Capex

Highlights Global Spread Product: The current low-volatility backdrop, triggered by more dovish central banks, will be maintained until there is more decisive evidence that global growth is rebounding. That will not occur until the latter half of 2019, thus keeping the window for corporate credit outperformance open for a few more months. Stay overweight global corporates versus governments, favoring the U.S. Canada: Much weaker-than-expected Canadian economic growth has surprised the Bank of Canada. Rate hikes are now off the table for at least the rest of 2019, and possibly longer. Upgrade Canadian government debt to neutral (3 out of 5) in global currency-hedged government bond portfolios. Feature Stick With A Tactical Overweight To Global Corporates We’ve dedicated our last few Weekly Reports to analyzing the outlook for government bond yields in the developed markets (DM), in light of the recent dovish shift in the policy stance of central banks. We concluded that yields had fully discounted a slower global growth backdrop, through lower inflation expectations and the pricing out of future interest rate hikes. Further declines in bond yields would require a deeper deceleration of activity than we are expecting, thus maintaining a below-benchmark medium-term duration stance is appropriate. That dovish shift by policymakers also took away a major roadblock for risk assets, namely the threat of a continued policy-induced rise in global yields at a time of slowing growth. The result has been sharp rallies in global equity and credit markets, with declining volatility (Chart of the Week). Chart of the WeekSlowing Growth Isn’t Always Bad For Risk Assets Slowing Growth Isn't Always Bad For Risk Assets Slowing Growth Isn't Always Bad For Risk Assets We upgraded global corporate debt, and downgraded global government bonds, on a tactical basis back on January 15 of this year.1 Since then, credit spreads have declined substantially across both DM and emerging markets (EM), most notably in Europe (Chart 2). Within our upgrade to overall global credit, we maintained a relative bias towards U.S. corporates versus non-U.S. equivalents, based on our expectation of relatively faster economic growth in the U.S. In our model bond portfolio, that meant moving U.S. corporates to an above-benchmark weighting, while reducing the size of the underweight in EM debt and only raising European credit to a neutral allocation. Chart 2 Looking at the performance of each of the major credit markets in excess return terms (versus duration-matched government bonds) since January 15, currency-hedged into U.S. dollars, there have not been huge differences between U.S. and non-U.S. returns. The exception is European high-yield which had an excess return of 4.4%, but only represents 0.8% of our custom benchmark index for our model portfolio (and where we are not underweight). Excess returns for investment grade and high-yield corporates in the U.S. have averaged 2.3%, compared to 2.2% for EM credit (averaging hard currency sovereign and corporate debt). We see the global “risk-on” dynamic continuing in next few months, fueled by benign monetary policies, thus we are sticking with our current overweight allocation to global corporates. With the benefit of hindsight, we know that the decision to upgrade overall global corporate debt versus government bonds has been far more important than adjusting any regional credit allocations. We see that global “risk-on” dynamic continuing in next few months, fueled by benign monetary policies, thus we are sticking with our current allocations to global corporates. Our cue to reverse our tactical overweight stance on corporates will come from the U.S. Any additional spread tightening and easing of overall financial conditions will keep U.S. economic growth above trend and eventually force the Fed to become more hawkish in the second half of 2019. This will turn global monetary policy from a tailwind for corporate credit to a headwind, justifying a downgrade of corporate allocations. In the meantime, we recommend continuing to earn carry in a policy-induced low volatility environment. Bottom Line: The current low-volatility backdrop, triggered by more dovish central banks, will be maintained until there is more decisive evidence that global growth is rebounding. That will not occur until the latter half of 2019, thus keeping the window for corporate credit outperformance open for a few more months. Stay overweight global corporates versus governments, favoring the U.S. Canada: Upgrade To Neutral Canadian government bonds have been clawing back much of the relative underperformance that occurred in 2017 and 2018 while the Bank of Canada (BoC) was delivering multiple rate hikes. The spread between the yields on the Bloomberg Barclays Canada Treasury index and the overall Global Treasury index has narrowed by -40bps since October 2018, after widening 69bps between May 2017 and October 2018 (Chart 3). Expressed as a relative return (duration-matched and currency-hedged into U.S. dollars), Canadian government debt has lagged the Global Treasury index by -232bps since May 2017. Chart 3Canadian Bonds No Longer Underperforming Canadian Bonds No Longer Underperforming Canadian Bonds No Longer Underperforming That underperformance was driven by the combination of a strong Canadian economy, accelerating inflation and tightening monetary policy. The year-over-year pace of real GDP growth reached 3.8% in mid-2017 and stayed above-trend for the following year. The unemployment rate fell to 5.8%, while core inflation accelerated back to the midpoint of the BoC’s 1-3% target band, alongside faster wage growth. The BoC – devotees of the Phillips Curve, like virtually every other DM central bank – took the message from the combination of tight labor markets and rising inflation and embarked on the long march away from a near-zero (0.5%) policy rate back in July 2017. Now, after 20 months and 125bps of rate hikes, Canada’s economy is weakening sharply. Real GDP only grew at a paltry 0.4% annualized pace in the 4th quarter of 2018, dragging the year-over-year pace to 1.6%. Inflation has followed suit, with headline CPI inflation falling from an early 2018 peak of 3% to 1.4% and the BOC’s median CPI index now growing at only a 1.8% pace. The most concerning part for the BoC is that the economy could be decelerating this rapidly with a policy rate of only 1.75%, which is well below the central bank’s estimated 2.5-3.5% range for the neutral rate. Our own BoC Monitor has rapidly fallen towards the zero line, indicating no pressure to either tighten or ease monetary policy (Chart 4). The more recent rapid decline in the BoC Monitor has been driven by the inflation-focused components of the indicator, while the growth-focused elements have been steadily drifting lower since that 2017 peak in real GDP growth. Chart 4Is The BoC Done, Well South Of Neutral? Is The BoC Done, Well South Of Neutral? Is The BoC Done, Well South Of Neutral? The BoC has been stunned by that shockingly weak Q4/2018 growth outturn. In the official policy statement released following the March 6 BoC meeting, the central bank’s Governing Council was forthright about how the growth uncertainty has put future rate hikes in question: “Governing Council judges that the outlook continues to warrant a policy interest rate that is below its neutral range. Given the mixed picture that the data present, it will take time to gauge the persistence of below-potential growth and the implications for the future inflation outlook. With increased uncertainty about the timing of future rate increases, Governing Council will be watching closely developments in household spending, oil markets and global trade policy.” Rising interest rates may be the big reason why growth has slowed so dramatically in Canada. The BoC’s economic projections for 2019 had already factored in some slowing global growth, as well a hit to business confidence and capital spending from global trade conflicts and last year’s decline in energy prices (a big deal for Canada’s huge oil industry). BoC officials, including Governor Stephen Poloz, have noted that a resolution of the U.S.-China trade tensions could therefore be a positive for the Canadian economy by removing a critical drag on Canadian business confidence and export demand. Yet when looking at the contribution to Canadian real GDP growth from the main components, there have been large drags on growth from consumer spending, capital spending and housing (Chart 5). That suggests that there is something more fundamental than just a series of external shocks at work here. Chart 5Broad-Based Weakness In Canadian Domestic Demand Broad-Based Weakness In Canadian Domestic Demand Broad-Based Weakness In Canadian Domestic Demand A look at the more interest-sensitive components of the Canadian economy suggests that rising interest rates may be a big reason why growth has slowed so dramatically. Consumer Durables Real consumer spending growth has plunged from a 4% pace in 2018 to 1.3% in Q4/2018, driven by a collapse in demand for consumer durables which contracted -1.2% year-over-year terms (Chart 6). Car sales plunged 7.5% on a year-over-year basis in Q4, suggesting that rising interest rates on auto loans may have been a major factor driving the weakness in durables spending. Softer incomes have also played a role, with wage growth rolling over even with the majority of evidence pointing to a very tight Canadian labor market that is getting even tighter (third panel). The fact that the drop was so focused on durables, however, suggests that higher interest rates were the more likely reason for the plunge in overall consumer spending. Chart 6Weak Canadian Consumption Concentrated In Durables Weak Canadian Consumption Concentrated In Durables Weak Canadian Consumption Concentrated In Durables Housing The overheated Canadian housing market has endured the double-whammy of rising mortgage interest rates and increasing macro-prudential changes to mortgage lending. House prices in the hottest Toronto and Vancouver markets – which should be most impacted by the changes in mortgage regulations – have stopped increasing, helping bring the growth in national house prices to only 1.9% (Chart 7). Yet the sharp deceleration of mortgage credit growth, alongside a contraction in housing starts and overall residential investment, suggests that higher mortgage rates could be the bigger driver of the housing weakness. Chart 7Some Long-Needed Cooling Of Canadian Housing Some Long-Needed Cooling Of Canadian Housing Some Long-Needed Cooling Of Canadian Housing The BoC has noted that it is difficult to disentangle the impact of regulatory changes in Canadian mortgages from that of rising interest rates. Yet the impact of higher mortgage rates on Canadian consumer spending power can be seen in the rising debt service ratio for Canadian households. As of Q4/2018, Canadians must now pay 14.5% of their household income to service their debts, an 0.53 percentage point increase over the past two years (Chart 8). For highly indebted Canadian households, who have mortgage debt equal to 107% of disposable income, even a modest pickup in mortgage rates can have a big impact on spending power through higher interest costs. Chart 8Leveraged Canadian Consumers Pinched By Higher Rates Leveraged Canadian Consumers Pinched By Higher Rates Leveraged Canadian Consumers Pinched By Higher Rates Does the fact that consumer spending has fallen so rapidly mean that the interest sensitivity of the Canadian economy is far greater than the BoC has assumed? If so, then the neutral range of 2.5-3.5% for the BoC policy rate may be too high, and the central bank could be closer to, if not already at, the end of its hiking cycle. The low level of the household savings rate – currently only 1.1%, a product of the housing bubble and the associated wealth effects on spending activity – makes Canadian consumers even more vulnerable to rate increases that diminish their spending power. For highly indebted Canadian households, even a modest pickup in mortgage rates can have a big impact on spending power through higher interest costs. Capital Spending Canadian companies have seen a steady decline in corporate profit growth over the past couple of years, decelerating from a 23% pace in 2017 to 2% late in 2018 on a top-down basis. Yet even allowing for that, the -8% contraction in year-over-year real non-residential investment spending in Q4/2018 is a shock. Particularly since the BoC’s Senior Loan Officer Survey showed that credit conditions have been easing, and our own Canadian Corporate Health Monitor is flashing that Canadian companies are in solid financial condition (Chart 9). Chart 9An Unusually Sharp Fall In Canadian Capex An Unusually Sharp Fall In Canadian Capex An Unusually Sharp Fall In Canadian Capex Business surveys from the BoC and the Conference Board did both show a sharp plunge in confidence and future sales expectations (bottom panel). This suggests that worries about global trade tensions and diminished trade activity may have weighed on Canadian business confidence and capital spending – especially coming alongside a big drop in oil prices as was seen last year, which hinders the ability of Canadian energy producers to ramp up investment. Canadian exports accelerated over the final half of 2018 while business confidence was falling. However, oil prices have now stabilized and, more importantly, Canadian exports accelerated over the final half of 2018 while business confidence was falling (Chart 10). That acceleration was seen for both energy and non-energy exports, but was also heavily concentrated in exports to China, which are now growing 24% on a year-over-year basis (a pace that is wildly at odds with the overall growth in Chinese imports, suggesting that Canadian exporters have increased their market share in China). Chart 10Should Canadian Companies Be Worried About Global Trade? Should Canadian Companies Be Worried About Global Trade? Should Canadian Companies Be Worried About Global Trade? Could higher corporate borrowing rates, rather than worries about plunging export demand, be the true reason why Canadian companies have so drastically cut back on capital spending? It is no surprise that the BoC has chosen to take a pause on its rate hiking cycle, given all those conflicting messages from the Canadian economic data. The growth slump could be related to global trade uncertainty, or regulatory changes in the housing market, or past declines in oil prices, or previous interest rate increases. Or all of the above. The BoC can also take some time before considering its next interest rate move given cooling inflation and wage growth (Chart 11). The central bank has reduced its estimate of the Canadian output gap to -0.5%, based off the downside surprises already seen in Canadian economic growth. A closed output gap, combined with accelerating inflation, was the main argument the BoC had been using to justify its interest rate increases over the past two years. Now, neither of those conditions is currently in place, and the BoC can take its time to assess the underlying trend of economic growth without having to worry about above-target inflation. Chart 11Slowing Inflation = More Dovish BoC Slowing Inflation = More Dovish BoC Slowing Inflation = More Dovish BoC The Governing Council next meets in April, when a new Monetary Policy Report and updated economic projections will be published. The 2019 growth and inflation forecasts will surely be downgraded, perhaps heavily as the European Central Bank just did in response to the sharp growth slowdown in Europe – which led to a new round of monetary easing measures. What will be more interesting from the point of view of Canadian bond investors will be the Bank’s assessment of the size of Canada’s output gap, the pace of trend growth and, perhaps, even the appropriate neutral range for the BoC policy rate. The lowering of any of those three elements would be supportive of Canadian bond yields staying lower for longer. We have maintained an underweight in Canadian government bonds since July 2017, based on our view that the BoC would follow in the Fed’s footsteps and attempt to normalize interest rates. A strong economy and rising inflation would allow them to do that. Now, both the Fed and BoC are on hold, with small probabilities of rate cuts now priced into Overnight Index Swap (OIS) curves (Chart 12). Chart 12BoC Now Less Likely To Follow The Fed BoC Now Less Likely To Follow The Fed BoC Now Less Likely To Follow The Fed Given the BCA view that Fed rate hikes will resume later this year on the back of a rebound in U.S. and global growth, we had been sticking with the bearish view on Canadian government bonds as well. Yet given the stunning drop in Canadian growth that startled the BoC, the odds now favor the BoC staying on hold for longer, even once the Fed begins to hike again. This would also provide additional easing of Canadian financial conditions through a soft Canadian dollar (bottom two panels). We are upgrading our recommended allocation to Canadian bonds to neutral(3 out of 5) this week from underweight (2 out of 5).  In light of this uncertainty over the BoC’s next move given the weak economy, the underlying rationale for our underweight Canada position is no longer applicable. Thus, we are upgrading our recommended allocation to Canadian bonds to neutral (3 out of 5) this week from underweight (2 out of 5). The excess return of Canadian government bonds versus the Global Treasury index since we went to underweight back in July 2017 was -0.83%, so our bearish recommendation did generate positive alpha. In our model bond portfolio, we are funding that additional Canadian allocation from a reduction of the overweight in Japanese government bonds. We are also closing our tactical trade of being long 10-year Canadian Real Return Bonds versus nominal 10-year government debt, at a loss as 10-year inflation breakevens are now 1.6%, or 16bps below the entry level on our trade (Chart 13). Chart 13Upgrade Canadian Government Bonds To Neutral Upgrade Canadian Government Bonds To Neutral Upgrade Canadian Government Bonds To Neutral We will contemplate any additional changes to our Canadian allocation after the releases of the latest BoC Business Outlook Survey and Senior Loan Officer Survey on April 15 and the new BoC Monetary Policy Report and economic projections at the April 24 monetary policy meeting. Bottom Line: Much weaker-than-expected Canadian economic growth has surprised the Bank of Canada. Rate hikes are now off the table for at least the rest of 2019, and possibly longer. Upgrade Canadian government debt to neutral (3 out of 5) in global currency-hedged government bond portfolios.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “Enough With The Gloom: Upgrade Global Corporates On A Tactical Basis”, dated January 15th 2019, available at gfis.bcarsearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index March Calmness March Calmness Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

An infrastructure bill has been the focus of economists and strategists as the next leg in fiscal easing to sustain the economy. On the face of it, such a thesis appears eminently believable. Despite historically low unemployment, 2018 has seen tremendous fiscal easing, both via the tax cuts at the end of 2017 and through the bipartisan spending agreement in early 2018, implying the current administration fears neither inflation nor deficits in its pursuit of economic growth. The logical investment conclusion from infrastructure stimulus would be to position overweight in infrastructure stocks. We created a basket of such equities to test this hypothesis. When compared to the historic U.S. federal budget deficit (top panel), we found that, while a correlation exists, there are prolonged periods where fiscal largesse has not translated into infrastructure stock outperformance. Drilling down, we found that EM stock performance (second panel) in general and capital spending in China (bottom panel)in particular have taken over as the principal drivers of these stocks. Please see this week’s Special Report for our deep dive into infrastructure stock performance and drivers as well as our sister Geopolitical Strategy Service’s take on why they believe an infrastructure bill worth $200-$400 billion over ten years has a greater than 50% chance of passing. What Drives Domestic Infrastructure Stocks Anyway? What Drives Domestic Infrastructure Stocks Anyway?

