Denmark

Highlights Prediction 1: A major financial downturn will trigger the next major economic downturn, and not the other way round. Prediction 2: The straw that will break the back of a fragile financial system will be the global long bond yield rising by 60 bps within a short space of time. But for those who can fine tune, the global long bond yield must rise a further 30-50 bps before reaching the tipping point for the global risk-asset edifice. Take short-term profits in the overweight position in 30-year government bonds. Take short-term profits in the underweight position in basic materials. Take short-term profits in the underweight positions in Italy (MIB) and Spain (IBEX) and overweight position in Denmark (OMX). Feature The twenty-first century has witnessed three major downturns: the first started in 2000; the second started in 2007 culminating in the Lehman crisis a year later; and the third started in 2011 (Chart of the Week). Today, we are going to stick our necks out and make two predictions about the century's fourth major downturn. Chart of the WeekThree Episodes When Equities Underperformed Bonds By 20 Percent Or More Three Episodes When Equities Underperformed Bonds By 20 Percent Or More Three Episodes When Equities Underperformed Bonds By 20 Percent Or More A major financial downturn will trigger the fourth major economic downturn. The straw that will break the back of a fragile financial system will be the global long bond yield rising by 60 bps within a short space of time. Where The Consensus Is Very Wrong As investment strategists, our primary focus should be the financial markets rather than the economy. On this basis, we define a major downturn in terms of the markets: an episode in which equities underperform bonds by more than 20 percent over a period of more than six months.1 All the same, our market based definition of a major downturn perfectly captures the three occasions that the European economy went into recession or stagnation (Chart I-2). Does this mean that the economic downturns triggered the financial market downturns? No, quite the reverse. The onset of the three major financial downturns clearly preceded the onset of the three major economic downturns. Chart I-2Three Episodes When The Euro Area Economy ##br##Contracted Or Stagnated Three Episodes When The Euro Area Economy Contracted Or Stagnated Three Episodes When The Euro Area Economy Contracted Or Stagnated On reflection, this is hardly surprising. The twenty-first century's major economic downturns have all resulted from financial market distortions and fragilities: the bubble valuations of the technology, media and telecom sectors in 2000 (Chart I-3); the mispricing of U.S. mortgages and credit in 2007 (Chart I-4); and the mispricing of euro area sovereign credit risk in 2011 (Chart I-5). Therefore, it makes perfect sense that the downturns in financial markets should precede the downturns in the economy, even when both are measured in real time. Chart I-3The Major Downturns Stemmed From##br## Financial Market Distortions: The Dot Com ##br##Bubble In 1999/2000... The Major Downturns Stemmed From Financial Market Distortions: The Dot Com Bubble In 1999/2000... The Major Downturns Stemmed From Financial Market Distortions: The Dot Com Bubble In 1999/2000... Chart I-4...The Mispricing Of U.S. ##br##Mortgages And Credit##br## In 2007/2008... ...The Mispricing Of U.S. Mortgages And Credit In 2007/2008... ...The Mispricing Of U.S. Mortgages And Credit In 2007/2008... Chart I-5...And The Mispricing Of Euro Area ##br##Sovereign Credit Risk##br## In 2010/2011 ...And The Mispricing Of Euro Area Sovereign Credit Risk In 2010/2011 ...And The Mispricing Of Euro Area Sovereign Credit Risk In 2010/2011 Today, the consensus overwhelmingly believes that an economic downturn will cause the next major downturn in financial markets. But history has taught us time and time again that the causality is much more likely to run the other way. Why not learn the lesson? So here's our first prediction: a major financial downturn will trigger the fourth major economic downturn, and not the other way round. This prediction raises some obvious questions: what could be the major fragility in financial markets, and what could fracture it? A Sharp Rise In Bond Yields Triggered The Last Three Major Downturns Look carefully at the financial market downturns that started in 2000, 2007 and 2011, and you will see another striking similarity. In each episode, the global long bond yield rose by 60 bps or more in the months that preceded the onset of the financial market downturn: April 1999 through January 2000 (Chart I-6); March through July 2007 (Chart I-7); and October 2010 through April 2011 (Chart I-8). This strongly suggests that the spike in the bond yield was the trigger for the subsequent major downturn in financial markets. Chart I-6A Sharply Rising Bond Yield Triggered ##br##The Major Downturn Of 2000 A Sharply Rising Bond Yield Triggered The Major Downturn Of 2000 A Sharply Rising Bond Yield Triggered The Major Downturn Of 2000 Chart I-7A Sharply Rising Bond Yield Triggered##br## The Major Downturn Of 2007 And 2008 A Sharply Rising Bond Yield Triggered The Major Downturn Of 2007 And 2008 A Sharply Rising Bond Yield Triggered The Major Downturn Of 2007 And 2008 Chart I-8A Sharply Rising Bond Yield Triggered ##br##The Major Downturn Of 2011 A Sharply Rising Bond Yield Triggered The Major Downturn Of 2011 A Sharply Rising Bond Yield Triggered The Major Downturn Of 2011 A sharp rise in bond yields is usually the straw that breaks the back of financial market fragilities, in (at least) one of three ways: it flushes out those actors that are reliant on cheap liquidity; it pressures interest rate sensitive sectors in the economy; and it weighs on the valuations of other assets such as equities, especially if those valuations are already extremely elevated. Which segues us neatly to the current fragility in the global financial system. As we wrote last week, the post-2008 global experiment with quantitative easing, and zero and negative interest rate policy has boosted the valuations of all risk-assets across all geographies across all asset-classes. And the total value of those global risk-assets is $400 trillion, equal to about five times the size of the global economy.2 We have also consistently highlighted that not only do the rich valuations of $400 trillion of risk-assets depend (inversely) on bond yields, but that this relationship is an exponential function.3 So here's our second prediction: the straw that will break the back of a fragile financial system will be the global long bond yield rising by 60 bps within a short space of time - just as it did in 2000, 2007 and 2011. But Bond Yields Haven't Gone Up Far Enough... Yet Now comes some bullish news, at least for those who can play shorter-term moves in the market. The global long bond yield has been trapped within a tight channel and is only 20 bps up from its recent low in April (Chart I-9). Therefore, it has the scope to rise a further 30-50 bps before reaching the tipping point for the global risk-asset edifice and unleashing a 'risk-off' phase. Chart I-9In 2018, The Bond Yield Has Not Risen Sharply...Yet In 2018, The Bond Yield Has Not Risen Sharply...Yet In 2018, The Bond Yield Has Not Risen Sharply...Yet For those who want to fine tune their investment strategy, the journey up to that turning point would define a phase when many of this year's cyclical sector underperformances would end or even switch to a phase of modest outperformances. Bear in mind that the cyclical sector underperformances this year have been substantial: European banks have underperformed healthcare by 35 percent; global basic materials have underperformed the market by 10 percent; emerging market equities have underperformed developed market equities by 15 percent. So it is prudent to take some short-term profits, especially as these trends are likely to end, at least in the near term. Hence, three weeks ago we closed our underweight banks versus healthcare position, booking a tidy profit of 23 percent. Today, we are closing our underweight position in basic materials versus the market, booking a profit of 6 percent. In a similar vein, we are taking the modest profits in our overweight position in 30-year government bonds. Sector allocation has unavoidable implications for stock market allocation - because the mainstream stock market indexes all have dominant sector skews which determine their relative performances (Chart I-10). Chart I-10Italy Vs. Denmark = Banks Vs. Healthcare Italy Vs. Denmark = Banks Vs. Healthcare Italy Vs. Denmark = Banks Vs. Healthcare On this basis, closing our underweight banks versus healthcare removes the justification for being underweight bank-dominant Italy (MIB) and Spain (IBEX) and the justification for being overweight healthcare-dominant Denmark (OMX). These three positions now move to neutral. While we consider our next shift, our European stock market allocation is temporarily reduced to just five positions. Overweight: France, Ireland, Switzerland. Underweight: Sweden, Norway. Finally, just to say that there will be no report next week as I will be attending our annual Investment Conference which is in Toronto this year. I look forward to seeing some of you there. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Based on the relative performance of the MSCI All Country World Index versus the JP Morgan Global Government Bond Index, both in local currency terms. 2 Please see the European Investment Strategy Weekly Report 'Trapped: Have Equities Trapped Bonds?' September 13 2018 available at eis.bcaresearch.com. 3 Please see the European Investment Strategy Weekly Report 'The Rule Of 4 For Equities And Bonds' August 2 2018 available at eis.bcaresearch.com. Fractal Trading Model* This week, we note that the very strong recent outperformance of U.S. telecoms versus U.S. autos is technically extended, reaching a fractal dimension that has previously signalled the start of a countertrend move. Hence, the recommended trade is short U.S. telecoms, long U.S. autos. Set a profit target of 9% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 U.S. Telecom VS. Autos U.S. Telecom VS. Autos 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 - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights In an environment where both interest rates and inflation are low but rising at a time of stretched equity valuations, what can investors do to enhance risk-adjusted portfolio returns? In this report, we investigate the roles of three types of popular instruments in a portfolio context: 1) Floating-Rate Notes, 2) Leveraged Loans and 3) Danish Mortgage Bonds. Floating-rate notes benefit from rising interest rates, but they are not a free lunch. Leveraged loans also benefit from rising interest rates; their very high correlation with high-yield bonds make them a good substitute for a portion of high-yield exposure in a rising-rate environment. Danish mortgage bonds have attracted foreign investors in recent years, but foreign ownership already accounts for about a quarter of the less than half a trillion USD market. Their positive correlation with aggregate bonds and negative correlation with equities in both Japan and the euro area make them a possible substitute for a portion of the bond basket in a balanced portfolio. Feature BCA has upgraded cash to overweight in the current environment, where inflation and interest rates are both low but rising, and equity valuations are stretched.1 For U.S. investors, holding cash is quite attractive as the cash yield is now higher than the equity dividend yield. For investors in the euro area, Switzerland, Sweden, Denmark and Japan, however, holding cash actually is a sure way to eat into portfolio returns, given the negative yields in these countries (Table 1). Table 1Current Yields* (%) Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment Some clients, particularly those in Europe, have asked where to put cash to get higher returns. Unfortunately, it's hard to increase return without assuming additional risk. As shown in Table 1, investors could pick up some yield by putting money in 3-month deposits instead of 3-month Treasury bills, but even 3-month deposit rates are still negative in some European countries. In this report, we investigate the roles of three types of popular instruments in a low but rising rate environment: 1) Floating-Rate Notes (FRNs), 2) Leveraged Loans (LLs) and 3) Danish Mortgage Bonds (DMBs). 