This underutilization measure is based on the number of unemployed and underemployed, those available to work but not seeking a job and those seeking a job but not available for one. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was decent: Retail sales ex. Autos increased at a 0.2% monthly pace, in line with expectations; Housing starts and building permits both beat expectations, coming in at 1.319 million and 1.354 million, respectively; Industrial production grew by 0.5% at a monthly pace, beating expectations; Capacity utilization also increased to 78%; Continuing and initial jobless claims both came out higher than expected; U.S. data continues to generally beat expectations, especially when contrasted with European data, representing a sharp reversal from last year's environment. The yield curve has flattened which has weighed on the greenback preventing the USD from rallying despite an outperforming U.S. economy. Report Links: U.S. Twin Deficits: Is The Dollar Doomed? - April 13, 2018 More Than Just Trade Wars - April 6, 2018 Do Not Get Flat-Footed By Politics - March 30, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data has been disappointing: German Wholesale price index increased by only 1.2%, less than the expected 1.5%; European industrial production grew at a 2.9% yearly pace, less than expectations of 3.8%; The ZEW Economic Sentiment and Current Situation Survey for Germany disappointed; European headline inflation disappointed, coming in at 1.3%, while core was in line with expectations of 1%. Signs of a slowdown are now emerging in European data, however the euro has yet to follow. The euro area's leading economic indicator is rolling over, suggesting that cyclical factors could drag the euro down in the coming months. The waning of inflationary pressures across the euro area is likely prompt a dovish tone in upcoming ECB communications, which will induce a downward revision in rate expectations by investors. Report Links: More Than Just Trade Wars - April 6, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been negative: Exports yearly growth underperformed expectations, coming in at 2.1%. Moreover, imports yearly growth also surprised to the downside, coming in at -0.6%. Finally industrial production yearly growth also disappointed, coming in at 1.6%. USD/JPY has remained relatively flat this week. Overall, we expect that the yen will continue to appreciate, as global geopolitical risks are on the rise and a potential slowdown in China's growth could will likely lead to a pick-up in FX market volatility. On the other hand, the yen remains at risk in the long term, given that economic data continues to underperform due to the strong yen and Japan's great exposure to global growth. This means that the BoJ will have to keep policy easy in order to support the economy. Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Headline inflation underperformed expectations, coming in at 2.5%. Moreover, core inflation also surprised negatively, coming in at 2.3%. Retail prices yearly growth also underperformed, coming in at 3.3%. However, the ILO unemployment rate surprised positively, coming in at 4.2%. After being up nearly 1.4% this week, GBP/USD fell more than a percentage point following the disappointing inflation numbers. Overall, the data follows our prediction from a couple of weeks ago: inflation in the U.K. is set to decline substantially despite a tightening labor market. This is because inflation in the U.K. is mainly driven by previous currency movements. Therefore, given the steep appreciation of the pound since 2017, prices will likely fall, causing the hawkishly-priced BOE to tighten less than expected, hurting the pound in the process. Report Links: Do Not Get Flat-Footed By Politics - March 30, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The Aussie has traded in a wave pattern against the greenback since the beginning of 2016. This week, AUD once again rebounded off the trough of the wave, catalyzed by higher prices in the metals space. Recent announcements by Anglo-Australian group BHP Billiton about curtailing production forecasts provided a boost to iron ore prices. This was coupled with the PBOC's decision to cut banks' reserve requirements which is raising the specter of a potential reflation wave in China. While, for now, external factors are proving to be positive for the Antipodean economy and its currency, the domestic story remains the same: labor market slack, high debt loads, and not enough wage inflation. Recent employment figures confirm this reality: employment grew by only 4,900, driven by a decline in full-time employment of 19,900. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been mixed: The food price index month-on-month growth came in at 1%. Meanwhile, headline inflation came in at 1.1%, in line with expectations. NZD/USD has fallen by nearly 1.3% this week. Overall, we expect that the NZD will suffer in the current environment of rising volatility and geopolitical risks. Moreover, on a long term basis, the kiwi continues to be at risk, given that the new populist government is set to decrease immigration and implement a dual mandate for the RBNZ; both factors would lower the real neutral rate. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 This year's disappointing first quarter GDP growth of 1.7% QoQ growth was regarded as an important factor in the BoC's decision this week to hold interest rates unchanged. The statement recognized the weaker housing market and flailing exports as the two culprits in this development. Bank officials denoted the tight capacity utilization as a constraint to further export growth, stating that growth will not be sufficient "to recover the ground lost during recent quarters". While this was an overall dovish policy statement, the Bank still continues to see robust growth going forward, revising their 2019 growth forecast from 1.6% to 2.1%. Importantly, this revision widened the output gap as the potential growth rate was revised higher. In terms of monetary policy, investors still predict two more rate hikes this year, bringing the benchmark rate to 1.75%, which is still below the Bank's estimated neutral rate of 2.5% - 3.5%. This means that if NAFTA is not abrogated in any major way - our base case scenario for the current negotiations - there is still plenty of upside for Canadian rates, and therefore, the CAD. Report Links: More Than Just Trade Wars - April 6, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 EUR/CHF has gone up by 1% this week. Overall, we continue to believe that the franc will continue to depreciate on a cyclical basis, given that Swiss inflationary pressures remain too weak and economic activity is still highly dependent on the easy monetary conditions brought about by the weak franc and low rates. Therefore, the SNB will remain very dovishly enclined in order to keep an appreciating franc from hurting the economy. Moreover, the Swiss franc continues to be expensive, putting further downward pressure on this currency. On a tactical basis however, this cross could have some downside in an environment of rising volatility and rising geopolitical risk. Report Links: The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 USD/NOK has been relatively flat this week. We continue to be negative on the krone against the U.S. dollar, even in an environment of rising oil prices. This is because this cross is more correlated to real rate differential than it is to crude. Therefore, in an environment where the Fed hikes more than expected, real rates should move in favor of the U.S., helping USD/NOK in the process. That being said, the krone will likely outperform other commodity currencies like the AUD, as oil has a relatively lower beta than industrial metals to global growth and Chinese economic activity. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 A slight economic slowdown is still being felt in the Scandinavian economy. As leading economic indicators in both Sweden and the euro area roll over, disinflationary winds continue to batter Swedish shores. As a result, EUR/SEK continues to trade at lofty levels, especially as global investors remain nervous about the risks of a global trade war. The Swedish yield curve has flattened 53 bps since January highs, which is one of the most severe moves in the G-10. It seems that Stefan Ingves' extreme dovishness is again being taken seriously by investors, especially as core CPI is at a mere 1.5%, despite CPIF clocking in at 2%. This core measure and global reflation will need to pick up for Ingves to change his view. While the SEK is cheap, and thus have limited downside from current levels, this economic backdrop suggests it is still risky for short-term investors to buy the SEK. Long-term players, however, should use current weaknesses as a buying opportunity. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Markets have been uneasy recently; last month saw the Fed raise rates, combined with language indicating a steeper path for interest rate moves in the coming two years. As of writing, markets are currently assigning a nearly 75% probability of at least two further rate hikes this year alone. However, amidst the Fed's tightening, the government has been embarking on fiscal largess. The recent tax cuts, budget announcements and potential infrastructure bill mean that we have entered a fairly rare period of loose fiscal policy and tight monetary policy; in our October 9th, 2017 Weekly Report, we highlighted seven such periods since the Second World War (shaded in Chart 1). Another two-year period of fiscal easing and tight money is upon us. Bull Markets Don't Die Of Old Age... To complete the adage above, "Bull markets don't die of old age, they are killed by higher interest rates". Thus the focus of roiled markets should be whether tight monetary policy can be offset by loose fiscal policy. In other words, can the government be stimulative enough to cushion the blow from higher interest rates and extend the business cycle? With all seven iterations of simultaneous fiscal easing and monetary tightening noted above resulting in positive stock market returns and the SPX rising by 16% on average, the answer appears to be a resounding yes (Table 1). Chart 1Loose Fiscal Policy Offsets##br## Tight Monetary Conditions Loose Fiscal Policy Offsets Tight Monetary Conditions Loose Fiscal Policy Offsets Tight Monetary Conditions Table 1SPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening Further, the infrastructure bill has not yet become part of the fiscal thrust in this current bull market, meaning that there is still dry powder in the stock market's battle against higher rates. Depending on the timing of the infrastructure bill (and the further away, the better for sustaining the equity market blow off phase), there are good odds that this bull market could be the longest in history (Table 2). Using months without an inverted yield curve as an alternative measure, we are already there as the current streak of 131 months beats the 104 month streak of much of the '90s (Chart 2). Table 2Bull Markets Since World War II Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening Chart 2Longest Positive Yield Curve Streak In 50 Years Longest Positive Yield Curve Streak In 50 Years Longest Positive Yield Curve Streak In 50 Years Look To Earnings For Direction Our view remains that earnings will have to take up the mantle to drive the SPX higher.1 At this stage in the bull market's life, the SPX is no longer discounting many years of future growth and higher rates weigh on this growth rate. The implication is a forward P/E multiple that should drift sideways to lower leaving profits to do all the heavy lifting and largely explaining the S&P 500's return (bottom panel, Chart 3). Importantly, the combination of synchronized global growth and a soft U.S. dollar underpin EPS. Tack on the effect of tax reform (at least this year) and the 20% and 10% EPS growth rates penciled in by the sell side for 2018 and 2019, respectively, are achievable, barring a recession. Considering that stocks and EPS growth move together (top panel, Chart 3), the path of least resistance is higher still for the SPX. This positive equity backdrop warrants a positioning update. Accordingly, we have analyzed the GICS1 industry groups and their average annualized performance in each of the most recent five periods for which we have data of loose fiscal and tight monetary policy. The results presented in Table 3, however, are nuanced. Chart 3Stocks And EPS Are Joined At The Hip Stocks And EPS Are Joined At The Hip Stocks And EPS Are Joined At The Hip Table 3Sector Relative Performance In Tight Monetary/Loose Fiscal Conditions Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening In the left column, our raw data suggests that technology is dominant in the periods we have examined. However, this is skewed by the 1998-99 iteration when this sector went parabolic as the dotcom bubble was inflating, making virtually all other sectors underperform, dramatically in most cases. We have adjusted for this exceptional period in the right column. The adjusted results are telling as cyclicals and positive interest rate sensitive sectors (the S&P financials and energy indexes) are the top performers. Conversely, defensives and negative interest rate sensitive sectors (the S&P utilities and real estate indexes) are the worst performers. Such a result is intuitive; loosening fiscal policy during expansions tends to extend/prolong the business cycle and may also arrive in late/later stages of the cycle where equity returns go parabolic and deep cyclicals roar. In addition, when the Fed raises rates, financials tend to benefit and competing fixed income proxies suffer. Further, there is a positive feedback loop in these actions as loose fiscal policy in good times is typically inflationary, especially when the economy is at full employment, which thus pushes the Fed to continue to or even accelerate its tightening mode. We note that we maintain a preference for cyclicals over defensives in our portfolio, based on our key investment themes for 2018: synchronous global capex growth and rising interest rates. Our analysis here serves to confirm our hypothesis. The purpose of this report is to identify winners and losers in times of easy fiscal and tight money phases, and provide a roadmap of how sector returns may pan out in the coming two year period of fiscal expansion and liquidity withdrawal, if history at least rhymes. Accordingly, what follows is an analysis of the two adjusted top and bottom performers noted above. Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And 'Nothing Else Matters'," dated December 18, 2017, available at uses.bcaresearch.com. Financials Are A Top Pick Financials benefit from both sides of a monetary tightening/fiscal loosening environment. Rising interest rates are a boon to sector EPS as the increasing price of credit translates directly into top line growth. The higher cost of borrowing should typically result in a slowdown in borrowing and consumption. With fiscal largesse serving to at least offset any natural demand declines, the result should be a banker's dream: simultaneous capital formation and better terms on the existing book of business. The benefits of monetary tightening and fiscal easing are not exclusive to businesses either; such an environment has typically been synonymous with soaring consumer confidence, keeping loan demand high (second panel, Chart 4). Further, low unemployment has historically meant peaking credit quality, implying a margin tailwind to the already-rising top lines of