Correlations

Highlights Subdued long-term inflation expectations and central bank bond purchases have suppressed the term premium. This is set to change, as quantitative easing turns into quantitative tightening and shrinking output gaps around the world start to push up inflation. The neutral rate in the U.S. is likely higher than the Federal Reserve realizes, which could leave the Fed behind the curve in normalizing monetary policy. A spike in the term premium is unlikely this year, given the prospect of a stronger dollar and ongoing stresses in emerging markets. Next year may be a different story, however. Fixed-income investors with a 12-to-18 month horizon should maintain duration risk at below-benchmark levels. Asset allocators should keep equity and credit exposure at neutral. Within the equity space, investors should favor developed market equities over their EM peers and defensive sectors over cyclicals. Feature The Mystery Of The Falling Term Premium The yield on a bond can be decomposed into the expected path of short-term rates and a term premium. Historically, the term premium has been positive, meaning that investors could expect to earn a higher return by purchasing a bond rather than by rolling over a short-term bill.1 More recently, the term premium has turned negative in many economies (Chart 1). Not only are investors willing to forego the extra return for taking on duration risk, but they are actually willing to sacrifice return when buying long-term bonds. Chart 1Term Premia Across Developed Markets Are Low Term Premia Across Developed Markets Are Low Term Premia Across Developed Markets Are Low There are two main reasons why the term premium has fallen: Long-term inflation expectations have been very subdued, which has made bonds a hedge against bad economic outcomes. Central bank purchases have depressed yields, while forward guidance has dampened interest-rate volatility. Bonds And Risk Some commentators like to describe the riskiness of a security by how volatile its price is, or if they want to get a bit more sophisticated, the skew of its returns. But this is not really the right way to think about risk. As Harry Markowitz first discussed in 1952 in his seminal paper "Portfolio Selection," investors ultimately care about their overall level of wealth. If the price of a certain security goes up when the prices of all others go down, investors should prefer to hold this particular security even if it offers a subpar expected return. Bonds today play the role of this safe security. Chart 2 shows the rolling correlation between monthly changes in the 10-year Treasury bond yield and the S&P 500. The correlation was generally negative between the late-1960s and late-1990s: Bond yields back then tended to rise whenever the S&P 500 was falling. This made bonds a bad hedge against lower equity prices. Chart 2Bond Yields Now Tend To Rise When Equity Prices Go Up Bond Yields Now Tend To Rise When Equity Prices Go Up Bond Yields Now Tend To Rise When Equity Prices Go Up Over the past two decades, however, bond yields have generally declined whenever the stock market has swooned. Since a lower bond yield implies a higher bond price, bonds have been a good hedge against equity risk in particular, and a weaker economy in general. As a consequence, investors are now willing to pay a premium to hold long-term bonds. This has bid up the price of bonds, so much so that the term premium has dipped into negative territory. Receding Inflation Fears Have Made Bonds Safer Why did the correlation between bond yields and stock market returns change? The answer has a lot to do with what happened to inflation. Bond yields can go up because of expectations of stronger growth or because of the anticipation of higher inflation. The former is good for equities, while the latter is typically bad for equities because it heralds additional monetary tightening. As inflation expectations became increasingly unhinged in the second half of the 1960s, inflationary shocks became the dominant driver of bond yields. When bond yields went up during that period, stock prices usually fell. That changed in the 1990s, as inflation stabilized at low levels and growth became the primary driver of yields once again (Chart 3). Chart 3Long-Term Inflation Expectations Have ##br##Remained Subdued For Over Two Decades Long-Term Inflation Expectations Have Remained Subdued For Over Two Decades Long-Term Inflation Expectations Have Remained Subdued For Over Two Decades Following the financial crisis, inflationary concerns were supplanted by worries about deflation. Falling inflation is generally good for bond investors. If inflation declines, the real purchasing power of a bond's interest and principal payments will go up. For investors who have to mark-to-market their portfolios, the benefits of lower inflation are especially clear. A decline in inflation will take the pressure off central banks to hike rates. This will cause the price of existing bonds to rise, delivering an immediate capital gain to their holders. Moreover, to the extent that falling inflation expectations typically accompany rising worries about the growth outlook, investors will benefit from a decline in the expected path of real interest rates. QE And The Term Premium While falling inflation expectations have been the most important driver of the decline in the term premium, central bank asset purchases have also lent a helping hand. In standard macroeconomic models, bond yields are determined at the margin by the willingness of private investors to hold the existing stock of debt. If a central bank buys bonds, this reduces the volume of bonds that the private sector can hold. To induce private investors to hold fewer bonds, bond yields must decline. There is no consensus about how much quantitative easing has depressed bond yields. A Fed study published in April of last year estimated that QE had depressed the 10-year yield by 100 basis points at the time of writing, a number that the authors expected to decline to 85 basis points by the end of 2017.2 Other studies found that the peak impact on yields has ranged from 90-to-200 basis points. One thing that is empirically undeniable is that there is a large international component to bond yields. The steep decline in the U.S. term premium in 2014 was mainly driven by the expectation - ultimately proven correct - that the ECB would launch its own QE program. Asset purchases by the Bank of Japan, along with its yield curve control policy, also contributed to lower bond yields in the rest of the world. Things are beginning to change, however (Chart 4). The Fed is now letting its balance sheet shrink by about $40 billion per month, a number that will rise to $50 billion in October. The Bank of England has kept its holdings of gilts and corporate bonds constant for over a year, while the ECB intends to start tapering asset purchases later this year. The Bank of Japan continues to buy assets, but even there, the pace of annual purchases has fallen from about 80 trillion yen in 2015-16 to 35 trillion at present. Meanwhile, the use of forward guidance - which was arguably even more instrumental in suppressing interest rate volatility and pushing down the term premium than QE - is likely to be scaled back, at least in the United States. Fed Chair Powell said on May 25: "I think [forward guidance] will have a significantly smaller role going forward." Incoming New York Fed President John Williams echoed this sentiment, noting in a Bloomberg interview that "I think this forward guidance, at some point, will be past its shelf life."3 Opening The Fiscal Spigots Just as central banks are purchasing fewer bonds in the open market, bond issuance is set to rise. Usually the U.S. budget deficit narrows whenever the unemployment rate declines, as strong economic growth draws in more tax revenue and spending on social programs drops (Chart 5). Things are different this time around. The Congressional Budget Office (CBO) expects the U.S. budget deficit to increase from 2.4% of GDP in 2015 to 4.6% of GDP in 2019. Chart 4From Quantitative Easing To ##br##Quantitative Tightening From Quantitative Easing To Quantitative Tightening From Quantitative Easing To Quantitative Tightening Chart 5Unlike In The Past, The U.S. Budget Deficit Is Set To Widen Even ##br##If The Unemployment Rate Continues To Decline Unlike In The Past, The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Unlike In The Past, The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The Trump tax cuts have imperiled the long-term fiscal outlook. Up until last year, the U.S. fiscal picture appeared much better than it once did. In 2009, the amount of federal debt held by the public was projected to exceed 250% of GDP in 2046. By 2016, that forecast had been reduced to 113% of GDP, thanks mainly to the economic recovery and slower projected spending growth on health care following the introduction of the Affordable Care Act (Chart 6). The Trump tax cuts have blown those forecasts out of the water. We estimate that government debt held by the public will increase to almost 190% of GDP in 2046 if current policies are maintained. Chart 6Trump Tax Cuts Have Put Debt Trajectory ##br##Back On An Unsustainable Path Term Premium Explosion: A Rising Risk To Markets Term Premium Explosion: A Rising Risk To Markets While the stock of debt, rather than the flow, determines bond yields in the standard bond pricing model, flows can still matter if they provide a reliable signal as to how large the stock of debt will be in the future. Given that changes in fiscal policy are often hard to reverse, the deterioration in the fiscal outlook suggests that the stock of government debt will be much larger than investors had expected a few years ago. This justifies a higher term premium today. Broken Accelerator? Subdued inflation expectations have kept the term premium in check, but the prospect of ill-timed fiscal stimulus raises doubts about whether this state of affairs will persist. What would happen to inflation if the economy found itself in an overheated state for a prolonged period of time? The truth is that no one really knows the answer to that question. Some prominent economists have contended that nothing terrible would transpire. They argue that the entire concept of the Non-Accelerating Inflation Rate of Unemployment (NAIRU) is passé. In their view, the magnitude of economic slack determines the level of inflation, not the rate of change in inflation. Recent data provides some support to their views. Shrinking output gaps in much of the world during the past eight years have failed to raise inflation by very much, let alone cause inflation to accelerate to the upside (Chart 7). If an overheated economy simply results in modestly higher inflation, rather than increasing inflation, central banks have little to fear. A bit more inflation would allow central bankers to target a higher nominal interest rate, thus giving them greater scope to cut rates in the event of an economic downturn. Higher inflation could also improve labor market flexibility by permitting real wages to fall in the presence of nominal wage rigidities.4 In addition, as we have argued in the past, modestly higher inflation could make the financial system less susceptible to asset bubbles.5 Unfortunately, the case for letting the economy overheat is not so straightforward. For one thing, the relationship between inflation and unemployment tends to be non-linear. As Chart 8 illustrates, an economy's aggregate supply curve is likely to be quite shallow when there is a lot of excess capacity but rather steep when most of the slack has been absorbed. We may simply have not yet reached the steep side of the aggregate supply curve. Chart 7Developed Markets: Inflation Has Remained ##br##Low Despite Shrinking Output Gaps Developed Markets: Inflation Has Remained Low Despite Shrinking Output Gaps Developed Markets: Inflation Has Remained Low Despite Shrinking Output Gaps Chart 8Inflationary Pressures Tend To Increase ##br##When Spare Capacity Is Absorbed Term Premium Explosion: A Rising Risk To Markets Term Premium Explosion: A Rising Risk To Markets The experience of the late 1960s illustrates this point. Core inflation was remarkably stable during the first half of the decade, even as the unemployment rate continued to drift lower. In economic parlance, the Phillips curve was very flat. However, once the unemployment rate fell below 4%, core inflation took off, rising from 1.5% in early 1966 to nearly 4% in 1967 (Chart 9). Inflation ultimately made its way to 6% in 1970, three years before the first oil shock struck. Anchors Away The upward trend in inflation observed during the 1970s underscores another point, which is that there is no unique mapping between the unemployment rate and inflation. To use a bit of economic jargon, not only does the slope of the Phillips curve vary depending on what the unemployment rate is, but the intercept of the curve could potentially move up or down in response to changes in long-term inflation expectations (Chart 10). Chart 9Inflation In The 1960s Took Off Once ##br##The Economy Began To Overheat Inflation In The 1960s Took Off Once The Economy Began To Overheat Inflation In The 1960s Took Off Once The Economy Began To Overheat Chart 10An Increase In Inflation Expectations Can ##br##Cause The Phillips Curve To Shift Upwards Term Premium Explosion: A Rising Risk To Markets Term Premium Explosion: A Rising Risk To Markets Chart 11Market Expectations Versus The Fed Dots Market Expectations Versus The Fed Dots Market Expectations Versus The Fed Dots This is a point that Milton Friedman and Edmund Phelps made more than fifty years ago. Friedman and Phelps argued that central banks could only stimulate the economy if they delivered more inflation than people were anticipating. Higher-than-expected inflation would push down real interest rates, leading to more spending. As the two economists correctly noted, however, such an outcome would only occur if people systematically underestimated what inflation would end up being. If people made inflation forecasts in a fairly rational manner, the apparent trade-off between higher inflation and lower unemployment would evaporate: Inflation would rise, but output would not be any greater than before. One of the errors that central banks made in the 1970s is that they kept interest rates too low for too long in the mistaken belief that slower growth was the result of inadequate demand rather than a decline in the growth rate in the economy's productive capacity and a higher equilibrium rate of unemployment. Today, the error may be in thinking that the neutral rate of interest is lower than it really is. As we argued several weeks ago, cyclical factors have probably pushed up the neutral rate quite a bit over the past few years.6 Neither the Fed dots nor market pricing are adequately discounting this possibility (Chart 11). Inflation is a notoriously lagging indicator. It typically does not peak until after a recession has begun and does not bottom until the recovery is well underway (Chart 12). By the time the Fed realizes it is behind the curve, inflation could already be substantially higher. The fact that the New York Fed's Underlying Inflation Gauge - which leads core CPI inflation by about 18 months - has risen to over 3% provides some evidence in support of this view (Chart 13). Chart 12Inflation Is A Lagging Indicator Term Premium Explosion: A Rising Risk To Markets Term Premium Explosion: A Rising Risk To Markets Chart 13Upside Risks To U.S. Inflation Upside Risks To U.S. Inflation Upside Risks To U.S. Inflation Investment Conclusions A sudden increase in the term premium could set in motion a vicious circle where bond yields rise and the stock market falls at the same. In such a setting, bonds would lose much of their appeal as a hedge against equity drawdowns. This could put even more upward pressure on the term premium, leading to even lower stock prices. Chart 14 shows that the MOVE index, a measure of implied volatility for the Treasury market, remains near historically low levels. Just as investors were too complacent about the possibility of an equity volatility spike earlier this year, they are too complacent about the possibility of an increase in bond volatility. Chart 14Investors Are Too Complacent Investors Are Too Complacent Investors Are Too Complacent Getting the timing of any change in the term premium is critical, of course. It often takes a while for an overheated economy to generate inflation. The unemployment rate fell nearly two percentage points below its full employment level in the 1960s before inflation took off. The U.S. economy is only now starting to boil over. Moreover, if the dollar continues to strengthen over the coming months, as we expect, this could put downward pressure on commodity prices. Thus, we do not foresee a major inflation-induced spike in the term premium this year. Next year may be a very different story. If inflation ratchets higher in 2019, the term premium could jump. The resulting tightening in financial conditions could pave the way for a recession in 2020. Fixed-income investors with a 12-to-18 month horizon should maintain duration risk at below-benchmark levels. We downgraded global equities and credit exposure to neutral last month. Within the equity space, investors should favor developed market equities over their EM peers and defensive sectors over deep cyclicals such as industrials and materials. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Note that the term premium and the slope of the yield curve are different concepts. The slope of the yield curve measures the difference in yields between two maturities at any given point in time. In contrast, the term premium measures the difference between the return on a long-term bond and the return an investor would receive by rolling over a short-term bill over the life of that bond. Unlike the slope of the yield curve, which can be observed directly, the term premium has to be estimated using market expectations of the future path of short-term rates. 2 Please see Brian Bonis, Ihrig, Jane, and Wei, Min, "The Effect of the Federal Reserve's Securities Holdings on Longer-term Interest Rates," FEDS Notes, Federal Reserve (April 20, 2017); Edison Yu, "Did Quantitative Easing Work?" Economic Insight, Federal Reserve Bank of Philadelphia Research Department (First quarter 2016); and "Unconventional Monetary Policies -- Recent Experience And Prospects," IMF (April 18, 2013). 3 Jeanna Smialek, "Powell Sees Significantly Smaller Role for Fed Forward Guidance," Bloomberg (May 25, 2018); and Jeanna Smialek, "The Incoming New York Fed Chief Talks About Inflation and the Yield Curve," Bloomberg (May 16 2018). 4 A low-inflation environment can have adverse economic consequences during economic downturns due to the presence of downward rigidity of nominal wages. Firms typically try to reduce costs when demand for their products and services declines, but employers tend to be unwilling or unable to cut nominal wages. In this context, higher inflation provides a potential way to overcome nominal wage rigidity as it helps real wages to adjust to negative shocks. When inflation is low, real wages become less flexible, making it more likely that firms will opt for job cuts as a means to decrease overall costs. 5 Please see Global Investment Strategy Weekly Report, "Tinbergen's Ghost," dated May 11, 2018. 6 Please see Global Investment Strategy Weekly Report, "U.S. Housing Will Drive The Global Business Cycle... Again," dated July 6, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Please note that we are also publishing a Special Report on Mexico. Highlights The selloff in EM financial markets has been induced by slowing global trade amid lingering poor EM fundamentals. The Federal Reserve's resolve to tighten is aggravating the situation but is not the main cause of the EM turmoil. Consequently, the necessary conditions for a reversal in ongoing EM turbulence are not the Fed turning dovish but rather a bottom in the global trade cycle and China's growth. The latter two are not on the horizon, and we therefore believe there is much more downside in EM risk assets and currencies. Feature In our trip to Asia last week, the majority of investors we met attributed the current emerging market (EM) selloff to Federal Reserve tightening and trade wars. While we are not suggesting that the Fed tightening or trade war rhetoric have not impacted EM risk assets, we do contend that these reasons are inadequate to explain the selloff. In our opinion, the EM selloff has as much been driven by a slowdown in global trade as by expectations of higher U.S. interest rates and other factors. Diagnosing the underlying bases of a market move correctly is instrumental in gauging its sustainability and an eventual reversal. If one believes that the EM selloff has been due to the Fed, it would require the Fed turning dovish for the selloff to halt and reverse. If, however, the EM carnage has been driven by slowing global trade, the necessary condition for a reversal would be a bottom in the global trade cycle. In such a case, a dovish turn by the Fed or a drop in U.S. bond yields in and of themselves are unlikely to be sufficient. While EM risk assets could rebound for a couple of weeks on lower interest rate expectations in the U.S., any rebound will prove to be short-lived, and EM will resume their downtrend. Assessing the dynamics of both financial markets and the business cycle has led us to conclude that the EM selloff has been not only due to Fed tightening and the U.S.