Cyclicals vs Defensives

The cyclical vs. defensive share price ratio has come full circle since our early-October 2017 initiation of the preference, having jumped initially and subsequently given up all those gains and more, before recovering to the original level currently. This begs the question: should investors commit capital to this tilt at this stage of the cycle and given the current global macro backdrop? The short answer is yes. A look at the relative balance sheet health of cyclicals versus defensives is revealing. Cyclicals are paying down debt and their cash flow continues to improve, still recovering from the late-2015/early 2016 global manufacturing recession. On the flipside, defensives are piling on debt. All four safe haven sectors have been degrading their balance sheets (relative net debt-to-EBITDA shown inverted, middle panel). Interest coverage sends a similar message: cyclicals are in excellent health both in absolute terms and compared with defensives (top panel). Lastly, the U.S. sales/inventories ratio is sending an unambiguously bullish signal for cyclicals at the expense of defensives (bottom panel). Bottom Line: Continue to the prefer S&P cyclicals to S&P defensives and we also reiterate our recent long S&P materials/short S&P utilities pair trade.1 Please see Monday’s Weekly Report for more details. Double Down On Cyclicals Vs. Defensives Double Down On Cyclicals Vs. Defensives         1 Please see BCA U.S. Equity Strategy Weekly Report, “Trader’s Paradise” dated January 28, 2019, available at uses.bcaresearch.com.  

Highlights Portfolio Strategy Chinese reflation, the ongoing global capex upcycle, and the Fed induced cap on the greenback with the knock-on effect of higher commodity prices, all signal that it still pays to overweight S&P cyclicals at the expense of S&P defensives.  Sustained EM stock outperformance, a soft U.S. dollar, improving semi equipment operating metrics, along with compelling relative valuations and technicals, all suggest that there are high odds that the recent semi equipment run up has more upside.   Recent Changes There are no changes in the portfolio this week. Feature The SPX consolidated the 350 point advance since the Christmas Eve trough last week, setting the stage for a durable advance in the coming months. The Fed stood pat last Wednesday, and signaled a much more dovish policy stance going forward. Chairman Powell was clearly humbled by last December’s convulsing equity market and abrupt tightening in financial conditions. On that front, in the latest FOMC statement the explicit mention of patience is significant: “the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate”. A definitively more dovish Fed, which will help restrain the greenback, remains one of the three key catalysts for a durable equity market advance as we have highlighted in recent research.1 Encouragingly, our proprietary Equity Capitulation Indicator (ECI) has bottomed at two standard deviations below the historical mean (Chart 1). Over the past two decades, such a depressed level in our ECI has marked previous equity market troughs including the early-2016, 2011, 2002 and 1998 iterations. Only the GFC episode was lower, falling to three standard deviations below the mean. Clearly the late-December selling frenzy registers as another investor capitulation point and, if history at least rhymes, more gains are in store for the broad equity market. Chart 1Capitulation Capitulation Capitulation Chart 2 shows some other measures of breadth that corroborate our ECI’s message: investors hit the panic button and exited equities in droves in Q4. The upshot is that with selling exhausted, stocks can now stage a durable recovery as long as profits continue to expand. As a reminder, the continuation of the earnings juggernaut is the second key catalyst we identified two weeks ago.2 Midway through earnings season, SPX EPS have held up well with growth approaching 16%. For calendar 2019 we expect mid-single digit EPS growth in line with the signal from our macro driven S&P 500 EPS growth model (please refer to Chart 4 from the mid-January Weekly Publication).3 Chart 2Selling Is Exhausted Selling Is Exhausted Selling Is Exhausted A positive resolution to the U.S./China trade spat is the third catalyst we highlighted recently in order for equities to break out to fresh all-time highs.4 Related to this, China’s reflation efforts are equally important. On that front, news of quasi QE from the PBOC suggests that the Chinese authorities remain committed to injecting liquidity into their economy.5 Already, the PBOC balance sheet, with over $5.5tn in assets, is expanding anew. Empirical evidence suggests that SPX momentum and the ebb and flow of the PBOC balance sheet are joined at the hip, and the current message is positive (second panel, Chart 3). Chart 3Heed The PBoC Message Heed The PBoC Message Heed The PBoC Message Beyond the PBOC balance sheet expansion, the Chinese six-month credit impulse is also in a sling shot recovery. This Chinese credit backdrop is enticing and moves more or less in tandem with the SPX six-month impulse (top panel, Chart 4). Chart 4Reflating Away Reflating Away Reflating Away Two forces explain these relationships. First, China’s rise to become the second largest economy in the world along with its insatiable appetite for commodities and durable goods. Second, 40% of S&P 500 sales are international and an increasing share now originates in emerging markets in general and in China in particular. Keep in mind that the S&P cyclicals/defensives ratio is not only a high beta play on the SPX itself (top panel, Chart 3), but also an S&P global versus domestic gauge. Thus, both of these Chinese indicators also enjoy a positive correlation with the cyclicals vs. defensives tilt (bottom panels, Charts 3 & 4). With that in mind, this week we are drilling deeper into why we continue to prefer S&P cyclicals over S&P defensives and also highlight a highly cyclical index we went overweight in mid-December that has gone parabolic. Double Down On Cyclicals Vs. Defensives Early-October 2017 marks the initiation of our cyclical vs. defensive preference. Initially, this tilt jumped and peaked in mid-2018 returning 18% since inception. Since then, it has given up all of those gains and then some before troughing with the market on Christmas Eve, suffering a 6% drop since inception. Currently, the ratio has moved full circle and is back to where it was when we first recommended this portfolio bent (Chart 5). Chart 5Full Circle Full Circle Full Circle Should investors commit capital to this tilt at this stage of the cycle and given the current global macro backdrop? The short answer is yes. Charts 3 & 4 show that China’s reflation efforts and the fate of the S&P cyclicals/defensives ratio are closely correlated. In addition to the PBOC’s expanding balance sheet and rising Chinese credit impulse, Chinese monetary easing also benefits S&P cyclicals at the expense of S&P defensives. The Chinese reserve requirement ratio (RRR) has plummeted to the lowest point since the GFC and Chinese interest rates are also plumbing multi-year lows (RRR shown inverted, top panel, Chart 6). Chart 6China Flashing Green China Flashing Green China Flashing Green Tack on a resurgent currency with the CNY briefly breaking 6.70 with the U.S. dollar, and factors are falling into place for a playable rally in the cyclicals/defensive ratio. Likely, the Chinese are trying to appease President Trump by underpinning the yuan, but the Fed’s recent more dovish stance on interest rate hikes is also pushing the greenback lower. Taken together, this is a boon for the commodity exposed U.S. cyclicals that also garner a significant share of their sales from abroad (bottom panel, Chart 6). Commodity prices troughed last September, staying true to their leading properties and have been in recovery mode ever since (top panel, Chart 7). Now that the Fed has capped the U.S. dollar, more gains are in store for commodities and that is a boon for commodity producers’ top line growth prospects. Chart 7Capex Remains Healthy Capex Remains Healthy Capex Remains Healthy The demand backdrop is also enticing at the current stage of the business cycle, not only domestically, but also in China. Capital outlays remain upbeat and despite some recent turbulence, U.S. capex intentions are near multi-year highs (third panel, Chart 7). In China, recent piece meal fiscal easing announcements are far from negligible; already infrastructure spending has jumped after contracting late last year (second panel, Chart 7). Were these announcements to get supplemented by a bigger and more comprehensive package, then commodity-levered equities will excel further. A look at the relative balance sheet health of cyclicals versus defensives is revealing. Cyclicals are paying down debt and their cash flow continues to improve, still recovering from the late-2015/early 2016 global manufacturing recession. On the flipside, defensives are piling on debt. All four safe haven sectors have been degrading their balance sheets (relative net debt-to-EBITDA shown inverted, middle panel, Chart 8). Interest coverage sends a similar message: cyclicals are in excellent health both in absolute terms and compared with defensives (top panel, Chart 8). Chart 8B/S Improvement Continues B/S Improvement Continues B/S Improvement Continues Sell-side analysts have not yet taken notice of the macro tide that is turning in favor of cyclicals over defensives. Relative forward profit growth has collapsed to nil and net EPS revisions are at previous nadirs (fourth & fifth panels, Chart 9). Chart 9Oversold And Unloved Oversold And Unloved Oversold And Unloved In sum, if our thesis pans out that China will continue to reflate, global capex will remain vibrant, the greenback will drift lower (U.S. dollar shown inverted, top panel, Chart 9) courtesy of a dovish Fed that will push the broad commodity complex higher, then a significant valuation rerating looms for the cyclicals/defensives tilt (second panel, Chart 9). Bottom Line: Continue to the prefer S&P cyclicals to S&P defensives. We also reiterate our recent long S&P materials/short S&P utilities pair trade.6 Semi Equipment: Buy Into Strength In mid-December we boosted the S&P semi equipment index to overweight from underweight and since then this niche chip subindex has outperformed the broad market by 17%.7 Semi equipment stocks are high beta (bottom panel, Chart 10) and, while we are recommending to buy into strength, from a portfolio risk management perspective, today we are also setting a trailing stop at the 10% return mark in order to protect profits in this tactical (three-to-six month time horizon) position. Chart 10Buy Into Strength... Buy Into Strength... Buy Into Strength... These high-octane highly-cyclical tech stocks move in lockstep with other volatile asset classes. Rebounding emerging market (EM) stocks and FX confirm the S&P semi equipment breakout, and signal additional gains in the coming months (Chart 11). Not only do they share the high-beta status, but also semi equipment stocks garner 90% of their sales outside U.S. shores and 21% of total revenues come from China (please refer to Table 3 in our December 17, 2018 Weekly Report). Thus, the tight inverse correlation with the greenback and positive correlation with the outperforming EM stocks comes as no surprise (Chart 11). Chart 11...But Expect Heightened Vol ...But Expect Heightened Vol ...But Expect Heightened Vol Importantly, Taiwan and Korea are chip manufacturing hubs and semi equipment stocks are levered plays on the macro backdrops of these two economies. Recent data suggests that a turn is in the making in two key indicators in these countries, respectively. Taiwanese tech capex has likely troughed at a depressed level (middle panel. Chart 12), and Korean electronic components manufacturing capacity is now contracting for the first time since late-1997 (bottom panel, Chart 12). The latter is significant as this abrupt and sizable reining in of productive capacity will soon help arrest the fall in chip prices, which serves as an excellent pricing power proxy for the semi equipment industry. Chart 12Green Shoots Green Shoots Green Shoots Historically, relative forward profit growth and DRAM price momentum are joined at the hip. Therefore, were DRAM prices to exit deflation on the back of constrained Korean capacity, that would be a boon for relative profit prospects (second panel, Chart 13). Chart 13Analysts Have Thrown In The Towel Analysts Have Thrown In The Towel Analysts Have Thrown In The Towel Despite these marginal positive developments, sell-side analysts’ pessimism reigns supreme. Industry revenue and profit growth expectations trail the broad market by a wide margin and net EPS revisions remain as bad as they get. The upshot is that these lowered profit and sales growth bars will be easy to surpass in 2019 (Chart 13). With regard to technicals and valuations, oversold conditions bounced, as we posited in mid-December using history as a guide, but still remain depressed (middle panel, Chart 14). Valuations are compelling with the S&P semi equipment forward P/E trading at a roughly 40% discount to the overall market (fourth panel, Chart 13). Chart 14Technicals Remain Depressed Technicals Remain Depressed Technicals Remain Depressed Finally, earnings season has revealed that the bifurcated semiconductor market has staying power with semi equipment stocks (we are overweight) outperforming their ailing semi producer brethren (we remain underweight). Netting it out, sustained EM stock outperformance, a soft U.S. dollar, improving industry operating metrics, along with compelling relative valuations and technicals, all suggest that there are high odds that the recent semi equipment run up has more upside. Bottom Line: Maintain the overweight stance in the S&P semi equipment index for a while longer, but set a trailing stop at the 10% relative return mark in order to protect profits in this tactical (three-to-six month time horizon) position. The ticker symbols for the stocks in this index are: BLBG: S5SEEQ – AMAT, LRCX, KLAC.   Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Dissecting 2019 Earnings” dated January 22, 2019, available at uses.bcaresearch.com. 2      Ibid. 3      Please see BCA U.S. Equity Strategy Report, “Catharsis” dated January 14, 2019, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Weekly Report, “Dissecting 2019 Earnings” dated January 22, 2019, available at uses.bcaresearch.com. 5      Please see Bloomberg Article, “PBOC Sets Up Swap Tool to Aid Bank Capital via Perpetual Bonds” dated January 24, 2019, available at www.bloomberg.com. 6      Please see BCA U.S. Equity Strategy Report, “Trader’s Paradise” dated January 28, 2019, available at uses.bcaresearch.com. 7      Please see BCA U.S. Equity Strategy Report, “Signal Vs. Noise” dated December 17, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Dear Client, This will be the last Global Investment Strategy report of 2018. Publication will resume on January 4th. On behalf of the entire Global Investment Strategy team, I would like to wish you a Merry Christmas, Happy Holidays, and a Healthy New Year! Best regards, Peter Berezin, Chief Global Strategist Feature 1.  Will the Fed raise rates more or less than what is priced into the futures curve? Answer: More. The fed funds futures curve is pricing in less than one rate hike in 2019 and rate cuts beyond then. In contrast, we think the Fed will raise rates three or four times next year and continue hiking into 2020. For all the worries about a slowdown, U.S. real GDP growth is still tracking at 3% in Q4 according to the Atlanta Fed, while consumption is set to rise by 4.1%. Ongoing fiscal stimulus, decent credit growth, rising wages, and a decline in the savings rate should continue to support the economy in 2019. Housing construction should also stabilize thanks to a low vacancy rate and a pickup in household formation. The fact that mortgage applications for purchase have rebounded swiftly in recent weeks is evidence that the housing market is not as weak as many people believe (Chart 1). Chart 1U.S. Housing: No Oversupply Problem, While Demand Is Firming U.S. Housing: No Oversupply Problem, While Demand Is Firming U.S. Housing: No Oversupply Problem, While Demand Is Firming 2.  Will U.S. 10-year Treasury yields rise more or less than expected? Answer: More. Treasurys almost always underperform cash when the Fed delivers more rate hikes than the market is discounting (Chart 2). We expect a modest bear flattening of the yield curve in 2019, with rising bond yields nearly offsetting the increase in short-term rates. Most of the flattening is likely to come in the next six months, as slower global growth and the disinflationary effects of lower oil prices keep bond yields contained. As we enter the second half of next year, global growth should reaccelerate as the effects of Chinese stimulus measures fully kick in and the drag on global growth from the recent tightening in financial conditions dissipates. By that time, the U.S. unemployment rate will be in the low 3% range, a level that could trigger material inflationary pressures. Chart 2Treasurys Will Underperform If The Fed Hikes Rates By More Than Expected Treasurys Will Underperform If The Fed Hikes Rates By More Than Expected Treasurys Will Underperform If The Fed Hikes Rates By More Than Expected 3. Will the yield spreads between U.S. Treasurys and other developed economy bond markets widen? Answer: Yes, particularly at the short end of the curve. The Fed is still the one central bank that is most likely to hike rates multiple times in 2019, which will support wider differentials between Treasurys and non-U.S. bond yields. The greatest potential for spread widening will be for Treasurys versus JGBs. With Japanese inflation still stubbornly low and fiscal policy set to tighten from a hike in the sales tax, the BoJ will be in no position to abandon its yield curve control regime. The 10-year Treasury-gilt spread could also widen if the Bank of England is forced to stay on the sidelines until Brexit uncertainty is resolved. Likewise, the U.S.-New Zealand spread will widen as the RBNZ stays on hold due to underwhelming growth and inflation momentum. The U.S.-Canada spread will be range-bound, with the Bank of Canada coming close to matching, but not surpassing, Fed tightening in 2019. While the ECB will refrain from raising rates next year, the U.S. Treasury-German bund spread should narrow marginally if the end of ECB QE lifts bund yields via a recovery in the German term premium. There is more (albeit still modest) scope for a narrowing in the 10-year U.S.-Australia and U.S.-Sweden spreads, as both the RBA and Riksbank begin a tightening cycle. 4. What will happen to U.S. corporate credit spreads? Answer: They are likely to finish 2019 close to current levels. As a rule of thumb, corporate bond returns are highest when the yield curve is very steep, and lowest when it is inverted (Table 1). The former generally corresponds to the early stages of business-cycle expansions, while the latter encompasses the period directly preceding recessions. We are still in the intermediate phase, when excess corporate bond returns (relative to cash) are positive but low. This conclusion is consistent with the observation that corporate balance-sheet leverage has increased over the past four years, but not by enough to instigate a major wave of defaults. Table 1Corporate Bond Performance Given The Slope Of The Yield Curve (1975-Present) 2019 Key Views: Ten Market Questions 2019 Key Views: Ten Market Questions 5. Will the U.S. dollar continue to strengthen? Answer: The dollar will strengthen until the middle of 2019 and then begin to weaken. Three main factors determine the short-to-medium term direction of the dollar: 1) momentum; 2) interest rate spreads between the U.S. and its trading partners; and 3) global growth. In general, the dollar does well when it is trending higher, spreads relative to the rest of the world are wide and getting wider, and global growth is slowing (Chart 3). For the time being, momentum continues to work in the greenback’s favor. Spreads have narrowed a bit recently, but the dollar still looks cheap relative to what one would expect based on the current level of spreads (Chart 4). As in 2017, the direction of global growth will likely be the key driver of the dollar next year. If growth bottoms in mid-2019, as we expect, the dollar will probably put in a top. Chart 3Dollar Returns Driven By Momentum, Rate Differentials, And Global Growth 2019 Key Views: Ten Market Questions 2019 Key Views: Ten Market Questions   Chart 4Wider Spreads Bode Well For The Dollar Wider Spreads Bode Well For The Dollar Wider Spreads Bode Well For The Dollar   6. Will global equities rise or fall? Answer: Rise. Our tactical MacroQuant stock market timing model finally moved back into neutral territory on Monday after having successfully flagged the correction that began in October (Chart 5). Having downgraded global equities this past summer, we will return to overweight if the ACWI ETF drops to $64, which is only 2.4% below yesterday’s close. The cyclical backdrop for stocks is reasonably constructive. We expect the MSCI All-Country World Index to rise by about 10%-to-15% in dollar terms from current levels by the end of 2019. The higher end of this range would leave it slightly below its January 2018 peak (Chart 6). The index is currently trading at 13.3-times forward earnings, similar to where it was in early-2016. The U.S. accounts for over 50% of global stock market capitalization (Chart 7). As such, the U.S. equity market tends to influence non-U.S. stocks more than the other way around. Sustained U.S. equity bear markets are rare outside of recessions (Chart 8). With another U.S. recession unlikely to occur at least until late-2020, that gives global stocks enough room to rally. Indeed, history suggests that the late stages of business-cycle expansions are often the juiciest for equity investors (Table 2).  Chart 5The MacroQuant Equity Score* Improves To Neutral 2019 Key Views: Ten Market Questions 2019 Key Views: Ten Market Questions   Chart 6Global Stocks Have Cheapened Global Stocks Have Cheapened Global Stocks Have Cheapened Chart 7The U.S. Is The Dominant Equity Market 2019 Key Views: Ten Market Questions 2019 Key Views: Ten Market Questions   Chart 8Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap     Table 2Too Soon To Get Out 2019 Key Views: Ten Market Questions 2019 Key Views: Ten Market Questions 7. Will cyclical stocks outperform defensives? Answer: Yes, although this is likely to be more of a phenomenon for the second half of 2019. Cyclicals typically outperform defensives when bond yields are climbing (Chart 9). Rising bond yields are usually a sign of stronger growth — manna from heaven for capital goods and commodity producers. As long as global growth is under pressure, cyclicals will struggle. But once growth bottoms in the middle of next year, cyclical stocks will have their day in the sun. Chart 9Cyclicals Tend To Outperform When Yields Rise Cyclicals Tend To Outperform When Yields Rise Cyclicals Tend To Outperform When Yields Rise 8. Will U.S. equities continue to outperform other global stock markets? Answer: Yes, but probably only until mid-2019. The U.S. stock market has less exposure to cyclical sectors such as industrials, materials, energy, and financials than the rest of the world (Table 3). Therefore, it stands to reason that an inflection point for cyclicals versus defensives will correspond to an inflection point for U.S. versus non-U.S. stocks. If this were to happen, it would resemble the period between October 1998 and April 2000, a time when bond yields rose, the dollar rally stalled, cyclicals outperformed defensives, and non-U.S. equities outperformed (Chart 10). Table 3Tech And Health Care Stocks Are Heavily Weighted In The U.S., While Financials And Materials Are Overrepresented In Markets Outside The U.S. 2019 Key Views: Ten Market Questions 2019 Key Views: Ten Market Questions   Chart 10Will The Late-1990s Pattern Be Repeated? Will The Late-1990s Pattern Be Repeated? Will The Late-1990s Pattern Be Repeated?   9. Will oil prices rise more than expected? Answer: Yes. The December-2019 Brent futures contract is currently trading at $61/bbl (Chart 11). Our energy strategists expect Saudi Arabia and Russia to cut production by enough to push prices to an average of $82/bbl in 2019. Looking further out, the outlook for oil prices is less favorable. As every first-year economics student learns, prices in a competitive market eventually converge to average costs. Shale companies are now the swing producers in the global petroleum market. Their breakeven costs are in the low-$50 range, a number that has been trending lower due to productivity gains. If that is the long-term anchor for oil prices, it means that any major rally in oil is unlikely to extend deep into the next decade. Chart 11Oil Prices Will Recover Oil Prices Will Recover Oil Prices Will Recover 10. Will gold prices finally rally? Answer: Yes, but only in the second half of 2019. Gold prices typically fall when the dollar is strengthening (Chart 12). Given our view that the dollar will rally into mid-2019, now is not the time to be loading up on bullion. However, once the dollar peaks and U.S. inflation moves decidedly higher late next year, gold should become a star performer. Chart 12Gold Will Shine Bright After The Dollar Peaks Gold Will Shine Bright After The Dollar Peaks Gold Will Shine Bright After The Dollar Peaks     Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com     Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

As promised in early September, this is the third installment of our four part Indicators series. In this Special Report, we follow a similar script to Part II but instead of sectors, we now cover the S&P 500, non-financial equities, cyclicals/defensives, small/large and growth/value, and document the most important Indicators in the same four broad categories (where applicable): earnings, financial statement reported data, valuations and technicals. Once again this is by no means exhaustive, but contains a plethora of Indicators we deem significant in aiding us in our decision making process of setting/changing a view on the overall market, cyclicals/defensives portfolio bent, and size and style preference. As a reminder, the charts in this Special Report are also available through BCA's Analytics platform for seamless continual updates. Finally, we are still aiming before the end of 2018, to conclude our Indicators series with Part IV that would feature our most sought after Macro Indicators per the eleven GICS1 S&P 500 sectors, along with value/growth, small/large and cyclicals/defensives. We trust you will find this comprehensive Indicator chartbook useful and insightful. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Dulce Cruz, Senior Analyst dulce@bcaresearch.com S&P 500 Chart 1S&P 500: Earnings Indicators S&P 500: Earnings Indicators S&P 500: Earnings Indicators Chart 2S&P 500: Earnings Indicators S&P 500: Earnings Indicators S&P 500: Earnings Indicators Chart 3S&P 500: ROE And Its Components S&P 500: ROE And Its Components S&P 500: ROE And Its Components Chart 4S&P 500: Financial Statement Indicators S&P 500: Financial Statement Indicators S&P 500: Financial Statement Indicators Chart 5S&P 500: Financial Statement Indicators S&P 500: Financial Statement Indicators S&P 500: Financial Statement Indicators Chart 6S&P 500: Valuation Indicators S&P 500: Valuation Indicators S&P 500: Valuation Indicators Chart 7S&P 500: Technical Indicators S&P 500: Technical Indicators S&P 500: Technical Indicators Non-Financial Broad Market Chart 8U.S. Non-Financial Broad Market: ROE And Its Components U.S. Non-Financial Broad Market: ROE Ant Its Components U.S. Non-Financial Broad Market: ROE Ant Its Components Chart 9U.S. Non-Financial Broad Market: Financial Statement Indicators U.S. Non-Financial Broad Market: Financial Statement Indicators U.S. Non-Financial Broad Market: Financial Statement Indicators Chart 10U.S. Non-Financial Broad Market: Financial Statement Indicators U.S. Non-Financial Broad Market: Financial Statement Indicators U.S. Non-Financial Broad Market: Financial Statement Indicators Chart 11U.S. Non-Financial Broad Market: Valuation Indicators U.S. Non-Financial Broad Market: Valuation Indicators U.S. Non-Financial Broad Market: Valuation Indicators Chart 12U.S. Non-Financial Broad Market: Technical Indicators U.S. Non-Financial Broad Market: Technical Indicators U.S. Non-Financial Broad Market: Technical Indicators S&P Cyclicals Vs. Defensives Chart 13Cyclicals Vs Defensives: Earnings Indicators Cyclicals Vs Defensives: Earnings Indicators Cyclicals Vs Defensives: Earnings Indicators Chart 14Cyclicals Vs Defensives: Earnings Indicators Cyclicals Vs Defensives: Earnings Indicators Cyclicals Vs Defensives: Earnings Indicators Chart 15Cyclicals Vs Defensives: ROE And Its Components Cyclicals Vs Defensives: ROE And Its Components Cyclicals Vs Defensives: ROE And Its Components Chart 16Cyclicals Vs Defensives: Financial Statement Indicators Cyclicals Vs Defensives: Financial Statement Indicators Cyclicals Vs Defensives: Financial Statement Indicators Chart 17Cyclicals Vs Defensives: Financial Statement Indicators Cyclicals Vs Defensives: Financial Statement Indicators Cyclicals Vs Defensives: Financial Statement Indicators Chart 18Cyclicals Vs Defensives: Valuation Indicators Cyclicals Vs Defensives: Valuation Indicators Cyclicals Vs Defensives: Valuation Indicators Chart 19Cyclicals Vs Defensives: Technical Indicators Cyclicals Vs Defensives: Technical Indicators Cyclicals Vs Defensives: Technical Indicators S&P 600 Vs. S&P 500 Chart 20S&P 600 Vs.S&P 500: Earnings Indicators S&P 600 Vs S&P 500: Earnings Indicators S&P 600 Vs S&P 500: Earnings Indicators Chart 21S&P 600 Vs.S&P 500: Earnings Indicators S&P 600 Vs S&P 500: Earnings Indicators S&P 600 Vs S&P 500: Earnings Indicators Chart 22S&P 600 Vs.S&P 500: Valuation Indicators S&P 600 Vs S&P 500: Valuation Indicators S&P 600 Vs S&P 500: Valuation Indicators Chart 23S&P 600 Vs.S&P 500: Technical Indicators S&P 600 Vs S&P 500: Technical Indicators S&P 600 Vs S&P 500: Technical Indicators S&P 500 Growth Vs. Value Chart 24S&P 500 Growth Vs.Value: Earnings Indicators S&P 500 Growth Vs Value: Earnings Indicators S&P 500 Growth Vs Value: Earnings Indicators Chart 25S&P 500 Growth Vs.Value: Earnings Indicators S&P 500 Growth Vs Value: Earnings Indicators S&P 500 Growth Vs Value: Earnings Indicators Chart 26S&P 500 Growth Vs Value: Valuation Indicators S&P 500 Growth Vs Value: Valuation Indicators S&P 500 Growth Vs Value: Valuation Indicators Chart 27S&P 500 Growth Vs.Value: Technical Indicators S&P 500 Growth Vs Value: Technical Indicators S&P 500 Growth Vs Value: Technical Indicators Table 1S&P 500 Growth/S&P 500 Value Sector Comparison Table White Paper: U.S. Equity Market Indicators (Part III) White Paper: U.S. Equity Market Indicators (Part III) Table 2S&P 600/S&P 500 Sector Comparison Table White Paper: U.S. Equity Market Indicators (Part III) White Paper: U.S. Equity Market Indicators (Part III)

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

Highlights Short oil and gas versus financials. Stick with underweights in the classically cyclical sectors. Downgrade the FTSE100 to neutral. Overweight France, Ireland, Switzerland and Denmark. Underweight Italy, Spain, Sweden and Norway. European equities will struggle to make much headway versus the technology-dominated S&P500 and MSCI Emerging Markets. Overall market direction will be range-bound through the summer. Feature Two market oddities stood out in the first half of the year. The first oddity was the abrupt decoupling of bank equity performance from bond yields (Chart I-2). For many years, bank equity performance and bond yields have been joined at the hip (Chart I-3). The faithful relationship exists because higher bond yields tend to signal stronger economic growth, either real or nominal. Stronger growth should be good for banks as it is associated with both accelerating credit growth and lower provisions for non-performing loans. Chart of the WeekWhen Technology Outperforms, European Equities Struggle Versus Emerging Market Equities When Technology Outperforms, European Equities Struggle Versus Emerging Market Equities When Technology Outperforms, European Equities Struggle Versus Emerging Market Equities Chart I-2Oddity 1: Banks Abruptly Decoupled##br## From Bond Yields Oddity 1: Banks Abruptly Decoupled From Bond Yields Oddity 1: Banks Abruptly Decoupled From Bond Yields Chart I-3Banks And Bond Yields Have Been ##br##Joined At The Hip For Years Banks And Bond Yields Have Been Joined At The Hip For Years Banks And Bond Yields Have Been Joined At The Hip For Years The second oddity was the abrupt decoupling of crude oil from industrial metal prices (Chart I-4). It is rare for crude oil to outperform copper by 30% in the space of just six months (Chart I-5). Chart I-4Oddity 2: The Crude Oil Price Abruptly ##br##Decoupled From Metal Prices It Is Rare For Crude Oil To Outperform Copper By 30% In Six Months It Is Rare For Crude Oil To Outperform Copper By 30% In Six Months Chart I-5It Is Rare For Crude Oil To Outperform ##br##Copper By 30% In Six Months It Is Rare For Crude Oil To Outperform Copper By 30% In Six Months It Is Rare For Crude Oil To Outperform Copper By 30% In Six Months Explaining The Oddities In The 1st Half The underperformance of banks is consistent with similar underperformances in the other classically growth-sensitive sectors - industrials, and basic materials (Chart I-6). Furthermore, the underperformances of these cyclicals is closely tracking the downswing in the global 6-month credit impulse (Chart I-7). Chart I-6The Odd Man Out: ##br##Oil And Gas The Odd Man Out: Oil And Gas The Odd Man Out: Oil And Gas Chart I-7The Underperformance Of Cyclicals Is Closely ##br##Tracking The Global 6-Month Credit Impulse The Underperformance Of Cyclicals Is Closely Tracking The Global 6-Month Credit Impulse The Underperformance Of Cyclicals Is Closely Tracking The Global 6-Month Credit Impulse Note also that these underperformances started well before any inkling of a trade spat. Hence, the recent escalation in the trade skirmishes is reinforcing a change of trend that was already in place. Taken together, this evidence would strongly suggest that global growth is not accelerating; it is decelerating. Oil is the odd man out because its supply dynamics, rather than demand dynamics, have been dominating its price action, lifting its year-on-year inflation rate to 60%. However, a large part of this surge in year-on-year inflation is also to do with the 'base effect', the dip in the oil price to $45 a year ago. The base effect is a statistical quirk, and shouldn't really bother markets. After all, most people do not consciously compare today's price with that exactly a year ago. Unfortunately, central banks' inflation targets are based on year-on-year comparisons, and this could explain why bond yields have decoupled from growth. If oil price inflation is running at 60% it will underpin headline CPI inflation, central bank reaction functions, and thereby bond yields. So here's the explanation for the oddities in the first half. Banks, industrials, and the other classically cyclical sectors are taking their cue from global growth and industrial activity, which does appear to be losing momentum. In contrast, bond yields are taking their cue from the oil price, given its major impact on headline inflation and on central bank reaction functions. Spotting An Opportunity In The 2nd Half Chart I-8Crude Oil's 12-Month Inflation Rate Is 60% Crude Oil's 12-Month Inflation Rate Is 60% Crude Oil's 12-Month Inflation Rate Is 60% Ultimately, an oil price spike based on supply dynamics without support from stronger demand is unsustainable - because the higher price eventually leads to demand destruction (Chart I-8). On the other hand, if global demand growth does reaccelerate, it is the beaten-down bank equity prices that have the recovery potential. Either way, this leads us to a compelling intra-cyclical trade: short oil and gas versus financials. In aggregate though, we expect cyclical sectors to continue underperforming defensives through the summer. Based on previous credit impulse mini-cycles, we can confidently say that mini-deceleration phases last at least six to eight months and that the typical release valve is a decline in bond yields. In this regard, the apparent disconnect between decelerating growth and slow-to-budge bond yields risks protracting this mini-deceleration phase. Therefore, through the summer, it is appropriate to stick with underweights in the classically cyclical sectors. The strategy has worked well since we initiated it at the start of the year, and it is too early to take profits. Likewise, the portfolio of high-quality government 30-year bonds which we bought in early May is performing well, and we expect it to continue doing so for the time being. Don't Over-Complicate The Investment Process! To reiterate, stick with an underweight to the classical cyclicals versus defensives; and within the cyclicals, short oil and gas versus financials. These sector stances then have a very strong bearing on regional and country equity allocation. This is because up to a quarter of the market capitalisation of each major stock market is in one dominant sector, and this dominant sector gives each equity index its defining fingerprint (Table I-1): for the FTSE100, it is oil and gas; for the Eurostoxx50 it is financials; for the Nikkei225 it is industrials. So all three of these regional indexes are dominated by classical cyclicals. Table I-1Each Major Stock Market Has A Defining Sector Fingerprint Oddities In The 1st Half, Opportunities In The 2nd Half Oddities In The 1st Half, Opportunities In The 2nd Half For the S&P500 and MSCI Emerging Markets indexes, the dominant sector is technology. Although the technology sector is not strictly speaking defensive, it is much less sensitive to growth accelerations and decelerations than the classical cyclicals. There is another important factor to consider: the currency. The FTSE100 oil and gas stock, BP, receives its revenue and incurs its costs in multiple major currencies, such as euros and dollars. In this sense, BP's global business is currency neutral. But BP's stock price is quoted in London in pounds. This means that if the pound strengthens, the company's multi-currency profits will decline relative to the stock price and weigh it down. Conversely, if the pound weakens, it will lift the BP stock price. So the currency is the channel through which the domestic economy can impact its stock market, albeit it is an inverse relationship: a strong currency hinders the stock market; a weak currency helps it. The upshot is that the defining sector fingerprints for the major indexes turn out to be: FTSE100 = global oil and gas shares expressed in pounds. Eurostoxx50 = global banks expressed in euros. Nikkei225 = global industrials expressed in yen. S&P500 = global technology expressed in dollars. MSCI Emerging Markets = global technology expressed in emerging market currencies. Professional investors might argue that this trivializes an investment process on which they spend a lot of time, resource, research, and ultimately money. But we would flip this argument around. To justify the large amounts of time and resource spent on the investment process, professional investors are often guilty of over-complicating it! We fully admit that many factors influence the financial markets, but these factors follow the Pareto Principle, also known as the 80:20 rule. A small number of causes explain the majority of effects. And the 20% that explains 80% of a stock market's relative performance is its defining sector fingerprint. The Chart of the Week and Chart I-9-Chart I-12 should dispel any lingering doubts that readers might have. Chart I-9FTSE 100 Vs. S&P 500 = Global Oil And Gas##br## In Pounds Vs. Global Tech In Dollars FTSE 100 Vs. S&P 500 = Global Oil And Gas In Pounds Vs. Global Tech In Dollars FTSE 100 Vs. S&P 500 = Global Oil And Gas In Pounds Vs. Global Tech In Dollars Chart I-10FTSE 100 Vs. Nikkei 225 = Global Oil And Gas ##br##In Pounds Vs. Global Industrials In Yen FTSE 100 Vs. Nikkei 225 = Global Oil And Gas In Pounds Vs. Global Industrials In Yen FTSE 100 Vs. Nikkei 225 = Global Oil And Gas In Pounds Vs. Global Industrials In Yen Chart I-11FTSE 100 Vs. Euro Stoxx 50 = Global Oil And Gas ##br##In Pounds Vs. Global Banks In Euros FTSE 100 Vs. Euro Stoxx 50 = Global Oil And Gas In Pounds Vs. Global Banks In Euros FTSE 100 Vs. Euro Stoxx 50 = Global Oil And Gas In Pounds Vs. Global Banks In Euros Chart I-12Euro Stoxx 50 Vs. S&P 500 = Global Banks ##br##In Euros Vs. Global Tech In Dollars Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Tech In Dollars Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Tech In Dollars So what does all of this mean for investors right now? A stance that is short oil and gas versus financials necessarily implies that the FTSE100 will struggle versus the Eurostoxx50, given the FTSE100's oil and gas fingerprint and the Eurostoxx50's banks fingerprint. Hence, today we are taking profits in our overweight to the FTSE100, and downgrading this position to neutral. This leaves us with overweight positions to France, Ireland, Switzerland and Denmark, and underweight positions to Italy, Spain, Sweden and Norway. Meanwhile, a stance that is underweight the classical cyclicals necessarily implies that European equities will struggle to make much headway versus the technology-dominated S&P500 and MSCI Emerging Markets. Finally, in terms of overall market direction, we expect the range-bound pattern established in the first half of the year to hold through the summer. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* There are no new trades this week. However, we reiterate that the outperformance of oil and gas versus financials is technically very stretched, which reinforces the fundamental arguments in the main body of this report to go short oil and gas versus financials. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-13 Short oil and gas versus financials Short oil and gas versus financials The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Portfolio Strategy A rare buying opportunity has emerged in the S&P consumer staples index, especially for long-term oriented capital. The bearish story is already baked into current valuations, and industry green-shoots are flying under the radar. Similarly, the bearish packaged foods narrative is well ingrained in depressed relative valuations, whereas the budding recovery in industry final demand is severely underappreciated. This offers investors a compelling entry point to this unloved and under-owned consumer products subgroup. Recent Changes There are no changes to our portfolio this week Table 1 Girding For A Breakout? Girding For A Breakout? Feature The S&P 500 digested receding geopolitical risks last week, and continued to consolidate recent gains. Stocks are poking at the upper end of the 10% trading range in place since early-February, and internal equity dynamics suggest that a breakout in a bullish fashion is in store for later in the summer, as we first posited in late April.1 Chart 1 shows our Equity Market Internal Dynamics Indicator (EMIDI) that does an excellent job capturing the shifting internal forces that drive market returns. This coincident-to-leading market Indicator comprising economically sensitive sectors and portfolio biases is signaling that the path of least resistance is higher for the SPX. Similar to the EMIDI, the Value Line Arithmetic Index (an equal weighted broad-based stock market index) broke out to fresh all-time highs and the Value Line Geometric Index (a gauge of median stock prices) is following closely behind (third & fourth panels, Chart 2). Market darling AAPL is making a run at a $1tn valuation, spearheading the tech-laden NASDAQ Composite that remains on a pattern of hitting higher highs (top panel, Chart 2). Equity buying power is also evident in the breakout of Thomson/Reuters' "Most Shorted Stocks Index" (second panel, Chart 2). All of this suggests that before long the SPX will follow the uptrend and vault to all-time highs, a message corroborated by the record highs in the broad market's advance/decline (A/D) line (bottom panel, Chart 2). Chart 1Breakout... Breakout... Breakout... Chart 2...Looming ...Looming ...Looming An enticing macro backdrop continues to underpin equities. The latest ISM manufacturing report confirmed the IHS Markit U.S. manufacturing PMI release that we highlighted in our Report two weeks ago2: the U.S. is firing on all cylinders and has the potential to pull global growth out of its recent lull. In particular, the reacceleration in the ISM new orders-to-inventories ratio suggests that equities will gain steam in the coming months (second panel, Chart 3). Another source of upbeat news was the backlog subcomponent of the May ISM manufacturing survey. Unfilled orders hit a 14-year high, just shy of the all-time record. Historically, backlogs have been an excellent leading indicator of SPX revenue growth and the current message is that S&P 500 top line growth is on a solid footing (bottom panel, Chart 3). The Fed acknowledged this mini economic overheating last week, and the FOMC slightly bumped its median expectation to a total of four hikes in calendar 2018. Moreover, fiscal easing will continue to gain thrust as the year progresses and the cash repatriation will also provide an assist to the stock market. We are modeling between $650bn-to-$800bn in equity retirement for calendar 2018. Chart 4 depicts our estimates and if the historical correlation between share buybacks and equity prices holds, then there is more upside to stocks in the back half of the year. Nevertheless, retail investors are replenishing cash coffers according to the American Association of Individual Investors (AAII), rather than actively participating in the latest market run up. At the margin, this beefing up of retail investor dry powder represents a headwind to additional equity market gains. We heed the message from this traditionally leading Indicator and in order for our cyclical (9-12 month horizon) sanguine equity market view to pan out, individual investors will have to drawdown their cash balances (AAII cash shown inverted, Chart 5). Chart 3Macro Tailwinds Macro Tailwinds Macro Tailwinds Chart 4Corporate Underpinnings... Corporate Underpinnings... Corporate Underpinnings... Chart 5...But Retail Investor Has To Participate ...But Retail Investor Has To Participate ...But Retail Investor Has To Participate This week we are revisiting a broad defensive sector and one of its key subcomponents. What To Do With Staples Investors have deserted consumer staples stocks at a dizzying speed, and valuations have cratered to a multi-decade low, according to our composite Valuation Indicator (Chart 6). Technicals are also as washed out as can be, as staples equities have been sold off indiscriminately. Other sentiment and breadth measures confirm that this safe haven sector has lost its allure: the A/D line is probing multi-year lows, EPS breadth is waning and groups with a positive 52-week rate of change and trading above the 40-week moving average have all but disappeared (Chart 7). Chart 6Buy Into Weakness Buy Into Weakness Buy Into Weakness Chart 7Bombed Out Sentiment Bombed Out Sentiment Bombed Out Sentiment Our sense is that this consumer staples wholesale liquidation provides a great buying opportunity, especially for longer-term oriented capital with a time horizon of at least 2-3 years. Even on a shorter-term outlook, a bounce seems likely from extremely depressed levels, as relative share prices may find support close to the pre-Great Recession trough (top panel, Chart 7). From a cyclical perspective we continue to view this defensive sector as a hedge to our overall portfolio position that sustains a pro-cyclical bent. Importantly, the bearish consumer staples case is well discounted in bombed out valuations. The stock-to-bond ratio is weighing on this fixed income proxy sector that sports a dividend yield on a par with the 10-year Treasury (top & second panels, Chart 8). Moreover, subsiding volatility bodes ill for relative share prices; the opposite is also true (bottom panel, Chart 8). On the demand front, once again the uninspiring non-cyclical spending backdrop is well entrenched in sinking relative share prices. Relative staples retail sales - both compared to discretionary and to total sales - are deflating as is typical in the late stages of the business cycle (top & second panels, Chart 9). Chart 8Bearish Narrative Baked In Bearish Narrative Baked In Bearish Narrative Baked In Chart 9Lack Of Demand... Lack Of Demand... Lack Of Demand... Such waning demand has weighed on industry selling prices at a time when executives are making labor additions, blowing out our wage bill proxy. As a result, profits margins are suffering a squeeze (Chart 10). However, there are some pockets of strength hidden beneath the surface. While non-discretionary demand is losing share versus overall outlays, spending on essentials as a percentage of disposable income is gaining steam. True, this could be a pre-cursor to recession, but our interpretation is that latent staples-related buying power may make a comeback from a still very depressed level and kick-start industry sales growth (bottom panel, Chart 9). Other industry green-shoots are also surfacing. Consumer staples exports are on a slingshot recovery path, expanding by a low double digit growth rate, defying the year-to-date trade-weighted U.S. dollar appreciation (second panel, Chart 11). In fact, given the defensive stature of this index, any additional greenback gains will boost relative profits especially in the first half of 2019 (third panel, Chart 11). Chart 10...Weighing On Margins... ...Weighing On Margins... ...Weighing On Margins... Chart 11...But Green-Shoots Surfacing ...But Green-Shoots Surfacing ...But Green-Shoots Surfacing Finally, CEO confidence of non-durable industries is far outpacing the broad animal spirit recovery according to The Conference Board, and this relative Chief Executive euphoria has historically been positively correlated with share price momentum, underscoring that better times lie ahead for consumer staples stocks (bottom panel, Chart 11). Adding it up, a rare buying opportunity has emerged in the S&P consumer staples index, especially for long-term oriented capital. The bearish story is already baked into current valuations, and industry green-shoots are flying under the radar. Tack on impressive industry return on equity and this index appears extremely undervalued (bottom panel, Chart 6). Bottom Line: Were we not already overweight the S&P consumer staples index, we would not hesitate to lift exposure to above benchmark. Appetizing Packaged Foods Not only have investors shunned consumer staples stocks in general, but the S&P packaged foods sub-index has also suffered, even trailing the broad staples sector. As a reminder, within consumer products we are overweight packaged foods and household products but maintain a below-benchmark allocation to soft drinks. Packaged foods relative share prices have returned to the mid-2000s level offering a compelling entry point for fresh capital, especially longer-term oriented money (top panel, Chart 12). Part of the reason that these stocks are under-owned boils down to their defensive characteristics. These safe-haven equities pay handsome, steadily growing and secure dividends. Thus, when the bond market's selloff gains steam, investors flock to deep cyclical stocks and trim fixed income proxied equities, and vice versa. Moreover, the Warren Buffett induced M&A premia have now fully reversed from this group, with the base effect weighing on relative performance (bottom panel, Chart 12). Nevertheless, we are not willing to throw in the towel in this staples sub-index that offers hidden value. A number of leading industry demand indicators are firming and suggest that a top line growth period is in the cards. Food and beverage exports are rising at a healthy clip, despite the U.S. dollar's year-to-date appreciation, and so are domestic consumer outlays (second panel, Chart 12). The industry's shipments-to-inventories ratio is sending a similar message, jumping to a level last seen four years ago (third panel, Chart 12. Importantly, relative to overall spending, real (volume) food and beverage spending is expanding smartly. Add on tame raw food commodity costs, especially compared with broad commodity price inflation and relative EPS will overwhelm extremely depressed analysts' expectations (relative grain prices shown inverted, bottom panel, Chart 13). Chart 12Budding Demand Recovery... Budding Demand Recovery... Budding Demand Recovery... Chart 13...Should Aid Top Line Growth ...Should Aid Top Line Growth ...Should Aid Top Line Growth This encouraging demand backdrop is showing up in industry pricing power. Rising food manufacturing shipments are underpinning food producers' selling prices (second panel, Chart 14), and coupled with the contained crude food input costs suggest that packaged foods margins will continue to expand (middle panel, Chart 14). Even down the supply chain, food manufacturers' appear to be making significant headway, a harbinger at least of a profit margin relief phase. While channel captains food retailers have been dictating pricing terms to food suppliers for the better part of the past five years, industry producer prices are now on an even keel with CPI foods, a good proxy of what super markets are charging the consumer (fourth panel, Chart 14). Any additional pricing power gains will represent a boost to industry margins and, thus, profitability. Finally, firming demand is also showing up on industry operating metrics: factory activity is running red hot with resource utilization rates vaulting to multi-decade highs and industry hours worked picking up momentum (third panel, Chart 15). While CEOs have expanded the labor footprint and wage inflation is a cause for concern (bottom panel, Chart 15), a simple industry productivity proxy (industrial production divided by employment) shows that profits should enjoy a lift in the coming quarters. Chart 14Margins Can Expand Further Margins Can Expand Further Margins Can Expand Further Chart 15Brisk Factory Activity Brisk Factory Activity Brisk Factory Activity Netting it out, the bearish packaged foods narrative is well ingrained in depressed relative valuations (bottom panel, Chart 14), whereas the budding recovery in industry final demand is severely underappreciated, offering investors a compelling entry point to this unloved and under-owned consumer products subgroup. Bottom Line: Stay overweight the S&P packaged foods index. The ticker symbols for the stocks in this index are: BLBG: S5PACK - MDLZ, KHC, GIS, TSN, K, CAG, HSY, MKC, SJM, HRL, CPB. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Lifting SPX Target," dated April 30, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Unwavering," dated June 4, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

As stocks have been stuck in a mini 'risk-off' phase, investors have begun to question whether the current global growth soft patch will prove transitory or morph into a severe global growth deceleration. We side with the former. The latest ISM manufacturing survey print is clearly signaling that SPX momentum will resume its ascent in the coming months (second panel). Further, the IHS Markit U.S. manufacturing PMI has been steeply diverging from the J.P. Morgan-calculated global manufacturing PMI (third panel) but, given America's heavy weighting in global output, recent strength in the U.S. should pull global growth higher. What could push our still constructive cyclical 9-12 month equity view offside is a surge in the U.S. dollar. The greenback's trough coincided with last year's peak in global growth (bottom panel), and further dollar appreciation would represent a meaningful headwind to earnings growth, particularly in the U.S. tech sector with its hefty foreign sales exposure. Netting it all out, there are high odds that the U.S. will lead global growth higher in the coming quarters and result in a recoupling higher of global growth, assuming the greenback stops appreciating. This would support low double digit calendar 2019 SPX profit growth. Under such a macro backdrop, it still pays to maintain a cyclicals over defensives portfolio bent; please see Monday's Weekly Report for more details. Maintain A Preference For Cyclicals Over Defensives Maintain A Preference For Cyclicals Over Defensives