lenders (third panel, Chart 4. Chart 4RS2 Financials Are In A Goldilocks Scenario Financials Are In A Goldilocks Scenario Financials Are In A Goldilocks Scenario As operating cash flows are soaring, it is likely that financials will increasingly embark upon shareholder friendly activities. The GFC saw lenders in particular shore up weakened balance sheets with enormous equity issues; the reversal in fortunes (especially given the record number of banks passing Fed stress tests) will see accelerated equity retirement, yet another benefit to EPS growth. In sum, S&P financials should be a core holding during periods of monetary tightening and fiscal easing, (see appendix, Chart 1A); we reiterate our overweight recommendation on financials and our high-conviction overweight on the key S&P banks sub index. Energy Is Just Getting Warmed Up As noted above, one of BCA's key investment themes for 2018 is synchronized global capex, of which the S&P energy sector is a key beneficiary, at least in part fueled by lower taxes and the upcoming infrastructure bill. Recently, the capital expenditures part of the Dallas Fed manufacturing outlook survey hit its highest level in a decade, and capex intentions in the coming six months are also probing multi-year highs. The overall message is that the budding recovery in energy capital budgets will likely gain steam (second panel, Chart 5). Chart 5Energy Should Benefit From High Capex Energy Should Benefit From High Capex Energy Should Benefit From High Capex Equally importantly, the recovery in the global economy has kept a solid floor underneath oil prices, which are pushing up against 3-year highs (top panel, Chart 5). Pricing power in energy is rising at its fastest pace this decade and (for now) the sector wage bill is continuing to contract (bottom panel, Chart 5), implying not only top line gains but also a much better margin profile. Still, monetary tightening represents a headwind for the sector. Higher interest rates tend to suppress investment demand and support the U.S. dollar which could put downward force on the price of oil. Our analysis suggests the stimulative effects from fiscal easing should more than offset any pressure from monetary tightening (see appendix, Chart 1B). Accordingly, we reiterate our high-conviction overweight recommendation on the S&P energy index. Be Cautious With Utilities We recently upgraded the beaten-down S&P utilities index to a benchmark allocation, based largely on a modest improvement in operating metrics, lifted by BCA's key 2018 capex growth investment theme; expansionary fiscal thrust should only enhance these metrics. Nat gas prices appear to have mostly stabilized and, as the marginal price setter for utilities, should support the nascent turnaround in industry pricing power (second panel, Chart 6). Further, the rebound in electricity production has peaked but remains comfortably in expansionary territory (third panel, Chart 6). Chart 6Higher Rates Offset Better Fundamentals Higher Rates Offset Better Fundamentals Higher Rates Offset Better Fundamentals Notwithstanding the operational positives, we think BCA's key theme of higher interest rates present a hefty offset. Utilities, a high dividend yielding sector, suffer when Treasury bond yields move higher, as competing risk free assets become more appealing (bottom panel, Chart 6). We suspect this fixed income-proxy characteristic is why the S&P utilities sector is historically the worst performer as the Fed is tightening monetary policy (see appendix, Chart 1C). Still, the sector has harshly sold down already and we think the positives and negatives are broadly in balance; we reiterate our neutral recommendation on the S&P utilities index. Real Estate Is Not Immune From Monetary Tightening Much like the S&P utilities index, the S&P real estate sector trades as a fixed income proxy. Accordingly, the anticipated advance in Treasury yields should weigh heavily on REIT prices (top panel, Chart 7), regardless of the underlying fundamentals; fortunately, there is some good news there. Chart 7CRE Prices Are Rising But ##br##How Much Further Can They Go? CRE Prices Are Rising But How Much Further Can They Go? CHART 10 CRE Prices Are Rising But How Much Further Can They Go? CHART 10 Lending standards had been tightening from 2013 until the middle of last year; since then, they have been loosening as fears of a second real estate recession gave way to general economic optimism. Given the tight correlation between lending standards and commercial property prices, a loosening of the former bodes well for the latter (second panel, Chart 7). Still, with commercial real estate prices approaching two standard deviations above the 30-year trend (bottom panel, Chart 7), the longevity of the good times should be questioned. Regardless of the modestly improving industry fundamentals, particularly in the context of the fiscal largesse that will certainly be stimulative, monetary tightening headwinds should at least provide an offset (see appendix, Chart 1D). On balance, we reiterate our neutral recommendation on the S&P real estate index. Appendix Chart 1A CHART 1A CHART 1A Chart 1B CHART 1B CHART 1B Chart 1C CHART 1C CHART 1C Chart 1D CHART 1D CHART 1D