-China trade confrontation, but even more so due to a slowdown in global trade. The latter has transpired even though U.S. economic growth remains very robust. Chart I-1 illustrates that EM currencies and sovereign spreads correlate well with global trade growth. Since the beginning of this year, global trade and EM manufacturing have been decelerating, despite ongoing strength in U.S. demand. This, in our opinion, has been the main reason for the selloff in EM risk assets. In fact, EM manufacturing PMI and EM non-financials' corporate profit growth have rolled over since early this year, explaining widening in EM credit spreads (Chart I-2). Chart I-1EM Cracks Have Opened As Global Trade##br## Has Begun Slowing Down EM Cracks Have Opened As Global Trade Has Begun Slowing Down EM Cracks Have Opened As Global Trade Has Begun Slowing Down Chart I-2Slowdown In EM Corporate Profits ##br##Explains Widening Of EM Credit Spreads Slowdown In EM Corporate Profits Explains Widening Of EM Credit Spreads Slowdown In EM Corporate Profits Explains Widening Of EM Credit Spreads In turn, Chart I-3 demonstrates that the correlation between EM corporate spreads and share prices on one hand and U.S. bond yields on the other is rather loose. Notably, U.S. bond yields are at the same level they were in early April when the EM-centred selloff began. Meanwhile, EM equity and credit markets have diverged from their U.S. peers since early April (Chart I-4). Chart I-3EM Risk Assets And U.S. Bond Yields: ##br##Loose Correlation EM Risk Assets And U.S. Bond Yields: Loose Correlation EM Risk Assets And U.S. Bond Yields: Loose Correlation Chart I-4The Recent Divergence##br## Between EM And U.S. The Recent Divergence Between EM And U.S. The Recent Divergence Between EM And U.S. In this context, an important question is as follows: Why are EM economies and financial markets more vulnerable to rising U.S. borrowing costs than the U.S. itself? In reality, the American economy, stock market and corporate credit should be more exposed to Fed tightening than EM economies and financial markets. Yet the U.S. economy, stocks and corporate credit market have so far weathered rising borrowing costs quite well. Most interest rate-sensitive segments such as mortgages for home purchases and the junk corporate credit market have remained resilient. Historically, the correlation between EM risk assets and the Fed funds rate has been mixed - albeit more positive than negative (Chart I-5). On this chart, we shaded the periods when EM stocks rallied despite rising Fed funds rate. Chart I-5EM Stocks And Fed Tightening Cycles EM Stocks And Fed Tightening Cycles EM Stocks And Fed Tightening Cycles The episodes when EMs crashed amid rising U.S. interest rates were the 1982 Latin America debt crisis and the 1994 Mexican Tequila crisis. Yet, it is vital to emphasize that these crises occurred because of poor EM fundamentals - elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits and pegged exchange rates. Chart I-6The 1997/98 EM Crises Pushed U.S. Bond Yields Lower The 1997/98 EM Crises Pushed U.S. Bond Yields Lower The 1997/98 EM Crises Pushed U.S. Bond Yields Lower Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-'98. These late 1990 EM crises occurred without much in the way of Fed tightening or rising U.S. bond yields (Chart I-6). In contrast, EM stocks, credit markets and currencies did well during a period of rising Fed funds rate in 1988-89, 1999-2000, and 2017 as illustrated in Chart I-5. Altogether, we conclude that rising U.S. interest rates in and of themselves are not a sufficient condition for EM to sell off. Only in combination with poor EM fundamentals and a weakening global business cycle are rising U.S. borrowing costs negative for EM financial markets. EM fundamentals have been and remain indigent since early this decade. The 2016-'17 rally in EM was due to improving global growth. Yet the global business cycle has rolled over since early this year. This, in combination with lingering weak fundamentals throughout EM and the Fed's tightening, has produced the current EM selloff. All in all, the ongoing selloff in EM risk assets has been mainly due to the slowdown in global trade/business cycle. When global trade expands, weak parts of the chain do well. Conversely, when global trade growth dwindles, these same weak links are the first to break. As we have argued repeatedly, EM fundamentals have remained destitute in spite of 2016-17 rally. Indeed as soon as global trade began decelerating, the weakest parts of the global chain cracked. Specifically, China's import volumes for many raw materials and commodities have decelerated significantly (Chart I-7A and Chart I-7B). Imports of consumer goods, machinery, and transport equipment remain strong (Chart 7A, bottom panel). We believe it is a matter of time before the ongoing slowdown in credit and capital spending brings about weaker imports of industrial goods and machinery. Chart I-7AChina: Imports Volumes Have Been Slowing Down China: Imports Volumes Have Been Slowing Down China: Imports Volumes Have Been Slowing Down Chart I-7BChina: Imports Volumes Have Been Slowing Down China: Imports Volumes Have Been Slowing Down China: Imports Volumes Have Been Slowing Down Even though consumer spending in China remains robust, it has had a limited impact on the global economy in general and the rest of EM in particular. Most consumer goods and services that Chinese households buy are produced and sold domestically by mainland companies. In short, China's impact on EM and the rest of the world are primarily via its imports of commodities/raw materials and industrial goods, which are very vulnerable. On-shore listed Chinese stocks are also signaling that a pronounced growth deceleration is underway. Even though the MSCI China investable equity indexes remain elevated, their onshore peers have plunged. Chart I-8A and 8B demonstrate that China's onshore listed stock prices - large cap, small cap and many sectors - have plunged to or below their early 2016 lows. Chart I-8AChinese Share Prices: Onshore And Offshore Markets Chinese Share Prices: Onshore And Offshore Markets Chinese Share Prices: Onshore And Offshore Markets Chart I-8BChinese Share Prices: Onshore And Offshore Markets What's Really Driving The EM Selloff? What's Really Driving The EM Selloff? Chart I-9New Cyclical Lows For EM Relative Performance New Cyclical Lows For EM Relative Performance New Cyclical Lows For EM Relative Performance This downbeat message from Chinese onshore equity prices along with the recent sharp depreciation of the RMB corroborate that the mainland growth slowdown is gaining speed, which in turn argues for a bearish outlook for EM financial markets. Bottom Line: Our diagnosis is that the selloff in EM financial markets has been induced by slowing global trade and China's growth deceleration amid lingering poor EM fundamentals. The Fed's resolve in tightening is aggravating the situation, but it is not the main cause behind the EM turmoil. Consequently, the necessary conditions for a reversal of the ongoing EM turbulence are not the Fed turning dovish but a bottom in the global trade cycle and Chinese growth. The latter two are not on the horizon, and we therefore posit there is much more downside in EM risk assets and currencies. EM relative equity performance versus DM has broken to new cycle lows for the small-cap and equal-weighted indexes (Chart I-9, top and middle panels). The market cap-weighted overall index will likely be heading to new lows for this cycle too (Chart I-9, bottom panel). Investors should stay short/underweight EM risk assets. Our recommended country allocation is presented below. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

While copper prices remain comfortably within the $2.90 to $3.30/lb range they've occupied this year, the rising threat of a Sino - U.S. trade war spilling into the global trading system, along with slowing credit and monetary stimulus in China, will continue to roil copper markets. Refined copper prices - like most commodities - are highly sensitive to the level of world copper demand and EM imports, particularly out of Asia, which are closely tied to income. EM income growth is expected to remain strong; however, a global trade war, or a significant slowing in trade that reduces investment in EM markets and stymies income growth will be bearish for copper prices. Highlights Energy: Overweight. Going into tomorrow's OPEC 2.0 meeting in Vienna, the Kingdom of Saudi Arabia (KSA) and Russia apparently were divided on how much crude oil production needed to be restored to the market. Increases of as little as 300k to 600k b/d and as much as 1.5mm b/d are flying around the market in the lead-up to the meeting.1 Meanwhile, China threatened to impose tariffs on oil imports from the U.S. if President Trump goes ahead with additional tariffs. The increased Sino - American acrimony on trade issues raises the likelihood China will significantly increase oil imports from Iran, in our estimation, which will exacerbate tensions even further. Base Metals: Neutral. Copper treatment and refining charges (TC/RCs) soared at the end of last week following the closure of India's largest smelter. The Metal Bulletin TC/RC index went to an average of $85/MT at the end of last week, up from $82.25/MT. The pricing service also reported China's primary copper-smelting capacity is lower in June due to environmental constraints. Precious Metals: Neutral. Gold prices dropped below $1,300/oz following the FOMC meeting last week, as Fed officials - e.g., Dallas Fed President Robert Kaplan - nodded toward a fourth rate hike this year, even though his base case remained at three. Ags/Softs: Underweight. Grains and beans are down as much as 10% in the past week, on the back of additional tariffs announced by the Trump administration - 10% on $200 billion worth of Chinese imports. The new tariffs were a retaliatory move by the administration, and represent an escalation of tit-for-tat measures by both sides. Feature Chart of the WeekMajor Drivers of Copper Prices Still Supportive Major Drivers of Copper Prices Still Supportive Major Drivers of Copper Prices Still Supportive Rising EM incomes and expanding world trade volumes, particularly EM imports, have supported base metals prices for the past two years. This was partly aided by expansionary fiscal and monetary policy in China, the world's largest base-metals market, in 2016, which reversed overly restrictive monetary and fiscal policy in the two years prior. For the most part, these supportive underpinnings are still in place for EM commodity growth over the next two years (Chart of the Week). However, their stability increasingly is being threatened by rising Sino - American trade tensions, and the limited room for credit and fiscal expansion in China.2 Global Copper Demand And Trade In its most recent update of global growth, the World Bank is expecting the rate of growth globally to level off this year and next. However, the Bank expects income growth in EM and developing economies - the growth engines of commodity demand - to go from 4.3% last year to 4.5% this year, and 4.7% next year. EM growth will be dominated by South Asia (Chart 2).3 EM GDP growth is of particular importance to commodity markets, since this constitutes the bulk of commodity demand growth generally, particularly in base metals and oil. For the largest EM economies, the income elasticity of demand for copper is 0.70, meaning a 1% increase in income leads to a 0.70% increase in copper consumption. The Bank notes, "The seven largest emerging markets (EM7) accounted for almost all the increase in global consumption of metals, and two-thirds of the increase in energy consumption" over the past 20 years.4 In what the Bank refers to as Low Income Countries (LICs) - a grouping of smaller economies loaded with commodity producers - GDP is expected to grow 6% p.a. on average over the 2018 - 2020 period. Chart 2World Bank Expects Solid EM Growth Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets EM GDP growth fuels copper demand. Since 2000, a 1% increase in global copper consumption ex-China translates into an almost 2% increase in high-grade refined copper prices, based on results of our modeling. When we replace ex-China demand with China, we see a 1% increase in China's consumption translates into a 0.75% increase in high-grade copper prices over the 2000 - 2018 interval. China's growth is expected to slow going forward, in the wake of a managed slowdown, and due to the fact that, as its economy evolves, more of its growth will come from services and consumer demand, which are less commodity intensive. GDP growth also fuels trade, and vice versa. The Bank estimates the income elasticity of trade averaged 1.5% from 2000 - 07, and 1.2% from 2010 - 17, meaning a 1% increase in income has led to a roughly 1.4% growth in trade over this period. In our modeling, we've found a 1% increase in EM trade volumes translates into a 1.3% increase in high-grade copper prices, an elasticity in line with post-GFC trade growth. The other key variable in our modeling is the broad trade-weighted USD, which remains a highly important variable for copper prices. In both our global copper-demand and EM import volume models for copper prices, the level of the USD is an important explanatory variable - a 1% increase (decrease) in the USD TWIB translates into ~ 3% decrease (increase) in copper prices since 2000 in our estimates.5 Tight Credit Conditions In China Can Weigh On Copper ... We've been expecting China's managed slowdown in 2H18 to be offset by strong global demand, which, all else equal, would keep copper demand fairly stable.6 While we still do not expect a hard landing in China, the slowdown we've been expecting is showing up in weaker industrial production prints, disappointing retail sales in May, and most significantly, regulatory and liquidity tightening weighing on money and credit. Chinese demand makes up ~ 50% of global metal consumption, these markets would be especially vulnerable in the case of a significant slowdown. The fear of a more serious slump is founded on tighter financial conditions restricting capital spending, and GDP growth. Granger causality tests to determine the direction of causation between Chinese monetary variables and copper prices point to causality running from de-trended levels of all four measures of money and credit to copper prices (Table 1).7 Table 1Chinese Credit And Copper Prices: Evidence Of Causality Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets Furthermore, y/y changes in copper prices are more highly correlated with monetary variables expressed in terms of de-trended levels, than with those same variables expressed as y/y growth rates, or impulses (Chart 3). Across the four credit and money measures, this expression yields an average correlation coefficient of 0.56, compared with 0.38 and 0.37 when expressed as y/y growth rates and impulses as a percent of GDP, respectively. Our modeling also indicates that it generally takes two to three quarters for the full effect of a change in China's credit conditions to be transmitted to copper markets. When we restrict the sample size to the period from 2010 to now we get similar results to our longer intervals (Chart 4). However monetary variables are more highly correlated with copper prices in the shorter sample. Chart 3Chinese Credit Leads Copper Prices By 3 Quarters... Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets Chart 4...A Slightly Longer Lead Time Since 2010 Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets Correlations in the period since 2010 average 0.61, 0.57, and 0.45 for the de-trended levels, y/y growth rates, and impulses, respectively. This can be put down to the fact that China's role as a demand market for copper has been steadily growing over this period. Given that between 2000 and 2017, China's share of global copper demand swelled from 12% to 50%, it is only natural that the impact of its domestic economy on global copper prices also increased (Chart 5). Furthermore, the time lag between Chinese monetary variables and copper markets in the more recent sample increased slightly, with money and credit variables leading prices by 9-10 months, compared to 6-8 months in the full sample. Chart 5China's Growing Role In Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets Bottom Line: De-trended Chinese money and credit variables statistically cause, and are correlated with, y/y changes in copper prices. While these relationships have generally strengthened with China's growing role in the demand side of global copper markets, rolling correlations highlight that there are also extended periods of weak correlations, suggesting fundamental factors can overwhelm the impact of China's credit environment on global copper markets, as has been the case for the past two years. ...But Other Factors Can Take Over In estimating the effect of China's money and credit conditions on copper markets, we find that the relationship can be dominated by supply - demand fundamentals, and overall global macro conditions. More specifically, we find that in periods where DM equity markets outperform EM equity markets, the coefficients in our models with y/y copper prices as the dependent variable are on average 13% lower than the full sample period (Chart 6). Similarly, in periods where EM outperforms DM, the models' credit coefficients are on average 15% higher than the full sample period.8 Our modeling indicates the pre-2005 period as well as the post-2015 intervals as periods during which strong copper demand from growing DM economies weakened the long-term relationship between Chinese money and credit variables and copper prices. Given our expectation that DM demand will remain supportive, this will, to some extent, offset the negative implications of the deteriorating credit environment in China on copper demand and prices. Similarly, in periods characterized by backwardated copper markets, the magnitude of the impact of Chinese money and credit variables on copper prices is on average 35% lower than the full sample (Chart 7). On the other hand, when the copper market is in contango, the magnitude of the impact of Chinese financial variables is on average 13% higher than the full sample period. This highlights the importance of physical fundamentals, and the fact that in cases where they deviate from the direction of the Chinese credit environment - such as during a supply shock - the physical fundamentals weaken historical correlation relationships. Chart 6Credit-Copper Relationship Weakens When DM Outperforms EM ... Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets Chart 7... And When Markets Are Backwardated Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets To rank the top explanatory financial variables in terms of their effect on the evolution of copper prices, we estimated regression models with monetary variables, along with the broad trade-weighted U.S. dollar, and world excluding China copper demand as independent variables (Table 2). Table 2USD Usually Dominates Copper's Evolution Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets The results, which can be interpreted as the y/y percentage point (pp) change in copper prices from a one y/y pp increase in each of the three explanatory variables, indicate that Chinese credit has a similar effect as a one y/y pp increase in world excluding China copper demand, a not-unexpected result, given the rest of the world accounts for 50% of demand. On the other hand, the USD has an outsized effect on the copper market. In our modeling, we've found that, in general, a one pp increase (decrease) in the broad trade-weighted USD translates into a one pp change in copper prices, using y/y models.9 Will Copper Vs. USD Correlations Return To Equilibrium? Our House view calls for a stronger USD going forward. Despite our expectation that DM demand will remain supportive, absent supply-side shocks, a stronger USD along with deteriorating credit conditions in China will weigh on copper prices.10 Ongoing trade disputes will only further bear down on the copper market. Stronger EM GDP growth and the associated increase in copper consumption and trade volumes will offset the strong-USD effects, but a trade war would undermine this support. A caveat to this conclusion is that while credit growth has been generally restrained, the Chinese government - fearful that its policy measures to date are spiraling out of control - may partially reverse its efforts and attempt some easing.11 Bottom Line: The impact of Chinese credit conditions on copper prices is weakened in periods where DM stock prices outperform EM, and when the copper forward curve is backwardated. In terms of the relative magnitude of the effect of China's credit conditions, we find that it has a similar sized effect as the rest of the world's copper demand on the red metal's price, while the USD has a relatively larger effect. This implies that a stronger USD, coupled with tighter financial conditions in China, will compete with expanding EM GDPs and trade growth going forward. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 OPEC 2.0 is the name we've coined for the oil producer coalition lead by KSA and Russia. In November 2016, the coalition agreed to remove 1.8mm b/d of production. We estimate actual production cuts amount to 1.2mm b/d, while as much a 1.5mm b/d of production has been lost to depletion and a lack of maintenance drilling (e.g., infill and other forms of enhanced oil recovery). 2 Our colleague Peter Berezin, writing in this week's Global Investment Strategy, noting slowing industrial production, retail sales and fixed-asset investment, observes, China's "policy response has been fairly muted." Further, unlike 2015, when China stimulated its economy and lifted EM generally, this go-round, there is less room to maneuver owing to high debt levels and overcapacity. Please see BCA Research Global Investment Strategy Special Report "Three Policy Puts Go Kaput: Downgrade Global risk Assets To Neutral," dated June 20, 2018, available at gis.bcaresearch.com. 3 Please see "The Role of Major Emerging Markets in Global Commodity Demand" in the Bank's Global Economic Prospects, June 2018, beginning on p. 61. 4 The Bank's EM7 are Brazil, China, India, Indonesia, Mexico, the Russian Federation, and Turkey. They account for ~ 25% of global GDP, and some 60% of global metals consumption. The income elasticities of aluminum and zinc demand for this group are 0.80 and 0.30, respectively. Please see Table SF1.1 on p. 70 of the Bank's June report. 5 The R2 statistic measuring the goodness of fit between actual copper prices and the modeled prices is 94% for the copper-consumption model, and 96% for the EM trade model over the 2000 - 2018 interval. The USD TWIB was used as an explanatory variable in both models. 6 Please see BCA Research Commodity & Energy Strategy Weekly Report "China's Managed Slowdown Will Dampen Base Metals Demand," dated March 29, 2018, available at ces.bcaresearch.com. 7 Given that in levels, the money and credit variables display a deterministic upward trend, we removed the trend from the data in order to isolate the fluctuations around this trend. This de-trended series is what is significant to copper demand, and thus the evolution of copper prices. 8 We use a threshold OLS model to estimate the y/y model coefficients. The average change in the value of the coefficient is based on the coefficients in the models' outputs of the four money and credit measures. 9 The R2 statistics measuring the goodness of fit between actual y/y changes and those estimated in our models were ~63% in all four models. 10 We discussed this at length last week in BCA Research Commodity & Energy Strategy Weekly Report "Correlations Vs. USD Weaken," dated June 14, 2018, available at ces.bcaresearch.com. 11 Some preliminary signs of potential easing include (1) the PBOC's most recent monetary policy decision in which it did not follow the US Fed's interest rate decision by hiking rates, as it generally does, and (2) a reduction in the reserve requirement ratio. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Insert table images here Trades Closed in Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets

Highlights As widely expected, the Fed raised the policy rate by 25bps last week. The central bank is also forecasting an additional rate hike for 2018, but one less for 2020. The labor market typically continues to improve after the economy reaches full employment, wage inflation begins to accelerate after the economy achieves full employment, while prices rise only gradually. Gold and Treasuries were the big winners and the dollar was the big loser in previous trade spats. Feature The dollar rose 1%, but gold, the S&P 500, and U.S. Treasury yields sunk last week amid a busy calendar of U.S. economic data and the Fed's new forecasts. The stats and the FOMC projections confirmed that the U.S. economy is already at full employment and that the market is underpricing the number of Fed hikes planned for this year. Meanwhile, U.S. President Trump's meeting with North Korea leader Kim Jong Un provided some relief on the geopolitical front, but there is still uncertainty on trade over impending tariffs on China. Chart 1Watch The 2.3% To 2.5% Level##BR##On TIPS Breakevens Watch The 2.3% To 2.5% Level On TIPS Breakevens Watch The 2.3% To 2.5% Level On TIPS Breakevens BCA's base case remains that U.S. equities will not be subject to an over-aggressive Fed until mid-2019 and that increasing bond yields are not a threat. That said, the timing is uncertain and depends importantly on how inflation and inflation expectations shift in the coming months. Inflation is only gradually moving higher at the moment and the Fed is willing to tolerate an overshoot of the 2% target. However, some inflation hawks at the Fed are worried given that the economy is already at full employment and expected to accelerate this year. The uptrend in inflation could suddenly become steeper in this macro environment. Alarm bells will ring when inflation hits 2.5% and the central bank will switch from normalizing policy to targeting slower growth, putting risk assets under pressure. We are also on the watch for a rise in the 10-year TIPS breakeven rate above 2.3% as a signal that the FOMC will become more aggressive in leaning against above-trend growth and a falling unemployment rate (Chart 1). That would be an important signal to trim exposure to risk assets. Although Trump's meeting with Kim lowered geopolitical risk, BCA's strategists note that the secular decline in U.S.-China ties and the "apex of globalization"1 are more relevant subjects than what happens on the Korean peninsula. While North Korea may still stir up concern, we recommend that investors monitor U.S.-China trade tensions, the East and South China Seas, and Taiwan. Elsewhere, U.S.-Iran tensions are the key understated geopolitical risk to markets. Moreover, BCA's Geopolitical Strategy service expects that trade-related uncertainty will persist at least until the U.S. mid-term elections in November.2 Two More In '18 As widely expected, the Fed raised the policy rate by 25bps last week. The central bank is also forecasting an additional rate hike for 2018, but one less for 2020 (Chart 2). Chart 2FOMC And Market Mostly##BR##Aligned On Economy And Rates FOMC And Market Mostly Aligned On Economy And Rates FOMC And Market Mostly Aligned On Economy And Rates Instead of three, the Fed now expects to deliver a total of four rate hikes in 2018. For 2019, the Fed continues to project a further three rate hikes. And for 2020, the Fed now believes only one rate hike will be warranted, down from two hikes in its previous forecast. What this means is that the Fed has simply brought forward one rate hike from 2020 to 2018. It left its median projection for the level of the Fed funds rate in 2020 unchanged at 3.375%. Moreover, the Fed kept its estimate of the neutral rate unchanged at 2.875%. In other words, the Fed is forecasting a marginally faster pace to rate hikes, but it has not changed its outlook for the full extent of the tightening cycle. This minor change to the policy outlook should not disrupt financial markets. Prior to last week's FOMC meeting, Fed funds futures were already pricing a 50% probability of a fourth rate hike this year. The bigger question is whether more upward adjustments to the interest rate outlook lie ahead. On this front, there are inconsistencies in the Fed's economic projections. In terms of the long-run steady state, the Fed believes the potential growth rate of the economy is 1.8% and NAIRU is 4.5%. Yet the Fed is forecasting real GDP growth of 2.4% and 2.0% (i.e. above-trend) for 2019 and 2020, respectively, but expects both the jobless rate and core inflation to remain steady at 3.5% and 2.1%, respectively. Above-trend growth should imply a further decline in the unemployment rate. And a jobless rate that's well below NAIRU should imply an acceleration in inflation. In turn, this should mean a higher path for interest rates. But rather than higher interest rates, the inconsistency in the Fed's economic forecasts can also be resolved in other ways. First, the Fed could simply be too optimistic on growth. If growth is weaker, then unemployment and inflation forecasts could be proven right. Second, the Fed's estimates of trend growth and NAIRU may be incorrect. If trend growth is higher and NAIRU is lower, the pressures on resource utilization and inflation will be less. Bottom Line: The tweaks to the Fed's interest rate projections are too small to have a material impact on financial market pricing. However, there is a risk that the inconsistencies in the Fed's economic forecasts will be resolved with more hawkishness in 2019. This could then prove problematic for global risk assets, depending on the evolution of inflation. Are We There Yet? The U.S. economy reached full employment in Q1 2017. The unemployment rate crossed below the Fed's measure of NAIRU in March 2017, a whopping 93 months after the start of the current expansion. Chart 3 shows that in the long expansions3 in the 1980s and 1990s, the economy reached full employment sooner; 54 months in the 1980s and 72 months in the 1990s expansion. After the economy attained full employment in the 1980s and 1990s, an average of another 27 months passed before the unemployment rate troughed. This means that the trough will occur in mid-2019 and our view is that the rate will bottom at around 3.5% in mid-2019.4 Moreover, the 1980s' economic recovery lasted another 34 months once the economy hit full employment and another 47 months once full employment was breached in the 1990s. If this historical pattern holds, then the next recession will begin in late 2020. This date is consistent with our prior work5 on the start date of the next downturn. Chart 3The Economy At Full Employment In Long Cycles The Economy At Full Employment In Long Cycles The Economy At Full Employment In Long Cycles The labor market typically continues to improve after the economy reaches full employment. Initial claims for unemployment insurance, as a share of the labor force, move lower for another two years, on average, after labor market slack disappears (Chart 4, panel 2). The monthly non-farm payrolls job count follows a similar pattern and it does not turn negative for another four years (panel 3). The Conference Board's jobs easy/hard to get shows that the labor market is hotter than in the previous long expansions (panel 4). The conclusion is that the labor market will continue to tighten for another year or so, consistent with our outlook. Wage inflation begins to accelerate after the economy achieves full employment. Chart 5 shows increases in the average hourly earnings (AHE), the Employment Cost Index (ECI), and compensation per hour after the unemployment rate fell below NAIRU in the 1980s and 1990s. However, unit labor costs (ULCs) did not accelerate in those years until well after the economy hit full employment. Many of these measures of wage inflation are also on the upswing today. However, none of the indicators are rising as quickly as they did in the 1980s and 1990s (See Appendix Table 1 for more details on performance of labor market, wage and inflation metrics after the economy reaches full employment). Inflation initially remained tame even after labor market slack was taken up in the previous two long expansions. Chart 6 shows that neither headline nor core CPI accelerated sharply after the economy arrived at full employment in the '80s and '90s. However, headline CPI inflation began rising not long after full employment was reached. It took a little longer for core inflation to perk up. Moreover, inflation tends to peak as the unemployment rate troughs. This occurs, on average, about three years after the unemployment rate crosses below NAIRU. Chart 4The Labor Market When##BR##The Economy Is At Full Employment The Labor Market When The Economy Is At Full Employment The Labor Market When The Economy Is At Full Employment Chart 5Wages And Compensation When##BR##The Economy Is At Full Employment Wages And Compensation When The Economy Is At Full Employment Wages And Compensation When The Economy Is At Full Employment Chart 6Inflation When The Economy##BR##Is At Full Employment Inflation When The Economy Is At Full Employment Inflation When The Economy Is At Full Employment Bottom Line: The U.S. economy has been at full employment since early 2017, but investors should be patient if they expect a marked acceleration in inflation. Inflation is already at the Fed's target and BCA expects two more rate hikes this year and at least three more increases in 2019 as inflation moves closer to 2.5%. Stay underweight duration. The labor market is as tight as it was at this point of the previous two long expansions. Moreover, the trends in inflation and wages are similar, although from a lower level. That said, while inflation is more muted today, interest rates are much, much lower, and the Fed does not want a major overshoot. If we follow the same path as the previous two long expansions, then inflation will rise only gradually, and the next recession is a ways off. But watch for an acceleration in ULC, because in the average of the last two long expansions, an acceleration in ULC coincided with an acceleration in core CPI inflation. That would cause the Fed to become more aggressive. Trump's Focus On China The U.S. is an old hand at trade wars and economic conflicts, with an endgame of dollar depreciation and compromises on trade.6 Since 1970 there have been seven major trade disputes involving tariffs, including the one that began in March of this year. Some were brief and several of those periods overlapped. Moreover, many other factors affected investment returns, including recessions, wars, major terrorist attacks, and financial crises. As a result, these periodic trade tiffs make it difficult to discern the implications for the financial markets. During episodes of trade-related uncertainty, stocks underperform Treasuries, the dollar falls both pre- and post-dispute, and gold performs much better both during and after. Treasuries are the most consistent performer, and this asset class beat stocks during five of the six periods. Meanwhile, the dollar fell during 5 of the 6 trade spats (Table 1). Chart 7 shows the performance of a wider set of U.S. financial assets before, during, and after trade tensions erupt. Table 1U.S. Stocks, Treasuries, The Dollar, Gold And Trade Disputes The Economy At Full Employment The Economy At Full Employment Chart 7U.S. Financial Assets And Trade Spats U.S. Financial Assets And Trade Spats U.S. Financial Assets And Trade Spats We begin our discussion of trade spats and their implication for financial markets in the early 1970s. In August 1971, with the dollar steeply overvalued, President Richard Nixon abandoned the gold standard and imposed a 10% surcharge on all dutiable imports. The purpose of the tariff was to force the U.S. allies to appreciate their currencies against the dollar. Some appreciation occurred as a result of the Smithsonian Agreement, but the effects were short-lived. The U.S. could not afford to alienate its allies amid the Cold War and removed the restrictions four months later. Table 1 shows that S&P 500 increased by nearly 40% in the year prior to the 1971 trade spat, but the economy was recovering from the 1969-70 recession. Equities easily beat Treasuries (+17%), the dollar declined by 3%, and gold jumped by 22%. However, during late 1971, the S&P 500 underperformed Treasuries, the dollar dropped by 5%, and gold was little changed. In the 12 months after the trade issue was resolved, U.S. stocks beat bonds, the dollar continued to move lower, and gold surged. This occurred as inflation ramped up. In a trade dispute episode during the 1980s, then President Reagan and a Democrat-leaning Congress became concerned with trade deficits and a sharply rising dollar. The Plaza Accord in 1985 consisted of a German and Japanese promise, once again, to appreciate their currencies. From 1985-89, a U.S.-Japan trade war was waged over Japan's growing share of the U.S. market and certain unfair trade practices affecting goods such as cars, semiconductors, and electronics (Chart 8). The combination of yen appreciation, voluntary export restraints and tariffs, resulted in compromises, and in the early 1990s the U.S. removed Japan from its list of targets. Chart 8The U.S.-Japan Trade Spat In The 1980s The U.S.-Japan Trade Spat In The 1980s The U.S.-Japan Trade Spat In The 1980s During the 1985-89 dispute, the U.S. stock market crashed, economic growth surged, inflationary pressures mounted, and the Fed hiked rates. Nevertheless, stocks crushed bonds as the dollar tumbled by 40% and gold soared by 30% (Table 1). Note that gold fell in the year before the trade dispute began and in the year after it ended. In the late 1990s, a series of trade disputes erupted between the U.S. and the European Union, most significantly on a tax device that allowed companies reduced taxes on profits derived from export sales. The EU won its case against the U.S. at the WTO and the U.S. eventually repealed the offending provisions in its tax code. At the same time, from 1999-2001, the U.S. contested EU policies on banana imports. Then in March 2002, President George W. Bush imposed steel tariffs affecting Europe, but these were subsequently reversed in December 2003 in the face of retaliatory threats. Trade tension in the late 1990s and early 2000s developed alongside the tech boom, the 2001 recession and recovery, and the first Gulf War. The 10-year Treasury outperformed the S&P 500 as Bush's steel tariffs were in effect, but the early part of this period coincided with the accounting scandals that buffeted U.S. equity markets. The U.S. dollar dropped nearly 25%, although the Fed cut rates in 2002 and 2003. Gold climbed 34% in this period, outpacing both stocks and bonds. President Trump's trade positions are reminiscent of both Nixon's and Reagan's policies and his trade team includes a notable veteran of the U.S.-Japan trade war, U.S. Trade Representative Robert Lighthizer. The focus, however, is not entirely the same. True, there is still a fixation on privileged manufacturing industries like steel and autos, both in the Section 232 actions on steel and aluminum and in the NAFTA renegotiation. But there is today a heightened focus on China's abuses of the international trade system, in particular its technology theft and intellectual property violations (the Section 301 actions). For investors, the critical issue is to separate the two areas of focus. The U.S. grievances with Europe, NAFTA, and Japan will cause more volatility this year and beyond, but are ultimately more manageable than those with China. U.S.-China trade tensions are caught up in a Great Power rivalry that will likely persist throughout this century, making trade tensions a permanent feature of the relationship going forward.7 China's rapid military growth and technological acquisition threaten U.S. global dominance. China will view any imposition of tariffs by the U.S., or demands for dramatic RMB appreciation, as a strategic attempt to derail China's rise. Moreover, while Congress will not attack President Trump for retreating from the trade war with the allies, it will attack President Trump for compromising on China. Recent U.S. elections have swung on Rust Belt Midwestern states that resent America's deindustrialization. In 2020, Democrats will attempt to reclaim their credibility as defenders of American workers and "fair trade," especially against China. President Trump stole their thunder with his protectionist platform. There is unlikely to be a "trade dove," and especially not a "China dove," in the White House from 2020-24. Bottom Line: The U.S. has historically used punitive trade measures to force its allied trading partners to appreciate their currencies versus the dollar. It has also sought to protect politically sensitive industries. Today, however, the trade war with China is inextricably tied to a strategic conflict that will play out over decades. Trump will likely impose Section 301 tariffs on China after June 15 and any deal to avoid confrontation will merely delay the decision on tariffs until after November's mid-term elections. Investors should recall that bonds beat stocks, the dollar fell, and gold rose during previous periods of trade tension. We also note that shifts in correlations between key U.S. asset classes tend to occur as trade spats begin and end, especially in the past 30 years (Chart 9). Moreover, gold usually continues to climb and the dollar falters even after these disputes are resolved. Chart 9U.S. Asset Class Correlations During Trade Disputes U.S. Asset Class Correlations During Trade Disputes U.S. Asset Class Correlations During Trade Disputes John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014. Available at gps.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," published April 4, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's Bank Credit Analyst Monthly Report, published March 2017. Available at bca.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Tightening Up", published May 14, 2018. Available at usis.bcaresearch.com. 5 Please see BCA Research's Global Investment Strategy Weekly Report, "Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000," published March 30 2018. Available at gis.bcaresearch.com. 6 Please see BCA Research's Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," published April 12, 2017. Available at gps.bcaresearch.com. 7 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," published March 14, 2018. Available at gps.bcaresearch.com. Appendix Appendix Table 1Key Labor Market And Inflation Indicators At Full Employment The Economy At Full Employment The Economy At Full Employment