Feature An infrastructure bill has been the focus of economists and strategists as the next leg in fiscal easing to sustain the economy. On the face of it, such a thesis appears eminently believable. Despite historically low unemployment, 2018 has seen tremendous fiscal easing (Chart 1), both via the tax cuts at the end of 2017 and through the bipartisan spending agreement in early 2018, implying the current administration fears neither inflation nor deficits in its pursuit of economic growth. Further, after the Republicans’ shellacking in the midterm elections, it is also logical to expect the GOP to double down on their Trump card through the 2020 presidential election cycle. Chart 1An Already-Strong Fiscal Thrust An Already-Strong Fiscal Thrust An Already-Strong Fiscal Thrust As such, much hope has been placed in the passage of an infrastructure bill, which began in late 2016 following the election of the Trump administration and its promise “to invest $550 billion to ensure we can export our goods and move our people faster and safer”. The excitement surrounding infrastructure diminished following the passage of the Tax Cuts and Jobs Act and the implied much lower probability of an infrastructure bill in light of the debt implications of the unfunded tax cut. Further, the White House released their infrastructure plan in February, 2018 which sought only $200 billion in funding, but planned to stimulate $1.5 trillion in new investment via the multiplicative effect of public-private partnerships (PPP). However, the midterm elections have made infrastructure a hot topic once again for our clients. Is passage of an infrastructure bill likely? Would such a bill prolong the business cycle? At first glance, the market’s dimmed hopes of an infrastructure bill seem justified, in the context of the already-powerful fiscal thrust. Still, our sister Geopolitical Strategy service believes the odds of passage are above 50%.   BOX 1 Will Trump And The Democrats Pass An Infrastructure Bill? President Donald Trump, laser focused on reelection in 2020, faces a big decision about how to conduct domestic policy in the wake of the midterm election. Will he negotiate and compromise with the opposition in the House, like President Bill Clinton did after 1994? Or will he become mired in disagreements, like President Barack Obama after 2010? Infrastructure spending is one of the few areas where Trump and the Democrats have a clear basis for passing a major piece of legislation. It is much harder for these two to agree on immigration – given Trump’s demand for funding the border wall – or health care – given Trump’s opposition to Obama’s Affordable Care Act (Obamacare). By contrast, Trump campaigned vociferously on the need for more infrastructure and proposed a $1.5 trillion spending plan ($200 billion in federal funds) in February.1 Democrats are fully in support of infrastructure investment. The likeliest next Speaker of the House, Nancy Pelosi (D-CA), has been saying “build, build, build” both before and after the midterms, and her lieutenant, Representative Steny Hoyer (D-MD), has recently emphasized his eagerness to work with Trump on this issue. There is no doubt whether the public will approve – infrastructure spending always receives high levels of support, and it is one of the few policy areas unaffected by partisanship and polarization (Chart 2). Senate Majority Leader Mitch McConnell (R-KY) and Pelosi have begun negotiations and Democratic Representative Peter DeFazio (D-OR), likely the next head of the House Transportation Committee, has already outlined a plan. Chart 2U.S. Public Wants Infrastructure Spending BCA’s Outlook For Infrastructure Stocks BCA’s Outlook For Infrastructure Stocks The chief constraint is funding, obviously. Republicans want to use a limited amount of federal seed money in order to spur public-private partnerships but Democrats want direct federal funding sourced through indexing the federal fuel tax to inflation and issuing government bonds. There will have to be a new Democratic-authored bill, which may or may not merge with aspects of Trump’s plan.  How much money are we talking about? Trump’s plan called for $1.5 trillion over 10 years, of which $200 billion would be federal. Hence $20 billion in federal spending per year, but with cuts to existing programs. Some analysts have argued that Trump’s plan would actually have seen a net reduction in federal infrastructure spending over the long run due to its cuts to existing federal programs (which happen to be infrastructure-oriented) in order to offset his proposed spending increases. Democrats will insist on no cuts to existing programs, plus funding for new building.2   The mainstream Democrats are proposing $100 billion in new spending per year for 10 years, but this number includes zero cuts to existing programs. Mainstream Democrats are therefore asking for less in actual new spending than meets the eye, but are unlikely to go for less than Trump’s $20 billion. As a reference, President Obama’s last budget proposal was looking at $32 billion in federal infrastructure increases per year.3 An agreement on $20-$40 billion per year in new spending is not insurmountable given that both sides agree that they could raise the $0.18 per gallon tax on gasoline, which has not been raised since 1993 and is not indexed to inflation. Trump has proposed raising it by $0.25 per gallon, and this is more than other proposals (at $0.15 per gallon) or than merely indexing to inflation. This would raise an estimated $375 billion over 10 years.4 In addition, the Democrats are looking to revise aspects of Trump’s tax cuts to fund infrastructure. While Secretary of Treasury Steve Mnuchin says no one in the administration is considering paring back the recent sharp reductions in the corporate rate, Trump has already signaled willingness to negotiate on the corporate rate to provide for a middle-class tax cut. This suggests that modifications to his 2017 Tax Cut and Jobs Act are not out of the question as infrastructure funding. Signature pieces of major legislation help presidents get reelected. The tax cuts were a product of traditional conservative policy, with limited popularity, whereas a populist compromise to the tax cuts in order to fund an infrastructure package (as long as it is still a net tax cut from pre-2017) could produce a signature piece of legislation from Trump “the builder” going into 2020. In other words, Trump can refrain from vetoing a federal gasoline tax hike or an adjustment to his own corporate tax cuts in order to pass a popular infrastructure initiative. The Democratic opposition will have written the bill, so both parties would “share the blame.” And the Democrats in the Senate would only need 15-18 GOP Senators to support a profligate infrastructure plan. Given popular and presidential support, and that the GOP-controlled Senate agreed with the budget spending blowout in early 2018, we think that more than enough Republican Senators can go along with an infrastructure plan. The bill will come at a time when other major legislative options are on ice and when both Trump and the Democrats will need at least one achievement to sell to voters in 2020. Might the Democrats sabotage such a bill in order to deny the president any fiscal help ahead of the 2020 election? Possibly. But they would have to pretend to negotiate before pulling out of the deal. It could backfire mightily. Whereas passing a big infrastructure bill would demonstrate their ability to govern and would help them win over voters in the vital Midwestern battleground states, where collapsing bridges and poisonous water systems have made headlines. Bottom Line: There is a greater than 50% chance that a bill will pass. As a baseline estimate, a bill worth $200-$400 billion over ten years is a reasonable estimate for a bill that could pass in late 2019 or (less likely) early 2020. Needless to say, $200-$400 billion over 10 years is a far cry from headline numbers like $1.5 trillion. It is an even farther cry from the progressive Democrats’ “People’s Infrastructure Plan” which calls for $2 trillion over ten years. Net new spending of $20-$40 billion per year is about 10%-20% of existing annual infrastructure spending and only 0.1%-0.20% of American GDP.   In our examination, we will frequently reference the 2009 American Recovery and Reinvestment Act (ARRA), the most recent major infrastructure bill aimed at stimulating the economy. This bill cost $787 billion, of which $500 billion was cash outlays (the remainder was tax incentives). However, only $105 billion of the ARRA was targeted at infrastructure spending ($20 billion per year). Still using the 2009 ARRA as an analogy, the midpoint of high and low estimates from the CBO’s post-mortem of the ARRA’s efficacy, the ARRA added 1.1% to real GDP in 2009, followed by 2.4% in 2010. If we assume the goal of this bill is truly to prolong the business cycle to align with the election cycle, it stands to reason that time is of the essence. Further, the PPP requirements to achieve the $1.5 trillion in new investment envisaged by the White House raise a host of issues. Buy-in from private partners, the associated incremental planning and an assumed dearth of shovel-ready PPP-appropriate projects lead us to believe that a Q1 passage of a bill would be necessary for it to achieve its goals. Lastly, when the 2009 ARRA became effective, the unemployment rate was 8.3%. It is 3.7% now (Chart 3). We would anticipate an inflation-fearing Fed to deliver a monetary response to this fiscal slack in the form of interest rate hikes that would at least partially offset the stimulus. With two opposing forces pushing on the economy, it is ambiguous to us whether the stimulus would, in fact, stimulate. Chart 3Historically Low Unemployment Historically Low Unemployment Historically Low Unemployment What Drives Domestic Infrastructure Stocks Anyway? As equity strategists, our role is to offer clients insights into the best way to play the anticipated fiscal largesse. Accordingly, we have created an index from a range of industrials and materials GICS3&4 indexes that should see a positive reaction to a spur in infrastructure demand; we present the BCA Infrastructure Basket in Chart 4 with details of its constituents included in an appendix following this report. Chart 4BCA's Infrastructure Basket… BCA's Infrastructure Basket… BCA's Infrastructure Basket… Much like the initial excitement surrounding the prospect of an infrastructure bill following Trump’s election, our infrastructure basket leapt in November 2016. However the diminishing hopes of a bill, especially of the size discussed on the campaign trail, are reflected in the basket’s mostly steady decline from its late 2016 peak. This decline accelerated following the passage of the tax cuts at the end of 2017. A reasonable assumption would be that the price of our basket of equities would track in line, by and large, with most leading economic indicators as they are broadly a reflection of the industrial economy. Testing this hypothesis over the past 30 years is revealing: we found no material correlation between domestic leading indicators, even capital expenditures and planned capital expenditures that should be significant top line drivers (Chart 5). The upshot is that domestic private sector sentiment is unrelated to infrastructure stock performance. Chart 5...Is Not Correlated With Leading Indicators ...Is Not Correlated With Leading Indicators ...Is Not Correlated With Leading Indicators When plotted against the historic budget deficit and government debt levels, a better picture emerges (Chart 6). Our inference is that public spending and the infrastructure basket tend to move together, which is corroborated by the aforementioned recent moves around rising and falling hopes for a Trump infrastructure bill. Still, this analysis is incomplete as the infrastructure basket and fiscal growth were inversely correlated between 2004 and 2009 before reestablishing a positive relationship and even then the relationship is relatively loose. Chart 6Fiscal Expansion And Infrastructure Stocks Mostly In Sync Fiscal Expansion And Infrastructure Stocks Mostly In Sync Fiscal Expansion And Infrastructure Stocks Mostly In Sync Accordingly, we widened our analysis to global indicators excluding the U.S., where we found a significantly tighter correlation (Chart 7), though only post-2001. We ascribe the close post-2001 relationship to China’s joining of the WTO and their resulting ascendency in driving equity returns in the emerging market space. Chart 8 confirms our hypothesis; our infrastructure basket and the EM equity index overlap. Chart 7Global Leading Indicators Are Better Global Leading Indicators Have a Tighter Correlation Global Leading Indicators Have a Tighter Correlation Chart 8EM And Infrastructure Go Hand In Hand EM And Infrastructure Go Hand In Hand EM And Infrastructure Go Hand In Hand Drilling down on China seems appropriate in this context and further corroborates our assertion that China is increasingly the driver of U.S. domestic infrastructure stock performance. Particularly in the post-GFC era, the slowdown in Chinese capex and money supply growth appear to be the principal drivers of these stocks (second and bottom panels, Chart 9). This message is echoed when we compare the infrastructure basket to the Chinese credit growth impulse and the Keqiang index (Chart 10). Chart 9Chinese Growth Drives Domestic Infrastructure Stocks Chinese Growth Drives Domestic Infrastructure Stocks Chinese Growth Drives Domestic Infrastructure Stocks Chart 10Slowing Growth In China Points To A Down Leg bca.uses_sr_2018_12_10_c10 bca.uses_sr_2018_12_10_c10 Bottom Line: Domestic private sector sentiment has little impact on the BCA Infrastructure Basket, though U.S. government spending clearly has a significant impact on the performance of the stocks. Still, it appears that Chinese growth is at least as important as domestic government spending to the relative performance of the infrastructure basket. In light of BCA’s view of flat or slowing growth in China, at least for the year ahead, we would wait for a positive catalyst before adding this basket as a holding.  A Value Trap In The Making Investors may correctly point out that our infrastructure basket has already been beaten up and the stage may be set for a relief rally. In fact, the basket has already notched two months of outperformance, lifting it off its decade low relative to the S&P 500 (Chart 11). However, as shown in the middle panel of Chart 12, this rally has come while forward EPS growth estimates have trailed the broad market, meaning that the rally has been exclusively a valuation rerating rather than a fundamental turning point in earnings (bottom panel, Chart 12). Chart 11Fairly Valued Over Long Term... Fairly Valued Over Long Term... Fairly Valued Over Long Term... Chart 12...And A Value Trap In The Short Term ...And A Value Trap In The Short Term ...And A Value Trap In The Short Term Further, while the bear market for this basket of stocks is set to enter its second year, we would caution that a turning point may be further off in the distance than optimists may hope. Witness the six year period from 1995 to 2001 when the infrastructure basket dramatically underperformed the market (Chart 11). Valuations in the infrastructure basket were only a third of the broad market before a rally occurred, a far cry from where they are now. As well, the relative rally likely had more to do with the souring of the tech sector than a particular affection for infrastructure stocks; it took another five years for the basket to reach its average valuation. We would further note that on a longer-term basis, while still a discount to the broad market, valuations remain roughly in line with their historical average (Chart 11). Bottom Line: History has shown bear markets for infrastructure stocks can be deep and prolonged. Thus while the infrastructure basket is relatively cheap compared to the recent past, looking further back in history tells us that this may not be the case. Accordingly, we think the BCA Infrastructure Basket has all the markings of a value trap. So What Does It All Mean The passage of an infrastructure bill seems likely, though the form it will take remains subject to debate. As well, the timing and efficacy of such a bill may mean that it both undershoots expectations with respect to its size and eventual economic impact. The BCA Infrastructure Basket has tended to trade off of domestic fiscal expansion but EM in general and China in particular appear to have taken over as the core drivers of relative stock performance. While bearishness has reigned in this basket for the past year, we caution that this still looks like the early stages of underperformance. We would wait for a positive catalyst in the EM and/or China before chasing the BCA Infrastructure Basket. Details on the composition of this basket are in an appendix that follows.   Chris Bowes, Associate Editor chrisb@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Appendix BCA’s Outlook For Infrastructure Stocks BCA’s Outlook For Infrastructure Stocks Footnotes 1      Please see the White House, “Legislative Outline for Rebuilding Infrastructure in America,” 2018, available at www.politico.com. 2      Please see Jacob Leibenluft, “Three Key Questions About The Trump Infrastructure Plan,” Center on Budget and Policy Priorities, January 30, 2018, available at www.cbpp.org. 3      Please see Senate Democratic Caucus, “Senate Democrats’ Jobs & Infrastructure Plan For America’s Workers,” March 7, 2018, available at www.democrats.senate.gov. 4      Please see Lauren Gardner, Tanya Snyder, and Brianna Gurciullo, “Trump endorses 25-cent gas tax hike, lawmakers say,” Politico, February 14, 2018, available at www.politico.com.