1. Floating-Rate Notes An FRN offers coupon payments that float or adjust periodically based on a predetermined benchmark rate. Typical benchmarks in the U.S. are Treasury bills, LIBOR, the prime rate or some other short-term interest rate. Once the benchmark is chosen, the issuer will establish an additional spread that it is willing to pay over the chosen benchmark rate. The spread mainly reflects an issuer's credit quality and the time to maturity of the note. Even though coupon reset frequency can vary between daily, weekly, monthly, quarterly and yearly, the average coupon rate has responded quickly to the fed funds rate, as shown in Chart 1. Issuers can be both government-sponsored enterprises and investment-grade corporations. Before the 2008 Great Financial Crisis, FRNs were mostly issued by corporations. Some of the notes, however, performed badly during the financial crisis, causing a drop in both total issuance and the share of corporate issuance (Chart 2). FRNs can be either callable or non-callable with or without caps and floors, so FRNs carry credit risk - and callable ones also carry call risk. In terms of interest rate risk, it applies mostly to the income received. Chart 1Rising Rate Environment Benefits FRNs Rising Rate Environment Benefits FRNs Rising Rate Environment Benefits FRNs Chart 2Corporate Dominance In FRN Market Corporate Dominance In FRN Market Corporate Dominance In FRN Market Because of the nature of floating rates, FRNs can benefit from rising interest rates and have limited price sensitivity to interest rates. As shown in Chart 3, the Bloomberg/Barclays U.S. Floating-Rate Note index has lower duration than the cash index, as represented by the Bloomberg/Barclays Treasury (<1 year) index, while it offers a nice yield pickup. Since the inception of the index in December 2003 it has, in general, outperformed the cash index. This reward, however, has come at a cost: it does not provide cash-like protection when such protection is needed in times like the Great Financial Crisis and the euro debt crisis in 2011 (Chart 3, panels 3 and 4). This is because the majority of FRNs are offered by corporations that carry credit risk. Consequently, FRNs have higher correlations to high-yield bonds and equities than to the aggregate bond index, as shown in Chart 4. Chart 3FRNs: Not A Free Lunch FRNs: Not A Free Lunch FRNs: Not A Free Lunch Chart 4FRNs: A Lower Risk Alternative To Junk Bonds FRNs: A Lower Risk Alternative To Junk Bonds FRNs: A Lower Risk Alternative To Junk Bonds The ideal time to invest in FRNs is when rates are low and are expected to rise. This is essentially our view on rates now. Instead of thinking of it as a cash alternative with higher risk, however, we recommend clients take the funding from the high-yield bucket, in line with our downgrade of high yield to neutral from overweight, and also our call of reducing portfolio duration. So how to invest in FRNs? According to Bloomberg Barclays, the U.S. FRN market has a market value of US$505.8 billion, which is small compared to the US$1,267.5 billion high-yield bond market. As such, FRNs are relatively less liquid to trade than corporate bonds. Therefore, they are mostly suitable for purchasing and holding to maturity. One can purchase individual floating-rate securities through a broker, or can invest in mutual funds that invest only in FRNs. Also, there are ETFs that only hold FRNs. Table 2 shows some basic information on three dedicated FRN ETFs. Table 2FRN ETFs* Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment 2. Leveraged Loans Leveraged loans, also known as bank loans or senior secured loans, are a type of corporate debt that also have floating coupon rates, which, like the FRNs, adjust to changes in prevailing interest rates and hence benefit from rising rates. These loans tend to be senior to an issuer's traditional corporate bonds, and are collateralized by a pledge of the issuer's assets. However, secured does not mean safe. These loans are private investments which are generally held by funds or large institutional investors. Most of them carry sub-investment-grade ratings and can default. They also tend to be very illiquid to trade, because physical delivery to the buyer is often needed from a seller (by faxing the paperwork, for example). As such, during periods of market volatility, these loans can be subject to significant price declines. Even though bank loans share the same feature of having "floating coupon rates" as FRNs, they are higher risk securities. In the U.S., bank loans have been mostly inferior to FRNs on a risk-adjusted return basis, as their higher return is offset by much higher volatility (Chart 5A). In the euro area, however, these loans have become more favorable than FRNs since the start of 2018 (Chart 5B). Chart 5ALeveraged Loans Vs. FRNs: U.S. Leveraged Loans Vs. FRNs: U.S. Leveraged Loans Vs. FRNs: U.S. Chart 5BLeveraged Loans Vs. FRNs: Euro Area Leveraged Loans Vs. FRNs: Euro Area Leveraged Loans Vs. FRNs: Euro Area Historically, when interest rates have risen, bank loans have outperformed traditional fixed-income securities, and vice versa, because of their floating-rate feature, as shown in Charts 6A and 6B. This positive correlation with rates has been more consistent when the relative performance of bank loans is compared to government bonds and investment-grade corporate bonds. When compared to high-yield bonds, however, the correlation appears weak, as shown in the bottom panels of Charts 6A and 6B. This is not surprising given that these loans share similar "sub-investment grade" credit quality with junk bonds. In fact, as shown in Chart 7, bank loans have a highly positive correlation with junk bonds, yet a mostly negative correlation with the aggregate bond index both in the U.S. and the euro area. Chart 6ALLs Outperform When Rates Rise: U.S. LLs Outperform Whe Rates Rise: U.S. LLs Outperform Whe Rates Rise: U.S. Chart 6BLLs Outperform When Rates Rise: Euro Area LLs Outperform When Rates Rise: Euro Area LLs Outperform When Rates Rise: Euro Area Chart 7Bank Loan Correlations With Traditional Bonds Bank Loan Correlations With Traditional Bonds Bank Loan Correlations With Traditional Bonds This correlation feature has two very interesting implications: a) Adding bank loans to a standard aggregate bond portfolio could add diversification, and b) replacing some high-yield holdings with bank loans could generate a sub-investment grade basket with a better risk/reward profile compared to high-yield alone. Chart 8 and Table 3 show that historically there has existed an "optimal" combination of bank loans and high-yield bonds that somewhat improves the risk-adjusted return of the sub-investment grade basket. It's worth noting, however, that this historically "optimal" combination is subject to data frequency and time period, as is the case for the U.S. where the optimal weight for bank loans has been about 40% from 2002 to the present, but about 80% in the period from 1997 to the present. As such, in addition to thorough credit analysis to evaluate the suitability of bank loans, investors should also consider the variable nature of correlation when considering replacing part of their high-yield bond exposure with bank loans. Chart 8Junk Bonds - Leverage Loans Basket Profiles Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment Table 3Risk Return Profiles Of Sub-Investment Grade Baskets Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment 3. Danish Mortgage Bonds A Danish mortgage bond (DMB) is essentially a loan to a borrower who has taken out a mortgage on his or her home. Mortgage bonds are issued by mortgage credit institutions which often have high credit ratings. Some DMBs have fixed rates, while others have floating rates with a minimum of zero percent. Some of these bonds can also be callable, often at par (100). With a solid history of over 200 years, the DMB market has survived numerous occasions of economic and political turmoil, including the bankruptcy of the Kingdom of Denmark in 1813, the Great Depression of the 1930s and the Great Financial Crisis and ensuing recession in 2008. Over its entire history, every single issued bond has been repaid in full to investors, in large part due to the strong legislative framework that protects the bond investors (see Appendix 1). As of the end of July 2018, the DMB market consisted of kr. 2.672 trillion of AAA-rated covered bonds. Once largely dominated by local pensions and insurance companies, the DMB market has seen increasing interest from foreign investors in recent years. According to data from the Danish central bank, foreign ownership of fixed rate mortgage bonds stood at kr. 295 billion (29%) in July 2018 compared to kr. 154 billion (18%) in January 2016 (Chart 9). In terms of total holdings of all mortgage bonds (fixed rate, variable rate and bonds backing interest adjustment loans), foreigners held kr. 614 billion (23%), an increase of kr. 27 billion compared to the beginning of 2016. Japanese investors, who have suffered many years of extremely low yields domestically, have been quite active in the DMB market. According to data from the Bank of Japan, Japanese investors purchased some kr. 50 billion of long-term Danish non-government bonds in the period from 2016 to June 2018.3 In June 2018, Nykredit, the largest Danish mortgage bank with a market share of about 40%, even created a DMB index hedged to yen using one-month forward rates due to popular demand and corresponding requests from Japanese investors. As shown in Chart 10, since 