Highlights After having written about the role of the U.S. yield curve in forecasting recessions, we are devoting this Special Report to addressing the widely asked question on the effectiveness of the yield curve in determining asset allocation. A naïve, rules-based approach is applied to the yield curve in each of seven countries/regions to produce a dynamic allocation signal between equities and bonds in each country/region. Despite its simplicity, we find that the dynamic portfolio systematically outperforms the 60/40 equity/bond benchmark portfolio in the U.S., Canada, euro area, Switzerland, U.K. and Australia from a long-term perspective (four years), with Japan being the outlier. Despite the dominance of the U.S. in the global economy and also in global asset markets, the equity/bond performance cycle outside the U.S. does not necessarily follow the U.S. Instead, the yield curve in each country provides a consistently better signal than just following U.S. decisions alone. Currently, signals from yield curves still favor equities over bonds. Feature U.S. yield curve inversion has been a good leading indicator for recessions in the U.S. Since the mid-1950s, every U.S. recession has been preceded with curve inversion, as shown in Chart 1. The lead time, however, varies from one month to 18 months. In addition, even though it is true that stocks underperform bonds in a recession, stocks can begin to underperform bonds long before a recession starts and can also continue to underperform long after a recession ends. For example, U.S. stocks/bonds performance ratio peaked in December 1999 and then troughed in September 2002 with a more than 50% drawdown, yet only about 6% occurred between March 2001 and November 2001 - the NBER official dates for the 2001 recession. So could information from the U.S. yield curve itself systematically add value to a stock-bond allocation decision in the U.S.? Even if it could in the U.S., could the same apply elsewhere, given that yield curves in different countries do not move in a synchronized fashion? (Chart 2) Chart 1U.S. Yield Curve Vs. Recession U.S. Yield Curve Vs. Recession U.S. Yield Curve Vs. Recession Chart 2Global Yield Curve Cycle Global Yield Curve Cycle Global Yield Curve Cycle In this Special Report, we use a simplified naïve, rules-based approach to attempt to demonstrate if information from yield curves in seven countries - the U.S., Japan, the U.K, Euro Area, Canada, Australia and Switzerland - can systematically add value in asset allocation decisions. Yield Curves Are An Effective Indicator For Long-Term Asset Allocation The test results are quite encouraging, despite the simplicity and need for further refinement. Except in Japan, yield curves in all six other countries provide value-add information for stock-bond allocation decisions. The solid lines in Chart 3 are the relative total return performance of the active stock/bond portfolio versus the benchmark for each country. The active portfolio is simply constructed based on a naïve rule such that a 10% underweight is given to equities and a 10% overweight is given to bonds when the yield curve reaches the lower band from above. Once the yield curve reaches the upper band from below, the allocation is reversed. The upper and lower bands are explained in our methodology section on page 5, we omit Japan from these charts because, as explained on page 9, its stock/bond ratio has not had a consistent relationship with the yield curve. The dash lines in Chart 3 are the monthly four-year rolling return differentials between the active portfolios and the benchmarks. It is encouraging to see that the four-year rolling performance in each country has suffered only very limited downside. Chart 4 is the same as Chart 3 except that the active bet is maxed out to 40% over- or underweight relative to the 60/40 equity/bond benchmark - i.e. when the signal is bullish for stocks, 100% is in stocks, and when it is bullish for bonds, the weights are 80% bonds and 20% stocks. This is a more extreme version of risk-taking, though the upside/downside trade-off is still quite impressive. This simple approach illustrates that in the long run, the yield curve is a useful indicator for equity/bond allocations. However, it does not do very well on a shorter-term time horizon. As shown in Chart 5, the one-year performance differentials are less appealing. Chart 3Backtest Base Case Backtest Base Case Backtest Base Case Chart 4Backtest Aggressive Case Backtest Aggressive Case Backtest Aggressive Case Chart 5Short-Term Risk Reward Less Appealing Short-Term Risk Reward Less Appealing Short-Term Risk Reward Less Appealing So how are the back tests conducted? The Methodology The Passive Benchmark: A 60/40 fixed-weight equity/bond benchmark is constructed for each country using the MSCI equity total return index and Bloomberg/Barclays Treasury Total Return Index, all in local currencies. The Active Allocation Rule: For each country, a range is set for its yield curve with an upper band and a lower band. The bands are set based on yield curve cycles and also their correlation with stock/bond performance cycles. When the curve reaches the upper band from below, an overweight is assigned to equities until the yield curve reaches the lower band from above, at which point the overweight then shifts to bonds. To determine how the size of the over- and underweight positions impacts the efficacy of the signal, we tested four different bet sizes - from 10% to 40% - in 10% increments, since no short selling is allowed. Objective: The active portfolio in each country is aimed to outperform its passive benchmark with a minimal four-year rolling drawdown. The same approach is applied to all seven countries. In terms of yield curve, the 3M/10 curve works better than the 2/10 curve for the U.S. because the former has better cyclicality. For all other countries, 2/10 yield curves are used. Despite the simplicity of our approach, some interesting observations are worth highlighting: U.S. And Canada: Reduce Risk When Yield Curve Inverts As shown in Chart 6, yield curve inversion in these two countries has historically been a good indication to reduce risk in equities. Bonds in general start to outperform equities after the curve is inverted and continue to do so as the yield curve steepens. However, when the curves steepens near to its cyclical high, then it's time to add risk in equities. Historically, the upper threshold for the U.S. 3M/10 is 3.4%, while for the Canadian 2/10 it is 1.8%. Currently, this indicator alone still favors equities in these two countries. Chart 6AU.S. & Canada: Curve Inversion ##br##Triggers Risk Reduction (I) U.S. & Canada: Curve Inversion Triggers Risk Reduction (I) U.S. & Canada: Curve Inversion Triggers Risk Reduction (I) Chart 6BU.S. & Canada: Curve Inversion ##br##Triggers Risk Reduction (II) U.S. & Canada: Curve Inversion Triggers Risk Reduction (II) U.S. & Canada: Curve Inversion Triggers Risk Reduction (II) Euro Area And Switzerland: Reduce Risk Before Yield Curve Approaches Inversion As shown in Chart 7, the yield curve of the euro area does not invert often, while the Swiss curve has never gone into inversion during the short period for which we have historical data. However, both curves have good cyclicality, which makes the 0.2%-1.8% range works very well for both. Chart 7AEuro Area & Swiss: Reduce Risk##br## Before Curve Inverts (I) Euro Area & Swiss: Reduce Risk Before Curve Inverts (I) Euro Area & Swiss: Reduce Risk Before Curve Inverts (I) Chart 7BEuro Area & Swiss: Reduce Risk ##br##Before Curve Inverts (II) Euro Area & Swiss: Reduce Risk Before Curve Inverts (II) Euro Area & Swiss: Reduce Risk Before Curve Inverts (II) U.K And Australia: Reduce Risk After Yield Curve Has Inverted 2/10 yield curves in both the U.K. and Australia invert more often than in other countries. However, unlike other countries, equities can continue to outperform bonds even after the curve is inverted. The turning point is about minus 50 basis points, as shown in Chart 8. The upper band for Australia is 1.25% and 0.9% for the U.K. Chart 8AU.K. & Australia: Reduce Risk ##br##After Yield Curve Has Inverted (I) U.K. & Australia: Reduce Risk After Yield Curve Has Inverted (I) U.K. & Australia: Reduce Risk After Yield Curve Has Inverted (I) Chart 8BU.K. & Australia: Reduce Risk ##br##After Yield Curve Has Inverted (II) U.K. & Australia: Reduce Risk After Yield Curve Has Inverted (II) U.K. & Australia: Reduce Risk After Yield Curve Has Inverted (II) Japan: Yield Curve Does Not Provide Consistent Information The Japanese stock/bond ratio does not have a consistent relationship with the 2/10 yield curve, as shown in Chart 9. This makes it very difficult to apply the simple approach employed here. Country Divergence U.S. economic cycles have been widely studied. But as shown in Chart 1, correctly identifying recessions in the U.S. does not systematically capture equity/bond relative performance cycles because even U.S. equities can underperform bonds before a recession starts and after a recession ends. Using the yield curve, on the other hand, does a much better job in capturing the equity/bond performance cycle in each country. Chart 10 shows that investors in different countries should pay more attention to local yield curve cycles other than just following a U.S.-centric analysis, even though the U.S. does play a dominant role in the global economy and in global equity and bond indices. Chart 9Japan Is The Outlier Japan Is The Outlier Japan Is The Outlier Chart 10Country Divergences Country Divergences Country Divergences Bottom Line: The yield curve is an effective indicator for equity/bond allocation in most developed countries from a long-run perspective. Currently, yield curve-based signals from the U.S., Canada, Euro Area, Switzerland, the U.K. and Australia all still favor equities over bonds. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com

Highlights Major and drawn-out financial market downturns usually occur in phases and often resemble a domino effect. There have been a number of noteworthy divergences in the EM space of late. They are probably part of a domino effect - some tiles have begun to drop, but other tiles down the chain still remain standing. The selloff in EM risk assets will broaden and intensify. A defensive positioning is warranted. India's relative equity performance has by and large been undermined by rising oil prices. A potential roll-over in crude prices will aid the Indian bourse's relative performance versus its EM peers. The South African rand remains on shaky foundation; stay short. Feature There have been a number of noteworthy divergences in financial markets of late, in particular between emerging markets (EM) and commodities, as well as between Chinese investable stocks trading outside the mainland and equity prices listed domestically. In our view, these divergences are part of a domino effect - some tiles have begun to drop, but other tiles down the chain still remain standing. In dominos, tiles do not all fall simultaneously. They fall one by one, and there is a time lag between the first domino and the last-standing domino to drop. Also, unlike in natural sciences, time lags and speed in economics and finance vary with each experiment - because they are contingent on complex human psychology and behavior, not on well defined natural phenomena such as gravity or motions of objects. Hence, they are impossible to forecast with much precision. A Message From Our Risky Versus Safe-Haven Currency Ratio Although U.S. share prices have lately been firm, EM stocks have broken below their 200-day moving average (Chart I-1, top panel). So has our risky versus safe-haven currencies ratio 1 (Chart I-1, bottom panel). Indeed, while having held up at its 200-day moving average several times in the past two years, the ratio has recently decisively broken below this technical support line. This indicator correlates extremely well with EM share prices, and its message is presently unambiguous: The rally in EM is over, and a bear market has likely commenced. Crucially, this ratio measures commodities currencies versus the average of the Japanese yen and Swiss franc - two defensive currencies - not against the U.S. dollar. Hence, it is not impacted by the greenback's trend. Given that all six risky currencies used in the numerator of this ratio - AUD, CAD, NZD, BRL, ZAR and CLP - are commodity currencies, it is not surprising that the ratio also correlates with commodities prices. In this context, it currently suggests the outlook for both industrial metals and oil is troublesome (Chart I-2). Chart I-1Beware Of These Breakdowns Beware Of These Breakdowns Beware Of These Breakdowns Chart I-2A Red Flag For Commodities Prices bca.ems_wr_2018_06_14_s1_c2 bca.ems_wr_2018_06_14_s1_c2 The common denominator that links all these financial variables is global growth. The risky versus safe-haven currencies ratio typically leads world trade cycles by several months, and it currently points to a notable slowdown in global export volumes (Chart I-3). Chart I-3Global Export Growth Is Set To Slow bca.ems_wr_2018_06_14_s1_c3 bca.ems_wr_2018_06_14_s1_c3 Further, commodities prices have exhibited a rare decoupling from the U.S. dollar. It is very unlikely that this divergence can be sustained for much longer. Our bias is that global trade will slow as China/EM demand weakens despite robust U.S. growth. Growth dynamics shifting in favor of the U.S. entails that the greenback will continue to appreciate. Consistently, EM/China growth disappointments and U.S. dollar's persisting strength suggest that commodities will reverse their current trend sooner rather than later. A relapse in commodities prices will reinforce EM currency depreciation, triggering more outflows from EM equities and fixed-income markets. Decoupling Or A Time Lag? Chart I-4Domino Effect In 2007-08 Domino Effect In 2007-08 Domino Effect In 2007-08 Major and drawn-out financial market downturns usually occur in phases and often resemble a domino effect. The EM crises in 1997-98 did not occur simultaneously across all EM countries. It began in July 1997 with Thailand, then it spread to Korea, Malaysia and Indonesia and finally, to the rest of Asia. In August 1998, Russian financial markets collapsed triggering the LTCM debacle. The last leg of this crisis appeared in Brazil and culminated in the real's devaluation in January 1999. Similarly, the U.S. financial/credit crisis commenced with the selloff in sub-prime securities in March 2007. Following that, corporate spreads began widening and bank share prices rolled over in June 2007. In the meantime, the S&P 500 and EM stocks peaked on October 9 and 29, 2007, respectively. Despite all of these developments, commodities prices and EM currencies continued rallying until summer of 2008 and then quickly collapsed in the second half of that year (Chart I-4). Finally the Lehman crash took place on September 29 of 2008. That marked the apogee of the crisis, causing a complete unravelling of financial markets and the global economy, and lasting until March of 2009. It seems some sort of domino effect is now taking hold of the EM universe. Initially, it started with Turkey and Argentina. Then, it spread to Indonesia, India and Brazil. The currency weakness across the wider EM universe has already led to EM credit spread widening. Yet, there are a few EM financial markets, particularly Chinese, Korean and Taiwanese, that are still holding up relatively well. Moreover, U.S. share prices and high-yield credit spreads have done quite well too. How should investors interpret these divergences? Our view has been, and remains, that EM risk assets will do poorly regardless of the direction of the S&P 500. In fact, an escalation in EM turmoil and a slowdown in developing economies are among the main risks to American share prices themselves. The primary link from EM financial markets to the S&P 500 is via the exchange rate - a strong dollar along with an EM/China growth slump will weigh on American multinationals' profits. The following three questions are presently vital for investors: 1. Can EM and U.S. risk assets de-couple from each other, and has a sustainable divergence happened in the past? Although short-term moves in U.S. and EM equity indexes often appear correlated, from a big-picture perspective there have been considerable divergences. The overall EM stock index is now at the same level it was in 2007 (Chart I-5). Meanwhile, the S&P 500 index is a hair below its all-time high. Chart I-5EM Share Prices And The S&P 500: A Long-Term Perspective EM Share Prices And The S&P 500: A Long-Term Perspective EM Share Prices And The S&P 500: A Long-Term Perspective The same is true for many EM currencies and the S&P 500. A substantial decoupling did occur in the not-so-distant past: EM currencies depreciated from 2011 to early 2016, while U.S. share prices rallied strongly from late 2011 until 2015 (Chart I-6). With respect to U.S. credit spreads, Chart I-7 illustrates that EM and U.S. credit spreads have had a much higher correlation than their respective equity indexes. During the 1997-'98 EM crises and the 2014 -'15 EM turmoil, U.S. high-yield corporate spreads widened. In brief, there has historically been little decoupling between U.S. and EM credit markets. Hence, the U.S. high-yield credit market's latest resilience in the face of widening in EM credit spreads is historically exceptional. Chart I-6EM Currencies And The S&P 500 EM Currencies And The S&P 500 EM Currencies And The S&P 500 Chart I-7EM Sovereign And U.S. Corporate Credit Spreads: A Long-Term Perspective EM Sovereign And U.S. Corporate Credit Spreads: A Long-Term Perspective EM Sovereign And U.S. Corporate Credit Spreads: A Long-Term Perspective As EM currencies continue to depreciate versus the U.S. dollar, EM sovereign and corporate credit spreads will widen. Given their past high correlation with U.S. credit markets, odds point to widening corporate credit spreads in the U.S. On the whole, if EM risk assets continue to sell off, which is our baseline scenario, the S&P 500 and U.S. credit markets could defy gravity for a while, but not forever. At some point, risks stemming from EM turbulence will cause a selloff in American stocks and corporate bonds. It is impossible to know when and by how much U.S. stocks will suffer. Our bias is that a U.S. equity selloff will likely be on par with the 2015-'16 episode. 2. Can North Asian equity markets such as China, Korea and Taiwan remain relatively resilient if the turbulence in other EM countries continues? Based on history, they can, but only for a short period of time. There have been a few episodes when emerging Asian and Latin American stocks de-coupled: In 1997-'98, the home-grown Asian crisis devastated regional markets, but Latin American stocks continued to rally until mid-1998 - at which point they began plummeting (Chart I-8, top panel). In 2007-'08, emerging Asian equities started tumbling along with the S&P 500 in late 2007, but Latin American bourses fared well until the middle of 2008 due to surging commodities prices (Chart I-8, middle panel). Finally, the bottom panel of Chart I-8 illustrates that in early 2015, Asian stocks performed well, supported by the inflating Chinese equity bubble. Meanwhile, Latin American stocks plunged. In all of these episodes, the de-coupling between Asia and Latin America proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside. Regarding Asia's business cycle conditions, the slowdown is already taking place and will likely intensify. Leading indicators of exports and manufacturing such as Korea's manufacturing shipments-to-inventory ratio and Taiwan's semiconductor shipments-to-inventory ratio herald further deceleration in their respective export sectors (Chart I-9). Chart I-8Asian And Latin American Equities: ##br##Unsustainable Divergences Asian And Latin American Equities: Unsustainable Divergences Asian And Latin American Equities: Unsustainable Divergences Chart I-9Asia's Export Slowdown Is In Making Asia's Export Slowdown Is In Making Asia's Export Slowdown Is In Making 3. Is there any other notable financial market decoupling that investors should be aware of? Chart I-10China: A Decoupling In Various Equity Segments China: A Decoupling In Various Equity Segments China: A Decoupling In Various Equity Segments Since early this year, there has been substantial decoupling between Chinese investable stocks and the onshore A-share market. First, the overall A-share index has dropped since early this year, but the MSCI Investable Chinese stock index has so far been resilient (Chart I-10). Second, while it might be tempting to explain this decoupling by discrepancies in the sectors' weights in these indexes, this has not been the case this time around. The fact remains that there has been considerable divergence between share prices of the same sectors. For example, onshore and offshore equity prices have diverged for the following sectors: real estate stocks, materials, industrials, technology, utilities and consumer discretionary (Chart I-11A and Chart I-11B). Only defensive sectors such as consumer staples and health care have done well in both universes. Share prices of financials and telecoms have dropped in both the onshore and offshore markets. Chart I-11AChinese Equity Sectors: Puzzling Decoupling Chinese Equity Sectors: Puzzling Decoupling Chinese Equity Sectors: Puzzling Decoupling Chart I-11BChinese Equity Sectors: Puzzling Decoupling Chinese Equity Sectors: Puzzling Decoupling Chinese Equity Sectors: Puzzling Decoupling Finally, a similar performance gap has appeared between Chinese small cap stocks trading onshore and in Hong Kong (Chart I-12). Chart I-12China's Small-Cap Stocks: A Perplexing Gap China's Small-Cap Stocks: A Perplexing Gap China's Small-Cap Stocks: A Perplexing Gap How do we explain these divergences? Our bias is that local investors in China are much more concerned about the mainland growth outlook than foreign investors. This is the opposite of what occurred in 2015. Back then, international investors were somewhat cautious on China - commodities prices and other China-related global financial market plays were in a bear market. Meanwhile, local investors were caught up in a full-fledged equity mania that ended with a crash. Given our downbeat outlook on China's capital spending and related plays in financial markets, we reckon that domestic investors in China will be proven right in the months ahead, while the international investment community will be left flat-footed. Importantly, there has been an unexplainable mismatch between monetary/credit tightening in China and complacency among international investors about the outlook for the mainland economy. Specifically, the cost of borrowing has gone up, and credit standards have tightened. Chart I-13 illustrates that both onshore and offshore corporate bond yields have risen to new cycle highs, Chinese banks' lending rates are rising, while banks' loan approvals are dropping. Consistently, money and credit growth have plunged. Importantly, this is occurring in an economy with immense credit excesses. Nevertheless, commodities prices have so far defied such a pronounced deceleration in money and credit aggregates in China (Chart I-14). Chart I-13China: Ongoing Credit Tightening China: Ongoing Credit Tightening China: Ongoing Credit Tightening Chart I-14China's Money/Credit And Commodities Prices China's Money/Credit And Commodities Prices China's Money/Credit And Commodities Prices All in all, we interpret these divergences by varying lead and lags rather than as a fundamental breakdown in the relationship between money/credit and the real economy. We continue to expect tightening liquidity and credit to escalate the growth slowdown in China. As a result, there continues to be considerable downside risks for Chinese investable stocks and commodities prices. Bottom Line: The dominos have begun to fall. We continue to recommend a defensive strategy and an underweight position in EM equities, credit and currencies versus their U.S./DM peers. High-yield local currency bonds that are a de-facto bet on the underlying currencies are vulnerable too. For investors willing to go short, it is not too late to short EM stocks and currencies. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Average of cad, aud, nzd, brl, clp & zar total return (including carry) indices relative to average of jpy & chf total returns. India's Equity Underperformance: Blame It On Oil Indian stocks have been underperforming their EM counterparts. Rising oil prices have created a toxic macro mix for India, triggering the equity underperformance (Chart II-1): Rising crude prices have led to widening current account and trade deficits. Oil price swings are often instrumental to trends in India's current account balance (Chart II-2). The deterioration in the nation's external accounts has been behind the rupee's poor performance. Chart II-1Higher Crude Oil Prices Hurt Indian Stocks Higher Crude Oil Prices Hurt Indian Stocks Higher Crude Oil Prices Hurt Indian Stocks Chart II-2Crude Oil And Current Account Deficit Crude Oil And Current Account Deficit Crude Oil And Current Account Deficit Given that India is a major oil importer, falling commodities prices - especially crude oil - will benefit India's stock market. The recent surge in oil prices has also reinforced inflation dynamics in India (Chart II-3). Chart II-3Higher Crude Oil Boosts Inflation Higher Crude Oil Boosts Inflation Higher Crude Oil Boosts Inflation The basis for the high correlation between core consumer price inflation (excluding energy and food) and oil prices is due to the fact that core inflation includes components that are heavily influenced by fluctuations in oil prices. For instance, the transportation and communication component of inflation is very sensitive to changes in oil prices. This component accounts for 18% of core consumer price index. Further, the personal care and effects component also correlates with crude oil. Personal care goods use petroleum products as an important input in their production process. This component accounts for 8% of core consumer price index. Together these components account for a non-trivial 26% of core consumer price index, and will likely subside as oil prices fall. On the inflation front, we highlighted in our April 19 Weekly Report that risks to inflation are tilted to the upside due to strong consumer and government spending in an otherwise under-invested economy.1 Domestic demand has been accelerating, providing tailwinds for higher inflation (Chart II-4). Higher inflation and currency weakness has led to a considerable rise in both government and corporates local currency bond yields (Chart II-5). Chart II-4Domestic Economy Is Strong Domestic Economy Is Strong Domestic Economy Is Strong Chart II-5Rising Borrowing Rates Rising Borrowing Rates Rising Borrowing Rates Given the very high equity valuations, share prices in India are especially sensitive to rising local borrowing costs. All in all, India's relative equity performance has by and large been undermined by rising oil prices. BCA's Emerging Markets Strategy team believes the risk-reward for oil prices is skewed to the downside due to the expected deterioration in EM/China oil demand, investors' extremely high net long positions in crude and appreciating dollar.2 That is why we are still reluctant to downgrade Indian stocks within the EM equity universe. It is vital to emphasize, however, that our overweight call is relevant to dedicated EM equity portfolios. We have been, and remain, negative on Indian share prices in absolute U.S. dollar terms. Bottom Line: Odds are that commodities prices will drop meaningfully in the months ahead and that will support India's relative equity performance versus the EM benchmark. EM dedicated investors should keep an overweight stance on Indian equities for now. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "Country Perspectives: India And Turkey," dated April 19, 2018, link available on page 21. 2 The Emerging Markets Strategy team's view on oil differs from BCA's house view which remains bullish. The South African Rand Remains On Shaky Foundations Although the rand has not been among the worse hit EM currencies, investors should remain cautious on it. The currency presently finds itself resting on very shaky foundations, raising odds of substantial depreciation for the remainder of the year: First, South Africa's external funding has solely been driven by portfolio inflows, leaving the exchange rate highly exposed to potential portfolio outflows. As illustrated in Chart III-1, net portfolio inflows reached all-time highs while net FDIs reached all-time lows at the end of 2017 (the latest available statistics). Meanwhile, foreign ownership of domestic bonds has reached new highs (Chart III-2). The total return in dollar terms on South Africa's local currency bond index1 has failed to break above its previous highs and has relapsed (Chart III-3). It seems this asset class has entered a new bear market. Further decline in the total return of bonds will spur more selling or hedging of currency risks by international bond investors. Chart III-1South Africa: Highly Exposed To Portfolio Flows South Africa: Highly Exposed To Portfolio Flows South Africa: Highly Exposed To Portfolio Flows Chart III-2Foreign Holdings Of South African Local Bonds Is Elevated Foreign Holdings Of South African Local Bonds Is Elevated Foreign Holdings Of South African Local Bonds Is Elevated Chart III-3South African Bonds Were Unable To Break Out South African Bonds Were Unable To Break Out South African Bonds Were Unable To Break Out Second, the country's trade balance is set to deteriorate. Despite continued episodes of currency weakness throughout last decade, there has been little to no import substitution in South Africa. Consequently, a reviving domestic demand will prompt higher imports. That, and a potential relapse in export (raw materials) prices, will lead to a widening trade balance. Chart III-4The Rand Is Not Cheap The Rand Is Not Cheap The Rand Is Not Cheap Finally, the rand is not cheap; its valuation is neutral (Chart III-4). When an exchange rate is close to its fair value, it can either appreciate or depreciate. In short, the rand's valuation is not extreme enough to be a major factor in driving the market right now. Bottom Line: Currency traders should stay short the ZAR versus both the USD and the MXN. Relative trade balance dynamics and valuations continue to play in favor of the Mexican peso relative to the South African rand. Predicated by our negative view on the rand, we recommend EM dedicated equity and fixed-income investors to maintain an underweight allocation to South Africa. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 JP Morgan GBI-EM Global Diversified Emerging Markets Government Bond Index for South Africa. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights In line with our House view, we expect the broad USD trade-weighted index (TWIB) to continue to appreciate over the next six to 12 months, as U.S. growth outpaces that of other DMs, and the Fed's pace of rate hikes outpaces that of other systemically important central banks. Ordinarily, this would be bad news for the overall commodities complex. However, most commodity prices disconnected from the U.S. dollar in 2015 - 16. This disconnect produced a not-often-seen positive correlation between commodities and the USD, which remained in place into 2017. Fundamentals are keeping oil and base metals correlations weaker vs. the USD. Precious metals and ags are most vulnerable to a stronger USD. Highlights Energy: Overweight. Cracks in Nigeria's Bonny pipeline system will further delay loadings already curtailed by a force majeure declaration, according to local sources. Elsewhere, the Kingdom of Saudi Arabia (KSA) apparently boosted production ahead of the regularly scheduled OPEC meeting in Vienna on June 22, as mounting losses in Venezuela and U.S. sanctions against Iran loom.1 KSA and Russia are pushing for higher production from OPEC 2.0 ahead of the Vienna meeting. Base Metals: Neutral. Although union negotiators took a conciliatory tone in discussions, contract terms between it and BHP Billiton in Chile's Escondida mine still have not been resolved. Among other things, the union proposed a salary increase of 5% and a $34,000 one-off bonus for workers.2 Precious Metals: Neutral. Gold prices held close to $1,300/oz going into this week FOMC meeting. Ags/Softs: Underweight: The USDA revised down its ending-stocks estimates for corn and soybeans for the 2017/18 and the 2018/19 crop years in its latest WASDE, which was released earlier this week. Feature Chart of the WeekUSD TWIB Vs. Chief Commodity Indices USD TWIB Vs. Chief Commodity Indices USD TWIB Vs. Chief Commodity Indices Broadly speaking, commodity prices are negatively correlated with the USD TWIB. The principal indices we follow - the CRB, Bloomberg and S&P GSCI index - all are cointegrated with the USD, i.e., they share a long-term trend, wherein commodity prices rise as the USD falls, and vice versa (Chart of the Week). Ordinarily, we would expect the near-term appreciation of the U.S. dollar to weigh on broad commodity indices' performance. These are not ordinary times. Surprisingly, what holds for these aggregate indices does not hold for individual commodity groups within the indices. We've ranked each commodity by industry group, and found that over the long term - and this is critical - oil and base metals are most sensitive to changes in the USD TWIB, while precious metals and ags are less sensitive. A 1% change in the U.S. dollar index leads to a change in the energy sub-index of the CRB of almost 5%, while a 1% change in the TWIB leads to a change of just under 4% for the base metals sub-index of the CRB. For the precious metals sub-index of the CRB, we would expect to see prices change by just under 3% for every 1% change in the dollar index, while for the ags sub-index of the CRB, broadly speaking, we could expect a change of just under 2.5%.3 USD's Complicated Relationship With Commodities To understand what's driving the broad indices and their component sub-indexes, we ran Granger-causality tests to get a better picture of what's driving what.4 On average, the U.S. dollar drives the broad indices, from a Granger-causality perspective. However, it does not drive the individual commodity sub-indexes in the same manner (Table 1). Table 1USD Vs. Commodities: What's Driving What? Correlations Vs. USD Weaken Correlations Vs. USD Weaken We found an interesting relationship between copper and oil: Copper's relationship with oil is stronger than its relationship with the USD - likely because both commodities respond to the same demand factors (e.g., global industrial growth), and that mining and refining copper are energy-intensive processes. We still see a long-term underlying common relationship with the U.S. dollar, but copper is more strongly tied to oil. Bottom Line: We ranked the four main commodity groups with respect to their historical sensitivity to the USD using two distinct metrics. Over the long haul, we found the order from most to least sensitive is (1) Energy, (2) Base Metals, (3) Precious Metals, (4) Ags. USD And Commodities Out Of Whack While most commodity indices exhibit strong and stable negative correlations with the U.S. dollar, many of these relationships were pushed out of their long-term equilibria in 2016, and, importantly, have remained out of whack for an unusually long period (Chart 2).5 In fact, we found most individual commodities and commodity groups haven't converged back to their long-term equilibrium correlation levels with the USD TWIB, and their respective divergences are once again moving higher (Chart 3). Chart 2CRB Sub-Indices Out Of Whack With USD Correlations Vs. USD Weaken Correlations Vs. USD Weaken Chart 3Short-Term Correlations Remain In Disequilibrium Correlations Vs. USD Weaken Correlations Vs. USD Weaken As we've shown in previous research, commodity prices can remain in disequilibrium with the dollar when important fundamental (supply - demand) shocks dominate price formation.6 Table 2 shows which commodity groups are most out-of-equilibrium since 2016 relative to their long-term historical correlation. Energy, especially oil, and base metals groups are at the top of this list. Despite the fact that both of these groups are the most sensitive to the USD, based on our long-term analysis discussed above, the fact that they remain in disequilibria with the USD suggests the increase in the U.S. dollar we expect over the next 6 months will have a limited impact on these commodities. This leaves ags and, notably, precious metals, most vulnerable to the USD appreciation foreseen in our House view. Table 3 shows how the sensitivities of the different commodity groups vs. the USD TWIB have changed from 2015 to now versus the 2000 to 2015 period preceding it.7 Moreover, we see that in the shorter period between 2015 and now, the base metals and oil sensitivities (in red) are not significant. Economically, this means prices have disconnected from the USD during this period, owing to the overwhelming influence of supply-demand fundamentals on the price-formation process. Table 2Rank Of Rolling Correlation Divergences##BR##In 6-Month Vs. 5-Year Rolling Correlations Correlations Vs. USD Weaken Correlations Vs. USD Weaken Table 3Fundamentals Overwhelm##BR##USD's Influence Since 2015 Correlations Vs. USD Weaken Correlations Vs. USD Weaken The most plausible explanation for this is base metals and oil markets experienced fundamental shocks over the period - especially since 2016, e.g. OPEC launching a market-share war in 2014 and surging production, followed by the OPEC 2.0 production cuts still in force in the market. In theory, and absent important fundamental (supply-demand) shocks in base metals and energy markets (e.g., a strike at major copper mines or an unexpected outcome at the OPEC 2.0 meeting next week), these correlations should converge back to the long-term equilibrium. However, the speed of convergence is unknown. As long as we observe a disequilibrium in the short-term correlations, we can assume that the disequilibrium will be maintained over the short term. The short-term correlation movements show most of the commodity groups were converging toward equilibrium in recent months, but have since reversed course, particularly oil (Chart 4 and Table 2). Chart 4Short- Vs. Long-Term Correlations Divergence Correlations Vs. USD Weaken Correlations Vs. USD Weaken We believe the historic correlation levels between base metals and oil prices and the USD TWIB gradually will be restored. However, a number of factors will have to be monitored in order to determine the timing and the level around which the correlations will stabilize - i.e., close to the 2008 - 2013 levels or to those of the 2000 - 2007 period (Chart 5). We found that the EM/DM business cycle - i.e., the relative performance of EM to DM economies - as well as the shape of the oil forward curve generally can act as mediating factors in restoring the correlations of the USD TWIB and commodity prices.8 The stronger EM economies are relative to DM economies, or the more in contango the oil forward curve is, the more negative the correlations between commodities, especially oil and base metals, and the USD TWIB. Obviously, should the opposite occur, we would expect the weaker correlations to persist, although this might not constitute a complete disequilibrium. The mediating factors we mentioned can diminish or enhance the USD - Commodity correlations, but that does not mean they completely break them down. Chart 5Oil Vs. USD TWIB Correlation Remains Out Of Whack Correlations Vs. USD Weaken Correlations Vs. USD Weaken Bottom Line: Commodity prices disconnected from the U.S. dollar in 2015 - 16, which led to a rare environment in which the correlations between the USD TWIB and commodities became positive. Surprisingly, this disconnect remained in place for an extended period, which led us to revise our USD-elasticity ranking of commodity groups. As long as the fundamental shocks in the energy and base metals groups continue to dominate price formation in these markets, precious metals and ags will remain the most vulnerable groups to U.S. dollar appreciation. Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "More delays to Nigerian Bonny Light as crude pipeline closes," published by Naija247 in Nigeria on June 11, 2018, and "Saudis Start to Ramp Up Oil Output, Ahead of OPEC Meeting," published by The Wall Street Journal, June 8, 2018. See also BCA Research's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Guiding to Higher Output; Volatility Set To Rise ... Again," published on March 31, 2018. Available at ces.bcaresearch.com. OPEC 2.0 is the name we coined for the oil-producer coalition led by The Kingdom of Saudi Arabia (KSA) and Russia. 2 Please see "Escondida Union to Copper Investors: Bet on Quick Wage Deal," published by bloomberg.com, June 7, 2018, and "BHP responds to contract proposal from union at Chile's Escondida mine," published by uk.reuters.com on 11 June 2018. 3 These elasticities are the average coefficients for each commodity group we calculated using two different cointegrating regressions - Dynamic Ordinary Least Square and Panel - covering Jan 2000 to now. 4 Granger-causality measures the extent to which changes in one variable cause (or allow one to predict) changes in another variable. This is based on the work of the 2003 Nobel laureate, Clive Granger, who began publishing on this in 1969. Please see "Investigating Causal Relations by Econometric Models and Cross-spectral Methods," Econometrica, Vol. 37, No. 3 (Aug., 1969), pp. 424-438. 5 We make sure the correlations we estimate use cointegrated random variables, which means the empirical results we get provide consistent estimates of actual population correlations. Please see Johansen, Soren (2007), "Correlation, regression, and cointegration of nonstationary economic time series," published by the Center for Research in Econometric Analysis of Time Series at the Aarhus School of Business, University of Aarhus. 6 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "OPEC 2.0 Vs. The Fed," dated February 08, 2018, available at ces.bcaresearch.com. 7 These sensitivities are coefficients in cointegrating regressions, which, given the construction of the regressions, are elasticities. 8 Using threshold regressions, we found the USD impact on BM and energy prices is, on average, weaker when DM stock prices outperform that of EM and when the oil forward curve is backwardated. These two variables act as mediators to the USD-Commodity relationship, and can be used to project the strength of the relationship. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Correlations Vs. USD Weaken Correlations Vs. USD Weaken Trades Closed in 2018 Summary of Trades Closed in 2017 Correlations Vs. USD Weaken Correlations Vs. USD Weaken

Highlights Since the end of the Bretton Woods system in 1971 there have been five major episodes where U.S. dollar moves were not uniform across all currencies. These episodes share common features: a rallying broad trade-weighted U.S. dollar, desynchronized global growth and falling commodity prices. The above conditions will likely be met in the coming months, producing a period of global currency divergence. Commodity and EM currencies will weaken the most against the U.S. dollar, then against the yen, and finally depreciating the least against the euro. Feature It is often assumed that the dollar behaves like a monolith. However, this is not always the case: some currencies do manage to occasionally buck the dollar's general trend (Chart 1). Interestingly, the yen is most often the currency that manages to avoid the broad dollar's general directionality. Chart 1Episodes Of Currency Divergence ##br##Versus the Dollar Episodes Of Currency Divergence Versus the Dollar Episodes Of Currency Divergence Versus the Dollar Our view has been and remains that the broad trade-weighted U.S. dollar still has meaningful upside this year, and that the EM currency complex will be under heavy selling pressure in the coming months. That said, it is worth asking whether all other currencies will share the same fate against a rising broad trade-weighted U.S. dollar, or whether some could diverge from the general dollar trend. This is essentially akin to trying to understand the pecking order of currencies outside the USD. To address these challenges, we believe it is important to understand how global growth will evolve, how relative growth dynamics among regions will shift, and how commodity prices will perform over the coming six to 12 months. When The Dollar Wears Many Masks There have been five major periods of currency divergence versus the U.S. dollar. These have lasted anywhere from one to three years (Table 1). Table 1Summary Of Currency Divergence Episodes Can There Be More Than One U.S. Dollar? Can There Be More Than One U.S. Dollar? Interestingly, they share some common features, heeding important insights for global investors. These features are as follows: 1) Common feature #1: A Rising Broad Trade-Weighted Dollar With the exception of the 2005-2007 episode, all other episodes where some currencies diverged from the general trend in the USD occurred when the broad trade-weighted U.S. dollar was in a bull market. 2) Common feature #2: Desynchronized Global Growth All episodes of divergence in the FX market occurred when global growth was desynchronized. This underscores the importance of growth as a key driver of FX movements. During the 1991-1993 period, the yen was able to buck the dollar's strength (Chart 2) even though Japanese growth was falling quite fast relative to the U.S. Explaining this seeming inconsistency was the policy conducted by the Bank of Japan at the time. The BoJ was cutting rates, from 6% in 1991 to below 2% in 1993, but it was not doing so fast enough to alleviate budding deflationary pressures. As a result, Japanese real interest rates did not fall. This caused real rate differentials to move firmly in favor of the yen. In the final months of 1991, Japanese 2-year and 10-year real rate spreads versus the U.S. were 50 basis points and -75 basis points respectively, but by June 1993, these spreads became 145 basis points and 115 basis points. In the 1995-1996 episode, all the economic blocks experienced a slowdown in growth relative to the U.S. While this time the yen plunged versus the dollar, commodity currencies managed to appreciate against the dollar. This was because commodity prices rose during this timeframe, creating a positive terms-of-trade tailwind that lifted these currencies (Chart 3). Chart 2Episode 1: The Yen Diverges Episode 1: The Yen Diverges Episode 1: The Yen Diverges Chart 3Commodity Currencies Diverge Commodity Currencies Diverge Commodity Currencies Diverge In 1997 and 1998, the euro was the currency that managed to remain stable versus the U.S dollar, while the yen and commodity currencies sagged meaningfully (Chart 4).The euro was able to defy the gravity of a strong dollar because the euro area's relative growth differential versus the U.S. remained stable. Essentially, in the late '90s, as the euro area periphery was enjoying the full dividend of convergence toward the living standards of core Europe, European domestic demand was left unaffected by the Asian crisis. Meanwhile, commodity producers and Japan - two groups with much deeper links with EM economies - were experiencing deeper repercussions from the EM economic contraction. The 2005-2007 period of de-synchronized currency action against the dollar is somewhat of an outlier (Chart 5). First, this particular episode of currency divergence materialized in an environment where the dollar was weak. Chart 4Episode 3: The Euro Diverges Episode 3: The Euro Diverges Episode 3: The Euro Diverges Chart 5Episode 4: The Yen Diverges Again Episode 4: The Yen Diverges Again Episode 4: The Yen Diverges Again Second, the outlier was the yen, which managed to depreciate against the dollar while all other currencies were strengthening against the greenback. Chart 6Episode 5: The Euro Diverges again Episode 5: The Euro Diverges again Episode 5: The Euro Diverges again Third, while Japanese growth was below that of the U.S. it was not falling versus the U.S. However, this still caused Japan to be the odd man out in terms of growth performance, as other economic blocs delivered better growth than the U.S. Moreover, Japan was not experiencing the same growth dividend from China's miraculous boom as emerging Asian or commodity producers were. Adding fuel to the fire was the endemic implementation of carry trades. The low FX and rate volatility of that era was an invitation to engage in this kind of strategy.1 But Japan's deflation, along with its sub-par economic performance when compared to non-U.S. economies, re-assured investors that the BoJ would keep rates at rock-bottom levels for the foreseeable future. This was an invitation to investors to sell the yen to fund these carry trades in EM and commodity currencies as well as the euro. Finally, during the 2012-2013 episode the euro area was the global growth laggard. However, the euro was the currency that was able to strengthen against the dollar, defying the greenback's broad appreciation (Chart 6). It is true that euro area domestic demand growth was slightly improving versus the U.S. More importantly though, this was the time period that followed European Central Bank President Mario Draghi's "whatever it takes" speech. These soothing words caused the break-up risk premia across euro area member states to collapse, lifting the euro in the process. 