Highlights Portfolio Strategy Higher interest rates, with the Federal Reserve tightening monetary policy three more times in the next seven months, will be the dominant theme next year. All four of our high-conviction underweight calls are levered to this theme. The later stages of the U.S. capex upcycle underpin three of our high-conviction overweight calls for 2019. Recent Changes Downgrade the S&P Home Improvement Retail index to underweight today. Trim the S&P Interactive Media & Services index to a below benchmark allocation today.  Table 1 2019 Key Views: High-Conviction Calls 2019 Key Views: High-Conviction Calls Feature Fed policy will dominate markets next year as the dual tightening backdrop – rising fed funds rate and accelerated downsizing of the Fed balance sheet – remains intact. Two weeks ago we raised the question: is the Fed tightening monetary policy too far too fast?1 In more detail, we put the latest monetary tightening cycle in historical perspective and examined trough-to-peak moves in the fed funds rate since the 1950s (Chart 1). Chart 1Too Far Too Fast? Too Far Too Fast? Too Far Too Fast? A good friend I call “the smartest man in California” correctly pointed out that 500bps of tightening today is not the same as in the 1970s or 1980s. Chart 2 adjusts for that by including the average nominal GDP growth rate during these tightening episodes and adds more color to each era. As a reminder, the latest cycle that commenced in December 2015 is already 25bps above the median, if one uses the Wu-Xia shadow fed funds rate to capture the full quantitative easing effect, and above-average nominal output growth. Chart 2Trough-To-Peak Tightening Cycle Already Above Historical Median 2019 Key Views: High-Conviction Calls 2019 Key Views: High-Conviction Calls Trying to answer the question, we are concerned that as the Fed remains committed to tighten monetary policy three more times by mid-2019, a yield curve inversion looms, especially if the U.S. economy suffers a soft patch in the first half of next year (please refer to our Economic Impulse Indicator analysis in the October 22ndand November 19th Weekly Reports). This would signal at least a pause, if not reversal, in Fed policy. With that in mind, this week we are revealing our high-conviction calls for 2019. Four of our calls are a play on this tightening monetary backdrop that is one of BCA’s themes for next year.2 The later stages of the U.S. capex upcycle underpin three of our high-conviction calls. Table 22018 High-Conviction Calls Recap 2019 Key Views: High-Conviction Calls 2019 Key Views: High-Conviction Calls However, before we highlight our 2019 high-conviction calls in detail, Table 2 tallies our calls from last year. We had a stellar performance in our 2018 high-conviction calls with an average excess return of 11.6% versus the S&P 500. As the year turns the corner, closing out the remaining calls brings down the average relative return to 7.5%, still a very impressive number, with a total of ten hits and only two misses for the year.    Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com     Software (Overweight, Capex Theme) Software stocks are our first hold out from last year’s high-conviction overweight list, levered to the capex upcycle theme. Chart 3 shows that relative capital outlays and the share price ratio are joined at the hip. Software upgrades offer the simplest, quickest and most effective capital deployment, especially when productivity gains ground to a halt. Importantly, leading indicators of overall capex remain upbeat and should continue to underpin software profits. Beyond capex, M&A has been fueling software stock prices. It did not take long for the large CA acquisition to get surpassed by RHT and more recently SYMC was also rumored to be in play (Chart 3). Inter-industry M&A activity is reaching fever pitch and this frenzy is bidding up premia to stratospheric levels. The push to the cloud, SaaS and even AI has boosted the appeal of software stocks and brought them to the forefront of potential takeout candidates. These are secular trends and will likely continue to gain steam irrespective of the different stages in the business cycle. As a result, software stocks should remain core tech holdings in equity portfolios. The recovery in the software price deflator (Chart 3), a proxy for industry pricing power, corroborates the upbeat demand backdrop. With regard to financial statements, software stocks have pristine balance sheets with more cash on hand than debt, which sustains the net debt-to-EBITDA ratio in negative territory. Interest coverage is great at 10x and free cash flow generation is expanding smartly. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, INTU, RHT, ADSK, SNPS, CTXS, ANSS, CDNS, FTNT and SYMC. Chart 3Software Software Software   Air Freight & Logistics (Overweight, Capex Theme) Air freight & logistics stocks are the second hold out from our high-conviction overweight list, although we added it to list only in late-March. This transportation sub-index laggered is a capex and trade de-escalation play for the first half of 2019. Importantly, energy costs comprise a large chunk of freight services input costs and the recent drubbing in oil markets will boost margins especially on the eve of the busiest season for courier delivery services (top panel, Chart 4). On that front, there are high odds that this holiday sales season will be another record setting one, as wage inflation is underpinning discretionary incomes. Keep in mind that the accelerating domestic manufacturing shipments-to-inventories ratio confirms that demand for hauling services is upbeat. The implication is that rising demand for freight services will buoy industry profits and lift valuations out of their recent funk (Chart 4). Firming industry operating metrics also tell a positive story and suggest that relative share prices will soon take off. Air freight pricing power has been healthy, in expansionary territory and above overall inflation measures. While the U.S./China trade tussle and the appreciating greenback are clear risks to our sanguine S&P air freight & logistics transportation subindex, most of the grim news is already reflected in depressed relative forward profit estimates, bombed out valuations and washed out technicals (Chart 4). The ticker symbols for the stocks in this index are: BLBG: S5AIRF - FDX, UPS, EXPD and CHRW. Chart 4Air Freight & Logistics Air Freight & Logistics Air Freight & Logistics   Defense (Overweight, Capex Theme) We have been overweight the pure-play BCA defense index since late-2015 and there are high odds that this juggernaut that really commenced with the George Walker Bush presidency remains in a secular growth trajectory. Our strategy is to add exposure on any meaningful pullbacks and keep this index as a structural overweight within the GICS1 S&P industrials index. The recent drawdown offers such an opportunity and we are adding this index to the 2019 high-conviction overweight list. The rise of global "multipolarity" - or competition between the world's great nations - and the decline of globalization, along with a global arms race and increased risk of cyber-attacks, have been documented in our "Brothers In Arms" Special Report. These trends all signal that global defense related spending will remain upbeat in the coming decade.3 In the U.S. in particular, where military spending in absolute terms is greater than the rest of the world put together, defense spending and investment have bottomed and will continue to accelerate (Chart 5). In fact, the CBO continues to project that defense outlays will jump further next year. While such a breakneck pace is clearly unsustainable, President Trump is serious about upgrading and updating the U.S. military in order to keep China's geopolitical and military ascendancy in check (as well as to deal with Russia and Iran).4 The upshot is that defense outlays will continue to expand into the 2020s. Such a buoyant demand backdrop is music to the ears of defense contractor CEOs, and represents a boost to defense equity revenue growth prospects. This capital goods sub-industry has extremely high fixed costs and thus any increase in top line growth flows straight to the bottom line. Put differently, defense contractors enjoy high operating leverage. No wonder M&A activity is robust: at least four large deals have been announced in the past year that are underpinning takeout premia. A closer look at operating metrics corroborates that defense goods manufacturers are firing on all cylinders. New orders recently jumped to fresh all-time highs and the industry's shipments-to-inventories ratio is rising, on track to surpass the 2008 peak. Unfilled orders are also running at a high rate, signaling that factories will keep on humming at least for the next few quarters. Importantly, the industry is not standing still and is making significant investments. U.S. defense capex as reported in the financial statements of constituent firms is growing at roughly 20%/annum or twice as fast as overall capex (Chart 5 on page 7). While interest coverage has been modestly deteriorating, it is twice as high as the overall market (Chart 5 on page 7). Impressively, defense ROE is running near 30%, again roughly double the rate of the broad market. The ticker symbols for the stocks in the BCA defense index are: LMT, LLL, NOC, GD and RTN. Chart 5Defense Defense Defense   Consumer Discretionary (Underweight, Higher Fed Funds Rate Theme) We recommend investors avoid the consumer discretionary sector that suffers when interest rates rise. Chart 6 depicts this inverse correlation consumer discretionary equities have with interest rates, especially the fed funds rate. Most discretionary equites are levered off of floating rates and thus any increase in the fed funds rates gets reflected immediately in banks' prime lending rate. Also, most consumer debt is floating rate debt and thus tighter monetary conditions, at the margin, dampen consumer debt uptake and, as a knock-on effect, weigh on discretionary consumer outlays. Recently we highlighted that, now that the Fed has been raising rates and allowing bonds to roll off its balance sheet, volatility is making a comeback. Unsurprisingly, the consumer discretionary share price ratio is inversely correlated with the VIX index, signaling that more pain lies ahead for this early cyclical index (VIX shown inverted, Chart 6). Sentiment and technical indicators also point to more downside ahead for this interest-rate sensitive index. Our sector advance/decline line is waning and EPS breadth has plunged. Worrisomely, sell-side analysts are penciling in an extremely optimistic 5-year outlook with EPS growth 23.4%/annum or 1.4 times higher than the overall market. Clearly this is not realistic as it assumes a tripling of EPS in the coming 5 years. Relative EPS estimates have already given way as AMZN commands very little EPS weight, despite its massive market cap weight (30% of the S&P consumer discretionary sector), and suggests that relative share prices will converge lower (Chart 6 on page 9). As a result, the 12-month forward P/E ratio is trading at a 24% premium to the broad market and significantly above the historical mean. Technicals are almost as extended as relative valuations and cyclical momentum has likely peaked, warning that a downdraft in relative share prices looms (Chart 6 on page 9). Chart 6Consumer Discretionary Consumer Discretionary Consumer Discretionary   Home Improvement Retail (Underweight, Higher Fed Funds Rate Theme) While the probablity of a housing recession remains low, we are concerned that too much euphoria is already priced in the S&P home improvement retail (HIR) index, and there are high odds that next year HIR will suffer the same fate as homebuilders did this year (Chart 7). Thus, we are downgrading the S&P HIR index to underweight and adding it to the high-conviction underweight list for 2019. Fixed residential investment (FRI) as a percentage of GDP is up 50% from trough to the recent peak, whereas relative HIR performance is up 170% in the same time frame. Our worry is that optimistic sell side analysts' relative profit forecasts will be hard to attain, let alone surpass as FRI is steadily sinking (Chart 7). Worrisomely, our HIR model has plunged on the back of the wholesale liquidation in lumber prices and rising interest rates (Chart 7). Lumber deflation will prove a profit headwind as building supply Big Box retailers make a set margin on wood products. Select industry operating metrics suggest that the easy profits are behind HIR. Not only is our productivity growth proxy (sales per employee) on the verge of deflating, but also an inventory surge has sunk the HIR sales-to-inventories ratio into the contraction zone. Finally, there is rising supply of new and existing homes for sale already on the market, and that puts off remodeling activity at least until this supply glut clears (months' supply shown inverted, Chart 7). The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW. Chart 7Home Improvement Retail Home Improvement Retail Home Improvement Retail   Short Small Caps/Long Large Caps (Higher Fed Funds Rate Theme) The days in the sun are over for small cap stocks and we are compelled to put the size bias favoring large caps in our high-conviction calls list for 2019. Small caps are severely debt saddled. Sustained small cap balance sheet degradation is worrying, with S&P 600 net debt-to-EBITDA close to 4 compared with less than 2 for the SPX (Chart 8). Such gearing is fraught with danger as the default rate has nowhere to go but higher. Small and medium enterprises (SMEs) have a higher dependency on bank credit as opposed to the bond market access that mega caps enjoy. Most bank credit is floating rate debt and so are lines of credit, and as the Fed remains firm on tightening monetary policy, interest expense costs are skyrocketing for SMEs. In a relative sense this will weigh on net profits. Moreover, small caps are a lot more sensitive to interest rates, and the selloff in the 10-year Treasury note heralds more pain in 2019 (Chart 8). Small caps are high(er) beta stocks and when volatility spikes they underperform large caps. When the Fed ballooned its balance sheet and dropped the fed funds rate to zero it suppressed volatility. Now that the Fed has been decreasing the size of its balance sheet and raising interest rates, this is working in reverse and volatility is making a comeback as we have been highlighting in our research, and will continue to weigh on small caps (VIX shown inverted, middle panel, Chart 8). Another way to showcase small caps' riskier status is the close correlation they have with the relative EM equity share price ratio. When EMs outperform the SPX, small caps follow suit and vice versa. Importantly a wide gap has opened recently and we suspect that it will narrow via small caps following the EM higher beta stocks lower (SPX vs. EM ratio shown inverted, fourth panel, Chart 8 on page 12). Chart 8Small Vs. Large Small Vs. Large Small Vs. Large   Interactive Media & Services (Underweight, Higher Fed Funds Rate Theme) In our initiation of coverage on the S&P interactive media & services index,5 we highlighted three key risks that offset the revenue & profit growth vigor of this group, comprised almost entirely of Alphabet (Google) and Facebook. These were a renewed regulatory focus, rapid unpredictable changes in tastes & technology and an appreciating U.S. dollar. It is the first of these that has risen most dramatically since that report. Tack on the inverse correlation these growth stocks have with interest rates (top panel, Chart 9) and that is causing us to lower our recommendation to underweight and include this index in the high-conviction underweight list for 2019. Increasing regulatory efforts on technology will be a key theme next year, one we explored this past summer.6 Our conclusion was that both antitrust (particularly in the case of Alphabet) and privacy regulation (particularly in the case of Facebook) added significant risk to these near monopolies; calls for legislating both have dramatically amplified. Tim Cook, Apple’s CEO, recently commented that more regulation for Facebook and Alphabet was inevitable; we agree. While the form such regulation might take remains open to debate (for example, the U.S. could adopt an EU-style General Data Protection Regulation (GDPR)), we fear the associated headline risk (not to mention likely profit headwinds) will impair stock prices in the S&P interactive media & services index. This communication services sub-index is particularly prone to such a risk when it already trades at close to a 40% valuation premium to the broad market (middle panel, Chart 9 on page 14). Adding insult to injury is the PEG ratio that is trading at a 60% premium to the broad market (bottom panel, Chart 9 on page 14). In the face of the Fed’s sustained tightening cycle these extreme growth stocks are vulnerable to massive gravitational pull. The ticker symbols in the stocks in this index are: S5INMS – GOOGL, GOOG, FB, TWTR and TRIP. Chart 9Interactive Media & Services Interactive Media & Services Interactive Media & Services Footnotes 1      Please see BCA U.S. Equity Strategy Report, "Manic Market," dated November 19, 2018, available at uses.bcaresearch.com. 2      Please see BCA The Bank Credit Analyst Report, "OUTLOOK 2019: Late-Cycle Turbulence", dated November 26, 2018, available at bca.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 4      Please see BCA Geopolitical Strategy Special Report, "A Global Show Of Force?" dated October 10, 2018, available at gps.bcaresearch.com. 5      Please see BCA U.S. Equity Strategy Special Report, "New Lines Of Communication," dated October 1, 2018, available at uses.bcaresearch.com. 6      Please see BCA U.S. Equity Strategy Special Report, "Is The Stock Rally Long In The FAANG?", dated August 1, 2018, available at uses.bcaresearch.com.   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights May's soft durable goods orders report is probably not a precursor of weaker capex. Despite shortages of inventory and rising rates, housing should add to GDP growth this year and next, and keep economic growth well above its long-term potential. BCA's Commodity & Energy Strategy service notes that oil markets are becoming increasingly concerned about possible supply disruptions. Oil price volatility is set to rise. Feature Despite a late-week rally, U.S. equities finished the week lower as investors worried about global trade, higher oil prices, and an economic slowdown in China. 10-Year Treasury yields fell even as inflation returned to the Fed's target. The trade-weighted dollar moved higher last week, and rose 5% in the second quarter. Last week's economic data skewed to the softer side of expectations, but despite the recent run of disappointing data, Q2 GDP growth is still tracking well above 3.0%. Chart 1Core Inflation Is At The Fed's Target Core Inflation Is At The Fed's Target Core Inflation Is At The Fed's Target Supply bottlenecks are a hallmark of late-cycle economic expansions. In recent months, the Fed's Beige Book identified supply shortages in the labor and product markets in the U.S.1 Many of these economic pinch points are in the energy sector, where businesses are running out of labor, rail and trucking capacity, and in some cases, roads.2 Capacity constraints are also an issue in the overseas oil markets and will lead to increased volatility. Moreover, there are signs that a growing scarcity of some raw materials may be affecting overall business capital spending in the U.S. Low inventories of new and existing homes for sale are factors in the soft activity in the housing sector. The tighter labor and product markets are pushing up U.S. inflation. At 1.96% year-over-year, the May reading on core PCE, the Fed's preferred measure of inflation, is near a cycle high and has returned to the central bank's target (Chart 1). Moreover, there were a record number of inflation words in the Fed's latest Beige Book. In the past, increased remarks about inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may still climb.3 Fed policymakers have signaled that they will not mind an overshoot of the 2% inflation target. However, with core PCE inflation at 2% and the unemployment rate well below the Fed's estimate of full employment, the FOMC will be slower to defend the stock market in the event of a swoon. Bottom Line: Product and labor markets continue to tighten and push inflation higher, raising the odds that the central bank will take a more aggressive stance in the next 12 months. Last week,4 we downgraded our 12-month recommendation on global equities and credit from overweight to neutral. Capital Spending Update Business capital spending remains upbeat, but may be near a peak. Core durable goods orders dipped by 0.2% m/m in May. The monthly data can be unreliable and it is more useful to look at the year-over-year rates of change. But even here, there is a softening trend. From a recent high of 12.9% y/y, the annual growth rate in core durable goods orders has slowed to 6.6% y/y. Nonetheless, we do not believe that a major down-cycle in U.S. capex has started. The regional Fed surveys of investment intentions remain at lofty levels (Chart 2, panel 2). In addition, managements' attitudes toward capital spending are still upbeat, according to the latest surveys from Duke University, the Conference Board and the Business Roundtable. However, there was a slight downtick in the Business Roundtable metric in Q2 because of the uncertainty surrounding tariffs (Chart 2, panel 1). Moreover, in his post FOMC meeting press conference last month, Fed Chair Powell noted that companies may be delaying decisions on investment spending due to uncertainty around trade policy.5 A tight labor market and accelerating wages mean that firms should look for ways to boost output through productivity-enhancing capex. Furthermore, the 2017 Tax Cuts and Jobs Act allowed for accelerated depreciation, which increased the immediate tax incentive for investment spending. Chart 3 illustrates that through Q1 2018, corporate outlays for dividends ran slightly ahead of previous cycles, while capex and buybacks were about average. BCA will continue to monitor this mix. The lack of business spending on share repurchases is surprising given the spike in buyback announcements in the wake of the tax legislation. (Chart 4, panel 1). However, the bottom panel of Chart 4 indicates that net equity withdrawal is muted and in a downtrend despite the elevated buyback announcements. Chart 2Capex Indicators Still Solid... Capex Indicators Still Solid... Capex Indicators Still Solid... Chart 3Comparison Of Corporate Outlays Across Four Economic Expansion Phases Running Out Of Room Running Out Of Room The positive reading on BCA's Capital Structure Preference Indicator supports our stance that buybacks will add to EPS growth this year (Chart 5, second panel). This indicator is defined as the equity risk premium minus the default-adjusted yield in high-yield corporate bonds. When the indicator is above zero, there is a financial incentive for firms to issue debt and buy back shares. Conversely, firms are incentivized to issue stock and retire debt when the indicator is below zero. The indicator is currently positive, although not as high as it was in 2015. Chart 4Still Some Room To Run For Buybacks Still Some Room To Run For Buybacks Still Some Room To Run For Buybacks Chart 5Buybacks Adding To EPS Growth Buybacks Adding To EPS Growth Buybacks Adding To EPS Growth Bottom Line: May's soft durable goods orders report is probably not a precursor of weaker capex. Corporate managers will look to escalate productivity via capital spending in the next few years as an offset to tight labor markets and scarce resources. The upswing in capital spending is another sign that the U.S. economy is in the late stages of the business cycle.6 Housing Slack Still On Decline The latest soundings on home construction and sales show that inventories of new and existing homes are close to record lows (Chart 6, panel 1 and 2) and that homeownership rates are in a clear uptrend albeit at near historical lows (panel 3), boosted by the tight labor market and rising incomes (panel 4). Most indicators show that the housing market continues to grow along the typical path of the classic boom/bust residential real estate cycle (Chart 7). As such, we expect residential investment will add to GDP growth this year and support housing-related investments. Chart 6Housing Fundamentals##BR##Are Stout Housing Fundamentals Are Stout Housing Fundamentals Are Stout Chart 7Still Plenty Of Gas Left##BR##In The Tank For Housing Still Plenty Of Gas Left In The Tank For Housing Still Plenty Of Gas Left In The Tank For Housing Even so, our past work7 indicated that housing reached a zenith several quarters before other sectors of the economy. BCA's view is that the 10-year treasury rate will peak at 3.80%.8 Nonetheless, housing affordability remains well above average and will be supportive of housing investment even if rates climb by 100 bps (Chart 8). Furthermore, mortgage payments as a share of median income will stay below average if rates escalate by 100 or even 200 bps (panel 2). However, a 200 bp increase in mortgage rates, admittedly an extreme scenario, would crimp housing affordability and nudge the mortgage payment as a share of median income above its long-term average (panels 1 and 2). Homebuilders' costs are rising. The Beige Books released this year pointed out that homebuilders face fierce competition for labor and input costs are rising. In addition, the Beige Book notes slow sales are due to a lack of inventory in some regions of the U.S.9 The implication is that home prices may rise if homebuilders pass on the higher labor and material costs to buyers. There is a shortage of demand for mortgage loans, despite the favorable lending conditions (Chart 9). In addition, first-time homebuyers, a key source of demand for existing homes, has turned from a tailwind to a modest headwind in recent years (Chart 10). Chart 8Housing Affordability Under##BR##Various Rate Assumptions Housing Affordability Under Various Rate Assumptions Housing Affordability Under Various Rate Assumptions Chart 9Easy To Get A Mortgage,##BR##But Mortgage Demand Is Softening Easy To Get A Mortgage But Mortgage Demand Is Softening Easy To Get A Mortgage But Mortgage Demand Is Softening Chart 10Is First Time Homebuyers##BR##Support For Housing Waning? Is First Time Homebuyers Support For Housing Waning? Is First Time Homebuyers Support For Housing Waning? Bottom Line: The housing market remains in an uptrend. A shortage of inventory may be hurting sales, but rising rates are not a threat to affordability. Rising costs for labor and raw materials may cut into homebuilder profits and a recent downshift in first-time homebuyers is a concern. Nonetheless, housing should add to GDP growth this year and next, and keep economic growth well above its long-term potential. In late May, BCA's U.S. Equity Strategy team upgraded the S&P 500 homebuilders industry group to neutral from underweight, citing lower bond yields, solid homebuilder fundamentals and compelling valuations.10 From a macro perspective, we will continue to closely monitor residential investment as we assess the onset of the next recession. Protect Or Defend? BCA's Protector Portfolio does not protect in sideways equity markets. In last week's report,11 we identified 10 periods since 1950 when the S&P 500 equity markets moved sideways for at least 5 months in a narrow range. Table 1 shows the performance of our Defensive and Protector Portfolios12 when U.S. equities are range bound. Our analysis is constrained by data limitations. Table 1S&P Defensives And BCA Protector Portfolios In Sideways Equity Markets Running Out Of Room Running Out Of Room On average, investors have been better off in the S&P 500 than in our Protector Portfolio during sideways phases that have occurred since 1986. Our portfolio outperformed the S&P 500 in only one (2004) of the seven sideways periods. On average, the S&P 500 returned 22% while the Protector Portfolio posted a 2.8% decline. Moreover, the portfolio lost value in the 1988 and 2015 sideways episodes (Chart 11A). Chart 11AS&P Defensives In##BR##Sideways Equity Markets S&P Defensives In Sideways Equity Markets S&P Defensives In Sideways Equity Markets Chart 11BBCA's Protector Portfolio In##BR##Sideways Equity Markets BCA's Protector Portfolio In Sideways Equity Markets BCA's Protector Portfolio In Sideways Equity Markets On the other hand, our Defensive Portfolio outperformed both the S&P 500 and the Protector Portfolio during the three sideways periods since its inception in 1995 (Chart 11B). Consistent with our shift in broad asset allocation this month, we have adjusted our global equity sector allocation to be more defensive. Materials and Industrials were downgraded to underweight, while Healthcare and Telecoms were upgraded (Consumer Staples was already overweight). Financials was downgraded to benchmark because the flattening term structure is expected to pressure net interest margins.13 Bottom Line: BCA's Protector Portfolio has underperformed the S&P 500 and defensive equities in sideways periods for U.S. equities. We recommend that investors put the proceeds from the sale of equity positions into cash. Nonetheless, investors seeking protection against a potential equity market sell-off should look to our Protector Portfolio over defensive-sector positioning. We do not currently recommend these portfolios for all clients, but we may do so if our key sell-off triggers are breached. If macro developments evolve as expected, then we will shift to an outright bearish stance on risk assets later this year or early 2019 in anticipation of a global recession in 2020. Absent a recession, we would move to underweight stocks if a wider trade war develops. Conversely, we would consider temporarily shifting our 12-month recommendation back to overweight if global equities sell-off by more than 15% in the next few months. This would be the case if our economic indicators remain constructive and the Fed either cuts rates or signals that it is on hold. Signs Of Stress In Oil West Texas Intermediate (WTI) oil futures hit a fresh 4-year high last week, despite OPEC 2.0's decision to pump more oil. BCA's Commodity & Energy Strategy service notes that oil markets are becoming increasingly concerned about possible supply disruptions.14 BCA's view is that the Kingdom of Saudi Arabia (KSA) and the core members of OPEC 2.0 - i.e. the seven states in the 24-state coalition that actually can increase production - are attempting to get ahead of an almost certain tightening of the global oil market. Our base case is that OPEC 2.0's core states will front-load their production increase with approx. 800k b/d added to the market in 2H18 and just over 210k b/d in 1H19.15 This will lift the core's total output by about 1.1mm b/d by the end of 1H19 versus 1H18. The increased output from core OPEC 2.0 is, however, offset by losses in the rest of OPEC 2.0 of approx. 530k b/d in 2H18 and just under 640k b/d in 1H19. This leaves OPEC 2.0's net output up by about 275k b/d in 2H18 and down by about 430k b/d in 1H19 compared with 1H18 levels (Chart 12). We keep demand growth at 1.7mm b/d in 2018 and 2019. Our oil strategists' base case is augmented with three possible scenarios: Venezuela's production collapses to 250k b/d from its current 1.3mm b/d, which would allow it to support the demand for domestically refined product and nothing more; A reduction in our forecasted increase in U.S. shale production arising from pipeline bottlenecks; and Both of these two scenarios occur simultaneously between October 2018 and September 2019. Chart 13 illustrates that our revised "ensemble" forecast, an average of the scenarios noted above, for 2H18 Brent stands at $70/bbl, versus $76/bbl last month, reflecting the front-loaded increase in OPEC 2.0 production The global benchmark will likely return to $77/bbl next year, against our previous expectation of $73/bbl. We continue to expect WTI to trade $6/bbl under Brent during the next 18 months. Chart 12OPEC 2.0's Core's Production Increase##BR##Offset By Non-Core Losses OPEC 2.0's Core's Production Increase Offset By Non-Core Losses OPEC 2.0's Core's Production Increase Offset By Non-Core Losses Chart 13Updated Ensemble Forecast Reflects##BR##Venezuela Deterioration, Shale Bottlenecks Updated Ensemble Forecast Reflects Venezuela Deterioration, Shale Bottlenecks Updated Ensemble Forecast Reflects Venezuela Deterioration, Shale Bottlenecks Elevated oil price volatility is a headwind for risk assets. The instability in crude oil markets will continue for the next 18 months, particularly if unplanned outages continue to occur. We identified seven prior periods of increasing oil price volatility. Chart 14 shows that three of these episodes of higher realized oil uncertainty occurred after the economy reached full employment (1998, 2001 and 2008). Two overlapped with recessions (2001 and 2008). Another three coincided with the Russian default crisis of 1998, the accounting scandals and Iraq war in 2002/2003, the U.S. debt downgrade, Arab Spring, the European debt crisis in 2011, and the China-led manufacturing slowdown in 2015. All of these events, at the margin directly or indirectly, affected oil supply demand or both. Because these were shocks of one sort or another-financial, geopolitical or economic-they raised markets' perceptions of risk on the upside and downside for oil prices. Chart 14Risk Assets During Oil Market Volatility Risk Assets During Oil Market Volatility Risk Assets During Oil Market Volatility Risk assets underperformed, other than in the 2002-2003 period of heightened oil market fluctuations associated with the General Strike in Venezuela, which took that country's production to zero for a brief period. The dollar fell in the first three phases of oil price volatility in Chart 14, but increased in the past four. Higher oil volatility tends to coincide with falling oil prices, but a price shock that lifts prices also can accompany higher volatility. Bottom Line: BCA's Commodity & Energy Strategy team notes that oil supply outages are mounting and will lead to more turbulence. Moreover, risk assets tend to underperform as oil volatility escalates. We are neutral on the energy sector. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report titled "Cleanup On Aisle Two", published June 4, 2018. Available at usis.bcaresearch.com. 2 Please see BCA Research's Energy Sector Strategy Weekly Report "Permian Pipeline Constraints Pose Risks To 2019 Shale Production Growth", published June 13, 2018. Available at nrg.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report titled "Cleanup On Aisle Two", published June 4, 2018. Available at usis.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report titled "Sideways", published June 25, 2018. Available at usis.bcaresearch.com. 5 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20180613.pdf 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," published October 16, 2017. Available at usis.bcaresearch.com. 7 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Tightening Up", published May 14, 2018. Available at usis.bcaresearch.com. 8 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Bond Bear Still In Tact," published June 5, 2018. Available at usbs.bcaresearch.com. 9 https://www.federalreserve.gov/monetarypolicy/beigebook201805.htm 10 Please see BCA Research's U.S. Equity Strategy Weekly Report "Seeing The Light", published May 29, 2018. Available at uses.bcaresearch.com. 11 Please see BCA Research's U.S. Investment Strategy Weekly Report "Sideways", published June 25, 2018. Available at usis.bcaresearch.com. 12 Please see BCA Research's U.S. Investment Strategy Weekly Report "A Golden Opportunity", published March 5, 2018. Available at usis.bcaresearch.com. 13 Please see BCA Research's Bank Credit Analyst Monthly Report "July 2018", published June 28, 2018. Available at bca.bcaresearch.com. 14 Please see BCA Research's Commodity & Energy Strategy Weekly Report " OPEC 2.0 Scrambles To Reassure Markets", published June 28, 2018. Available at ces.bcaresearch.com. 15 OPEC 2.0 is the coalition led by Saudi Arabia (KSA) and Russia. This past week it agreed to boost production by 1mm b/d beginning in July. The core consists of KSA, Russia, Iraq, UAE, Kuwait, Oman and Qatar.

Highlights The recent weakness in emerging markets (EM) has not yet altered the Fed's view of the U.S. economy. Capital spending in the U.S. remains upbeat despite a slowdown in economic momentum outside the country. May's Beige Book continued to highlight labor shortages, especially among skilled workers in key areas of the economy. Feature Chart 1The Labor Market Continues To Tighten The Labor Market Continues To Tighten The Labor Market Continues To Tighten U.S. risk assets dipped along with Treasury yields last week as investor worry about Italy, emerging markets and global trade mounted. BCA's stance is that despite the increase in financial market and economic stress overseas, the Federal Reserve will stick to its gradual pace of rate hikes for now. Policymakers at the central bank would need to see a direct and prolonged impact on U.S. financial conditions before adjusting the path of rate hikes. Data released last week on housing, capital spending and the labor market confirmed that the U.S. economy is growing well above its long-term potential in 1H 2018 and that inflation remains at the Fed's 2% target (see section below). The U.S. added 223,000 jobs in May. The 3-month average, at almost 180,000, is well above the expansion in the labor force. Thus, the unemployment rate ticked down to 3.8%, matching the low seen during the height of the tech bubble in 2000 (Chart 1). For the FOMC, the unemployment rate has already reached the level policymakers had projected for the end of the year (3.8%). Indeed, by later this year unemployment is likely to drop below the FOMC's projection for the end of 2019 (3.6%). The Fed has signaled that it is comfortable with an overshoot of the 2% inflation target, but it will likely be forced by early 2019 to transition from simply normalizing monetary policy at a "gradual" pace to targeting slower growth. This would set the stage for a recession in 2020. Julia Coronado, a panelist at BCA's upcoming 2018 Investment Conference in Toronto, noted recently that inflation may fall short of the Fed's target and cause the Fed to scale back its planned hikes.1 Italy remains a key source of concern for markets. BCA's Geopolitical Strategy service notes that a new election is likely in Italy after August, prolonging the political uncertainty there. BCA's stance is that while Italian policymakers' fight with Brussels, Berlin, and the ECB will last throughout 2018, they are not looking to exit the euro area yet. Over the next ten years, however, BCA's Geopolitical Strategy service expects Italy to test the markets with a euro area exit attempt. We are sticking to our view that such an event is far more likely to occur following a recession than it is today.2 The Trump Administration re-ignited the trade war last week. We discuss below, in the context of the Fed's Beige Book, which noted an uptick in uncertainty surrounding trade. Is EM Weakness A Risk? The recent weakness in emerging markets has not altered the Fed's view of the U.S. economy. Chart 2, Chart 3 and Chart 4 show the performance of key U.S and EM financial market earnings and economic metrics indexed to the peak of MSCI's Emerging Market Index in mid-1997, late 2014 and early 2018. Chart 2 (panel 1) shows that the dollar's strength since the EM markets peaked last year is modest compared with prior cycles. Moreover, oil prices are rising today; in 1997-98 and 2014-15 prices collapsed. The implication is that rising oil prices suggest that global economic activity is in an uptrend. Last week, BCA's Commodity and Energy Service team revised their forecasts for oil prices in 2018 and 2019 warning investors to expect more volatility in oil markets.3 U.S. financial conditions (panel 3) have eased since the EM peak in early 2018. This contrasts with 1997-98 and in 2014-2016 when financial conditions tightened considerably. S&P 500 forward EPS estimates (panel 4) have climbed since the top in EM equities, but the rise is related to the 2017 tax bill. Analysts' estimates for U.S. large cap earnings also rose during the EM crisis in the late 1990s, but then fell in 2014 and 2015 as oil prices dropped. U.S. real final demand climbed after EM equities peaked in 1997 and 2014. BCA's view is that the U.S. economy will accelerate in the final three quarters of 2018 and run well above its long-term potential of 1.8%. Chart 2U.S. Financial Conditions, ##br##Oil And EPS During EM Stress U.S. Financial Conditions, Oil And EPS During EM Stress U.S. Financial Conditions, Oil And EPS During EM Stress Chart 3EM Assets 1997-98, ##br##2014-15 And Today EM Assets 1997-98, 2014-15 And Today EM Assets 1997-98, 2014-15 And Today Chart 4U.S. Stocks, Treasuries, ##br##Spread Product And EM Stress U.S. Stocks, Treasuries, Spread Product And EM Stress U.S. Stocks, Treasuries, Spread Product And EM Stress The rise in the dollar and Fed rate hike expectations have pressured some EM currencies, financial markets and economies. That said, the response is muted relative to previous cycles. A Boston Fed paper4 found that during recent bouts of international financial market turmoil, EM economies with fewer economic vulnerabilities performed better than economies that were more exposed. However, the paper also noted that during crises in the late 1990s and early 2000s, there was little differentiation in EM market performance. Chart 3 shows that in the late 1990s and between 2014 and 2016, EM currencies declined about 8.2% in the first few months after EM equity prices peaked. Today, EM currencies are down just 3.8% versus the dollar since the EM equity peak (panel 1). Panel 2 shows EM stocks relative to U.S. stocks since the EM summit and panel 3 shows the global LEI (ex the U.S.) is tracking the mid-1990s episode, but not the 2014-2016 experience. China's Li Keqiang Index (LKI) is also following the late 1990s episode. BCA's China Investment Strategy service states that China's economy will continue to weaken, but that the deceleration will not be as severe as the 2014-2016 slowdown (panel 4).5 U.S. Treasury yields are on the rise; in the late 1990s and 2014-2016 (Chart 4, panel 1) they headed downhill. That said, the yield on the 10-year Treasury note has dipped 3 bps in the past week as investor worry about EM, global trade and Italy more than offset a strong batch of U.S. economic data. Panels 2 and 3 show that the S&P 500 and the U.S. stock-to-bond ratio dipped after the peak in EM stocks this year and in the earlier episodes. We note that at this point in the previous two instances, both U.S. equity prices and the stock-to-bond ratio began to climb and soon surpassed their prior heights. BCA's view is that some caution is warranted on U.S. stocks in the next few months. However, in the next 12 months, the U.S. stock-to-bond ratio will move higher. Investment-grade (panel 4) and high-yield spreads (panel 5) climbed this year after the top in EM stock prices. Moreover, the escalation in high-yield spreads is muted relative to the increase in 2014 as oil prices peaked. We also note that current spread levels are well above those in the late 1990s. BCA's U.S. Bond Strategy service recommends investors overweight high-yield bonds relative to Treasuries.6 Previous periods of EM-related stress in the financial markets led to shifts in the relationship between the dollar and certain U.S. asset classes. The top panel of Chart 5 shows that the correlation between changes in U.S. stock prices and the dollar tends to increase during these episodes. The relationship is more consistent prior to 2000. Since that time, the dollar and U.S. equities have moved in opposite directions during intervals of EM stress. There is no clear pattern in the relationship between the stock-to-bond ratio and the dollar when EM stress intensifies (panel 2). There is a very choppy correlation between S&P operating earnings and the dollar (panel 3). Chart 5U.S. Financial Markets' Correlation With The Dollar During EM Stress U.S. Financial Markets' Correlation With The Dollar During EM Stress U.S. Financial Markets' Correlation With The Dollar During EM Stress Likewise, there is no consistent interconnection between bond yields and the dollar (Chart 5, panel 4) as EM stress increases. However, as the pressure mounts, we note that the correlation between the dollar and the 10-year begins to shift. Oil and gold prices and the dollar tend to move in opposite directions during times of EM stress (not shown). Moreover, since the early 2000s, there is a consistently negative relationship between the dollar, gold and oil. In recent years, an escalating dollar has been aligned with small cap stocks outperforming large caps. Larger companies have more exposure to overseas sales than small cap firms in the S&P 500.7 Bottom Line: Dollar strength and rising U.S. bond yields are a classic late-cycle combination that often spells trouble for emerging market assets. Escalating turmoil in EM financial markets could potentially lead the Federal Reserve to put the rate hike campaign on hold. However, that would require some signs of either domestic financial stress or slowing growth. Stay short duration over a 12 month horizon. BCA's U.S. Bond Strategy service is looking for a trough in economic surprise and a capitulation in speculative positioning in the Treasury market to signal the end to the recent pullback in yields.8 Dollar Impact Capital spending in the U.S. remains upbeat despite a slowdown in economic momentum outside the country. BCA's view is that global growth will cool for the next few months and then reaccelerate. Chart 6 shows that global capital goods imports have rolled over (panel 1), but that new capital goods orders in the G3 remain in an upward trend (panel 2). Nonetheless, most of the strength in the G3 is from the U.S. BCA's model for nominal and real business investment (panel 3) suggests that capex is poised to rocket in the coming quarters. Moreover, CEO confidence measured by Duke and the Business Roundtable remain at cycle highs (Chart 7, panel 1) while business spending plans in the regional Fed surveys are still elevated (panels 2 and 3). Higher oil prices are not the only story behind the boom in U.S. business spending. Chart 8 shows that energy capex troughed (panel 3) a few months after oil prices (panel 1) in early 2016. Business spending outside the oil patch never turned negative on a year-over-year basis (panel 2) and it is still on the upswing. The 2017 tax bill and corporations' search for labor-saving machinery as wage and compensation metrics rise are behind the surge in spending. Robust corporate earnings also provide a tailwind for capex (panel 4). Chart 6Global Growth Is Rolling Over... Global Growth Is Roilling Over… Global Growth Is Roilling Over… Chart 7..But U.S. Growth Is Poised To Lift Off ..But U.S. Growth Is Poised To Lift Off ..But U.S. Growth Is Poised To Lift Off Chart 8Oil Is A Tailwind For Capes, ##br##But Not The Whole Story Oil Is A Tailwind For Capes,But Not The Whole Story Oil Is A Tailwind For Capes,But Not The Whole Story Last week's report on corporate profits allows us to compare the trajectory of the S&P 500's profits and margins to the NIPA measures (Chart 9). Both metrics indicate that earnings jumped in recent quarters (panel 1) to record heights (panel 2). Any disconnect between the two indicators has disappeared.9 Chart 10 shows that S&P 500 revenues dipped in Q1 (panel 1), but NIPA-based sales measures continued to climb (panel 2). However, panel 2 shows a divergence in margins. The BEA sounding leaped ahead in Q1 while the S&P 500 version levelled off. BCA's view is that S&P 500 earnings growth on a trailing four-quarter basis will peak later this year (Chart 11). Moreover, we anticipate the secular mean reversion of margins to re-assert itself in the S&P data, perhaps beginning later in 2018. Chart 9S&P And NIPA Profit Measures Are Aligned S&P And NIPA Profit Measures Are Aligned S&P And NIPA Profit Measures Are Aligned Chart 10NIPA And S&P Sales And Profit Margins NIPA And S&P Sales And Profit Margins NIPA And S&P Sales And Profit Margins The dollar's recent strength is not yet a threat to U.S. corporate profits nor the U.S. equity market. BCA's view is that the dollar will advance by 5% in the next 12 months. The appreciation would trim EPS growth by roughly 1 to 2 percentage points, although most of this would occur in 2019 due to lagged effects. Indeed, the dollar would only climb in the context of robust U.S. economic growth and an expanding corporate top line. Nonetheless, the stronger greenback is not yet evident in forward EPS estimates for 2018 or 2019. (Chart 12). Chart 11Strong S&P 500 EPS Growth Ahead, ##br##Will Start To Slow Soon Strong S&P 500 EPS Growth Ahead, Will Start To Slow Soon Strong S&P 500 EPS Growth Ahead, Will Start To Slow Soon Chart 12Is the Stronger Dollar Starting To Impact 2019 EPS Estimates? Is the Stronger Dollar Starting To Impact 2019 EPS Estimates? Is the Stronger Dollar Starting To Impact 2019 EPS Estimates? Bottom Line: BCA's view is that the slowdown in growth outside the U.S. is not the start of a more significant downturn. Monetary policy is still accommodative worldwide, U.S. fiscal policy is loose and governments outside the U.S. are no longer tightening policy. The implication is that a big slide in global growth is not likely and that by the end of the summer, global growth will probably reaccelerate. Therefore, risks to the dollar are much more balanced and we do not foresee much more upside in the greenback. Stay long stocks versus bonds. However, investors with longer horizons should begin to prepare for lower real returns in the 2020s after a recession early in that decade. Beige Book Update The Beige Book released last week ahead of the FOMC's June 12-13 meeting suggested that uncertainty surrounding U.S. trade policy remained an important headwind in April and May. The Fed's business and banking contacts mentioned either tariffs or trade policy 34 times in the Beige Book. This was below 44 mentions in the April edition, but well above the 3 mentions in March. Moreover, uncertainty came up 13 times in May (Chart 13, panel 5); 10 were related to trade policy. There were nine mentions of trade in April and only two in March. Chart 13Rise Of Inflation Words ##br##And Uncertainty Stand Out Rise Of Inflation Words And Uncertainty Stand Out Rise Of Inflation Words And Uncertainty Stand Out BCA's view is that trade-related uncertainty will persist at least until the midterm elections in November.10 The Trump administration announced a new round of tariffs on Chinese products last week. Moreover, the U.S. plans to end the exemptions it provided to E.U. steelmakers on the tariffs that the U.S. imposed earlier this year. BCA's Geopolitical Strategy service notes that the U.S.-China trade war is back on. The significance of the administration's about-face on trade is that it invalidates the conventional view that President Xi and Trump would promptly make a deal to ease tensions. President Trump's election, however, has revealed the preference of the median voter in the U.S. on trade. That preference is far less committed to free trade than previously assumed. Despite the headwind from trade, BCA's quantitative approach to the Beige Book's qualitative data continues to point to underlying strength in the U.S. economy, a tighter labor market and higher inflation. Moreover, references to a stronger dollar have disappeared from the Beige Book. Chart 13, panel 1 shows that at 67% in May, BCA's Beige Book Monitor ticked up from April's 55% reading, which was the lowest level since November 2017 when doubts over the tax bill weighed on business sentiment. The number of weak words in the Beige Book remained near four-year lows. On the other hand, the number of strong words climbed in May, but remains below last fall's post-hurricane highs. The tax bill was noted 3 times in the latest Beige Book, down from 12 in April and 15 in March. The legislation was cast in a positive light in two of the three mentions. BCA's stance is that the dollar will move modestly higher in 2018. The trade-weighted dollar is up 4.1% since mid-April, but the elevated value of the greenback is not yet a concern for Beige Book respondents. Furthermore, based on the minimal references to a robust dollar (only eight in the past eight Beige Books), the dollar should not be an issue for corporate profits in Q2 2018. The handful of recent references sharply contrasts with the surge in comments during 2015 and early 2016 (Chart 13, panel 4). The last time that eight consecutive Beige Books had so few remarks about a strong dollar was in late 2014. Table 1Labor 'Shortages' Identified In The Beige Book Cleanup On Aisle Two Cleanup On Aisle Two The disagreement on inflation between the Beige Book and the Fed's preferred price metric narrowed in May (Chart 13, panel 3). The number of inflation words rose to a fresh cycle zenith, surpassing the July 2017 peak. Core PCE also increased in early 2018. However, in the past year, inflation measured by the PCE deflator, failed to match the escalation in inflation references. In the past, increased remarks about inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may still climb. May's Beige Book continued to highlight labor shortages, especially among skilled workers in key areas of the economy. Shortages of qualified workers were reported in various specialized trades and occupations, including truck drivers, sales personnel, carpenters, electricians, painters and information technology professionals. The Beige Book noted that many firms responded to the lack of qualified workers by increasing wages and compensation packages. Moreover, the word "widespread", which is part of BCA's inflation words count, was used 11 times in May, to describe both labor shortages and rising input costs. Table 1 shows industries with labor shortages. In the year ended April 2018, the gain in average hourly earnings in most of the industries was faster than average. Moreover, in nearly all these categories, labor market conditions are the tightest since before the onset of the 2007-2009 recession. More details can be found in a recent Fed study on labor shortages in the manufacturing sector.11 BCA's Beige Book Commercial Real Estate (CRE) Monitor12 remains in a downtrend (Chart 14). The Fed has highlighted valuation concerns in CRE and BCA's Global Investment Strategy service recently stated that the sector is increasingly vulnerable.13 Chart 14Beige Book Commercial Real Estate Monitor Beige Book Commercial Real Estate Monitor Beige Book Commercial Real Estate Monitor Bottom Line: May's Beige Book supports our stance that inflation will lead to at least three more Fed rate hikes by the end of the year. Moreover, labor shortages may be spreading from highly skilled to moderately skilled workers, and rising input costs are widespread. The nation's tax policy still gets high marks from the business community, but ongoing concerns over trade policy will restrain growth. The Fed may back off from this gradual path if stress in the emerging markets leads to tighter U.S. financial conditions. Still, it will take more than the recent spate of EM turmoil to deter the Fed. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 https://www.rutgersrealestate.com/blog-re/low-inflation-the-good-and-the-bad/ 2 Please see BCA Research's Geopolitical Strategy "Italy, Spain, Trade Wars... Oh My!", published May 30, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's Commodity And Energy Strategy "OPEC 2.0 Guiding To Higher Output; Volatility Set To Rise ... Again", published May 31,2018. Available at ces.bcaresearch.com. 4 https://www.bostonfed.org/-/media/Documents/Workingpapers/PDF/rpa1702.pdf 5 Please see BCA Research's China Investment Strategy Weekly Report, "11 Charts to Watch", published May 30, 2018. Available at cis.bcaresearch.com. 6 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary, "Coming To Grips With Gradualism", published May 8, 2018. Available at usbs.bcaresearch.com. 7 Please see BCA Research's U.S. Equity Strategy Weekly Report, "Too Good To Be True", published January 22, 2018. Available at uses.bcaresearch.com. 8 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Pulling Back And Looking Ahead", published May 22, 2018. Available at usbs.bcaresearch.com. 9 Please see BCA's U.S. Investment Strategy Weekly Report, "Summer Stress Out", July 3, 2017. Available at usis.bcaresearch.com. 10 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," April 4, 2018. Available at gps.bcaresearch.com. 11 https://www.federalreserve.gov/econres/notes/feds-notes/evaluating-labor-shortages-in-manufacturing-20180309.htm 12 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Summer Stress Out", dated July 3, 2017. Available at usis.bcaresearch.com. 13 Please see BCA Research's Global Investment Strategy Weekly Report, "Three Tantalizing Trades - Four Months On", dated January 19, 2018. Available at gis.bcaresearch.com.

Highlights The spike in volatility in early 2018 did not change the trajectory of most of the cross-asset correlations that we track. The 2017 tax bill, rising energy prices, and banks' willingness to lend all suggest strong capital spending this year. Our view is that stagflation is not a near-term threat. Nonetheless, investors are concerned about a return of a period of decelerating growth and rising inflation. We examine the performance of U.S. financials in and out of stagflation. We reexamine the link between inflation, deficits, credit and money supply growth. Feature Chart 11H GDP Tracking Well Above Potential 1H GDP Tracking Well Above Potential 1H GDP Tracking Well Above Potential The VIX moved lower last week even as U.S. bond yields rose. Tensions with North Korea re-escalated, but Trump's trade spat with China eased. On balance, the spike in volatility in early 2018 did not change the trajectory of most of the cross-asset correlations that we track. Economic growth prospects in the U.S. remained upbeat. A series of reports for April and May on housing, consumer spending, manufacturing and capital spending all indicated that real GDP growth in Q2 2018 was tracking to over 4% after a 2.3% gain in Q1, well above the economy's potential growth rate of 1.8% (Chart 1). Capital spending remains poised to lift off in 2018 aided by the supply-side impact of the 2017 tax cut bill and higher oil prices. Despite upbeat economic news in the U.S., there were additional signs last week that growth outside the U.S. was slowing.1 This deceleration, coupled with recent readings on wage and price inflation, suggest that investors may be concerned that stagflation is imminent. BCA's view is that the next bout of stagflation is still several years away. In this week's report, we look at the longer-term relationship between inflation, money supply, credit growth and deficits. Early 2018 Volatility Spike: An Update Surges in volatility do not signal either the end of a business cycle or an equity bear market. Moreover, while there are many examples of shifts in correlation around elevated equity volatility, there is no consistent relationship between the two.2 Nonetheless, 60% of volatility upheavals outside of recessions occurred during the late stages of a business cycle. Thus, the recent jump in volatility is another signal that the economy is in the final stages of expansion. Our November 13, 2017 report discussed financial market volatility and its relationship with the business cycle, monetary policy and economic volatility.3 In that report, we noted that any meaningful pickup in inflation would upset the 'low vol' applecart. Prices of U.S. dollar financial assets have recovered since early February's market turbulence, but are not back to pre-spike levels. Chart 2 shows that at 13.7, the VIX is 63% lower than its early February peak. Neither the stock-to-bond ratio (panel 2) nor the S&P 500 (panel 3) has returned to its late January high, but both have bounced up. Small caps (panel 4) have hit a new record, but emerging market equity prices (in U.S. dollars) have languished. The price of West Texas Intermediate oil reached a fresh cycle high in late March and is now above $70 (Chart 3, panel 2). BCA's Commodity & Energy Strategy service expects West Texas to average $70/bbl this year. Moreover, increasing geopolitical risks to supplies (Venezuela and Iran) raise the chances of WTI prices reaching $80/bbl by the end of the year, with Brent prices threatening $90/bbl.4 Our stance on oil prices this year supports more energy-related capex (see next section). Panel 3 shows that despite higher realized inflation and inflation expectations, gold prices have rolled over since the volatility spike. High-yield spreads briefly returned to their late January lows in mid-April, but are now back to the middle of the range that they have been in since early February (panel 4). The dollar has surged in recent months (panel 5). BCA's view is that the dollar will continue to strengthen as the Fed raises rates more than the market expects and as U.S. economic growth outpaces growth outside the U.S.5 Chart 2The VIX And U.S. Financial Assets... The VIX And U.S. Financial Assets... The VIX And U.S. Financial Assets... Chart 3...Before And After The February Vol Spike ...Before And After The February Vol Spike ...Before And After The February Vol Spike Chart 4 shows three-year rolling correlations between several major U.S. asset classes. The early 2018 volatility spike coincided with a shift in the link between the 10-year Treasury yield and the broad dollar (panel 2). The relationship between Treasury yields and oil troughed prior to the spike and continues to climb (panel 4). Otherwise, the longer-term, cross-asset class correlations in place prior to early February are still in play. Chart 4Spike In Vol Vs. Stock, Bond Dollar, Oil Correlations Spike In Vol Vs. Stock, Bond Dollar, Oil Correlations Spike In Vol Vs. Stock, Bond Dollar, Oil Correlations However, shorter-term correlations within the S&P 500 have shifted (Chart 5). The early February volatility run up marked a bottom in the correlation between sectors, industries and individual S&P 500 stocks. This is consistent with what happened in the wake of volatility spikes in 2010 and 2011, but not following the 2015 episode. Bottom Line: The recent vol spike did not signal the end of the expansion or the bull market. Stay long stocks over bonds. Chart 5Intra-S&P 500 Correlations Shifted After The Vol Spike Intra-S&P 500 Correlations Shifted After The Vol Spike Intra-S&P 500 Correlations Shifted After The Vol Spike Soundings From The Supply Side BCA expects the U.S. economy to grow above its long-term potential this year and into next year, further reducing slack in both the product and labor markets, and ultimately pushing up inflation. We discussed the housing and consumer sectors in early May6 and this week, we assess business capital spending. Our recent reports7 discussed the near-term benefits to the U.S. economy from higher government spending, but there are supply side benefits as well. The Congressional Budget Office (CBO) boosted its estimate of the economy's long-run potential growth rate due to the supply-side benefits of lower taxes on the labor market and the immediate expensing of capital outlays. Faster growth in the long run would reduce the projected cumulative budget deficit from 2018-2027 by $1 trillion. The CBO also expects that labor force growth will pick up as lower personal income tax rates encourage workers to work longer hours.8 BCA's view is that capital spending was on the upswing before the tax bill passed last year (Chart 6). Moreover, our model for business capital spending suggests gains even without higher oil prices (Chart 7). Chart 8 shows that banks are easing their lending standards for C&I loans (panel 1) and that higher rates have not yet increased the cost of funding to restrictive levels (panel 2). However, demand has been tepid, although it is still trending higher (panel 3). The tax repatriation portion of the 2017 tax cut may have temporarily reduced businesses' demand for loans. Chart 6S&P 500 Sensitive To Oil ##br##Prices And Oil Driven Capex S&P 500 Sensitive To Oil Prices And Oil Driven Capex S&P 500 Sensitive To Oil Prices And Oil Driven Capex Chart 7Business Spending Poised To Lift Off Business Spending Poised To Lift Off Business Spending Poised To Lift Off Chart 8Supply And Demand For C&I Loans Supply And Demand For C&I Loans Supply And Demand For C&I Loans Bottom Line: A surge in U.S. capital spending is likely in the second half of 2018 and into 2019. The rising cost of human capital and sagging productivity are additional incentives for firms to spend on labor-saving equipment. Moreover, increased oil prices will drive additional spending in the energy sector. Our U.S. Equity Strategy team recommends an overweight to the Industrials sector.9 While surging capex this year and next will help to boost productivity in the short run, a comprehensive, economy-wide infrastructure package would be helpful in steering the economy away from stagflation in the long run. Stagflation Scenario BCA's 2018 Outlook10 notes that stagflation may be not be present in the U.S. for several more years, likely not until the early 2020s after the next recession. However, BCA's Global Fixed Income Strategy service states that the global economy may be entering a period of mild stagflation characterized by slowing economic growth and rising inflation.11 Nonetheless, some investors are concerned that a prolonged period of stagflation may ensue. We define stagflation as episodes of decelerating real economic growth and accelerating core inflation (Chart 9). Accordingly, stagflation occurred in the 1960s, 1970s and early 1980s. Since then, there have been an additional six episodes, all of them milder than earlier occurrences. The last bout was between July 2015 and October 2016. Chart 9Risk Assets And Stagflation Risk Assets And Stagflation Risk Assets And Stagflation We show the performance of U.S. financial assets, commodities, the dollar and S&P 500 earnings when stagflation was present (Table 1) and when it was not (Table 2). Note that recessions occurred during four of the stagflationary periods (late '60s/early '70s, early-to-mid '70s, late '70s, and late '90s-to-early 2000s). There were two recessions (early 1980s and 2007-2009) when stagflation did not appear. Table 1Risk Assets, Commodities, Gold Oil And The Dollar During Stagflation Too Soon For Stagflation? Too Soon For Stagflation? Table 2Risk Assets, Commodities, Gold Oil And The Dollar When No Stagflation Is Present Too Soon For Stagflation? Too Soon For Stagflation? U.S. stocks, the stock-to-bond ratio, investment-grade credit and high-yield bonds outperform when there is no stagflation. Small cap performance relative to large caps is also better when stagflation is present. Gold (average gain of 85%) and oil (86%) are the standout performers during these cycles. Without stagflation present, gold rises by only 13% on average and oil prices fall by 11%. The dollar climbs by 4% on average without stagflation and declines by 5% when stagflation develops. Restricting our analysis to only the more benign bouts of stagflation in the past 20 years we find similar results; stocks, the stock-to-bond ratio, investment grade and high yield credit perform better when there are bouts of benign stagflation. A notable exception is that there has been little difference in the performance of gold in or out of stagflation in the past two decades. Bottom Line: BCA expects inflation to reach the Fed's 2% target this year and accelerate in 2019, prompting more aggressive central bank actions in mid-2019 through mid-2020 than the market currently prices in. Increased rates will send the economy into recession in 2020. Stagflation will likely take hold as the economy recovers from that recession. Stay overweight stocks versus bonds for now, but look to pare back exposures later this year. Investors with longer time horizons should begin to prepare for lower real returns in the 2020s after the end of the recession early in the decade. Inflation: A Longer-Term View Some investors are concerned that rising deficits will immediately lead to higher inflation. We take a longer-term approach based on our analysis of the link between inflation and federal government interest payments, private credit growth, money supply growth and federal budget deficits. There is only a loose relationship between federal government interest payments as a share of GDP and inflation (Chart 10). For example, interest payments were high relative to GDP in the 1990s, but inflation was low. In the 1970s, inflation was high while interest payments as a share of GDP were not at an extreme. However, there is a strong connection between the growth of private credit and money supply, and inflation. Chart 11 shows that elevated rates for private credit growth are associated with increased inflation and vice versa. High inflation in the 1970s was accompanied by strong credit growth. In this decade, we have experienced meager private credit creation and very low inflation. Chart 12 shows a similar relationship between M2 growth and inflation. Note that strong M2 growth in the 1970s coincided with high inflation, while minimal growth in money supply in the 1930s was accompanied by deflation. On the other hand, there is only a tenuous connection between deficits as a share of GDP and inflation (Chart 13). In the inflationary 1970s, deficits averaged just 2% of GDP. However, the 1950s and 1960s saw both exceedingly low inflation and deficits. So far in the 2010s, deficits have averaged near 5% of GDP, but inflation has been muted at barely over 1%. Chart 10Long Run Relationship Between Federal ##br##Net Interest Payments And Inflation Too Soon For Stagflation? Too Soon For Stagflation? Chart 11Long Run Relationship Between ##br##Private Credit Growth And Inflation Too Soon For Stagflation? Too Soon For Stagflation? Chart 12Long Run Relationship Between ##br##M2 Growth And Inflation Too Soon For Stagflation? Too Soon For Stagflation? Chart 13Long Run Relationship Between Federal ##br##Budget Deficits And Inflation Too Soon For Stagflation? Too Soon For Stagflation? Moreover, the fiscal stimulus put in place late last year and early this year is likely to push inflation higher as it adds to aggregate demand in an economy that is already at full employment. Bottom Line: BCA expects inflation to reach the Fed's 2% target based on the core PCE measure this year, and move above that goal next year, which would drive up both short and long rates. Stay short duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Global Fixed Income Strategy Weekly Report "Serenity Now," published May 15, 2018. Available at gfis.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report "Late Innings," published February 26, 2018. Available at usis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report "Patience Required," published November 13, 2017. Available at usis.bcaresearch.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Feedback Loop: Spec Positioning & Oil Price Volatility," published May 10, 2018. Available at ces.bcaresearch.com. 5 Please see BCA Research's Global Investment Strategy Weekly Report "Swan Songs," published May 18, 2018. Available at gis.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report "Stressing The Consumer And Housing Sectors," published May 7, 2018. Available at usis.bcaresearch.com. 7 Please see BCA Research's The Bank Credit Analyst, published May 2018 and U.S. Investment Strategy Weekly Report "Late Innings," published February 26, 2018. Available at bca.bcaresearch.com and usis.bcaresearch.com. 8 https://www.cbo.gov/system/files/115th-congress-2017-2018/reports/53651… 9 Please see BCA Research's U.S. Equity Strategy Weekly Report "Earnings Take Center Stage," published October 2, 2018. Available at uses.bcaresearch.com. 10 Please see BCA Research's The Bank Credit Analyst "2018 Outlook - Policy And The Markets: On A Collision Course," published November 20, 2017. Available at bca.bcaresearch.com. 11 Please see BCA Research's Global Fixed Income Strategy Weekly Report "Stagflation-ish," published April 18, 2018. Available at gfis.bcaresearch.com.

Feature A Conversation With Ms. Mea I met with some of our European clients over the past few weeks, and used the opportunity to connect with Ms. Mea, a long-standing client of BCA who visited us last fall.1 As always, Ms. Mea was keen to scrutinize our viewpoints, delve into intricacies of our analysis and understand the differences between our interpretations of the global macro landscape and the prevailing market consensus. I hope clients find our latest dialogue insightful. Ms. Mea: It seems your negative call on emerging markets (EM) is finally beginning to work out: EM share prices in both absolute terms and relative to developed markets (DM) have dropped to their 200-day moving averages (Chart I-1). It seems we are at a critical juncture: If share prices bottom at these levels, a major upleg is likely and, conversely, if they break below this technical support, considerable downside may be in the cards. What makes you think this is not a buying opportunity? Indeed, EM stocks are testing a critical technical level. I doubt this is a buying opportunity. It looks like EM corporate profit and revenue growth have peaked (Chart I-2, top and middle panels). The question is not if but how much downside there is. I believe the downside will be substantial because the forces that drove this recovery are in the process of reversing. Chart I-1EM Equities Are At Critical Juncture EM Equities Are At Critical Juncture EM Equities Are At Critical Juncture Chart I-2EM Profits Have Topped Out EM Profits Have Topped Out EM Profits Have Topped Out First, the Chinese credit and fiscal stimulus of early 2016 has been reversed, and our China credit and fiscal spending impulse projects considerable downside in EM non-financial corporate earnings growth (Chart I-2, bottom panel). Second, Asia's manufacturing cycle is downshifting (Chart I-3). Korea's export growth is flirting with contraction (Chart I-3, bottom panel). Even if U.S. final demand remains robust, U.S. imports could slow, hurting the rest of the world. Chart I-4 illustrates that America's imports have been growing faster than its final demand, implying re-stocking of imported goods. Typically, periods of re-stocking are followed by waves of de-stocking. During the latter periods, import growth decelerates. Chart I-3Asia: Trade Is Decelerating Asia: Trade Is Decelerating Asia: Trade Is Decelerating Chart I-4U.S.: Final Demand And Imports U.S.: Final Demand And Imports U.S.: Final Demand And Imports Third, investor sentiment remains quite bullish on EM and EM equity valuations are not cheap in both absolute and relative terms (Chart I-5). Meanwhile, credit spreads as well as local bond yield spreads over U.S. Treasurys are very narrow. Chart I-5EM Equities Are Not Cheap EM Equities Are Not Cheap EM Equities Are Not Cheap Last but not least, U.S. wage growth and core inflation are rising. This warrants rising U.S. interest rate expectations and a rally in the dollar. As EM currencies depreciate against the greenback, EM stocks and bonds will sell off too. In a nutshell, it appears that the December and January spike in EM share prices was the final blow-off phase of this cyclical bull market. It is typical for a major market move to culminate with a bang. It seems this was the case with EM share prices, currencies and local bonds in December and January. Interestingly, the fact that EM share prices have failed to break above their previous highs is a bad omen (Chart I-1 on page 1). If our negative outlook on China's industrial cycle, commodities prices and the bullish view on the U.S. dollar play out, the current selloff in EM risk assets will progress into another bear market similar to the 2014-'15 episode. Ms. Mea: There is a widely held belief in the investment community that we are in the late expansion phase of the global business cycle. Late cyclical equity sectors, especially commodities and industrials, typically outperform at this stage. If so, this warrants overweighting EM as high commodities prices are going to help EM equities outperform DM ones. This is contrary to your recommended strategy of underweighting EM versus DM. Where and why do you differ from the consensus view? When discussing cycles, it is important to specify which economy we are referencing. With respect to the U.S. economy, I agree that we may be in a late-cycle expansion phase, when growth is strong, and wages and inflation are rising. In fact, in my opinion, U.S. wages and core CPI are likely to surprise to the upside (Chart I-6). Based on America's current economic dynamics, it makes sense to be overweighting late cyclicals. That said, just because the U.S. is in the late phase of its own expansion cycle doesn't mean China is at the same stage too. China's business cycle varies greatly from that of the U.S. and Europe. In my opinion, China's industrial sector in general, and capital spending in particular, are re-commencing the downtrend that took place between 2012-'16, but was interrupted by the injection of massive credit and fiscal stimulus in early 2016. Chart I-7 portrays China's manufacturing cycle along with the performance of EM stocks relative to their DM peers, as well as commodities prices. A few observations are in order: Chart I-6U.S. Wages And Inflation To Rise Further U.S. Wages And Inflation To Rise Further U.S. Wages And Inflation To Rise Further Chart I-7Where Are EMs & Commodities In The Cycle? Where Are EMs & Commodities In The Cycle? Where Are EMs & Commodities In The Cycle? China's capital spending and most of its industrial sectors were in their late cycle expansion phase in 2009-2011. The post-Lehman monetary and fiscal stimulus produced an unprecedented boom in investment spending. Yet, it was unsustainable because it created a misallocation of capital, enormous amounts of debt and asset bubbles. During this period, EM outperformed DM by a large margin, and global late cyclicals - such as materials, energy and industrials - outperformed the global equity benchmark. From 2012 to early 2016, there was a major downtrend in China's capital spending. Demand for capital goods/machinery and commodities downshifted and in some cases contracted (Chart I-8). After the new round of stimulus in early 2016, the Chinese economy recovered. However, the impact of this stimulus has now waned, and policymakers have been tightening policy since early 2017. Consequently, the downtrend in the mainland's industrial sector appears to be re-commencing and will likely deepen. In short, I view the rally in EM and commodities over the past two years as a mid-cycle hiatus in the bear market that began in 2011. Odds are that EM and commodities will sell off even if DM demand holds up. Chart I-9 denotes that global machinery and chemical stocks have already been underperforming the global equity benchmark. Energy stocks are still being supported by the rally in oil prices, but in my opinion it is a matter of time before oil prices roll over (we discuss our oil outlook below). However, given energy stocks have done so poorly relative to other sectors amid rising crude prices, they may not underperform, even if oil prices relapse. Chart I-8China: Construction Industry Profile China: Construction Industry Profile China: Construction Industry Profile Chart I-9Global Late Cyclicals Have Underperformed Global Late Cyclicals Have Underperformed Global Late Cyclicals Have Underperformed In 2010, I made the call that EM share prices, currencies and commodities had peaked for the decade. At the same time, I argued that technology, health care, and the equity markets with large weights in these sectors, namely the U.S., would deliver strong returns. This roadmap by and large remains pertinent. Chart I-10China Accounts For 50% Of ##br##Global Metals Demand Where Are EMs In The Cycle? Where Are EMs In The Cycle? Typically, winners of the previous decade perform poorly during the entire following decade. EM and commodities were the superstars of the last decade. There are still two more years to go in this decade. Consistent with this roadmap, we expect EM risk assets and commodities to relapse anew in the next 12-18 months. While the last two years were very painful not to chase the EM and commodities rallies, odds are that this has been a mid-cycle hiatus in a decade-long downtrend. Ms. Mea: Don't you think strong growth in DM will drive commodities prices higher, despite weakness in China? Are you bearish on oil because of China's demand too? I am optimistic about domestic demand in the U.S. and Europe. Yet, commodities prices, especially industrial commodities, are driven by China, not the U.S., EU or India. China consumes at least 50% of industrial and base metals (Chart I-10). Consistent with our view of a downtrend in China's capital spending in general, and construction in particular, we remain downbeat on industrial metals prices. Regarding oil prices, China's share in global oil demand is much smaller than it is for metals - the country consumes 14% of the world's petroleum products. Further, we are not negative on Chinese household demand for gasoline, but we are negative on mainland diesel demand. The latter fluctuates with industrial activity, as Chart I-11 illustrates. Importantly, oil prices will likely go down even if China's oil consumption growth remains robust. The basis is as follows: Investors' net long positions in oil are at record high levels (Chart I-12). Chart I-11China's Diesel Demand China's Diesel Demand China's Diesel Demand Chart I-12Investors Are Record Long Oil Investors Are Record Long Oil Investors Are Record Long Oil Traders have been buying oil because of rollover yield. Since the oil market is in backwardation, investors have been capturing rollover yield when they roll over contracts. Oil has been a carry trade over the past year as expectations of tight supply and a weaker U.S. dollar have spurred record numbers of investors to go long oil. As the U.S. dollar strengthens and China's growth slows, these traders will likely head for the exits with respect to their long oil positions. China has been importing more oil than it consumes since 2014. Our hunch is it has been accumulating strategic oil reserves. With oil prices spiking to $70, the pace of accumulation of strategic oil reserves may slow, and prices could retreat. China traditionally purchases commodities on dips. Finally, oil typically shoots up in the late stages of the business cycle. Chart I-13 illustrates that oil prices lag or at best are coincident with the global industrial cycle. In fact, often these spikes in oil prices - like the current one - occur due to supply constraints in the late stages of the business cycle. Nevertheless, they often mark the top. Chart I-13Oil Is Often Late To Peak Oil Is Often Late To Peak Oil Is Often Late To Peak In brief, while the case for oil is different than for industrial metals, risks to crude prices are tilted to the downside over the next six-to-nine months or so.2 Ms. Mea: One of the key drivers of your view on global markets has been a strong U.S. dollar. Why do you think the recent rebound in the dollar has staying power, and how far will it rally? Odds are that the U.S. dollar has made a major bottom and has entered a cyclical bull market. While we are not sure whether the greenback will surpass its early 2016 highs, it will at least re-test those levels on many crosses, especially versus EM and commodities currencies. The euro and other European currencies will likely not drop to their early 2016 lows, and as a result, EM currencies stand to depreciate considerably versus both the U.S. dollar and the euro. This will undermine the dollar- and euro-based investors' returns in EM equities and local currency bonds, and lead to an exodus of foreign funds. Contrary to market consensus thinking, the EM local interest rate differential over DM does not drive EM exchange rates. In fact, there is an inverse relationship between local interest rate spreads over U.S. rates and their currencies (Chart I-14). It is the exchange rate that drives local rates in EM. Currency depreciation pushes interest rates up, and exchange rate appreciation leads to lower interest rates. Many EM currencies correlate with commodities prices and global trade. The latter two will likely weigh on EM exchange rates in the next six to nine months. What's more, EM are much more leveraged to China than to DM. Both EM currencies as well as EM's relative equity performance versus DM mirror marginal shifts between Chinese and DM imports - the latter is a proxy for their domestic demand (Chart I-15). Chart I-14EM Currencies And Yields Differential Over U.S. EM Currencies And Yields Differential Over U.S. EM Currencies And Yields Differential Over U.S. Chart I-15EM Is Much More Sensitive To China Than DM EM Is Much More Sensitive To China Than DM EM Is Much More Sensitive To China Than DM As China's growth slumps, EM will likely catch pneumonia, while DM gets away with just a cold. This entails that EM currencies will come under downward pressure against both the U.S. dollar and the euro. Finally, provided EM ex-China has accumulated a lot of U.S. dollar debt, their currency depreciation will elevate debt stress. While we do not expect this to result in massive defaults, the ability of debtor companies with foreign currency liabilities to invest and expand will be curtailed. This is a negative for growth. EM debtors with dollar debt are much more vulnerable to an appreciating dollar than rising U.S. interest rates. From the perspective of their debt servicing costs alone, 10% dollar appreciation is much more painful than a 100 basis point rise in U.S. dollar rates. Hence, regardless of whether the greenback's rally occurs amid rising or falling U.S. bond yields, it will impose meaningful pain on EM debtors. In this context, EM sovereign and corporate spreads are too tight and will likely widen if and as EM currencies and commodities prices decline. Ms. Mea: In last week's statement, China's Politburo omitted the word "deleveraging" and the People's Bank of China cut the Reserve Requirement Ratio (RRR). Notably, onshore bond yields have dropped a lot. Does this not mean that stimulus is in the pipeline and the point of maximum stress for EM and commodities is now behind us? I doubt it. First, China's official media outlet, Caixin,3 explicitly stated that the Politburo statement does not mean either new stimulus or that the policy of battling financial excesses has been abandoned. Second, the RRR cut has led to only small net liquidity injections in the banking system. Its primary goal was to reduce interest rate costs for banks. Are falling bond yields in China a bullish or bearish signal for China-related risk assets? It is not clear. In 2017, interest rates rose considerably, yet China/EM risk assets completely ignored it. I was puzzled by this. Meanwhile, the recent drop in bond yields has coincided with falling EM share prices (Chart I-16). Third, the budget plan for 2018 does not entail major fiscal stimulus. Table I-1 denotes aggregate fiscal and quasi-fiscal spending will rise by 8% in 2018 compared to an actual rise of 8.6% in 2017 and 8.1% in 2016. All numbers are for nominal growth. Table I-1China: Fiscal And Quasi-Fiscal Spending (Annual Nominal Growth Rates) Where Are EMs In The Cycle? Where Are EMs In The Cycle? The government can always change its budgetary plans and boost fiscal spending beyond what is initially planned. This was the case in 2016. However, without material deterioration in growth, it is unlikely. The authorities undertook the 2015-2016 stimulus because of extremely weak growth and plunging global financial markets. Fourth, some commentators have noted that land sales have been strong, entailing more local government revenues and hence more infrastructure investment. Yet Chart I-17 portrays that the broad money impulse leads land sales. If their past relationship holds, land sales will decrease in the next 12 months. Chart I-16China's Bond Yields And EM Stocks China's Bond Yields And EM Stocks China's Bond Yields And EM Stocks Chart I-17China: Land Sales Are To Slump bca.ems_sr_2018_05_03_s1_c17 bca.ems_sr_2018_05_03_s1_c17 Finally, the regulatory clampdown on banks and shadow banking is ongoing. This along with the anti-corruption campaign in the financial industry could have a larger impact on credit origination than a marginal drop in interest rates or marginal liquidity provision. On the whole, if the authorities, again, open the credit and fiscal spigots wide, they will relinquish their pledge of structural reforms, a reduction of financial excesses and containing rising leverage. This would entail policymakers opting for a short-term gain in sacrifice of the country's long-term economic outlook. Growth financed by banks originating money out of thin air will ultimately (in the years ahead) lead to lower productivity and higher inflation - i.e., stagflation. I believe Beijing understands this and will not open the credit and fiscal taps too fast or too wide. In brief, China-related risk assets will likely sell off a lot before the next round of stimulus arrives. Ms. Mea: What about Chinese consumer spending and the outlook for technology companies that have become dominant in the EM equity index? Does your negative outlook for investment spending entail a downtrend in household spending? I have been bearish on China's industrial cycle and capex, but not on consumer spending. In fact, household expenditure growth is booming and is unlikely to slow a lot, even amid a downtrend in the construction sector. However, there are a number of reasons to expect a moderation of the current torrid pace of household spending: Capital spending accounts for 42% of GDP, and as it slumps, job creation and income gains will slow. If banks originate less credit, there will be less investment, and income growth will likely be affected. Contrary to widely held beliefs, Chinese households have become a bit leveraged - the ratio of household debt to disposable income is slightly higher in China than in the U.S. (Chart I-18). Further, borrowing costs in China are above those in the U.S. This entails that debt servicing costs as a share of disposable income are higher for households in China than in the U.S. Chart I-18Household Leverage: China And U.S. Household Leverage: China And U.S. Household Leverage: China And U.S. Not surprisingly, the authorities are clamping down on banks and shadow banking lending to households. It seems that policymakers in China worry much more about credit and leverage excesses than global investors. We published an in-depth Special Report on China's real estate market on April 6 where we argued that excesses remain large and a period of property price deflation cannot be ruled out.4 This means that property wealth effects could turn from a tailwind to a headwind for households for a period of time. All that said, I am not bearish on household spending, apart from real estate purchases. What does this entail for mega-cap companies' share prices, like Tencent and Alibaba? For sure, technology will continue to gain importance in China, like elsewhere. However, given these stocks have seen significant share price inflation and trade at high multiples, buying these stocks at current levels may not be a good investment. Valuations and business models as well as regulatory risks are key in the current circumstances. We, like all macro strategists, can add little value on how to value internet/social media companies and assess their business models. From a big-picture perspective, Chart I-19 demonstrates that Tencent's and Amazon's share prices have gone up 12- and10-fold, respectively, in real U.S. dollar terms since January 2010, as much as the run-up that occurred during previous bubbles. Chart I-19Each Decade Had A Mania Each Decade Had A Mania Each Decade Had A Mania With respect to performance of other heavyweights like TSMC and Samsung, the electronics cycle - like overall trade in Asia - has topped out, as evidenced by relapsing semiconductor prices (Chart I-20). Chart I-20Semiconductor Prices Have Rolled Over Semiconductor Prices Have Rolled Over Semiconductor Prices Have Rolled Over This is a very cyclical sector, and a further slowdown is to be expected following the growth outburst of the past 18 months. This may be enough to cause a meaningful correction in technology hardware and semi stocks. Ms. Mea: Finally, translating these themes into market strategy, what are your strongest conviction recommendations? Investment and asset allocation strategy should favor DM over EM in equity, currency and credit spaces. This strategy will likely pay off in both risk-on and risk-off environments. Our overweights within the EM equity universe are Mexico, Taiwan, Korea, India, Thailand and central Europe. In the meantime, Brazil, Turkey, South Africa and Malaysia are our strong-conviction underweights. In terms of sector trades, I would emphasize our long-standing short EM banks / long U.S. banks position. Finally, it seems EM currencies are breaking down versus the U.S. dollar. There is much more downside, and traders and investors should capitalize on this trend by being short a basket of EM currencies like the BRL, the ZAR, the CLP, the MYR and the IDR versus the dollar. For fixed-income investors, depreciating EM currencies are a major headwind for both local currency and U.S. dollar bonds, and we recommend defensive positioning. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Special Report "Ms. Mea Challenges The EMS View," dated October 19, 2017, available on emsbcaresearch.com 2 This differs from BCA's house view which is bullish on oil prices. 3 "Caixin View: Politburo Comments on Expanding Domestic Demand Don't Signal Stimulus," Caixin Global, April 2017. 4 Please see Emerging Markets Special Report "China Real Estate: A New-Bursting Bubble?," dated April 6, 2018, the link available on page 18. Equity Recommendations Fixed-Income, Credit And Currency Recommendations