2009, the DMB index hedged to yen has outperformed both JGBs and Japanese corporate bonds. Chart 9Foreign Ownership of Danish Fixed Rate Mortgage Bonds* Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment Chart 10DMBs For Japanese Investors DMBs For Japanese Investors DMBs For Japanese Investors Even though interest rates in the U.S. are much higher than those in the euro area, investing in the U.S. after hedging the currency is not really attractive for euro investors. For example, U.S. bank loans have outperformed European bank loans in local currency terms; after being hedged into euro, however, the yield advantage disappears. In terms of government bonds, euro investors really have no incentive to invest in U.S. Treasurys, hedged or unhedged (Chart 11). Given the Danish krone's peg to the euro, it is natural for euro investors to look at the DMB market. Chart 12 shows that DMBs have indeed outperformed both government and corporate bonds in the euro area when 3-month deposit rate turns negative. During the 2008 financial crisis, DMBs also outperformed euro area corporate bonds. However, they did underperform both euro area corporate and government bonds when the European Central Bank started buying bonds after the euro debt crisis. So, how would the exposure of DMBs impact a portfolio's risk/return profile? We have two interesting observations from Chart 13: Chart 11Rate Advantage Vs. Currency Risk Rate Advantage Vs. Currency Risk Rate Advantage Vs. Currency Risk Chart 12DMBs For Euro Investors DMBs For Euro Investors DMBs For Euro Investors Chart 13DMBs As A Domestic Bond Substitute? DMBs As A Domestic Bond Substitute? DMBs As A Domestic Bond Substitute? In Japan, hedged DMBs have a very low correlation with equities, corporate bonds and JGBs, even though the correlation with equities has generally been negative, and with bonds generally positive. In the euro area, DMBs have a negative correlation with equities, but a highly positive correlation with both government and corporate bonds. And the correlation to government bonds is quite similar to that of corporate bonds. Therefore, in theory, replacing part of a standard bond portfolio with DMBs could improve a balanced portfolio's risk/return profile for both Japanese and euro area investors. Table 4 shows the risk/return profiles of hypothetical 60/40 standard domestic equity/bond portfolios for Japan and euro area that have a certain percentage of domestic bonds replaced with Danish mortgage bonds: for Japan, the DMBs are hedged to yen, and for the euro area they are unhedged but converted into euros. Table 460/40 Equity/Bond Portfolio Profile with DMB Exposures Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment As expected, for Japan, substituting domestic aggregate bonds with hedged DMBs increases portfolio return more than volatility, thereby improving risk/adjusted returns. For the euro area, however, the story is not straightforward. Over a longer time frame, DMBs have not been a good substitute for euro area aggregate bonds. Since the 3-month euro rate turned negative in June 2015, however, DMBs have largely improved a balanced portfolio's risk/return profile. It is also worth noting that, unlike Japanese investors who benefit from a positive hedging gain since the Danish three-month rate has been lower than Japan's since 2015, euro area investors do not have such a benefit. Also, even though the DMB market is the largest covered bond market in the world, its market size is less than half a trillion USD. Given the fact that foreign investors already account for about a quarter of the market, it is not clear how euro area investors can significantly deploy more capital to enhance portfolio returns. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Appendix 1: The Danish Mortgage Act4 Danish mortgage bonds are issued under the Danish Mortgage Act. Two key features of the Act protect investors in DMBs. First, the central element in the Danish Mortgage Act is the "balancing principle." This principle requires that there is a match between the inflows and outflows of a mortgage-issuing bank, and limits the amount of risk (interest rate, FX, volatility and liquidity) that a Danish mortgage bank can undertake. In addition, Danish mortgage banks must meet minimum capital requirements of 8% of risk-weighted assets. Second, the "Danish title number and land registration systems and efficient compulsory sale procedure" ensures well-defined property rights through a general register of all properties in Denmark. Ownership and encumbrances on individual properties are easily identified, and that information is available to the public. If a borrower defaults on a payment, the mortgage bank can take over the property and the compulsory sale procedure ensures that a mortgage bank can sell the property in the real estate market or through a forced sale. The period from default to a forced sale to be completed can be as short as six months. 1 Please see Global Investment Strategy Special Report entitled, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. 2 Please see "Fixed Rate Mortgage Bonds Are Attractive For Foreigners," Portfolio Investment, Danmarks Nationalbank, dated August 28, 2018. 3 Please see "Fixed Rate Mortgage Bonds Are Attractive For Foreigners," Portfolio Investment, Danmarks Nationalbank, dated August 28, 2018. 4 Please see "Danish Covered Bond Handbook," Danske Bank, dated September 15, 2017.

Dear Client, I am travelling in Europe this week visiting clients. Instead of our Weekly Report, we are sending you a Special Report written by my colleague Xiaoli Tang of BCA's Global Asset Allocation. The report examines three types of instruments investors can look to in order to enhance risk-adjusted portfolio returns at a time when interest rates and inflation are low but rising: floating-rate notes, leveraged loans and Danish mortgage bonds. I trust you will find it informative. Best regards, Peter Berezin, Chief Global Strategist Highlights In an environment where both interest rates and inflation are low but rising at a time of stretched equity valuations, what can investors do to enhance risk-adjusted portfolio returns? In this report, we investigate the roles of three types of popular instruments in a portfolio context: 1) Floating-Rate Notes, 2) Leveraged Loans and 3) Danish Mortgage Bonds. Floating-rate notes benefit from rising interest rates, but they are not a free lunch. Leveraged loans also benefit from rising interest rates; their very high correlation with high-yield bonds make them a good substitute for a portion of high-yield exposure in a rising-rate environment. Danish mortgage bonds have attracted foreign investors in recent years, but foreign ownership already accounts for about a quarter of the less than half a trillion USD market. Their positive correlation with aggregate bonds and negative correlation with equities in both Japan and the euro area make them a possible substitute for a portion of the bond basket in a balanced portfolio. Feature BCA has upgraded cash to overweight in the current environment, where inflation and interest rates are both low but rising, and equity valuations are stretched.1 For U.S. investors, holding cash is quite attractive as the cash yield is now higher than the equity dividend yield. For investors in the euro area, Switzerland, Sweden, Denmark and Japan, however, holding cash actually is a sure way to eat into portfolio returns, given the negative yields in these countries (Table 1). Table 1Current Yields* (%) Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment Some clients, particularly those in Europe, have asked where to put cash to get higher returns. Unfortunately, it's hard to increase return without assuming additional risk. As shown in Table 1, investors could pick up some yield by putting money in 3-month deposits instead of 3-month Treasury bills, but even 3-month deposit rates are still negative in some European countries. In this report, we investigate the roles of three types of popular instruments in a low but rising rate environment: 1) Floating-Rate Notes (FRNs), 2) Leveraged Loans (LLs) and 3) Danish Mortgage Bonds (DMBs). 1. Floating-Rate Notes An FRN offers coupon payments that float or adjust periodically based on a predetermined benchmark rate. Typical benchmarks in the U.S. are Treasury bills, LIBOR, the prime rate or some other short-term interest rate. Once the benchmark is chosen, the issuer will establish an additional spread that it is willing to pay over the chosen benchmark rate. The spread mainly reflects an issuer's credit quality and the time to maturity of the note. Even though coupon reset frequency can vary between daily, weekly, monthly, quarterly and yearly, the average coupon rate has responded quickly to the fed funds rate, as shown in Chart 1. Issuers can be both government-sponsored enterprises and investment-grade corporations. Before the 2008 Great Financial Crisis, FRNs were mostly issued by corporations. Some of the notes, however, performed badly during the financial crisis, causing a drop in both total issuance and the share of corporate issuance (Chart 2). FRNs can be either callable or non-callable with or without caps and floors, so FRNs carry credit risk - and callable ones also carry call risk. In terms of interest rate risk, it applies mostly to the income received. Chart 1Rising Rate Environment Benefits FRNs Rising Rate Environment Benefits FRNs Rising Rate Environment Benefits FRNs Chart 2Corporate Dominance In FRN Market Corporate Dominance In FRN Market Corporate Dominance In FRN Market Because of the nature of floating rates, FRNs can benefit from rising interest rates and have limited price sensitivity to interest rates. As shown in Chart 3, the Bloomberg/Barclays U.S. Floating-Rate Note index has lower duration than the cash index, as represented by the Bloomberg/Barclays Treasury (<1 year) index, while it offers a nice yield pickup. Since the inception of the index in December 2003 it has, in general, outperformed the cash index. This reward, however, has come at a cost: it does not provide cash-like protection when such protection is needed in times like the Great Financial Crisis and the euro debt crisis in 2011 (Chart 3, panels 3 and 4). This is because the majority of FRNs are offered by corporations that carry credit risk. Consequently, FRNs have higher correlations to high-yield bonds and equities than to the aggregate bond index, as shown in Chart 4. Chart 3FRNs: Not A Free Lunch FRNs: Not A Free Lunch FRNs: Not A Free Lunch Chart 4FRNs: A Lower Risk Alternative To Junk Bonds FRNs: A Lower Risk Alternative To Junk Bonds FRNs: A Lower Risk Alternative To Junk Bonds The ideal time to invest in FRNs is when rates are low and are expected to rise. This is essentially our view on rates now. Instead of thinking of it as a cash alternative with higher risk, however, we recommend clients take the funding from the high-yield bucket, in line with our downgrade of high yield to neutral from overweight, and also our call of reducing portfolio duration. So how to invest in FRNs? According to Bloomberg Barclays, the U.S. FRN market has a market value of US$505.8 billion, which is small compared to the US$1,267.5 billion high-yield bond market. As such, FRNs are relatively less liquid to trade than corporate bonds. Therefore, they are mostly suitable for purchasing and holding to maturity. One can purchase individual floating-rate securities through a broker, or can invest in mutual funds that invest only in FRNs. Also, there are ETFs that only hold FRNs. Table 2 shows some basic information on three dedicated FRN ETFs. Table 2FRN ETFs* Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment 2. Leveraged Loans Leveraged loans, also known as bank loans or senior secured loans, are a type of corporate debt that also have floating coupon rates, which, like the FRNs, adjust to changes in prevailing interest rates and hence benefit from rising rates. These loans tend to be senior to an issuer's traditional corporate bonds, and are collateralized by a pledge of the issuer's assets. However, secured does not mean safe. These loans are private investments which are generally held by funds or large institutional investors. Most of them carry sub-investment-grade ratings and can default. They also tend to be very illiquid to trade, because physical delivery to the buyer is often needed from a seller (by faxing the paperwork, for example). As such, during periods of market volatility, these loans can be subject to significant price declines. Even though bank loans share the same feature of having "floating coupon rates" as FRNs, they are higher risk securities. In the U.S., bank loans have been mostly inferior to FRNs on a risk-adjusted return basis, as their higher return is offset by much higher volatility (Chart 5A). In the euro area, however, these loans have become more favorable than FRNs since the start of 2018 (Chart 5B). Chart 5ALeveraged Loans Vs. FRNs: U.S. Leveraged Loans Vs. FRNs: U.S. Leveraged Loans Vs. FRNs: U.S. Chart 5BLeveraged Loans Vs. FRNs: Euro Area Leveraged Loans Vs. FRNs: Euro Area Leveraged Loans Vs. FRNs: Euro Area Historically, when interest rates have risen, bank loans have outperformed traditional fixed-income securities, and vice versa, because of their floating-rate feature, as shown in Charts 6A and 6B. This positive correlation with rates has been more consistent when the relative performance of bank loans is compared to government bonds and investment-grade corporate bonds. When compared to high-yield bonds, however, the correlation appears weak, as shown in the bottom panels of Charts 6A and 6B. This is not surprising given that these loans share similar "sub-investment grade" credit quality with junk bonds. In fact, as shown in Chart 7, bank loans have a highly positive correlation with junk bonds, yet a mostly negative correlation with the aggregate bond index both in the U.S. and the euro area. Chart 6ALLs Outperform When Rates Rise: U.S. LLs Outperform Whe Rates Rise: U.S. LLs Outperform Whe Rates Rise: U.S. Chart 6BLLs Outperform When Rates Rise: Euro Area LLs Outperform When Rates Rise: Euro Area LLs Outperform When Rates Rise: Euro Area Chart 7Bank Loan Correlations With Traditional Bonds Bank Loan Correlations With Traditional Bonds Bank Loan Correlations With Traditional Bonds This correlation feature has two very interesting implications: a) Adding bank loans to a standard aggregate bond portfolio could add diversification, and b) replacing some high-yield holdings with bank loans could generate a sub-investment grade basket with a better risk/reward profile compared to high-yield alone. Chart 8 and Table 3 show that historically there has existed an "optimal" combination of bank loans and high-yield bonds that somewhat improves the risk-adjusted return of the sub-investment grade basket. It's worth noting, however, that this historically "optimal" combination is subject to data frequency and time period, as is the case for the U.S. where the optimal weight for bank loans has been about 40% from 2002 to the present, but about 80% in the period from 1997 to the present. As such, in addition to thorough credit analysis to evaluate the suitability of bank loans, investors should also consider the variable nature of correlation when considering replacing part of their high-yield bond exposure with bank loans. Chart 8Junk Bonds - Leverage Loans Basket Profiles Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment Table 3Risk Return Profiles Of Sub-Investment Grade Baskets Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment 3. Danish Mortgage Bonds A Danish mortgage bond (DMB) is essentially a loan to a borrower who has taken out a mortgage on his or her home. Mortgage bonds are issued by mortgage credit institutions which often have high credit ratings. Some DMBs have fixed rates, while others have floating rates with a minimum of zero percent. Some of these bonds can also be callable, often at par (100). With a solid history of over 200 years, the DMB market has survived numerous occasions of economic and political turmoil, including the bankruptcy of the Kingdom of Denmark in 1813, the Great Depression of the 1930s and the Great Financial Crisis and ensuing recession in 2008. Over its entire history, every single issued bond has been repaid in full to investors, in large part due to the strong legislative framework that protects the bond investors (see Appendix 1). As of the end of July 2018, the DMB market consisted of kr. 2.672 trillion of AAA-rated covered bonds. Once largely dominated by local pensions and insurance companies, the DMB market has seen increasing interest from foreign investors in recent years. According to data from the Danish central bank, foreign ownership of fixed rate mortgage bonds stood at kr. 295 billion (29%) in July 2018 compared to kr. 154 billion (18%) in January 2016 (Chart 9). In terms of total holdings of all mortgage bonds (fixed rate, variable rate and bonds backing interest adjustment loans), foreigners held kr. 614 billion (23%), an increase of kr. 27 billion compared to the beginning of 2016. Japanese investors, who have suffered many years of extremely low yields domestically, have been quite active in the DMB market. According to data from the Bank of Japan, Japanese investors purchased some kr. 50 billion of long-term Danish non-government bonds in the period from 2016 to June 2018.3 In June 2018, Nykredit, the largest Danish mortgage bank with a market share of about 40%, even created a DMB index hedged to yen using one-month forward rates due to popular demand and corresponding requests from Japanese investors. As shown in Chart 10, since 2009, the DMB index hedged to yen has outperformed both JGBs and Japanese corporate bonds. Chart 9Foreign Ownership of Danish Fixed Rate Mortgage Bonds* Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment Chart 10DMBs For Japanese Investors DMBs For Japanese Investors DMBs For Japanese Investors Even though interest rates in the U.S. are much higher than those in the euro area, investing in the U.S. after hedging the currency is not really attractive for euro investors. For example, U.S. bank loans have outperformed European bank loans in local currency terms; after being hedged into euro, however, the yield advantage disappears. In terms of government bonds, euro investors really have no incentive to invest in U.S. Treasurys, hedged or unhedged (Chart 11). Given the Danish krone's peg to the euro, it is natural for euro investors to look at the DMB market. Chart 12 shows that DMBs have indeed outperformed both government and corporate bonds in the euro area when 3-month deposit rate turns negative. During the 2008 financial crisis, DMBs also outperformed euro area corporate bonds. However, they did underperform both euro area corporate and government bonds when the European Central Bank started buying bonds after the euro debt crisis. So, how would the exposure of DMBs impact a portfolio's risk/return profile? We have two interesting observations from Chart 13: Chart 11Rate Advantage Vs. Currency Risk Rate Advantage Vs. Currency Risk Rate Advantage Vs. Currency Risk Chart 12DMBs For Euro Investors DMBs For Euro Investors DMBs For Euro Investors Chart 13DMBs As A Domestic Bond Substitute? DMBs As A Domestic Bond Substitute? DMBs As A Domestic Bond Substitute? In Japan, hedged DMBs have a very low correlation with equities, corporate bonds and JGBs, even though the correlation with equities has generally been negative, and with bonds generally positive. In the euro area, DMBs have a negative correlation with equities, but a highly positive correlation with both government and corporate bonds. And the correlation to government bonds is quite similar to that of corporate bonds. Therefore, in theory, replacing part of a standard bond portfolio with DMBs could improve a balanced portfolio's risk/return profile for both Japanese and euro area investors. Table 4 shows the risk/return profiles of hypothetical 60/40 standard domestic equity/bond portfolios for Japan and euro area that have a certain percentage of domestic bonds replaced with Danish mortgage bonds: for Japan, the DMBs are hedged to yen, and for the euro area they are unhedged but converted into euros. Table 460/40 Equity/Bond Portfolio Profile with DMB Exposures Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment As expected, for Japan, substituting domestic aggregate bonds with hedged DMBs increases portfolio return more than volatility, thereby improving risk/adjusted returns. For the euro area, however, the story is not straightforward. Over a longer time frame, DMBs have not been a good substitute for euro area aggregate bonds. Since the 3-month euro rate turned negative in June 2015, however, DMBs have largely improved a balanced portfolio's risk/return profile. It is also worth noting that, unlike Japanese investors who benefit from a positive hedging gain since the Danish three-month rate has been lower than Japan's since 2015, euro area investors do not have such a benefit. Also, even though the DMB market is the largest covered bond market in the world, its market size is less than half a trillion USD. Given the fact that foreign investors already account for about a quarter of the market, it is not clear how euro area investors can significantly deploy more capital to enhance portfolio returns. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Appendix 1: The Danish Mortgage Act4 Danish mortgage bonds are issued under the Danish Mortgage Act. Two key features of the Act protect investors in DMBs. First, the central element in the Danish Mortgage Act is the "balancing principle." This principle requires that there is a match between the inflows and outflows of a mortgage-issuing bank, and limits the amount of risk (interest rate, FX, volatility and liquidity) that a Danish mortgage bank can undertake. In addition, Danish mortgage banks must meet minimum capital requirements of 8% of risk-weighted assets. Second, the "Danish title number and land registration systems and efficient compulsory sale procedure" ensures well-defined property rights through a general register of all properties in Denmark. Ownership and encumbrances on individual properties are easily identified, and that information is available to the public. If a borrower defaults on a payment, the mortgage bank can take over the property and the compulsory sale procedure ensures that a mortgage bank can sell the property in the real estate market or through a forced sale. The period from default to a forced sale to be completed can be as short as six months. 1 Please see Global Investment Strategy Special Report entitled, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. 2 Please see "Fixed Rate Mortgage Bonds Are Attractive For Foreigners," Portfolio Investment, Danmarks Nationalbank, dated August 28, 2018. 3 Please see "Fixed Rate Mortgage Bonds Are Attractive For Foreigners," Portfolio Investment, Danmarks Nationalbank, dated August 28, 2018. 4 Please see "Danish Covered Bond Handbook," Danske Bank, dated September 15, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The global economic mini-cycle is set to weaken while the euro is set to grind higher. Upgrade Telecoms to overweight. Also overweight Healthcare and Airlines. Underweight Banks, Basic Materials and Energy. Overweight France, Ireland, U.K., Switzerland and Denmark. Underweight Italy, Spain, Sweden and Norway. The Eurostoxx50 will struggle to outperform the S&P500. Feature We are strong believers in Investment Reductionism, a philosophy synthesized from the Pareto Principle and Occam's Razor.1 Investment reductionism offers a liberating thesis - the incessant barrage of investment research, newsfeeds and ten thousand word commentaries is largely superfluous to the investment process. What seems like a complexity of investment choice usually reduces to getting a few over-arching decisions right. Chart of the WeekIn Quadrant 4, Overweight Domestic Defensives And Underweight International Cyclicals The Four Quadrants Of Cyclical Investing The Four Quadrants Of Cyclical Investing For equity sector and country allocation, two over-arching decisions dominate: Whether the global economic mini-cycle is set to strengthen or weaken (Chart I-2). Whether the domestic currency is set to strengthen or weaken. Chart I-2The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The four permutations of these two decisions create the four quadrants of cyclical investing (Chart of the Week). Right now, European investors find themselves in quadrant four: the global economic mini-cycle is set to weaken while the euro is set to grind higher. This favours an overweight stance to defensives, especially domestic-focused defensives. Therefore today, we are upgrading Telecoms to overweight. We also recommend an underweight stance to the most cyclical sectors, especially international-focused cyclicals such as Basic Materials and Energy. Country allocation then just drops out of this sector allocation. The Global Economic Mini-Cycle Is Set To Weaken We can predict the changes of the seasons and the tides of the sea with utmost precision. How? Not because we have an ingenious leading indicator for the seasons and tides, but because we recognise that these phenomena follow perfectly regular cycles. Regular cycles create predictability. Significantly, global bank credit flows also exhibit remarkably regular cycles with half-cycle lengths averaging around eight months. Recognizing these mini-cycles is immensely powerful because, just as for the seasons and the tides, it creates predictability. Furthermore, if most investors are unaware of these cycles, the next turn will not be discounted in today's price - providing a compelling investment opportunity for those who do recognise the predictability. The empirical evidence for credit mini-cycles is irrefutable. The theoretical foundation is also rock solid, based on an economic model called the Cobweb Theory.2 This states that in any market where supply lags demand, both the quantity supplied and the price must oscillate. Given that credit supply clearly lags credit demand, the quantity of credit supplied and its price (the bond yield) must experience mini-cycles (Chart I-3). And as the quantity of credit supplied is a marginal driver of economic activity, economic activity will also experience the same regular oscillations. Today, the global 6-month credit impulse is turning from mini-upswing to mini-downswing, with all three subcomponents - the euro area, the U.S. and China - now in decline (Chart I-4). This is exactly in line with prediction. Mini half-cycles average eight months, and the latest mini-upswing started eight months ago. Chart I-3The Global Economic Mini-Cycle##br## Is Set To Weaken The Global Economic Mini-Cycle Is Set To Weaken The Global Economic Mini-Cycle Is Set To Weaken Chart I-4All Three Subcomponents Of The Global 6-Month ##br##Credit Impulse Are Now Declining All Three Subcomponents Of The Global 6-Month Credit Impulse Are Now Declining All Three Subcomponents Of The Global 6-Month Credit Impulse Are Now Declining More importantly, as we enter a mini-downswing, we can also predict that global growth is likely to experience at least a modest deceleration through the coming two to three quarters. The Euro Is Set To Grind Higher, Except Versus The Yen Chart I-5Lost In Translation Lost In Translation Lost In Translation Nowadays, mainstream stock markets tend to be eclectic collections of multinational companies which happen to be quoted on bourses in Frankfurt, Paris, New York, and so on. For example, BASF is not really a German chemical company, it is a global chemical company headquartered in Germany. For operational hedging, multinational companies like BASF will intentionally diversify their sales and profits across multiple major currencies, say euros and dollars. But of course, the primary stock market quotation will be in the currency of its home bourse, euros. Therefore, when the euro strengthens, the company's multi-currency profits, translated back into a stronger euro, will necessarily weaken (Chart I-5). Clearly, more domestic-focused companies like telecoms will not experience such a strong currency-translation headwind. We expect the main euro crosses to continue strengthening over the next 8 months, with the exception being the cross versus the Japanese yen. Our central thesis is that the payoff profile for a foreign exchange rate just tracks the bond yield spread. This means that when a central bank has already taken bond yields close to their lower bound, its currency possesses a highly attractive asymmetry called positive skew. In essence, as the ECB is at the realistic limit of ultra-loose policy, long-term expectations for the ECB policy rate possess an asymmetry: they cannot go significantly lower, but they could go significantly higher. Exactly the same applies to long-term expectations for the BoJ policy rate. In contrast, long-term expectations for the Fed policy rate possess full symmetry: they could go either way, lower or higher. This stark asymmetry of central bank 'degrees of freedom' favours the euro and the yen over the dollar. Which Sectors And Countries To Own And Which To Avoid? Pulling together the preceding two sections, the global economic mini-cycle is set to weaken while the euro is set to grind higher. This puts Europe in quadrant four of our four quadrant framework for cyclical investing. Unsurprisingly, the relative performance of the most cyclical sectors - Banks, Basic Materials and Energy - very closely tracks the regular mini-cycles in the global 6-month credit impulse. In a mini-downswing these cyclical sectors always underperform (Chart I-6, Chart I-7 and Chart I-8). Accordingly, underweight these three sectors on a two to three quarter horizon. Chart I-6In A Mini-Downswing, ##br##Banks Always Underperform In A Mini-Downswing, Banks Always Underperform In A Mini-Downswing, Banks Always Underperform Chart I-7In A Mini-Downswing,##br## Basic Materials Always Underperform In A Mini-Downswing, Basic Materials Always Underperform In A Mini-Downswing, Basic Materials Always Underperform Chart I-8In A Mini-Downswing,##br## Energy Always Underperforms In A Mini-Downswing, Energy Always Underperform In A Mini-Downswing, Energy Always Underperform Conversely, overweight the relatively defensive Healthcare sector. Also overweight the Airlines sector. Airlines' performance is a mirror-image of the oil price cycle, given that aviation fuel comprises the sector's main variable cost. Furthermore, as aviation fuel is priced in dollars, it also insulates European Airlines against a strengthening euro. Today, we are also upgrading the Telecoms sector to overweight given its relative non-cyclicality (Chart I-9), its domestic-focus, and the excessively negative groupthink towards it (Chart I-10). Chart I-9In A Mini-Downswing, ##br##Telecoms Always Outperform In A Mini-Downswing, Telecoms Always Outperform In A Mini-Downswing, Telecoms Always Outperform Chart I-10Telecoms Are Due ##br##A Trend Reversal Telecoms Are Due A Trend Reversal Telecoms Are Due A Trend Reversal In summary: Overweight: Healthcare, Telecoms, and Airlines Underweight: Banks, Basic Materials and Energy Then to arrive at a country allocation, just combine the cyclical view on the major sectors with the country sector skews in Box 1. The result is the following unchanged European equity market allocation. Overweight: France, Ireland, U.K., Switzerland and Denmark Neutral: Germany and Netherlands Underweight: Italy, Spain, Sweden and Norway Lastly, what is the prognosis for the Eurostoxx50 relative to the S&P500? Essentially, this reduces to a battle between the multinational cyclicals - especially banks - that dominate euro area bourses and the multinational technology giants that dominate the U.S. stock market. With the global economic mini-cycle set to weaken and the euro set to grind higher, the Eurostoxx50 will struggle to outperform the S&P500. Box 1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 The Pareto Principle, often known as the 80-20 rule, says that 80% of effects come from just 20% of causes. Occam's Razor says that when there are many competing explanations for the same effect, the simplest explanation is usually the best. 2 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11, 2018 and available at eis.bcaresearch.com. Fractal Trading Model* This week's recommended trade is to short the Helsinki OMX versus the Eurostoxx600. Apply a profit target of 3% with a symmetrical stop-loss. In other trades, we are pleased to report that short Japanese Energy versus the market achieved its 8% profit target at which it was closed. This leaves four open positions. 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 11 Helsinki OMX Vs. Eurostoxx 600 Helsinki OMX Vs. Eurostoxx 600 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 The euro is cheap. To cease being cheap, EUR/USD needs to approach 1.35. Euro area bonds are expensive. To cease being expensive, the yield spread between the euro area and U.S. long bond needs to compress from -135 bps to -40 bps. Never pick mainstream stock markets on the basis of seeming cheapness. Sector effects, step changes in sector valuations and currency effects make relative valuations very difficult to interpret. Always pick mainstream stock markets on the basis of the sector and currency biases you wish to express. Overweight Denmark's OMX and Ireland's ISEQ on a 6-9 month horizon. Feature A very common question we get asked is: are European investments attractively priced compared to those elsewhere in the world? To which the current answers are: yes for the euro currency; no for euro area government bonds; and highly unlikely for the aggregate European stock market. That said, we can still identify individual European stock markets that are well placed to outperform major equity indexes, including the S&P500, over the coming 6-9 months. Chart of the WeekWhen Healthcare Outperforms, Denmark's OMX Outperforms The S&P 500 When Healthcare Outperforms, Denmark"s OMX Outperforms The S&P 500 When Healthcare Outperforms, Denmark"s OMX Outperforms The S&P 500 The Euro Is Cheap... Says The ECB We can confidently claim that the euro is cheap because the ECB's own indicators say so.1 According to the ECB, the euro needs to appreciate at least 7% to cancel the euro area's over-competitiveness versus its top 19 trading partners. In terms of EUR/USD this translates to 1.32. Admittedly, 1.32 encapsulates a spectrum of fair values for the individual euro area economies: 1.45 for Germany; around 1.30 for France, Spain and Netherlands; and around 1.20 for Italy (Chart I-2). Chart I-2The Euro Needs To Appreciate 7% To Cancel The Euro Area's Over-Competitiveness The Euro Needs To Appreciate 7% To Cancel The Euro Area"s Over-Competitiveness The Euro Needs To Appreciate 7% To Cancel The Euro Area"s Over-Competitiveness The ECB indicators also assume that the euro began its life close to fair value. This seems plausible. Twenty years ago, the euro area's constituent economies were broadly in internal balance and had a lot in common. Remarkably, Germany and Italy scored identically on total debt as a share of GDP as well as on exports as a share of GDP. Furthermore, euro area trade was in external balance, and the bloc's real competitiveness versus its major trading partners was exactly in line with its long-term average. After its birth, the euro first became extremely undervalued in the dot com bubble, then extremely overvalued in the global credit boom, and most recently, extremely undervalued again. Seen in this bigger picture, the euro's current ascent is just a recovery from an extreme undervaluation, an argument that even Mario Draghi made at the last ECB press conference: "Movements in the exchange rate, to the extent that it is justified by the strengthening of the economy, is part of nature." At what level would EUR/USD cease to be cheap? Based on the average of the ECB's three competitiveness indicators, EUR/USD needs to approach 1.35. Euro Area Bonds Are Expensive The yield spread between the euro area and U.S. long bond stands at an extreme -135 bps.2 This compares with an average -40 bps through the twenty year life of the euro - indicating that euro area government bonds are very expensive relative to U.S. T-bonds. Over the completion of this cycle, this yield spread is highly likely to compress to its long-term average of -40 bps, given that the yield spread just tracks relative real GDP per head - which is itself mean-reverting (Chart I-3). Interestingly, the euro area versus U.S. annual inflation differential has also averaged -40 bps (Chart I-4), so the real interest rate differential has averaged zero. This means that the so-called 'neutral' (or mid-cycle) real interest rates in the euro area and the U.S. have been identical through the past twenty years. Growth in real GDP per head has also been identical (Chart I-5). Chart I-3Euro Area-U.S.: Average Interest ##br##Rate Differential = -40bps Euro Area-U.S.: Average Interest Rate Differential = -40bps Euro Area-U.S.: Average Interest Rate Differential = -40bps Chart I-4Euro Area-U.S.: Average Inflation ##br##Differential = -40bps Euro Area-U.S.: Average Inflation Differential = -40bps Euro Area-U.S.: Average Inflation Differential = -40bps Chart I-5The Euro Area And U.S. Have Generated##br## Identical Growth Per Head The Euro Area And U.S. Have Generated Identical Growth Per Head The Euro Area And U.S. Have Generated Identical Growth Per Head The past twenty years provide a good template for what the future holds, at least in relative terms if not in absolute terms. This is because 1999-2018 captures multiple manias and crises, some centred in Europe, some in the U.S. With no difference in neutral real rates over the past two decades, is there any reason to expect the future neutral rate to be meaningfully lower in the euro area compared to the U.S.? Our starting assumption has to be no. This assumption would be at risk if the existential threat to the euro resurfaced. Looking at the political calendar, the immediate concern might be the Italian election on March 4. Specifically, the anti-establishment Five Star Movement and Northern League could poll well enough to hold some sway in the next government and ruffle the markets. However, while both the Five Star Movement and Northern League have agendas that are unashamedly disruptive, anti-establishment and anti-austerity, neither party is standing on an anti-euro platform. Unless there is a major change in emphasis, the Italian election should not pose an existential threat to the euro. Our central expectation is that the euro area versus U.S. yield spread has the scope to compress substantially from its current -135 bps. In other words, euro area government bonds are very expensive relative to U.S. T-bonds. Never Pick Stock Markets On The Basis Of Seeming Cheapness Compared with currencies and bonds, stock markets are much less connected with their domestic economies. Mainstream stock markets are eclectic collections of multinational companies, with each stock market possessing its own unique fingerprint of sector and industry skews. Therefore, a head-to-head comparison of European stock market valuations either with each other or with non-European stock markets is a meaningless and potentially dangerous exercise. Two sectors with vastly different structural growth prospects - say, Financials and Personal Products (Chart I-6) - must necessarily trade on vastly different valuations. So the sector with the lower valuation is not necessarily the cheaper sector. By extension, a stock market with a lower valuation because of its sector fingerprint is not necessarily a cheaper stock market. Chart I-6Two Sectors With Vastly Different Growth Prospects Will Trade On Vastly Different Valuations Two Sectors With Vastly Different Growth Prospects Will Trade On Vastly Different Valuations Two Sectors With Vastly Different Growth Prospects Will Trade On Vastly Different Valuations Some people suggest comparing a valuation with its own history, and assessing how many 'standard deviations' it is above or below its norm. The problem with this standard deviation approach is that it assumes 'stationarity' - meaning, no step changes in a sector's valuation through time. Unfortunately, sector valuations can and do undergo major step changes when they enter a vastly different economic climate. For example, the structural outlook for bank profits undergoes a step change when a debt super-cycle ends. Therefore, comparing a bank valuation after a debt super-cycle with the valuation during a debt super-cycle is like comparing an apple with an orange. Another issue for stock markets that contain multinational companies is the so-called 'currency translation effect'. A multinational company will intentionally diversify its sales and profits across multiple major currencies - say, euros, dollars and yen - but of course its primary stock market listing will be in just one currency - say, euros. So when the other currencies weaken versus the euro, the company's profit growth (quoted in its home currency of euros) will necessarily weaken too. If investors anticipate this effect - because they see that the euro is structurally cheap today - they might downgrade the stock market's profit growth expectations. Thereby, they will also downgrade the stock market's valuation. Pulling together these complexities of sector effects, step changes in sector valuations and currency effects, we offer some very strong advice: picking stock markets on the basis of relative valuation is a wrong and very dangerous way to invest. The correct and safe way to invest is to pick stock markets on the basis of the sector and currency biases you wish to express (Chart I-7). This brings us to one of the major advantages of investing in Europe. The plethora of stock markets - each with their own unique fingerprint of sector and industry skews - means that there are always European bourses worth overweighting, whatever your economic outlook. Right now, two of our sector recommendations are to overweight Healthcare and to underweight Energy. Please review our report Beware The Great Moderation 2.0 for the underlying thesis, which we will not repeat here.3 If these sector recommendations pan out as we expect, Denmark's OMX is highly likely to outperform the S&P500 given the OMX's substantial overweighting to Healthcare (Chart of the Week). Likewise, Ireland's ISEQ is highly likely to outperform the S&P500 given the ISEQ's substantial underweighting to Energy via its large exposure to budget airline Ryanair (Chart I-8). Chart I-7Eurostoxx50 Vs. S&P500 Is Just 3 Banks Vs.##br## 3 Tech Stocks! Eurostoxx50 Vs. S&P500 Is Just 3 Banks Vs. 3 Tech Stocks! Eurostoxx50 Vs. S&P500 Is Just 3 Banks Vs. 3 Tech Stocks! Chart I-8When Energy Underperforms, Ireland's ##br##ISEQ Outperforms The S&P 500 When Energy Underperforms Ireland"s ISEQ Outperforms The S&P 500 When Energy Underperforms Ireland"s ISEQ Outperforms The S&P 500 Overweight Denmark's OMX And Ireland's ISEQ. A final salutary observation illustrates the importance of the sector approach to picking stock markets. As a result of favourable sector biases - overweight Healthcare, underweight Energy - a 50:50 combination of Denmark and Ireland has kept pace with the S&P500 over the past 20 years, while the Eurostoxx50 has been left a very long way behind (Chart I-9). Chart I-9Sector Biases Helped Denmark's OMX And Ireland's ISEQ, But Hindered The Eurostoxx 50 Sector Biases Helped Denmark"s OMX And Ireland"s ISEQ, But Hindered The Eurostoxx 50 Sector Biases Helped Denmark"s OMX And Ireland"s ISEQ, But Hindered The Eurostoxx 50 Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Available at https://www.ecb.europa.eu/stats. The ECB calculates three Harmonised Competitiveness Indicators for the euro area versus its top 19 trading partners based on unit labour costs (ULCs), GDP deflators, and consumer price indices (CPIs), with the latest readings referring to Q3 2017 for ULCs and GDP deflators and January 2018 for CPIs. Updating these for the euro's move to February 20 2018, the three indicators suggest that the trade-weighted euro is still undervalued by 7%, 12% and 7% respectively. 2 Calculated from the over 10-year government bond yield: euro area average, weighted by sovereign issue size, less U.S. 3 Please see the European Investment Strategy Weekly Report 'Beware The Great Moderation 2.0' published on February 1, 2018 and available at eis.bcaresearch.com. ­­ Fractal Trading Model* This week our fractal model has produced a very interesting finding. The 130-day fractal dimension for the U.S. 10-year T-bond is approaching a level which has consistently signalled a technical inflection point. This suggests that the recent sell-off in bonds might be close to running its course. We are not putting on a countertrend position yet, but expect to do so within the next few weeks. 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-10 Long U.S. 10-Year Gov. Bond Long U.S. 10-Year Gov. Bond 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 Should the U.S. 10-year T-bond yield approach 3% it would be a red flag, and a trigger to downgrade equities. Equity investors should stay overweight defensive-heavy Switzerland and Denmark. Contrary to what the consensus is expecting, global growth will lose steam in the first half of 2018. EUR/USD will continue to trend higher through 2018 as long-term interest rate differentials converge further. The multi-year prognosis for GBP/USD is higher. U.K. parliamentary arithmetic simply does not support a hard Brexit. Furthermore, a hard Brexit would require either a North/South or East/West hard border in Ireland, which will be politically impossible to deliver. Feature A happy and prosperous 2018 to you all! In this first report of the year, we describe some investment outcomes in 2017 that at first glance seemed odd or unexpected; but that on deeper reflection provide valuable insights for 2018. Some of these insights deviate substantially from the BCA house view. Bonds Became More Risky Than Equities The first oddity of 2017 concerns the 'drawdowns' suffered by bonds and equities. A drawdown is defined as an investment's peak to trough decline. In 2017, the odd thing was that the drawdowns suffered by government bonds - a supposedly safe asset-class - were equal to or worse than those suffered by equities - a supposedly risky asset-class (Chart of the Week, Chart I-2 and Chart I-3). Chart of the WeekBonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Chart I-2Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Chart I-3Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Contrary to classical theory, empirical evidence now proves that investors do not define an investment's risk in terms of its volatility, the fluctuations of its return around a mean. Instead, investors define risk as the ratio of large and sudden drawdowns versus potential gains. This unattractive asymmetry in an investment's return is technically known as negative skew. And it is as compensation for this negative skew that investors demand an excess return, the so-called 'risk premium'. Significantly, at low bond yields, the mathematics of bond returns necessarily means that their negative skew increases. The risk of large and sudden drawdowns rises while the prospect for price gains diminishes. But if bond risk becomes 'equity-like', it follows that equities' prospective long-term return should become 'bond-like'. Meaning, equities should no longer offer a meaningful risk premium over bonds. Is this the case? According to my colleague Martin Barnes, BCA Chief Economist, the answer appears to be yes - at least in certain major markets. In BCA's Outlook 2018, Martin projects that from current valuations U.S. equities are set to deliver a total nominal return of 2.6% a year to 2028 - almost indistinguishable from the 2.5% a year that a U.S. 10-year T-bond will deliver over the same period. But the mathematics of bond pricing tells us that the negative skew on bond returns fully disappears when a yield approaches 3%. At which point the risk of bonds once again declines to become 'bond-like', and the required return on equities should once again rise to become 'equity-like'. This higher required return would necessarily require today's equity prices to drop, perhaps substantially. Admittedly in Europe there is a bigger gap between the expected returns from equities and bonds than there is in the U.S. The trouble is that global capital markets move together and a chain is only as strong as its weakest link. Hence, one lesson for 2018 is that investors should downgrade equities to neutral should the U.S. 10-year T-bond yield approach 3%. In this event, investors should redeploy the funds into U.S. T-bonds, because any substantial adjustment in risk-asset prices would trigger supportive flows into haven bonds, reversing the spike in yields. Euro/Dollar Hit A 3-Year High EUR/USD ended 2017 touching 1.21, a 3-year high. At first glance, this might seem odd given that the ECB has committed to maintaining its zero and negative interest rate policy for at least another year while the Federal Reserve has already hiked interest rates five times. But EUR/USD is not tracking short-term rate differentials. It is tracking long-term rate differentials, and EUR/USD at a 3-year high is fully consistent with the 30-year T-bond/German bund yield spread converging to its narrowest for several years (Chart I-4). Chart I-4Further Convergence In Long-Term Interest Rate Differentials Will Support EUR/USD Further Convergence In Long-Term Interest Rate Differentials Will Support EUR/USD Further Convergence In Long-Term Interest Rate Differentials Will Support EUR/USD Where will this yield spread go from here? Let's consider both sides of the spread. On the ECB side, policy is at the realistic limit of ultra-looseness, so policy rate expectations cannot go significantly lower, but they can go higher. On the Federal Reserve side, long-term policy rate expectations are not far from our upper bound of the 'high 2s' at which risk-assets become vulnerable to a sell-off, perhaps substantial. So these interest rate expectations cannot go sustainably higher, but they can go lower. Considering this strong asymmetry, the most likely outcome is that the 30-year T-bond/German bund yield spread will continue to converge. The upshot is that EUR/USD will continue to trend higher through 2018. No Connection Between Economic Outperformance And Stock Market Outperformance Chart I-5The Eurostoxx50 Underperformed Even Though##br## The Euro Area Economy Outperformed The Eurostoxx50 Underperformed Even Though The Euro Area Economy Outperformed The Eurostoxx50 Underperformed Even Though The Euro Area Economy Outperformed 2017 proved that there is no positive correlation between relative economic performance and relative equity market performance. For example, the euro area was one of the best performing developed economies, yet the Eurostoxx50 was one of the worst performing stock market indexes (Chart I-5). This seems odd, until you realise that major stock market indexes are dominated by multinational rather than domestic stocks. And that when stock markets have vastly different sector weightings, the sector effect completely swamps the domestic economy effect. Therefore the first decision for international equity investors should never be which regions to own. The first decision should always be which sectors to own, and above all whether to tilt to cyclicals or defensives. The regional and country allocation then just drops out automatically. At the moment, our mini-cycle framework for global growth suggests tilting to defensives rather than to cyclicals. Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging 8 months. As the current mini-upswing started last May we can infer that it is likely to end at some point in early 2018 (Chart I-6 and Chart I-7). So one surprise could be that global growth will lose steam in the first half of 2018 rather than in the second half - contrary to what the consensus is expecting. Chart I-6The Current Mini-Upswing##br## Is Long In The Tooth The Current Mini-Upswing Is Long In The Tooth The Current Mini-Upswing Is Long In The Tooth Chart I-7China Has Driven The Global 6-Month##br## Credit Impulse Higher China Has Driven The Global 6-Month Credit Impulse Higher China Has Driven The Global 6-Month Credit Impulse Higher We will provide further ammunition for our mini-cycle thesis in next week's report. In the meantime, we will leave you with one ramification of paring back equity exposure to cyclicals and redeploying to defensives. Stay overweight defensive-heavy Switzerland and Denmark. Realpolitik Will Prevent A Hard Brexit For the FTSE100, the paradox is that its relative performance is negatively correlated with relative economic performance. When the U.K. economy outperforms, the FTSE100 underperforms. And vice-versa (Chart I-8). Chart I-8FTSE 100 Relative Performance Is The Inverse ##br##Of U.K. Economic Relative Performance FTSE 100 Relative Performance Is The Inverse Of U.K. Economic Relative Performance FTSE 100 Relative Performance Is The Inverse Of U.K. Economic Relative Performance The simple explanation is that FTSE100 multinational sales and profits tend to be denominated in dollars and euros, whereas the FTSE100 index is denominated in pounds. The upshot is that an outperforming U.K. economy weighs on the U.K. stock market because a strengthening pound diminishes the FTSE100's multi-currency profits in pound terms. And vice-versa. Compared to a year ago, investors can be more optimistic about the long-term prospects for the U.K. economy and the pound (and therefore expect long-term underperformance from the FTSE100). This is because after the unexpectedly disastrous 2017 election for Theresa May, the parliamentary arithmetic simply does not support a hard Brexit. Furthermore, a hard Brexit would require either a North/South or East/West hard border in Ireland, which will be politically impossible to deliver. The constraints that come from this realpolitik means that Brexit's endpoint will retain much of the current trading relationship with the EU, albeit the journey to that eventual destination is likely to be a wild roller coaster ride. Therefore, the multi-year prognosis for GBP/USD is higher. But investors who want to optimize their timing into 'cable' can wait for one of the inevitable roller coaster dips in 2018. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* We are delighted to say that three of our recent trades quickly hit their profit targets: short bitcoin 29%, long silver 4.5% and long NZD/USD 3%. Against this, short Nikkei/long Eurostoxx50 hit its 3% stop-loss. This week's trade recommendation is to go short palladium. Set a profit target of 6% with a symmetrical stop-loss. This leaves us with three open trades. Chart I-9 Short Palladium Short Palladium 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. * 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 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. 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 For the time being, our cyclical stance is to underweight the globally-sensitive Energy, Materials and Banks sectors versus Healthcare - in both the equity and credit asset-class. Combined with our expectation of a weakening pound/euro, this necessarily means the following European equity market allocation: Overweight: France, Ireland, U.K., Switzerland and Denmark. Neutral: Germany, Netherlands and Sweden. Underweight: Italy, Spain, and Norway. We anticipate shifting to a more cyclical sector (and country) allocation by the late summer, especially on dips. Feature It is worth reminding readers that picking mainstream equity markets1 is overwhelmingly about the industry sectors and dominant stocks that you are buying, wittingly or unwittingly. Picking equity markets is seldom about the prospects of the underlying domestic economies or head-to-head valuations.2 Chart of the WeekGlobal Energy Has Just Tracked The Global 6-Month Credit Impulse (Down) Global Energy Has Just Tracked The Global 6-Month Credit Impulse (Down) Global Energy Has Just Tracked The Global 6-Month Credit Impulse (Down) The usual top-down approach to picking stock markets ignores two dominant features of these markets. First, they have huge variations in their sector exposures. Second, large industry sector groups like Energy, Banks, Healthcare and Technology tend to move en masse under the influence of global or regional rather than domestic drivers. The combination of these two features means that for most stock markets, the sector (and dominant company) impact swamps the effect that comes from the domestic economy. Right now, by far the most important consideration for country pickers is the relative outlook for the globally-sensitive Energy and Banks sectors versus the more defensive Healthcare. As an example, consider the choice between Spain and Switzerland. Spain's IBEX is at the mercy of its huge weighting to Banks, dominated by Santander and BBVA; while Switzerland's SMI is at the mercy of its similarly dominant weighting in the Healthcare sector, via Novartis and Roche. Box I-1 - Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks (Chart 2). France (CAC) is underweight Banks and Basic Materials (Chart 3). Italy (MIB) is overweight Banks (Chart 4). Spain (IBEX) is overweight Banks (Chart 5). Netherlands (AEX) is overweight Technology, underweight Banks (Chart 6). Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy (Chart 7). And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound (Chart 8). Switzerland (SMI) is overweight Healthcare, underweight Energy (Chart 9). Sweden (OMX) is overweight Industrials (Chart 10). Denmark (OMX20) is overweight Healthcare and Industrials (Chart 11). Norway (OBX) is overweight Energy (Chart 12). The U.S. (S&P500) is overweight Technology, underweight Banks (Chart 13). It follows that if Banks underperform Healthcare, it is highly likely that Spain's IBEX will underperform Switzerland's SMI, irrespective of the performances of the Spanish and Swiss domestic economies. For long-term investors, the large skews in sector exposure also mean that a head-to-head comparison of country valuations can be very misleading. At first glance, Spain, trading on a forward price to earnings (PE) multiple of 15.5, appears 15% cheaper than Switzerland, trading on a multiple of over 18. But this head-to-head difference just reflects the impact of forward PEs of Banks at 11 and Healthcare at 18. The Bank sector's lower multiple does not necessarily make it better value than Healthcare. Unlike two developed economies - whose long-term growth prospects tend to be broadly similar - two industry sectors could end up experiencing very different structural growth outcomes. Which would justify very different multiples. Despite its low multiple, a structural underweight to Banks might nonetheless be a good strategy if the sector's structural growth outlook is poor. In such a case, the low multiple is potentially a value trap. Picking Stock Markets The Right Way To reiterate, the decision to overweight or underweight a mainstream equity index should not be based on your view of the country's underlying economy - unless, of course, the country is the potential source of a major tail-risk event. Instead, the decision should be based on your over-arching sector view, combined with the country's skews to specific dominant stocks and sectors (Box I-1). Chart I-2, Chart I-3, Chart I-4, Chart I-5, Chart I-6, Chart I-7, Chart I-8, Chart I-9, Chart I-10, Chart I-11, Chart I-12 and Chart I-13 should leave readers in absolutely no doubt. A market's dominant sector skew is by far the most important determinant of its relative performance. Chart I-2Germany (DAX) Is Overweight Chemicals,##br## Underweight Banks Germany (DAX) Is Overweight Chemicals, Underweight Banks Germany (DAX) Is Overweight Chemicals, Underweight Banks Chart I-3France (CAC) Is Underweight Banks##br## And Basic Materials France (CAC) Is Underweight Banks And Basic Materials France (CAC) Is Underweight Banks And Basic Materials Chart I-4Italy (MIB) Is Overweight Banks Italy (MIB) Is Overweight Banks Italy (MIB) Is Overweight Banks Chart I-5Spain (IBEX) Is Overweight Banks Spain (IBEX) Is Overweight Banks Spain (IBEX) Is Overweight Banks Chart I-6Netherlands (AEX) Is Overweight Technology,##br## Underweight Banks Netherlands (AEX) Is Overweight Technology, Underweight Banks Netherlands (AEX) Is Overweight Technology, Underweight Banks Chart I-7Ireland (ISEQ) Is Overweight Airlines (Ryanair) ##br##Which Is, In Effect, Underweight Energy Ireland (ISEQ) Is Overweight Airlines (Ryanair) Which Is, In Effect, Underweight Energy Ireland (ISEQ) Is Overweight Airlines (Ryanair) Which Is, In Effect, Underweight Energy Chart I-8The U.K. (FTSE100) Is Effectively ##br##Underweight The Pound The U.K. (FTSE100) Is Effectively Underweight The Pound The U.K. (FTSE100) Is Effectively Underweight The Pound Chart I-9Switzerland (SMI) Is Overweight Healthcare, ##br##Underweight Energy Switzerland (SMI) Is Overweight Healthcare, Underweight Energy Switzerland (SMI) Is Overweight Healthcare, Underweight Energy Chart I-10Sweden (OMX) Is ##br##Overweight Industrials Sweden (OMX) Is Overweight Industrials Sweden (OMX) Is Overweight Industrials Chart I-11Denmark (OMX20) Is Overweight ##br##Healthcare And Industrials Denmark (OMX20) Is Overweight Healthcare And Industrials Denmark (OMX20) Is Overweight Healthcare And Industrials Chart I-12Norway (OBX) Is ##br##Overweight Energy Norway (OBX) Is Overweight Energy Norway (OBX) Is Overweight Energy Chart I-13The U.S. (S&P500) Is Overweight Technology, ##br##Underweight Banks The U.S. (S&P500) Is Overweight Technology, Underweight Banks The U.S. (S&P500) Is Overweight Technology, Underweight Banks Which brings us to the key consideration for country allocation right now: how to allocate to the sectors that feature most often in the skews: Energy and Banks versus Healthcare. For Energy relative performance, note the very strong recent connection with the global 6-month credit impulse. The downswing in the impulse - heralding a very clear growth pause - lines up with the setback in energy and resource prices and the underperformance of these globally-sensitive equity sectors (Chart of the Week and Chart I-14). Meanwhile, in the most recent mini-cycle, Banks' relative performance is tracking the bond yield almost tick for tick (Chart I-15). There are two reasons. For banks, lower bond yields presage both slimmer net interest margins and weaker economic growth. Chart I-14Commodity Price Inflation Is Just Tracking ##br##The Global 6-Month Credit Impulse Commodity Price Inflation Is Just Tracking The Global 6-Month Credit Impulse Commodity Price Inflation Is Just Tracking The Global 6-Month Credit Impulse Chart I-15Financials Are Just Tracking ##br##The Bond Yield Financials Are Just Tracking The Bond Yield Financials Are Just Tracking The Bond Yield So for both Energy and Banks relative performance the overriding question is: when will this mini-downswing end? To answer this question, we note that we are 4-5 months into the global mini-downswing, whose average duration tends to be around 8-9 months. On this basis, now is a little too early to switch to an aggressively pro-cyclical sector allocation. But we would look for potential opportunities by the late summer, especially on sharp dips. Hence, for the time being our cyclical stance is to underweight the globally-sensitive Energy (and Materials) and Banks versus Healthcare. Combined with our expectation of a weakening pound/euro, this necessarily means the following European country allocation: Overweight: France,3 Ireland, U.K., Switzerland and Denmark. Neutral: Germany, Netherlands, and Sweden. Underweight: Italy, Spain, Netherlands and Norway. Clearly, if you have a different cyclical and over-arching sector view, you will arrive at a different country allocation. That's fine. The important point is that the stock and sector skew approach is the right way to pick between mainstream equity indexes. Financials Drive The European Credit Market Finally, an over-arching sector view is also highly relevant for the European corporate credit market. In the euro area, the credit market is heavily skewed towards bank and other financial sector bonds, which account for almost half of euro area corporate bonds by value. By comparison, the U.S. credit market is not so skewed to one dominant sector. Hence, the outlook for the European credit asset-class hinges on the prospects for one sector: Financials (Chart 16). With the European high yield credit spread already close to a 20-year low, we would again wait for a better opportunity before adding aggressively to the European credit asset-class. Chart I-16Mirror Image: European High Yield Credit Spread And Bank Equity Prices Mirror Image: European High Yield Credit Spread And Bank Equity Prices Mirror Image: European High Yield Credit Spread And Bank Equity Prices Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In the developed world. 2 Please also see the three European Investment Strategy Special Reports 'Picking 5 European Countries The Right Way' November 13, 2014, 'Picking Countries The Right Way: Part 2' March 26, 2015 and 'Picking Countries The Right Way: Part 3' November 12, 2015. 3 But expect a small near-term countertrend underperformance in the CAC40. See page 11. Fractal Trading Model* There are no new trades this week. Last week's trade, long nickel / short palladium has made an encouraging countertrend move at the classic limit of a trend. 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-17 Long Nickel / Short Palladium Long Nickel / Short Palladium 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

We test three channels of contagion from the Brexit shock: political, banking system, and economic.

The latest conclusions from the sector-based (right) way to pick stock markets. Plus some important conclusions for credit markets.