3) Common feature #3: Commodity Prices Were Falling In three out of five episodes, commodity prices were falling, which is consistent with the fact that four out of the five episodes were periods of broad trade-weighted U.S. dollar strength. The only exceptions were the 1995-1996 and 2005-2007 episodes, where commodities rallied. The latter period was further marked by a weak broad trade-weighted U.S. dollar. Bottom Line: Looking back at history, there have been five episodes where some major currencies diverged from the U.S. dollar's broad trend. In the majority of these episodes, the broad trade-weighted U.S dollar was rising, global growth was desynchronized, and commodity prices were falling. When Is The Next Episode On The Air? The aforementioned three common features can be thought of as pre-conditions for some currency divergence to transpire. So, when can investors expect the next episode to hit the proverbial airwaves? In our view, this scenario is most likely to materialize over the coming six to 12 months. Our main macro themes have been and remain2 that the global macro landscape over the coming months will be shaped by two tectonic shifts: on the one hand, America's fiscal stimulus will sustain robust U.S. growth, and on the other hand, the continued slowdown in money and credit in China will culminate in a relapse in capital spending. The Chinese leg of the scenario will depress commodity prices and consequently emerging market economies; meanwhile, thanks to considerable fiscal stimulus, easy financial conditions and relative economic insularity, U.S. growth will remain steady, leaving it as the global growth outperformer. These dynamics are bullish for the broad trade-weighted U.S. dollar: The U.S. economy is growing robustly despite rising interest rates. In fact, interest rate-sensitive sectors are showing no signs of slowing down, confirming the resilience of the economy at this stage of the cycle. Both the housing market and commercial lending standards are not flagging growth risks (Chart 7). Chart 8 demonstrates that BCA's broad money measure (M3) for China leads import volumes and industrial metals prices by about six months. Based on the indicator's track record, odds are that industrial commodity prices will fall meaningfully over the coming months. Chart 7U.S. Economy Is Weathering##br## Rising Interest Rates U.S. Economy Is Weathering Rising Interest Rates U.S. Economy Is Weathering Rising Interest Rates Chart 8China's Money/Credit Is Bearish ##br##For Industrial Metals bca.fes_sr_2018_06_08_c8 bca.fes_sr_2018_06_08_c8 While oil prices could hold out for longer due to supply dynamics and geopolitics, positioning remains extremely elevated. As such, we are not ruling out a meaningful pullback in crude as traders head for the exits - all in the context of slowing global demand. Bottom Line: Pieces are falling in place to create the conditions necessary for some currency decoupling: global growth is set to become desynchronized, and commodity prices are likely to weaken - all in the context of a rising broad trade-weighted U.S. dollar. A Reverse Currency Pecking Order Slowing global trade as well as a growth deceleration in China's capital spending and demand for commodities will have the biggest repercussions for commodity and EM Asian currencies (Chart 9). This leaves the euro and the yen as the two most likely candidates to potentially diverge from the broad U.S. dollar in this coming episode. In our view, we think the yen could win this title. First, while the euro area economy is less leveraged to a slowdown in China/EM than Japan, it is still extremely vulnerable. Investors are still very long the euro, and therefore are vulnerable to negative surprises. Euro area industrial production could be the impulse to continue generating underwhelming economic numbers, as it is very much leveraged to China (Chart 10), mainly due to Germany's own deep trade links with EM and China. Notably, the German IFO index for business expectations in German manufacturing - a good leading indicator for global trade - is pointing to a further slowdown in global exports (Chart 11, top panel). Furthermore, German manufacturing new orders from non-euro area countries are starting to roll over, suggesting German exports will weaken imminently (Chart 11, middle panel). Lastly, the Swiss KOF leading indicator has come in below 100 (Chart 11, bottom pane Chart 9EM Asia & Commodity Currencies To Remain Weak EM Asia & Commodity Currencies To Remain Weak EM Asia & Commodity Currencies To Remain Weak Chart 10When China Decelerates, So Does Europe When China Decelerates, So Does Europe When China Decelerates, So Does Europe Chart 11Global Trade Is Slowing Down Global Trade Is Slowing Down Global Trade Is Slowing Down Second, it seems that historically the yen has a greater ability to rally than the euro when commodity prices are falling or when the broad trade-weighted U.S. dollar is in a bull market, highlighting the counter-cyclical nature of the Japanese currency. This happened in the early to mid-'90s and in 2008 (Chart 12). The only exception was in 1998, when the euro was able to rally amid a selloff in commodity prices and a strengthening dollar because domestic growth was so resilient. Today, euro area domestic growth is healthier than it was in 2012-2013, but it is still much weaker than is the case in the U.S., especially as the latter is receiving a shot in the arm thanks to a large dose of late-cycle stimulus. Chart 12The Yen Has Counter Cyclical Attributes The Yen Has Counter Cyclical Attributes The Yen Has Counter Cyclical Attributes Chart 13Euro Long Positioning Is Higher Than For The Yen Euro Long Positioning Is Higher Than For The Yen Euro Long Positioning Is Higher Than For The Yen As such, we believe the euro has more downside than the yen against the U.S. dollar in this coming episode. Furthermore, speculators remain too long the euro versus the yen (Chart 13). Third, the yen is a crucial funding currency in global carry trades, while the euro has not been used by traders for this purpose over the past 18 months.3 As such, a selloff in EM and commodity currencies, which is our base case, could spur a rush to the exits for short yen positions, while the euro is not likely to benefit from a similar short squeeze. Additionally, Japan sports a large positive net international investment position of US$3.1 trillion, while Europe's stands at -US$0.6 trillion. Consequently, Japanese investors have proportionally more funds held abroad than European investors to repatriate home in the event of an upsurge in global/EM market volatility, adding a further impetus for the yen to buck the dollar trend. One of the best currency valuation metrics is the real effective exchange rate based on unit labor costs, because it takes into account both wages and productivity. Unfortunately, this data set does not exist for all countries. On this metric, the U.S. dollar is not expensive (Chart 14, top panel). Adding credence to our view that the yen will be more resilient than the euro this year, according to the unit labor costs-based measures, the JPY appears to be cheap in trade-weighted terms and relative to the EUR (Chart 14, bottom panel). Chart 14The Yen Is Cheaper Than the Euro,##br## Dollar Is Fairly Valued The Yen Is Cheaper Than the Euro, Dollar Is Fairly Valued The Yen Is Cheaper Than the Euro, Dollar Is Fairly Valued Chart 15The Korean Won##br## Is Expensive The Korean Won Is Expensive The Korean Won Is Expensive Chart 16Commodity Currencies ##br##Are Not Cheap Commodity Currencies Are Not Cheap Commodity Currencies Are Not Cheap The Korean won - the only emerging Asian currency for which this measure is available - seems to be expensive (Chart 15). Chart 16 demonstrates that commodity currencies including those of Australia, New Zealand and Chile are on the expensive side, while the Canadian dollar and the Colombian peso are fairly valued. Bottom Line: Putting all the pieces together, our reverse pecking order for global investors from the weakest to strongest currency against the U.S. dollar is as follows: commodity currencies, non-commodities EM currencies (primarily Asian), the euro, and the yen. Investment Conclusions We recommend the following strategy to best navigate the coming global currency divergence episode over the coming six to 12 months: Global asset allocators should underweight the following currencies, from most to least, in the following order: First, the extremely vulnerable commodity currencies (BRL, IDR, ZAR, CLP, COP, AUD, NZD, NOK, and CAD); second, the EM Asian currencies (KRW, MYR, SGD, TWD, and PHP); third, the euro; and lastly, the yen. Currency traders stand to benefit the most in this coming episode by going short commodity and EM Asian currencies versus the U.S. dollar. That said, Japanese and European investors also stand to benefit by selling or underweighting commodity and EM currencies. The yen and the euro will depreciate significantly less than commodity and EM currencies, with the yen potentially ending flat versus the U.S. dollar. To capture these dynamics we suggest a new currency trade: long JPY / short SGD. The rationale behind this trade is that the Monetary Authority of Singapore (MAS) manages the Singapore dollar against a basket of currencies of its major trading partners. Consequently, if as we anticipate the Japanese yen strengthens versus all other currencies with the exception of the greenback, the MAS will likely have to depreciate the Singapore dollar versus the yen. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com 2 Please see Emerging Markets Strategy Weekly Report, titled "Two Tectonic Macro Shifts", dated January 31, 2018, available at ems.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Euro: Risk On Or Risk Off?", dated November 17, 2017, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Italy is a live drama. However, both Italy and Brussels have constraints that should lead to a compromise on fiscal stimulus. Italy will not leave the euro in the foreseeable future, and the European Central Bank has little incentive not to continue accepting Italian bonds. With the recent capitulation in the Italian bond market, the euro could experience a brief respite, potentially rallying toward 1.18 to 1.19. However, for the euro to endure a more durable bottom, global bond yields need to stop falling. Until then, EUR/USD could move toward 1.12. Falling bond yields imply more downside for EUR/JPY and EUR/CHF as well. NOK/SEK is not yet a buy. The trend in gold prices can be used to gauge where the fed funds rate stands vis-à-vis r-star. Feature In July 64AD, the Great Fire of Rome erupted, causing untold damage to the great imperial capital. Various Roman sources suggest that Emperor Nero started the fire to clear land in order to build himself a new palace, the Domus Aurea.1 This fire was a calamity, and was followed by a period of economic tumult and currency debasement. However, Rome recovered, the empire conquered more nations, and ultimately survived another 412 years. We have held a bearish view on the euro for 2018, expressed by recommending investors buy DXY and sell EUR/CAD, EUR/JPY and EUR/CHF. However, this view is underpinned by economic divergences and a softening in global growth. Our negative bias on the euro has greatly benefited from the fire that has engulfed Italian politics and bond markets. Taking stock of this week's political theatre, does it still make sense to be short the euro, and by extension long the dollar? As we foresee more downside in global bond yields, we think yes. However, while Italy is currently burning, it is not at risk of causing a collapse of the euro area. Pricing an end to the "empire" is thus an inappropriate reason to stay short the euro. The Italian Job Italy has once again become a trouble spot for investors. The M5S / Lega Nord coalition's manifesto proposes blowing out the fiscal deficit to above 7% of GDP by instituting a flat tax regime, increasing spending and undoing pension reforms instigated by the Monti government in 2012. In response to these developments, president Mattarella has removed the proposed finance minister, Paolo Savona, arguing he was too anti-euro and that abandoning the euro area was unconstitutional. He went on to nominate Carlo Cottarelli, nicknamed "Mr. Scissors," as a caretaker prime minister tasked with leading a technocratic government until new elections are implemented. However, the coalition rightfully argued that this move was executed under a false pretext, as its current policy proposal does not include leaving the euro area. Even before the drama had fully blossomed, Italy on Monday had been put on downgrade watch by Moody's. In light of the political developments, investors then worried that a new election would result in Italy potentially exiting the euro area. Italian 2-year yields spiked to a spread of 350 basis points against German Schatz. This implied a perceived probability of 11% that Italy will choose to exit the euro area over the course of the next two years. Another possible outcome discounted by investors was that the European Central Bank would stop accepting BTPs as repo collaterals, or stop buying them in its Asset Purchase Program. Chart I-1Italian Support For The Euro##br## Is Low But Well Above 50% Italian Support For The Euro Is Low But Well Above 50% Italian Support For The Euro Is Low But Well Above 50% Which of these two risks is more likely to materialize? We think the current implied probability of Italy electing to leave the euro over the coming two years is very low. Italians exhibit the lowest support toward the euro of any eurozone member state. However, a majority of Italians, 59% of them, still support the common currency (Chart I-1). In response to this constraint, the very nimble Five Star Movement, while still hell-bent on fiscal profligacy, has already greatly downplayed its Euroscepticism. While Lega Nord still has more Eurosceptic inclinations, it has not put leaving the euro area at the core of its coalition agreement with M5S. BCA has a great degree of confidence in this view, but it is important to not be dogmatic. BCA's Geopolitical Strategy service recommends investors closely follow the statements of these two parties over the course of the summer. The second risk is more real. The fiscal proposal of the coalition would blow the Italian budget deficit from 2.3% to more than 7% of GDP. Ratings agencies are already putting Italy on downgrade watch. Italy has a credit rating of Baa2, and only bonds with ratings of Baa3 or better are eligible at the ECB. It is possible that the central bank, in coordination with Brussels, exerts the same kind of pressure as it did in August 2011 when Jean Claude Trichet and Mario Draghi wrote a letter to Silvio Berlusconi demanding his resignation in exchange for financial market support for Italy. Despite this risk, we expect Italy to ultimately play ball and not blow up the deficit to 7% of GDP - simply because of economic constraints. These constraints are also likely to create an additional limit on the willingness and capacity of Italy to leave the euro area. The arguments we made in a joint Special Report with BCA's Geopolitical Strategy service titled "Europe's Divine Comedy Part II: Italy In Purgatorio," published in June 2017, remain valid: Italy will feel the pain from its transgressions before it can implement them.2 This is happening today as we write. Essentially, Italy's problem is rooted in the poor health of its banking system. Italian banks have capital in the order of EUR165 billion and NPLs of EUR130 billion, leaving EUR35 billion in excess capital. However, Italian commercial banks hold approximately EUR350 billion in BTPs. Thus, any decline in BTP value of 10% or more would render the Italian banking system insolvent (Chart I-2). Since suggesting abandoning the euro or conducting policy that exclude Italian debt from the ECB's window would cause a greater than 10% fall in BTP prices, this would kill off credit issuance in Italy as the banking sector would not have the wherewithal to extend new loans. This would prompt a large collapse in the credit impulse, and thus GDP growth (Chart I-3). The ensuing painful recession would cause Italians to backtrack on their intentions to leave the euro area. If Italy's credit rating and its access to the ECB is the reason for the collapse in BTP prices, the same dynamics will also force the Italian government to adopt a more realistic fiscal policy. This is why we do not believe the current M5S/Lega Nord government will be able to blow up the budget by as much as it currently wants. Chart I-2The Italian Constraints Lies##br## In The Banking Sector The Italian Constraints Lies In The Banking Sector The Italian Constraints Lies In The Banking Sector Chart I-3Credit Trends Explain##br## Italian Growth Credit Trends Explain Italian Growth Credit Trends Explain Italian Growth There are, however, incentives for Brussels to be more lenient on Italy. Italy is not Greece. The Troika had room to play hardball with Greece. Greek debt was EUR346 billion, or 10% of Germany's GDP (the perceived ultimate backer). The same cannot be said about Italy. Rome's debt stands at EUR2383 billion or 70% of Germany's GDP. In other words, as J. Paul Getty once said, "If you owe the bank $100, that's your problem. If you owe the bank $100 million, that's the bank's problem." Italy is the EU's problem. Chart I-4If You Owe The Bank 442 Billion, ##br##That's The Bank's Problem If You Owe The Bank 442 Billion, That's The Bank's Problem If You Owe The Bank 442 Billion, That's The Bank's Problem This problem is most evident in the Target 2 of the Bank of Italy. The Italian national central bank owes EUR442 billion to the Eurosystem, the most of any nation (Chart I-4). Claims on Italy can also be found on the balance sheets of commercial banks across Europe. French, Spanish, German, and Dutch commercial banks have Italian exposure of EUR426 billion, with EUR310 billion held by French banks alone. Italy's problems are definitely Europe's problem. A collapse of Italy could therefore impair the entire European banking sector. This means that the EU and the ECB have a strong built-in incentive to be lenient toward Italy. As a result, we expect that Brussels will be forced to accept a larger Italian deficit than 3% of GDP, as it did at the turn of the millennium when France and Germany were also in violation of the Stability and Growth Pact. The ECB could also make a conditional exception in terms of accepting Italian bonds. So What? The Italian situation remains fluid. While an election this summer, as early as July 29th, has been touted, efforts to form a government are still taking place. No matter what happens, the constraints on both Italy and the European institutions suggest that both sides of the table will have to come to a compromise regarding Italian public spending. The EU will have to tolerate a greater than 3% of GDP deficit, and the Five Star Movement, with whoever it coalesces, will not be able to blow up the budget deficit above 7% of GDP. Investors have made a mistake by pricing in an Italian exit. Hence, Italian 2-year yields could experience downside in the coming week. In fact, the daily move in Italian 2-year yields on Tuesday was the largest on record, despite what are still very low levels of interest rates by historical standards (Chart I-5). This suggests that May 29th represented a day of capitulation in the Italian bond market, at least on a short-term basis. As a result, the very oversold euro, which has declined more or less without a pause for the past 29 trading days, could stage a relief rally as investors re-evaluate the Italian risks (Chart I-6). Chart I-5Capitulation In The BTP Market Capitulation In The BTP Market Capitulation In The BTP Market Chart I-6The Euro Short-Term Rebound Can Continue The Euro Short-Term Rebound Can Continue The Euro Short-Term Rebound Can Continue This begs a crucial question: Is it time to bail on our various short bets on the euro as well as our long bet on the DXY? While a temporary resolution in Italy could easily prompt a euro rally toward 1.18-1.19, many issues that have prompted us to implement these views have yet to fully play out. For example, the euro's fair value, as implied by real short rate differentials, the slope of the euro area yield curve relative to the U.S. and growth differentials between the rest of the world and the U.S. - as captured by the price of copper relative to the price of lumber - still pegs an equilibrium for EUR/USD at 1.12 (Chart I-7). Chart I-7The Euro Has Yet To Purge Its Previous Excesses The Euro Has Yet To Purge Its Previous Excesses The Euro Has Yet To Purge Its Previous Excesses Additionally, while traders have capitulated on Italian bonds, investors have yet to capitulate on the euro. Speculators are still very long, and investor sentiment is still not consistent with a bottom (Chart I-8). Additionally, the trend in relative inflation still points toward a weaker euro, as it portends to an easing of European monetary policy relative to the U.S. (Chart I-9). The tension in Italy and the widening spreads in innocent Spain could play toward the ECB adjusting its forward guidance toward no hike for longer than is currently priced into the EONIA curve. Chart I-8No Capitulation Here No Capitulation Here No Capitulation Here Chart I-9Inflation Dynamics Point To A Lower EUR/USD Inflation Dynamics Point To A Lower EUR/USD Inflation Dynamics Point To A Lower EUR/USD However, the most important question right now for the euro is the direction of bond yields. Much will depend on the performance of bonds over the course of the coming months. Bottom Line: Italy is a political landmine, and the recent drama has weighed on the euro, causing EUR/USD to depreciate much faster than we anticipated. However, markets are currently embedding too-large a risk premium of an Italian exit. Both Italy and the EU will not stay as intransigent as they currently pretend, suggesting the market action will force a political compromise on the thorny question of deficits. As a result, while a rally in coming weeks of EUR/USD toward 1.18-1.19 is a very probable scenario, we anticipate the euro's weakness to end closer to 1.12 than currently recorded levels. All About Bond Yields BCA believes that bond yields are globally on a cyclical upswing, being lifted by the fact that global central banks are slowly but surely exiting the emergency stimulus measures put in place directly after the great financial crisis. Moreover, we also expect inflation to slowly come back, especially in the U.S. and Canada, also justifying higher yields. In response to these forces, BCA's three factor bond model, based on global manufacturing PMIs, the U.S. employment-to-population ratio and the dollar's bullish sentiment, suggests the fair value of 10-year Treasurys is at 3.3%, 46 basis points above current yields. However, markets do not move in a straight line. The bond market is especially prone to reversals as interest rates are a key determinant of the cost of capital. Thus, higher yields slow global economic activity, diminishing the reason why yields increased in the first place, creating a stop-and-go pattern. This time is no exception. In fact, Ryan Swift has been arguing in BCA's U.S. Bond Strategy service that after their sharp up-move from 2.04% to 3.11%, bond yields have downside on a short-term basis.3 A few factors explain why bond yields could experience a bit more downside in the coming months: Bond aggregates have been oversold (Chart I-10), with their 100-day rate of change hitting levels associated with a subsequent rebound in prices. This rebound is underway and doesn't look to have yet been fully played out. Chart I-10Bonds Were Too Oversold To Keep Falling In A Straight Line Bonds Were Too Oversold To Keep Falling In A Straight Line Bonds Were Too Oversold To Keep Falling In A Straight Line Positioning remains too skewed. Speculators are still very short Treasurys, and duration surveys conducted by J.P. Morgan Chase suggest there is still more room to surprise investors, prompting them to lighten their short-duration calls (Chart I-11). The changes in 10-year U.S. yields are very correlated with the U.S. surprise index. However, this economic indicator is highly mean-reverting. The increase in investors' expectations suggests there is room for disappointment on the economic front for market participants. Ryan's autoregressive model for economic surprises, which captures the mean-reverting behavior of this series, suggests that surprises will deteriorate further in the coming weeks (Chart I-12). Chart I-11Still No Capitulation In ##br##Bond Positioning Still No Capitulation In Bond Positioning Still No Capitulation In Bond Positioning Chart I-12Economic Surprise Index U.S. Surprise ##br##Index Can Mean-Revert Further Economic Surprise Index U.S. Surprise Index Can Mean-Revert Further Economic Surprise Index U.S. Surprise Index Can Mean-Revert Further Global growth continues to show signs of deterioration, as the diffusion index of our global leading economic indicators highlights that only 24% of the world's major economies are experiencing expanding LEIs (Chart I-13). Moreover, the deliquescence of EM carry trades funded in yen also points toward additional deceleration in global industrial activity, and export volumes growth out of Asia continues to slow (Chart I-13, bottom panels). Here, the recent performance of gold is most revealing. The yellow metal is a good gauge of global liquidity conditions, and it tends to perform well when bond yields, especially real rates, weaken. However, despite a fall in real yields in recent weeks, and despite the rising geopolitical risks associated with Italy and the re-emergence of trade wars, gold prices are softer than expected. This implies that bond yields have not yet fallen enough to put a floor under global growth. So why does the absolute trend in Treasury yields matter for EUR/USD? Simply because since 2008, EUR/USD has performed very poorly when bond yields have declined, displaying an average annualized rate of return of -6.3% as well as a median return of -9.7%, and weakening two-thirds of the time (Table I-1). This essentially confirms our previous analysis showing that generally, the euro is a rather pro-cyclical currency. This also suggests that even if the euro could experience a temporary rally in response to a re-pricing of Italian exit risk, it will be hard for the common currency to rally durably so long as bond yields have downside. Chart I-13Global Growth Is Slowing Signs##br## Of Soft Global Growth Global Growth Is Slowing Signs Of Soft Global Growth Global Growth Is Slowing Signs Of Soft Global Growth Table I-1Bond Rallies And The Currency Market Rome Is Burning: Is It The End? Rome Is Burning: Is It The End? Table I-1 also shows that the yen has experienced large upside in a falling yield environment, and most importantly has risen in all instances against the USD. As a result, we remain comfortable with our January 12, 2018 recommendation to sell EUR/JPY.4 Not only does EUR/JPY weaken 83% of the time when bond yields fall, but as Chart I-14 shows, relative positioning in EUR/JPY has more room to deteriorate, as previous excesses on the long side tend to be followed by periods of excessive short positioning. Moreover, as the bottom panel illustrates, a reversal in the performance of momentum stocks also comes hand in hand with a weak EUR/JPY. Chart I-15 also highlights that rising dollar funding costs tend to lead to a weaker EUR/JPY. Chart I-14EUR/JPY Is Still Vulnerable EUR/JPY Is Still Vulnerable EUR/JPY Is Still Vulnerable Chart I-15Funding Pressure Point To A Weaker EUR/JPY Funding Pressure Point To A Weaker EUR/JPY Funding Pressure Point To A Weaker EUR/JPY Table I-1 further shows that despite our positive long-term view on EUR/CHF, if we believe that yields could correct further, it is intellectually coherent to be short EUR/CHF on a tactical basis, as the pair has also fallen in 83% of the occurrences of bond market rallies. We are thus sticking with this short-term trade. Chart I-16CAD Benefits From A Valuation Cushion CAD Benefits From A Valuation Cushion CAD Benefits From A Valuation Cushion Table I-1 however, is more mixed for our short EUR/CAD bet. EUR/CAD rallies on half the instances where bond yields weaken, and generates an average annualized gain of 1%. Yields are therefore an unreliable gauge of this cross's trend. Instead, we continue to favor the CAD over the EUR on the basis of relative monetary policy dynamics and valuations. The Canadian economy has no slack, core inflation is at 1.9%, and the Bank of Canada just re-opened the door to hiking rates this year - essentially a mirror image to the euro area. Also, while EUR/USD is overvalued by 4.9% based on our preferred model, USD/CAD is overvalued by 14% based on our model using oil and relative rate expectations (Chart I-16). We are therefore sticking with this position, even though we are likely to experience volatility after a straight move down from 1.61 to 1.5. Yesterday's announcement that the White House is imposing tariffs on steel and aluminium on Canada and the EU is likely to be a crucial contributor to this episode of volatility. Finally Table I-1 shows that our negative view on commodity currencies is the correct one to hold in the current context, especially regarding the AUD, which within this group suffers by the greatest extent when yields fall. Additionally, this analysis confirms our assessment regarding NOK/SEK. We were long this pair, and continue to foresee upside for the Norwegian krone relative to the Swedish krona on a cyclical basis. However, we closed this trade as NOK/SEK was getting very overbought. Adding another justification for this tactical decision, a falling yield environment has been associated with this cross weakening in 83% of cases and depreciating on average by a 4.9% annualized rate - or 5.7% if we take the median fall. We will therefore wait to see a stabilization in bond yields before re-opening our NOK/SEK trade. Bottom Line: The rebound in bond prices expected by our U.S. bond strategist has further to run, as the global economy is experiencing a soft patch and U.S. economic surprises have additional downside. This suggests that EUR/USD is likely to depreciate more, prompting us to stick with our 1.12 target for now. EUR/JPY and EUR/CHF possess ample downside as well. While commodity currencies all weaken when bond yields decline, the AUD declines most often, and by the greatest extent. NOK/SEK can correct further before resuming its uptrend; only once bond yields stabilize will we buy this cross again. Gold, The Fed And R-star Following last week's report where we discussed the interaction of the dollar, the fed funds rate, and r-star,5 we received a few questions regarding the implication of this analysis for the gold market. While the message of this analysis was very clear for the dollar - the dollar weakens when the Fed increases rates and the fed funds rate is below the r-star, but strengthens significantly when the Fed lifts rates above r-star - the implications for gold of the interaction between rates and r-star is much murkier. Table I-2 shows the returns of gold, as well as the batting averages of the results, under the four states explored last week. We use medians instead of means, as average returns have been distorted by a few outliers. Table I-2Gold And The Interaction Between ##br##Rates And R* Rome Is Burning: Is It The End? Rome Is Burning: Is It The End? This table highlights that the best environment to hold gold has been the same environment that was harshest to the dollar: a rising fed funds rate, but one that stands below the neutral rate. Essentially, this suggests that in this environment, despite the efforts of the Fed to tighten monetary conditions, global liquidity remains plentiful, which fuels both global growth and gold prices. In this context, gold rallies 76% of the time by a median annualized rate of 14.4%. Chart I-17Gold As A Gauge For R* Gold As A Gauge For R* Gold As A Gauge For R* Perplexingly, there is no clear implications in the other states. When the fed funds rate rises and stands above the neutral rate, gold falls by a median annualized rate of 1.3%, but this only works 55% of the time. This probably reflects the fact that when the real fed funds rate rises in this environment, while in and of itself this should hurt gold, the growing incidence of accidents in global financial markets and the global economy helps gold, undoing the damage created by tighter monetary policy. When the fed funds rate is falling, gold's annualized returns are mixed, but most importantly the distribution of returns is no better than random. So while this analysis does not provide a clear signal for gold next year, it does help us generate a useful inference. If the Fed is indeed soon set to lift interest rates above the neutral rate, as the Laubach-Williams measure of r-star implies, the violent rally that gold experienced in 2017 should taper off. If gold were to continue to rally vigorously, maintaining its strong trend despite higher rates (Chart I-17), this would imply that the fed funds rate is still below r-star. As a corollary, the business cycle would have greater upside, the dollar greater downside, and EM assets should prove more resilient than we anticipate. Bottom Line: Where we stand in the interest rate cycle is less useful for calling the gold market than it is for calling the dollar. While a rising fed funds rate that stands below the neutral rate creates a very supportive environment for gold, other combinations are more opaque. However, this can help generate useful insights on the equilibrium rate. If faced with higher interest rates, gold remains on the strong upward trend it experienced in 2017, this would mean that U.S. policy is still accommodative as the fed funds rate would still be below r-star. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Tacitus, the main source describing the fire, was unsure of the veracity of these allegations. 2 Please see Foreign Exchange Strategy and Geopolitical Strategy Special Report, titled "Europe's Divine Comedy Part II: Italy In Purgatorio", dated June 21, 2017, available at fes.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, titled "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, titled "Yen: QQE Is Dead! Long Live YCC!", dated January 12, 2018, and the Weekly Report, titled "The Yen's Mighty Rise Continues... For Now", dated February 16, 2018, both available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, titled "This Time Is NOT Different", dated May 25 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was generally weak this week: Q1 GDP growth was revised down to an annualized pace of 2.2%, profit growth was weak; Core personal consumption expenditure grew at a 2.3% quarterly pace, underperforming expectations of 2.5%; Core PCE inflation came in line with expectations at 1.8%. The March number was revised down to 1.8% as well from 1.9% previously; However, the U.S. labor market continues to tighten, with both continuing and initial jobless claims falling more than expected. Washington is ramping up its hawkish stance on trade, implementing its steel and aluminum tariffs on the EU, Canada, as well as Mexico. The U.S. is nonetheless likely to fare better than the rest of the G-10 in the current soft patch for global growth as it is a less cyclical economy. Furthermore, with the dollar recoupling with rate differentials, Fed hikes will serve as an important tailwind for the greenback for the rest of this year. Report Links: This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Amidst the surfeit of political angst across Italy and Spain, some positive economic data have contributed to some relief to the euro's persistent decline this month. German headline and harmonized inflation surprised to the upside, both coming in at 2.2%; German unemployment declined to 5.2%; German retail sales increased by 2.3% on a monthly pace; Spanish harmonized inflation came in at 2.1%, beating expectations; Euro area headline and core inflation came in at 1.9% and 1.1%, respectively, an improvement over previous figures; Unemployment also declined to 8.5% from 8.6%, but came in higher than the expected 8.4%. In addition to abating political anxiety in Italy, ECB Executive Board Member Sabine Lautenschläger, noted that "all the conditions for inflation to kick in are in place". While these factors provided a relief for the euro, it is likely that interest rate differentials, waning global growth, and a labor market replete with slack will keep the upside in the euro capped for the remainder of this year. The longer-run outlook, however, is bullish, as the common currency remains cheap across several valuation metrics. Report Links: This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Retail trade yearly growth came in above expectations, coming in at 1.6%. It also increased from 1% last month. However, large retailer's sales growth surprised negatively, coming in at -0.8%. Moreover, the jobs/applicants ratio also underperformed expectations, coming in at 1.59. Finally, the consumer confidence index also surprised to the downside, coming in at 43.8. USD/JPY has fallen by roughly 1%, as political risks originating from Italy have helped safe heaven assets like the yen. Overall, we continue to be bullish on this cross on a tactical basis, given that we expect a slowdown in global growth to accentuate the current risk off environment. However the BoJ will likely intervene if the yen keeps going up, which makes a bearish stance on the yen appropriate on a cyc lical basis. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Yen's Mighty Rise Continues... For Now - February 16, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been negative Total Business Investment yearly growth underperformed expectations, coming it at 2%. Nationwide Housing Prices yearly growth also surprised negatively, coming in at 2.4%. Finally, mortgage approvals also surprised to the downside, coming in at 62.455 thousand. GBP/USD has fallen by roughly 0.6% this week. As of this week, we have reached the target of our tactical short GBP/USD trade with a tk% gain. While the rally in the dollar could certainly continue, pushing cable lower in the process, it is more prudent to adopt a more neutral stance toward this cross, given that it has depreciated by more than 7% since its highs on mid-April. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Do Not Get Flat-Footed By Politics- March 30, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was on the weak side: Building permits contracted by 5% in monthly terms, and only increased by 1.9% in yearly terms, much less than the previous 15.6% and the expected 4.1%; Private sector credit grew by 0.4% in monthly terms, in line with expectations; Private capital expenditure also grew by only 0.4%, a weaker result than the expected 0.7%. After a meaningful fall, AUD/USD has been relatively flat for the last month. Markets seem to be fully aware of the slack currently hampering the Australian economy. The Australian interest rates futures curve continues to flatten, pricing in a lower probability of any hikes. Furthermore, U.S. trade protectionism is becoming more aggressive, which may pose a further threat to the AUD as Australian growth is highly levered to global trade. We remain bearish on this antipodean currency in both the short and the long term. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 NZD/USD has rallied by roughly 1% this week. Overall, we are negative on the NZD versus the U.S. dollar, given that pro-cyclical currencies like the kiwi tend to suffer in periods of heightened volatility and increasing risks. Continued trade tensions, as well as slowing global growth and political risks emanating from Italy will likely perpetuate the current environment going forward, hurting the kiwi in the process. That being said we are positive on this currency against the Australian dollar, as Australia's economy is much more sensitive to the Chinese industrial cycle than New Zealand's. Therefore a slowdown in emerging markets should weigh more heavily on the AUD than on the NZD. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Canadian data was disappointing this week: Industrial product price increased by 0.5% in monthly terms in April; The Raw Material Price Index increased 0.7%; The current account decreased to CAD-19.5 billion in Q1 of 2018; Quarterly GDP growth came in at 1.3%, disappointing expectations. On Wednesday, the CAD was buoyed by the BoC's hawkish monetary policy statement. According to the statement, the Governing Council will now take a "gradual" approach to policy adjustments, as opposed to the "cautious" one noted in previous statements. In addition, the reference to continued monetary accommodation and labor market slack was also removed. However, the White House announced on Thursday the imposition of tariffs on Canadian exports, which erased most of Wednesday's gain. While this adds substantial risk to the view, the outlook for trade negotiations is still murky, and could surprise on the upside. The CAD still remains cheap on key valuation metrics, with an economy exhibiting less slack than other G-10 counterparts. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 More Than Just Trade Wars - April 6, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: The trade balance outperformed expectations, coming in at 2,289 million. This measure also came in above last month figure. However, the KOF leading indicator underperformed expectations, coming in at 100. It also decreased substantially from last month's reading. Finally, yearly GDP growth also surprised negatively, coming in at 2.2%. EUR/CHF has depreciated by roughly 1.5% this week. Overall, this cross should continue to depreciate given that we expect the current period of risk aversion to persist. Even if Italian political risks start to subside, investors will still have to worry about trade tensions, slowing global growth, and the deleterious impact of lower bond yields on this cross. This should help safe-haven assets like the franc outperform. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been positive: Retail sales growth outperformed expectations, coming in at 0.5%. Moreover the Norges Bank credit indicator came in line with expectations, at 6.3%. USD/NOK has rallied by nearly 1.2% this week, as the rise in the dollar coupled with lower oil prices, have resulted in a toxic combination for the krone. Overall, we are positive on the krone relative to other commodity currencies. The krone has a large NIIP and current account surplus which makes it more resilient to terms of trade shocks. Moreover, oil should outperform other commodities given that it is more levered to DM growth than to the Chinese industrial cycle and given that the supply backdrop for crude is more favorable. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data from Sweden has improved: Retail sales beat expectations, growing at a 0.6% monthly pace and a 3.6% annual pace; GDP growth accelerated to 3.3% in Q1 of 2018, higher than the 2.9% growth recorded last year; The trade balance declined by SEK6.5 billion in May; Consumer confidence also suffered slightly to 98.5 from 101. The SEK has strengthened substantially against the euro since its multi-year lows this month. Political woes subsided the euro, while rosy data from Sweden lifted the krona. Against the dollar, the SEK has weakened in recent weeks, due to the greenback's recent surge. We expect the SEK to remain strong against the euro for the remainder of this year, owing to cheap valuations and resurging inflationary pressures. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The global trade slowdown will intensify, even if U.S. domestic demand remains robust. The large emerging Asian bourses will recouple to the downside with their EM peers. Market-neutral EM equity portfolios should consider going long consumer staples while shorting banks. In Chile, receive 3-year swap rates. Continue to overweight stocks relative to the EM benchmark. Short the Colombian peso versus the Russia ruble. Stay neutral on Colombian equities and local bonds but overweight sovereign credit within their respective EM universes. Feature Performance of large equity markets in north Asia - Korean, Taiwanese and Chinese investable stocks -- has been relatively resilient compared with other EM bourses. Specifically, the EM ex-China, Korea and Taiwan equity index has already dropped 16% in U.S. dollar terms, while the market cap-weighted index of investable Chinese, Korean and Taiwanese stocks is down only 8% from its peak in late January.1 These three markets account for 60% of the MSCI EM stock index. A pertinent question is whether these North Asian markets will de-couple from or re-couple with the rest of EM. Our bias is that they will re-couple to the downside. Global equity portfolios should continue to underweight Asian stocks versus the DM bourses in general, and the S&P 500 in particular. That said, dedicated EM equity portfolios should overweight Korea and Taiwan and maintain a neutral stance on China and Hong Kong relative to the EM and Asian equity benchmarks. The Global Trade Slowdown Will Intensify Emerging Asian stock markets are very sensitive to global trade cycles. Slowing global trade is typically negative for them. There is growing evidence that the global trade deceleration will intensify: The German IFO index for business expectations in German manufacturing - a good leading indicator for global trade - is pointing to a further slowdown in global exports (Chart I-1). Chart I-1Global Trade Slowdown Will Persist Global Trade Slowdown Will Persist Global Trade Slowdown Will Persist Export volume growth has already slowed across manufacturing Asia (Chart I-2). The most recent data points for these series are as of April. Asia's booming tech/semiconductor industry is also slowing. Both Taiwan's export orders growth and Singapore's technology PMI new orders-to-inventory ratio have relapsed (Chart I-3). Chart I-2Asian Exports Growth: Heading Southward Asian Exports Growth: Heading Southward Asian Exports Growth: Heading Southward Chart I-3Asian Tech: Feeling The Pinch Asian Tech: Feeling The Pinch Asian Tech: Feeling The Pinch One of the causes of weakness in the global semiconductor cycle could be stagnating global auto sales (Chart I-4). The latter are being weighed down by weakness in auto sales in China and the U.S. Cars require a significant amount of semiconductors, and lack of improvement in global auto sales will suppress semiconductor demand. So far, China has not been at the epicenter of investors' concerns, but this will soon change as its growth slowdown intensifies. Credit conditions continue to tighten in China, which entails downside risks to mainland capital spending and consequently imports. China's imports are set to slump considerably, reinforcing the global trade downturn.2 First, China's bank loan approvals have dropped considerably in the past 18 months, suggesting a meaningful slowdown in bank financing and in turn the country's investment expenditures (Chart I-5). Chart I-4Global Auto And Semiconductor Sales Global Auto And Semiconductor Sales Global Auto And Semiconductor Sales Chart I-5China: Bank Loan Approval And Capex China: Bank Loan Approval And Capex China: Bank Loan Approval And Capex Second, not only are bank loan standards tightening but costs of financing are also rising. The share of loans extended above the prime lending rate has risen to a 15-year high (Chart I-6, top panel). This represents marginal tightening. Finally, onshore corporate bond yields as well as offshore U.S. dollar-denominated corporate bond yields have broken to new highs in this cycle (Chart I-6, bottom panels). Mounting borrowing costs and tighter credit standards in China point to further deceleration in credit-sensitive spending such as investment expenditures and property purchases. On the whole, rising interest rates and material currency depreciation in EM ex-China and credit tightening in China will prompt a considerable slump in imports, depressing world trade. EM including Chinese imports account for 30% of global imports, while the U.S. and EU together make up 24% of global imports values. Hence, global trade will disappoint if and as EM and Chinese imports stumble. A final word on the history of de-coupling among EM regions is in order. There have been a few episodes when emerging Asian and Latin American stocks de-coupled: In 1997-'98, the home-grown Asian crisis devastated regional markets, but Latin American stocks continued to rally until mid-1998 - when they plummeted (Chart I-7, top panel). Chart I-6China: Rising Borrowing Costs China: Rising Borrowing Costs China: Rising Borrowing Costs Chart I-7De-coupling Between Asia And Latin America De-coupling Between Asia And Latin America De-coupling Between Asia And Latin America In 2007-'08, emerging Asian equities tumbled along with the S&P 500, but Latin American bourses fared well until the middle of 2008 due to surging commodities/oil prices (Chart I-7, middle panel). Finally, the bottom panel of Chart I-7 illustrates that in early 2015, Asian stocks performed well, supported by the inflating Chinese equity bubble. Meanwhile, Latin American stocks plunged. In all of these episodes, the de-coupling between Asia and Latin America proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside. Bottom Line: Global trade is set to head southward, even if U.S. demand remains robust. China's growth slump will be instrumental to this global trade slowdown. Consequently, Chinese, Korean and Taiwanese equities will be vulnerable. Heeding To Market Signals Financial markets often move ahead of economic data, and simply tracking data is not always helpful in gauging turning points in business cycles. By the time economic data change course, financial markets would typically have already partially adjusted. Besides, past economic and financial market performance is not a guarantee of future performance. This is why we rely on thematic fundamental analysis and monitor intermediate- and long-term trends in financial markets to navigate through markets. There are presently several important market signals that investors should be heeding to: EM corporate bond yields are surging, which typically foreshadows falling EM share prices (Chart I-8). Meanwhile, there is no robust correlation between EM equities and U.S. bond yields. Chart I-8EM Share Prices Always Decline When EM Corporate Bond Yields Rise EM Share Prices Always Decline When EM Corporate Bond Yields Rise EM Share Prices Always Decline When EM Corporate Bond Yields Rise The basis: So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate bond yields decline and EM share prices rally. But when EM corporate (or sovereign) yields rise, irrespective of whether this is due to rising U.S. Treasury yields or widening EM credit spreads, EM equity prices come under considerable selling pressure. Lately, both EM credit spreads have been widening, offsetting the drop in U.S. bond yields. Hence, a drop in U.S. bond yields is not in and of itself sufficient to halt a decline in EM share prices. So long as EM corporate and sovereign credit spreads are widening by more than the decline in U.S. Treasury yields, EM corporate and sovereign bond yields will rise, heralding lower EM share prices. The ratio of total return (including carry) of six commodities currencies relative to safe-haven currencies3 is breaking below its 200-day moving average after having bounced from this technical support line several times in the past 12 months (Chart I-9). This could be confirming that the bull market in EM risk assets is over, and a bear market is underway. Chinese property stocks listed onshore have broken down, and those trading in Hong Kong seem to be forming a head-and-shoulder pattern (Chart I-10). In the latter case, such a technical formation will likely be followed by a considerable down-leg. Chart I-9An Important Breakdown bca.ems_wr_2018_05_31_s1_c9 bca.ems_wr_2018_05_31_s1_c9 Chart I-10Chinese Property Stocks Look Very Vulnerable Chinese Property Stocks Look Very Vulnerable Chinese Property Stocks Look Very Vulnerable Further, China's onshore A-share index has already dropped by 15% from its cyclical peak in late January. Finally, both emerging Asia's relative equity performance against developed markets, as well as the emerging Asian currency index versus the U.S. dollar (ADXY) seem to be rolling over at their long-term moving averages (Chart I-11). The same technical pattern is presenting itself for global energy and mining stocks in absolute terms, and also in the overall Brazilian equity index (Chart I-12). Chart I-11Asian Equities And Currencies Are ##br##At Critical Juncture Asian Equities And Currencies Are At Critical Juncture Asian Equities And Currencies Are At Critical Juncture Chart I-12Commodity Equities And Brazil ##br##Are Facing Technical Resistance Commodity Equities And Brazil Are Facing Technical Resistance Commodity Equities And Brazil Are Facing Technical Resistance The failure of these markets to break above their long-term technical resistance levels may be signalling that their advance since early 2016 has been a cyclical - not structural - bull market, and is likely over. These technical chart profiles so far confirm our fundamental analysis that the EM and commodities rallies since early 2016 did not represent a multi-year secular bull market. If correct, the downside risks to EM including Asian markets are substantial, and selling/shorting them now is not too late. Bottom Line: EM including Asian stocks, currencies and credit markets are at risk of gapping down. Absolute-return investors should trade these markets on the short side. Asset allocators should underweight EM markets relative to DM in general and the U.S. in particular. A complete list of our currency, fixed-income and equity recommendations is available on pages 20-21. An EM Equity Sector Trade: Long Consumer Staples / Short Banks EM consumer staples have massively underperformed banks as well as the overall EM index since January 2016 (Chart I-13). The odds are that their relative performance is about to reverse. Equity investors should consider implementing the following equity pair trade: long consumer staples / short banks: Consumer staples are a low-beta sector because their revenues are less cyclical. As EM growth downshifts, share prices of companies with more stable revenue streams will likely outperform. Bank stocks are vulnerable as local interest rates in many EMs rise in response to the selloff in their respective currencies (Chart I-14). Consumer staples usually outperform banks when local borrowing costs are rising. Chart I-13Go Long EM Consumer Staples / ##br##Short EM Banks Go Long EM Consumer Staples / Short EM Banks Go Long EM Consumer Staples / Short EM Banks Chart I-14EM Banks Stocks Are Inversely Correlated With##br## EM Local Bond Yields EM Banks Stocks Are Inversely Correlated With EM Local Bond Yields EM Banks Stocks Are Inversely Correlated With EM Local Bond Yields We expect more currency depreciation in EM, which will exert further upward pressure on local rates, including interbank rates. Further, growth weakness in EM economies typically leads to rising non-performing loan (NPL) provisions. Chart I-15A and Chart I-15B demonstrates that weakening nominal GDP growth (shown inverted on the charts) leads to higher provisioning. Hence, a renewed EM growth slowdown will hurt bank profits. Chart I-15AWeaker Nominal GDP Growth Entails ##br##Higher NPL Provisions Weaker Nominal GDP Growth Entails Higher NPL Provisions Weaker Nominal GDP Growth Entails Higher NPL Provisions Chart I-15BWeaker Nominal GDP Growth Entails ##br##Higher NPL Provisions Weaker Nominal GDP Growth Entails Higher NPL Provisions Weaker Nominal GDP Growth Entails Higher NPL Provisions Our assessment is that banks in many EM countries have provisioned less than what is probably necessary following years of a credit boom. Indeed, in the last 12-18 months or so, many banks have even been reducing their NPL provisions to boost profits. Hence, a reversal of these dynamics will undermine banks' earnings. Bottom Line: Market-neutral EM equity portfolios should consider going long consumer staples while shorting banks. This is in addition to our long-term strategy of shorting EM banks versus U.S. banks as well as shorting banks in absolute terms in individual markets such as Brazil, Turkey, Malaysia and small-cap banks in China. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 These calculations are done using MSCI investible stock indexes in U.S. dollars terms. 2 Please see Emerging Markets Strategy Weekly Report, "The Dollar Rally And China's Imports", dated May 24, 2018, available at ems.bcaresearch.com. 3 Average of cad, aud, nzd, brl, clp & zar total returns (including carry) relative to average of jpy & chf total returns (including carry). Chile: Stay Overweight Equities, Receive Rates 31 May 2018 Chart II-1Chilean Equities Relative Performance And Copper Prices Chilean Equities Relative Performance And Copper Prices Chilean Equities Relative Performance And Copper Prices It is often assumed that Chilean financial markets are a play on copper. While this largely holds true for the Chilean peso, it is not always correct regarding its stock market's relative performance to its EM peers. Chile has outperformed in the past amid declining copper prices (Chart II-1). Despite our negative view on copper prices, we are reiterating our overweight allocation to this bourse within an EM equity portfolio. There are convincing signs that growth in the Chilean economy is moving along fine for now (Chart II-2). While weakness in global trade will weigh on the economy, the critical variable that makes Chile stand out from other commodities producers in the EM universe is its ability to cut interest rates amid currency depreciation. Chart II-3 illustrates that interest rates in Chile can and do fall when the peso depreciates. This stands in stark contrast with many others economies in the EM universe. There are a number of factors that suggest inflationary pressures will remain dormant for some time. This will allow the Central Bank of Chile (CBC) to cut rates as and when required. Chart II-2Chile: Economic Conditions Chile: Economic Conditions Chile: Economic Conditions Chart II-3Interest Rates In Chile Can Fall When Peso Depreciates Interest Rates In Chile Can Fall When Peso Depreciates Interest Rates In Chile Can Fall When Peso Depreciates First, the output gap is negative and has been widening, which has historically led to falling core inflation (Chart II-4). Second, a wide range of consumer inflation measures - services and trimmed-mean inflation rates - are very low and remain in a downtrend (Chart II-5). Chart II-4Chile: Output Gap And Inflation Chile: Output Gap And Inflation Chile: Output Gap And Inflation Chart II-5Chile: Inflation Is Very Low And Falling Chile: Inflation Is Very Low And Falling Chile: Inflation Is Very Low And Falling Finally, there are no signs of wage inflation, which is the key driver of genuine inflation. In fact, wage growth is decelerating sharply (Chart II-6). Odds are that this disinflationary rout will go on for longer, given Chile's demographic and labor market dynamics. The country's labor force growth has accelerated and the economy does not seem able to absorb this excess labor supply (Chart II-7). Consistently, our labor surplus proxy - calculated as the number of unemployed looking for a job divided by the number of job vacancies - has surged to all-time highs (Chart II-8). Chart II-6Chile: Wage Growth Is Very Weak Chile: Wage Growth Is Very Weak Chile: Wage Growth Is Very Weak Chart II-7Chile: Rising Labor Force Chile: Rising Labor Force Chile: Rising Labor Force Chart II-8Chile: Excessive Labor Supply... Chile: Excessive Labor Supply... Chile: Excessive Labor Supply... Interestingly, this is not happening because of weak employment. Chart II-9 shows that the employment-to-working population ratio is at a record high, while employment growth is robust. This upholds that decent job growth is not sufficient to absorb the expanding supply of labor. All in all, a structural excess supply of labor as well as a cyclical slowdown in global trade and lower copper prices altogether will likely warrant a decline in interest rates in Chile. Consequently, we recommend a new fixed income trade: Receive 3-year swap rates. The recent rise provides a good entry point (Chart II-10). Chart II-9...Despite Robust Employment Growth ...Despite Robust Employment Growth ...Despite Robust Employment Growth Chart II-10Chile: Receive 3-Year Swap Rates Chile: Receive 3-Year Swap Rates Chile: Receive 3-Year Swap Rates The ability to cut interest rates will mitigate the effect of weaker exports on the economy. We recommend dedicated EM investors maintain an overweight allocation in Chile in their equity, local currency bond and corporate credit portfolios. For absolute return investors, the risk-reward profiles for Chilean stocks and the currency are not attractive. The peso will depreciate considerably, and shorting it versus the U.S. dollar will prove profitable. Consistent with our negative view on copper prices, we have been recommending a short position in copper with a long leg in the Chilean peso. This allows traders to earn some carry while waiting for copper prices to break down. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Colombia: The Currency Will Be A Release Valve The structural long-term outlook for Colombia is positive, as a combination of pro-market orthodox policies and reform initiatives amid positive tailwinds from demographic should ensure a reasonably high potential GDP growth rate. In the first round of presidential elections held last weekend, the gap between right wing candidate Ivan Duque and left-wing candidate Gustav Petro came out large enough to make a Duque victory highly likely in the second round to be held on June 17. His election would entail a positive backdrop for the reform agenda and business investment over the coming years. Yet despite the positive structural backdrop, Colombia is still facing a major imbalance - excessive reliance on oil in sustaining stable balance of payments (BoP) dynamics. The trade balance deficit - including oil - is $8 billion, while excluding oil it stands at $20 billion, or 7.5% of GDP (Chart III-1). Hence, if oil prices drop materially in the second half of this year - as we expect - Colombia's balance of payments will be strained. Consequently, the currency will come under depreciation pressure. The peso is presently fairly valued as the real effective exchange rate based on unit labor costs is at its historical mean (Chart III-2). Chart III-1Colombia's Achilles' Hill: Trade Balance Excluding Oil Colombia's Achilles' Hill: Trade Balance Excluding Oil Colombia's Achilles' Hill: Trade Balance Excluding Oil Chart III-2The Colombian Peso Is Fairly Valued The Colombian Peso Is Fairly Valued The Colombian Peso Is Fairly Valued The central bank has adopted a "hands-off" approach toward the exchange rate, and is likely to allow the peso to depreciate if the BoP deteriorates. Weak economic conditions will likely prevent it from hiking interest rates to bolster the peso: Even though the central bank has reduced its policy rate by 350 basis points since the end of 2016, lending rates remain restrictive when compared with the nominal GDP growth rate (Chart III-3, top panel). Fiscal policy has been tight, with government expenditures subdued and the primary deficit narrowing (Chart III-3, bottom panel). This is unlikely to change for now if conservative candidate, Ivan Duque, wins the election. Consumer and business demand has failed to pick up, and shows little sign of recovery (Chart III-4). Non-performing loans (NPL) continue to rise, forcing banks to raise their NPL provisioning (Chart III-5). Weak nominal GDP growth suggests provisions may rise further. Chart III-3Colombia: Little Sign Of Recovery Colombia: Little Sign Of Recovery Colombia: Little Sign Of Recovery Chart III-4Colombia: Little Sign Of Recovery Colombia: Little Sign Of Recovery Colombia: Little Sign Of Recovery Chart III-5Colombian Banks: NPL And NPL Provision Continue Rising bca.ems_wr_2018_05_31_s3_c5 bca.ems_wr_2018_05_31_s3_c5 Overall, banks' balance sheets remain impaired, hampering their ability to extend loans. Investment Recommendations Despite a favorable structural outlook, Colombia's cyclical growth and financial market outlooks remain poor. Chances are that the peso will come under selling pressure as the external environment deteriorates - i.e., the currency will act as a release valve. We recommend staying neutral on Colombian stocks and local bonds relative to their EM peers, and to overweight Colombian sovereign credit within an EM credit portfolio. The basis is that sound and tight fiscal policies and a continuation of supply side reforms will benefit this credit market. To capitalize on potential currency depreciation while hedging for the uncertainty of oil price decline, we recommend shorting the peso against the Russian ruble. Although Colombia's structural outlook is more promising than Russia's, the latter's BoP dynamics is healthier and its cyclical growth outlook is better than Colombia's. Andrija Vesic, Research Analyst AndrijaV@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations