Europe

Highlights Wage inflation in the EU28 is running at exactly the same rate as in the U.S. In the euro area, it is only modestly lower. As the current business cycle completes, the euro area versus U.S. bond yield spread will narrow, one way or the other. European equities are structurally handicapped by their substantial underexposure to technology, their substantial overexposure to financials, and the structurally undervalued currency. Still, there will be phases in which financials outperform technology and therefore in which European equities outperform. We anticipate that the next such phase to overweight European equities will occur later this year. In the near term, one European stock market that could outperform is Switzerland's SMI. Feature Largely unnoticed and without great fanfare, Europe has just overtaken the U.S. on a very important labour market measure. For the first time in living memory, the percentage of the working age (15-64) population that is in the labour force is higher in Europe than it is in the U.S., for both men and women (Chart of the Week). Chart of the WeekMale Labour Force Participation Is Now Higher In Europe Than In The U.S. Male Labour Force Participation Is Now Higher In Europe Than In The U.S. Male Labour Force Participation Is Now Higher In Europe Than In The U.S. One putative explanation is that as U.S. baby boomers have aged, people older than 64 have chosen to remain in the labour force, which has indirectly weighed on the U.S. 15-64 participation rate. But the phenomenon of baby boomers staying in the workforce is common to both Europe and the U.S. and cannot explain the extent of outperformance in European labour participation - a ten percentage point catch-up since the start of this millennium (Chart I-2). Chart I-2Labour Force Participation Is Now Higher ##br##In Europe Than In The U.S. Labour Force Participation Is Now Higher In Europe Than In The U.S. Labour Force Participation Is Now Higher In Europe Than In The U.S. The true explanation is that the European female participation rate has been in a major structural uptrend (Chart I-3) while the U.S. male participation rate has been in a major structural downtrend (Chart I-4). Chart I-3European Female Labour Force Participation##br## Is In A Structural Uptrend European Female Labour Force Participation Is In A Structural Uptrend European Female Labour Force Participation Is In A Structural Uptrend Chart I-4U.S. Male Labour Force Participation##br## Is In A Structural Downtrend U.S. Male Labour Force Participation Is In A Structural Downtrend U.S. Male Labour Force Participation Is In A Structural Downtrend Misleading Comparison 1: The Unemployment Rate In Europe Vs The U.S. This week, our purpose is not to discuss the reasons behind these labour participation trends - as we covered these in our recent report How Women Are Powering The European Economy.1 Rather, we want to point out one important repercussion: when the participation rate is changing, the unemployment rate is a misleading measure of labour market slack. When labour participation is rising, a seemingly high unemployment rate overstates true slack; conversely, when labour participation is falling, a seemingly low unemployment rate understates true slack. To understand why, consider a population in which the numbers employed, unemployed, and officially inactive stand at 95:5:25. The unemployment rate is 5%. But let's assume that ten officially inactive people could, with some mild encouragement, participate in the formal labour market. This means the true slack is fifteen people, or 14%.2 Now imagine that five of the officially inactive people join the formal labour force, albeit with a slightly higher unemployment rate given their inexperience in the formal labour force. Under these circumstances, the numbers employed, unemployed, and officially inactive might reasonably change to 99:6:20. The unemployment rate has increased to 5.7%, suggesting slack has increased. But the truth is that slack has actually decreased to eleven people, or 10%.3 Clearly, the process also works the other way. If somebody leaves the formal labour force, it might depress the unemployment rate, giving the impression of a tight labour market. But the impression would be misleading. As a recent paper from the Federal Reserve Bank of Boston pointed out:4 "Informal work arrangements, such as gig economy jobs... embodies an economically significant amount of labour market slack that is not captured in the U-3 unemployment rate and other standard estimates of slack... Informal work can be viewed as slack because most informal work participants would drop informal work for formal work, (thereby) adding potential labour supply to the formal market that could reduce pressure on measured wages" Is there any direct evidence for this thesis? Yes, the evidence is compelling. Standard measures of slack, such as the unemployment rate, suggest that the labour market has substantially more slack in Europe than in the U.S. (Chart I-5). Yet wage inflation is running at exactly the same rate in the EU28 as in the U.S. (Chart I-6). And in the euro area, it is only modestly lower (Chart I-7). Chart I-5The Unemployment Rate Suggests Much More ##br##Slack In Europe Than In The U.S. ... The Unemployment Rate Suggests Much More Slack In Europe Than In The U.S. ... The Unemployment Rate Suggests Much More Slack In Europe Than In The U.S. ... Chart I-6...But Wage Inflation ##br##Is Identical! ...But Wage Inflation Is Identical! ...But Wage Inflation Is Identical! Chart I-7Euro Area Wage Inflation##br## Is Not Far Behind Euro Area Wage Inflation Is Not Far Behind Euro Area Wage Inflation Is Not Far Behind This brings us to a glaring structural anomaly which must eventually correct. The gulf in monetary policy between the ECB and the Fed - reflected in the bond yield spread - has become unsustainably stretched relative to the economic fundamentals, specifically the difference in wage inflation which in reality is very modest (Chart I-8). As the current business cycle completes, we expect this bond yield spread to narrow, one way or the other. Chart I-8The U.S.-Euro Area Bond Yield Spread Is Stretched ##br##Relative To The Wage Inflation Differential The U.S.-Euro Area Bond Yield Spread Is Stretched Relative To The Wage Inflation Differential The U.S.-Euro Area Bond Yield Spread Is Stretched Relative To The Wage Inflation Differential Misleading Comparison 2: Equity Valuations In Europe Vs The U.S. Staying on the theme of Europe versus U.S. comparisons which are highly misleading, let's share one of the most common questions we get: are European equities relatively cheap, as their headline valuation suggests? The answer is an emphatic no. Compared with currencies and bonds, mainstream stock markets have little connection with the economies of their countries or regions of domicile. Mainstream stock markets are just collections of multinational companies, with each stock market defined by its own unique sector fingerprint. Sectors with vastly different structural growth prospects - say, financials and technology - must necessarily trade on vastly different valuations. So the sector with the lower headline valuation is not necessarily the cheaper sector. By extension, the stock market with the lower headline valuation because of its sector fingerprint is not necessarily the cheaper stock market. This means that a head-to-head comparison of European stock market valuations either with each other or with non-European stock markets is highly misleading. To which, a frequent follow-up question is: within the same sector, are European companies cheaper than their counterparts elsewhere in the world? The answer is, not necessarily. To understand why, consider the international cruise company Carnival which has a dual listing, one in London, one in New York. The London listing has recently traded at a substantial discount to the New York listing (Chart I-9 and Chart I-10). Does this mean that the London listing is cheap? Of course not. If it were, the markets would arbitrage away this valuation anomaly instantaneously! Chart I-9Carnival Can Trade On A Different Valuation##br## In London And New York... Carnival Can Trade On A Different Valuation In London And New York... Carnival Can Trade On A Different Valuation In London And New York... Chart I-10...Because Of The Currency##br## Translation Effect ...Because Of The Currency Translation Effect ...Because Of The Currency Translation Effect On the face of it, the valuations of Carnival's two listings should be the same because the underlying company is the same. However, the London and New York valuations can deviate substantially because of the so-called 'currency translation effect'. An international company like Carnival will intentionally receive its sales and profits across multiple global currencies - say, dollars and pounds, but a stock market listing is denominated in just one currency. If investors anticipate the dollar ultimately to weaken versus the pound - because they see that the pound is structurally cheap today - they might downgrade Carnival's multi-currency profit growth expectations in pound terms. Thereby, the London listing will trade at a discount to the New York listing. But the discount is a false impression. Allowing for the anticipated decline in the dollar versus the pound, the London listing is not cheap. It follows that any multinational listed in Europe will give a false impression of cheapness if investors see European currencies as structurally undervalued. European Equity Relative Performance Has Little Connection With European Economic Relative Performance Given the large distortions to stock market valuations from sector effects and currency translation effects, picking markets on the basis of relative valuation is a 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. This creates a paradox. The overall economic fundamentals in Europe, correctly measured, are not inferior to those in the United States. Yet European stock market relative performance has very little to do with Europe's relative economic performance. European equities are structurally handicapped by their substantial underexposure to technology, their substantial overexposure to financials, and the structurally undervalued currency. Unfortunately, this will necessarily weigh on their long-term relative performance prospects. Still, there will be phases in which financials outperform technology and therefore in which European equities outperform other major markets. We anticipate that the next such phase to overweight European equities will occur later this year. In the near term, one European stock market that could outperform is Switzerland's SMI. Given its overweighting to healthcare - Novartis and Roche - and healthcare's outperformance this year, the SMI should have fared well in the first half. However, this tailwind was countered by a stronger headwind - the SMI has a huge underweight to oil and gas, which is the one cyclical sector that has outperformed. But as we pointed out last week, the performance of oil and gas equities is technically stretched, and will require strong momentum in the crude price to extend further. Therefore, we like the combination of overweight healthcare, underweight oil and gas - which is precisely what Switzerland's SMI offers (Chart I-11). Chart I-11Switzerland = Long Healthcare, Short Energy Switzerland = Long Healthcare, Short Energy Switzerland = Long Healthcare, Short Energy Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report, 'How Women Are Powering The European Economy' dated June 7, 2018 available at eis.bcaresearch.com 2 5/(95+5) = 5%, (5+10)/(95+5+10) = 14% 3 6/(99+6) =5.7%, (6+5)/(99+6+5) = 10% 4 The Federal Reserve Bank of Boston Current Policy Perspectives No. 18-2 'Wage Inflation and Informal Work' by Anat Bracha and Mary A. Burke, October 2017. Fractal Trading Model This week we note that the outperformance of consumer services versus consumer goods is technically stretched. The 65-day fractal dimension is at a limit that has reliably signalled reversals. The recommended trade is short global consumer services versus consumer goods. Set a profit target of 2.5% 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-12 Long Consumer Goods Vs. Consumer Services Long Consumer Goods Vs. Consumer Services 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

NOTE: We will not be publishing a report next week. The next Global Fixed Income Strategy Weekly Report will be published on Tuesday, July 10th. Highlights Global Corporates: The clash between monetary policy and the markets that we have been expecting to unfold in 2018 is upon us. Downgrade global spread product exposure to neutral (3 of 5) from overweight, and raise government bond exposure to neutral. Maintain a below-benchmark portfolio duration, however, as global bond yields have not yet peaked for this cycle. Country Allocation: Move to neutral on U.S. investment grade and high-yield corporates, while staying underweight (2 of 5) on euro area corporates. Downgrade emerging market hard currency sovereign and corporate debt to maximum underweight (1 of 5) - the combination of a rising dollar, Fed tightening and slower Chinese growth will remain a huge problem for emerging market assets. Feature Chart Of The Week3 Big Reasons To Downgrade Spread Product 3 Big Reasons To Downgrade Spread Product 3 Big Reasons To Downgrade Spread Product Last week, BCA as a firm moved to a less positive stance on global equities and credit, downgrading both to neutral from overweight on a cyclical (6-12 month) horizon.1 Dating back to our 2018 Outlook published at the end of last December, we had anticipated that we would be shifting to a less aggressive asset allocation sometime around mid-year.2 The expected trigger would be a move by central banks to a more restrictive policy stance that would start to impact future growth expectations. That time has come, and we are now recommending moving to a less bullish stance on global credit. Many of the tailwinds that supported the stellar performance of risk assets in 2017 - most importantly, coordinated global growth, accommodative monetary policies and a weakening U.S. dollar - have transformed into headwinds over the course of 2018 and are unlikely to reverse before risk assets suffer a setback (Chart of the week). At a minimum, there is now enough uncertainty, at a time when many asset classes are richly priced, to make the risk/reward balance for being long growth-sensitive assets like equities and corporate debt less attractive. This week, we are downgrading our recommended stance on global spread product to neutral (3 out of 5) from overweight, while upgrading our recommended allocation for government bonds to neutral from underweight. This represents an unwind of a long-standing recommendation that dates back to January 31st, 2017 when we strategically downgraded U.S. Treasury exposure and upgraded U.S. corporate debt.3 We are closing that recommendation at a relative total return gain of 2.3% for U.S. investment grade and 6.7% for U.S. high-yield over Treasuries (Chart 2). Chart 2Closing A Successful Overweight Stance ##br##On U.S. Corporates Time To Take Some Chips Off The Table: Downgrade Global Corporate Bond Exposure To Neutral Time To Take Some Chips Off The Table: Downgrade Global Corporate Bond Exposure To Neutral We still believe that global bond yields will remain under upward pressure from both higher inflation and a less favorable supply/demand balance for fixed income (more issuance, less central bank buying). The fact that bond yields will NOT be able to fall much to reinvigorate softening global growth - because of rising inflation at a time of diminished economic slack - is a critical reason why we are turning more cautious on global credit. Thus, we are maintaining our recommended below-benchmark overall portfolio duration stance, even as we upgrade our government bond allocation to neutral. We recommend placing the proceeds of a reduction of global corporate debt exposure into shorter-maturity government bonds, which we are doing in our model bond portfolio (see page 15). At the country level, we are downgrading U.S. corporate bonds, both investment grade and high-yield, to neutral from overweight. We still are of the view that U.S. corporates are better positioned to outperform non-U.S. credit, however, even in a more challenging environment for credit returns. Thus we are keeping our recommended underweight allocations to euro area corporate debt (2 out of 5 for both investment grade and high-yield). We see a much nastier backdrop brewing for emerging markets (EM), however - a stronger dollar, higher U.S. interest rates, slowing Chinese growth, diminished global capital flows - so we are downgrading both EM hard currency sovereign and corporate debt to maximum underweight (1 out of 5). In terms of other spread product categories, we are maintaining our neutral allocation to U.S. mortgage-backed securities, while downgrading U.K. and Canadian corporate debt to underweight. For those that can invest in U.S. muni debt, we are upgrading that sector to overweight (4 out of 5). The Reasons To Cut Corporate Credit Exposure Now Global credit has not performed well in the first half of 2018, with only U.S. high-yield corporates providing a positive return year-to-date among the major markets: U.S. investment grade: -3.6% total return, -1.7% excess return over duration-matched Treasuries U.S. high-yield: +0.7% total return, +1.5% excess return Euro area investment grade: -0.3% total return, -1.1% excess return Euro area high-yield: -0.5% total return, -1.0% excess return EM USD-denominated sovereign debt: -5.5% total return, -3.6% excess return EM USD-denominated corporate debt: -2.9% total return, -1.7% excess return Chart 3The Start Of Something Big? The Start Of Something Big? The Start Of Something Big? While there have been plenty of geopolitical tensions for markets to fret over this year (U.S. trade policy, North Korea), the biggest reason for the underperformance of credit is due to the most typical of reasons - tightening global monetary policy. One way to measure the stance of monetary policy is to look at the slope of government bond yield curves. According to the Bloomberg Barclays government bond index data, the "global yield curve" - the spread between the Global Treasury index yield for the 7-10 year and 1-3 year maturity buckets - is now a mere 6bps (Chart 3). That is the flattest the global curve has been since the first quarter of 2007. That is a potentially ominous sign given that the Global Financial Crisis began brewing around the same time. The global yield curve became deeply inverted in the late 1990s, as well, which preceeded the 1998 EM crisis and, later, the global telecom bust. Fundamentally, we see four main reasons to downgrade global credit now: 1. Global growth is slowing and becoming less synchronized The first half of 2018 has seen a deceleration of global economic activity from the robust pace of 2017. This has been a broad-based cooling of activity so far, with cyclical indicators like manufacturing PMIs still well above the 50 level that suggests expanding growth in all major economies. Yet there are signs that the pullback in growth may persist throughout 2018 and into 2019. The OECD's global leading economic indicator (LEI) is rolling over and our LEI diffusion index - a leading indicator of the LEI - suggests additional weakness should be expected. This is significant for credit markets, as returns on corporate bonds are highly correlated to the swings in the global LEI (Chart 4). This is true even in the U.S., which is bucking the slowing global growth trend and where confidence is booming and domestic leading indicators are accelerating (Chart 5). Chart 4Corporate Bonds Follow The Global LEI Corporate Bonds Follow The Global LEI Corporate Bonds Follow The Global LEI Chart 5Upside Risks For U.S. Growth Upside Risks For U.S. Growth Upside Risks For U.S. Growth That easing of non-U.S. growth is likely rooted in the slowdown underway in China. Policymakers there have been tightening monetary conditions and acting to reign in excessive debt growth. This has resulted in a slowing of overall economic growth after the stimulus-fueled boom in 2016 that helped kick-start global growth last year through robust Chinese imports and consumption of industrial commodities. Given the sheer size of Chinese demand, the global economy will look very different when Chinese imports are growing at a 30% pace rather than the current pace below 10%. Our most reliable forward-looking indicators for Chinese growth, like our Li Keqiang leading indicator, are calling for additional cooling of Chinese economic activity in the latter half of 2018 (Chart 6). This reinforces the signal given by our global LEI diffusion index, with both indicating that additional struggles in the performance of global credit markets should be expected (based off the relationship shown in Chart 4). One additional point: the ongoing trade tensions between the Trump administration and all of the major U.S. trading partners represents an additional potential downside risk to global growth. The story is still quite fluid, as it always is with this president, but the uncertainty created by the trade frictions is definitely a negative for risk assets, at a minimum. 2. Global inflation pressures are rising, most notably in the U.S. Even with the latest dip in non-U.S. growth, the global economy is still operating with the least amount of spare capacity since the mid-2000s boom. The U.S. unemployment rate is down to 3.8%, the lowest level in eighteen years. 75% of OECD countries now have unemployment rates below the OECD's estimate of the full-employment NAIRU, with capacity utilization rates also rising. The pricing backdrop is as healthy as it has been since 2011, according to the measure of world export prices from the Netherlands-based Bureau for Economic Policy Analysis which is now growing at a 10% annual rate (Chart 7). Chart 6Downside Risks For Chinese Growth Downside Risks For Chinese Growth Downside Risks For Chinese Growth Chart 7A More Inflationary Global Backdrop, Especially In The U.S. A More Inflationary Global Backdrop, Especially In The U.S. A More Inflationary Global Backdrop, Especially In The U.S. The previous two times export prices grew that rapidly in 2008 and 2011 - two very challenging years for financial markets - global CPI inflation rates expanded rapidly, especially in the U.S. Headline CPI inflation ended up reaching peaks of 6% and 4%, respectively, during those prior two episodes. Non-U.S. inflation rates also accelerated, but not to the same degree as in the U.S. A similar dynamic is playing out in 2018, with U.S. inflation rates accelerating (both headline and core), at a faster pace than in the other major developed economies. With the U.S. labor market growing tighter each month, and with U.S. growth likely to continue expanding at an above-potential pace for the next few quarters, it is unlikely that the current upturn in U.S. inflation will slow on its own. This will ensure that the Fed will continue on its planned monetary tightening path that will soon take U.S. monetary conditions into restrictive territory - eventually weighing on U.S. growth expectations and raising concerns over future downgrade and default risks, and returns, in U.S. corporate bond markets. 3. Growth and monetary policy divergences will continue to boost the value of the U.S. dollar The divergences between growth, inflation and monetary policy in the U.S. and the rest of the world are now helping raise the value of the U.S. dollar, which had declined nearly 10% on peak-to-trough basis in 2017. The dollar has been rising in 2018, which has been weighing on EM currencies and financial markets as is typically the case during periods of dollar strength. EM economies have been rapidly accumulating dollar-denominated debt in recent years, leaving EM borrowers as highly exposed to the swings in the dollar and interest rates as they have been since the late 1990s. The current backdrop is setting itself up for a repeat of the 2015/16 period when pro-U.S. growth divergences caused the dollar to soar and triggered major selloffs in EM financial assets that spilled over into U.S. and developed market equities and credit (Chart 8). Right now, the moves have been far more modest than seen in the 2015/16 period. Since the start of 2018, the U.S. trade-weighted dollar is up 4% and EM equities are down -6% (in U.S. dollar terms), while U.S. investment grade credit spreads have risen 37bps from the February lows. This is far less than the moves seen in 2015/16, where the dollar rose 16%, EM equities sold off -34% and U.S. credit spreads widened nearly 100bps. Those moves were enough to cause the Fed to delay its rate hike plans after the initial post-QE rate hike in December 2015, triggering a significant decline in U.S. bond yields (bottom panel) and the dollar that eventually stabilized global financial markets. With the U.S. economy in a much healthier position today than two years ago, and with U.S. core inflation running close to the Fed's 2% target, it will take much larger market moves than have been seen of late before the Fed would consider taking a pause on its current 25bps-per-quarter pace of rate hikes. The mechanism for that to happen will be a stronger dollar and any associated impact on U.S. financial markets. However, it must be a very large move (as it was in 2015/16) to have enough of a negative impact on the U.S. economy, U.S. corporate profits or U.S. inflation for financial markets, and the Fed, to take notice. In Chart 9, we show the U.S. trade-weighted dollar with three different scenarios for the change in the currency to the end of 2018: flat, up 5% and up 10%. We show the dollar in level terms in the top panel, while showing the year-over-year growth rate of the dollar (on an inverted scale) in the bottom three panels. In those last three panels, we also show the potential areas where a strong dollar would impact the U.S. economy the most: net exports, corporate profit growth from earnings earned outside the U.S. (using top-down profit data) and headline inflation. Chart 82015/16 Revisited? Not Yet 2015/16 Revisited? Not Yet 2015/16 Revisited? Not Yet Chart 9A Much Stronger USD Is Needed To Impact U.S. Growth & Inflation A Much Stronger USD Is Needed To Impact U.S. Growth & Inflation A Much Stronger USD Is Needed To Impact U.S. Growth & Inflation The charts show that a 10% rise in the dollar by year-end would likely take enough of a bite out of U.S. growth and inflation for U.S. equity and credit markets to sell off and for the Fed to take a pause on its rate hike plans. A more modest 5% rise in the dollar will have a more muted impact, especially with stronger underlying U.S. growth and inflation pressures than was the case in 2015/16. That latter scenario of a more moderate rise in the dollar would be our most likely scenario - one that would prove to be challenging for U.S. credit market performance. The dollar increase would be enough to keep EM financial markets on the defensive, but would not be large enough to get Fed rate hikes out of the way and allow for a big decline in Treasury yields that would help support risk assets. A slowly rising dollar is another reason to reduce credit exposure in fixed income portfolios. 4. Central bank liquidity provision through asset purchases is slowing rapidly One of our major themes for 2018 has been that the removal of the extraordinary liquidity expansion by central banks would weigh on asset returns. This would occur through the Fed allowing maturing bonds accumulated during its QE program to begin running off its balance sheet, and through a slower pace of bond buying in the case of the European Central Bank (ECB) and the Bank of Japan (BoJ). Already, the increase in developed market bond yields, and the lowering of returns in global equities and credit, have largely followed the path laid out by our indicator of central bank liquidity provision - the annual growth in the balance sheets of the Fed, ECB, BoJ and Bank of England (Chart 10). Our central bank liquidity indicator suggests that there is still more upside for global government bond yields as central banks become less directly active in bond markets. At the same time, the diminished liquidity growth means there is less investor money to be forced out of risk-free government bonds into risky assets like corporate credit, which should help erode credit market returns on the margin. This will occur through reduced inflows into credit that are just chasing yield, and a return to more fundamental drivers of credit market valuation like growth, inflation, leverage and downgrade/default risks - all of which are now on the rise in the U.S. Bottom Line: The clash between monetary policy and the markets that we have been expecting to unfold in 2018 is upon us. Tightening monetary policies, rising bond yields, slowing global growth, widening growth divergences, increasing U.S. inflation pressures, a strengthening U.S. dollar, emerging market instability, diminished central bank liquidity, reduced global capital flows, global trade tensions - all are now creating a backdrop that is more challenging for risk assets. Downgrade global spread product exposure to neutral (3 of 5) from overweight, and raise government bond exposure to neutral. Maintain a below-benchmark portfolio duration, however, as global bond yields have not yet peaked for this cycle. Asset Allocation Decisions To Be Made So in terms of our fixed income asset allocation recommendations, but in our strategic tables on page 16 and our model bond portfolio on page 15, we are making the following changes: Downgrade U.S. Investment Grade & High-Yield Corporates To Neutral (3 out of 5) The bulk of our primary indicators for U.S. credit are at levels that are consistent with a neutral allocation (Chart 11). Our top-down Corporate Health Monitor is right at the line dividing the deteriorating health and improving health regimes (although this is only because of a cyclical improvement in some of the underlying indicators). U.S. monetary policy is close to neutral, as measured by the real fed funds rate versus the Fed's r-star estimate. The U.S. Treasury curve is very flat, although it is not yet inverted as typically precedes the end of a credit cycle. Finally, bank lending standards are only modestly in "net easing" territory according to the Fed's senior loan officer survey. Chart 10Fading Impact Of Global QE On Bond Markets Fading Impact Of Global QE On Bond Markets Fading Impact Of Global QE On Bond Markets Chart 11Downgrade U.S. IG & HY Corporates To Neutral Downgrade U.S. IG & HY Corporates To Neutral Downgrade U.S. IG & HY Corporates To Neutral With all these indicators hovering around neutral levels, a neutral allocation to U.S. corporates seems justified. Additionally, we recommend cutting across all credit tiers for both investment grade and high-yield, rather than focusing on cutting a specific tier more than another. Our preferred valuation metric - the 12-month breakeven spread relative to its history - is near the bottom quartile for all credit tiers (Charts 12 & 13) without one looking particularly more expensive than the others. Chart 12Not Much Of A Spread Cushion In U.S. Investment Grade ... Not Much Of A Spread Cushion In U.S. Investment Grade ... Not Much Of A Spread Cushion In U.S. Investment Grade ... Chart 13... Or U.S. High-Yield ... Or U.S. High-Yield ... Or U.S. High-Yield Keep Euro Area Investment Grade & High-Yield At Underweight (2 out of 5) We have maintained this strategic view based on the convergence between our top-down Corporate Health Monitors for both the U.S. and euro area. Right now, the cyclical improvement in U.S. financial metrics has come at the same time as a cyclical deterioration of euro area metrics from very healthy levels (Chart 14). The spread between the two Monitors has proven to be a good directional indicator for the relative performance between U.S. and euro area credit. That spread continues to point to additional expected outperformance by U.S. corporates, even in an overall more challenging environment for global credit markets. Throw in increased Italian political turmoil, softer euro area growth and the upcoming ECB tapering of its asset purchases - which will include corporate debt that the ECB has been buying steadily for the past three years - and the case for underweighting euro area corporates, especially versus U.S. equivalents, is a strong one. Downgrade EM Hard Currency Sovereign & Corporate Debt To Maximum Underweight (1 out of 5) We have been favoring U.S. investment grade credit over EM credit the past several months. The growth divergence between the U.S. and EM has been widening, while EM market valuations had gotten very rich. Now, EM spread widening is starting to correct that mis-valuation, although is still early in the process. The spread differential between U.S and EM credit is a good leading indicator of the relative returns between the two asset classes (Chart 15), thus last year's EM outperformance is leading to this year's underperformance. Chart 14Stay Underweight Euro Area Corporates Stay Underweight Euro Area Corporates Stay Underweight Euro Area Corporates Chart 15Move To Maximum Underweight EM Credit Move To Maximum Underweight EM Credit Move To Maximum Underweight EM Credit We wish to maintain the same "two notch" gap between our recommended level of U.S. and EM credit exposure, so by downgrading U.S. corporates to neutral (3 of 5), we must downgrade EM corporates to maximum underweight (1 of 5). All of the above changes will be reflected in our model bond portfolio on page 15. One final point - we should lay out the case for out next move from here. If the Fed tightening cycle goes as we envision it will, with U.S. growth staying strong and inflation expectations rising back to levels consistent with the Fed's inflation target, then we expect the next move will be to downgrade U.S. corporates to underweight. However, if there is enough of a market setback to cause the Fed to delay its rate hike cycle, as was the case in 2016, then we may consider moving back to overweight U.S. corporates on a tactical basis. We suspect, however, that the moves today are the beginning of the end game for the current credit cycle - the negatives for corporates are now outweighing the positives, and that gap is likely to get wider in the coming months. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 19th 2018, available at gis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "2018 Key Views: BCA's Outlook & What It Means For Global Fixed Income Markets", dated December 5th 2017, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "The Global Growth Upturn Has Legs: Reduce Duration, Upgrade Credit Exposure", dated January 31st 2017, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Time To Take Some Chips Off The Table: Downgrade Global Corporate Bond Exposure To Neutral Time To Take Some Chips Off The Table: Downgrade Global Corporate Bond Exposure To Neutral Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Feature Valuations, whether for currencies, equities or bonds, are always at the top of the list of the determinants of any asset's long-term performance. This means that after large FX moves like those experienced so far this year, it is always useful to pause and reflect on where currency valuations stand. In this optic, this week we update our set of long-term valuation models for currencies that we introduced In February 2016 in a Special Report titled, "Assessing Fair Value In FX Markets". Included in these models are variables such as productivity differentials, terms-of-trade shocks, net international investment positions, real rate differentials and proxies for global risk aversion.1 These models cover 22 currencies, incorporating both G-10 and EM FX markets. Twice a year, we provide clients with a comprehensive update of all these long-term models in one stop. The models are not designed to generate short- or intermediate-term forecasts. Instead, they reflect the economic drivers of a currency's equilibrium. Their purpose is therefore threefold. First, they provide guideposts to judge whether we are at the end, beginning or middle of a long-term currency cycle. Second, by providing strong directional signals, they help us judge whether any given move is more likely to be a countertrend development or not, offering insight on its potential longevity. Finally, they assist us and our clients in cutting through the fog, and understanding the key drivers of cyclical variations in a currency's value. The U.S. Dollar Chart 1Dollar: Back At Fair Value Dollar: Back At Fair Value Dollar: Back At Fair Value 2017 was a terrible year for the dollar, but the selloff had one important positive impact: it erased the dollar's massive overvaluation that was so evident in the direct wake of U.S. President Donald Trump's election. In fact, today, based on its long-term drivers, the dollar is modestly cheap (Chart 1). Fair value for the dollar is currently flattered by the fact that real long-term yields are higher in the U.S. than in the rest of the G-10. Investors are thus betting that U.S. neutral interest rates are much higher than in other advanced economies. This also means that the uptrend currently evident in the dollar's fair value could end once we get closer to the point where Europe can join the U.S. toward lifting rates - a point at which investors could begin upgrading their estimates of the neutral rate in the rest of the world. This would be dollar bearish. For the time being, we recommend investors keep a bullish posturing on the USD for the remainder of 2018. Not only is global growth still slowing, a traditionally dollar-bullish development, but also the fed funds rate is likely to be moving closer to r-star. As we have previously showed, when the fed funds rate rises above r-star, the dollar tends to respond positively.2 Finally, cyclical valuations are not a handicap for the dollar anymore. The Euro Chart 2The Euro Is Still Cheap The Euro Is Still Cheap The Euro Is Still Cheap As most currencies managed to rise against the dollar last year, the trade-weighted euro's appreciation was not as dramatic as that of EUR/USD. Practically, this also means that despite a furious rally in this pair, the broad euro remains cheap on a cyclical basis, a cheapness that has only been accentuated by weakness in the euro since the first quarter of 2018 (Chart 2). The large current account of the euro area, which stands at 3.5% of GDP, is starting to have a positive impact on the euro's fair value, as it is lifting the currency bloc's net international investment position. Moreover, euro area interest rates may remain low relative to the U.S. for the next 12 to 18 months, but the 5-year forward 1-month EONIA rate is still near rock-bottom levels, and has scope to rise on a multi-year basis. This points toward a continuation of the uptrend in the euro's fair value. For the time being, despite a rosy long-term outlook for the euro, we prefer to remain short EUR/USD. Shorter-term fair value estimates are around 1.12, and the euro tends to depreciate against the dollar when global growth is weakening, as is currently the case. Moreover, the euro area domestic economy is not enjoying the same strength as the U.S. right now. This creates an additional handicap for the euro, especially as the Federal Reserve is set to keep increasing rates at a pace of four hikes a year, while the European Central Bank remains as least a year away from lifting rates. The Yen Chart 3Attractive Long-Term Valuation, But... Attractive Long-Term Valuation, But... Attractive Long-Term Valuation, But... The yen remains one of the cheapest major currencies in the world (Chart 3), as the large positive net international investment position of Japan, which stands at 64% of GDP, still constitutes an important support for it. Moreover, the low rate of Japanese inflation is helping Japan's competitiveness. However, while valuations represent a tailwind for the yen, the Bank of Japan faces an equally potent headwind. At current levels, the yen may not be much of a problem for Japan's competitiveness, but it remains the key driver of the country's financial conditions. Meanwhile, Japanese FCI are the best explanatory variable for Japanese inflation.3 It therefore follows that any strengthening in the yen will hinder the ability of the BoJ to hit its inflation target, forcing this central bank to maintain a dovish tilt for the foreseeable future. As a result, while we see how the current soft patch in global growth may help the yen, we worry that any positive impact on the JPY may prove transitory. Instead, we would rather play the yen-bullish impact of slowing global growth and rising trade tensions by selling the euro versus the yen than by selling the USD, as the ECB does not have the same hawkish bias as the Fed, and as the European economy is not the same juggernaut as the U.S. right now. The British Pound Chart 4Smaller Discount In The GBP Smaller Discount In The GBP Smaller Discount In The GBP The real-trade weighted pound has been appreciating for 13 months. This reflects two factors: the nominal exchange rate of the pound has regained composure from its nadir of January 2017, and higher inflation has created additional upward pressures on the real GBP. As a result of these dynamics, the deep discount of the real trade-weighted pound to its long-term fair value has eroded (Chart 4). The risk that the May government could fall and be replaced either by a hard-Brexit PM or a Corbyn-led coalition means that a risk premia still needs to be embedded in the price of the pound. As a result, the current small discount in the pound may not be enough to compensate investors for taking on this risk. This suggests that the large discount of the pound to its purchasing-power-parity fair value might overstate its cheapness. While the risks surrounding British politics means that the pound is not an attractive buy on a long-term basis anymore, we do like it versus the euro on a short-term basis: EUR/GBP tends to depreciate when EUR/USD has downside, and the U.K. economy may soon begin to stabilize as slowing inflation helps British real wages grow again after contracting from October 2016 to October 2017, which implies that the growth driver may move a bit in favor of the pound. The Canadian Dollar Chart 5CAD Near Fair Value CAD Near Fair Value CAD Near Fair Value The stabilization of the fair value for the real trade-weighted Canadian dollar is linked to the rebound in commodity prices, oil in particular. However, despite this improvement, the CAD has depreciated and is now trading again in line with its long-term fair value (Chart 5). This lack of clear valuation opportunity implies that the CAD will remain chained to economic developments. On the negative side, the CAD still faces some potentially acrimonious NAFTA negotiations, especially as U.S. President Donald Trump could continue with his bellicose trade rhetoric until the mid-term elections. Additionally, global growth is slowing and emerging markets are experiencing growing stresses, which may hurt commodity prices and therefore pull the CAD's long-term fair value lower. On the positive side, the Canadian economy is strong and is exhibiting a sever lack of slack in its labor market, which is generating both rapidly growing wages and core inflation of 1.8%. The Bank of Canada is therefore set to increase rates further this year, potentially matching the pace of rate increase of the Fed over the coming 24 months. As a result of this confluence of forces, we are reluctant to buy the CAD against the USD, especially as the former is strong. Instead, we prefer buying the CAD against the EUR and the AUD, two currencies set to suffer if global growth decelerates but that do not have the same support from monetary policy as the loonie. The Australian Dollar Chart 6The AUD Is Not Yet Cheap The AUD Is Not Yet Cheap The AUD Is Not Yet Cheap The real trade-weighted Australian dollar has depreciated by 5%, which has caused a decrease in the AUD's premium to its long-term fair value. The decline in the premium also reflects a small upgrade in the equilibrium rate itself, a side effect of rising commodity prices last year. However, despite these improvements, the AUD still remains expensive (Chart 6). Moreover, the rise in the fair value may prove elusive, as the slowdown in global growth and rising global trade tensions could also push down the AUD's fair value. These dynamics make the AUD our least-favored currency in the G-10. Additionally, the domestic economy lacks vigor. Despite low unemployment, the underemployment rate tracked by the Reserve Bank of Australia remains nears a three-decade high, which is weighing on both wages and inflation. This means that unlike in Canada, the RBA is not set to increase rates this year, and may in fact be forced to wait well into 2019 or even 2020 before doing so. The AUD therefore is not in a position to benefit from the same policy support as the CAD. We are currently short the AUD against the CAD and the NZD. We have also recommended investors short the Aussie against the yen as this cross is among the most sensitive to global growth. The New Zealand Dollar Chart 7NZD Vs Fair Value NZD Vs Fair Value NZD Vs Fair Value After having traded at a small discount to its fair value in the wake of the formation of a Labour / NZ first coalition government, the NZD is now back at equilibrium (Chart 7). The resilience of the kiwi versus the Aussie has been a key factor driving the trade-weighted kiwi higher this year. Going forward, a lack of clearly defined over- or undervaluation in the kiwi suggests that the NZD will be like the Canadian dollar: very responsive to international and domestic economic developments. This gives rise to a very muddled picture. Based on the output and unemployment gaps, the New Zealand economy seems at full employment, yet it has not seen much in terms of wage or inflationary pressures. As a result, the Reserve Bank of New Zealand has refrained from adopting a hawkish tone. Moreover, the populist policy prescriptions of the Ardern government are also creating downside risk for the kiwi. High immigration has been a pillar behind New Zealand's high-trend growth rate, and therefore a buttress behind the nation's high interest rates. Yet, the government wants to curtail this source of dynamism. On the international front, the kiwi economy has historically been very sensitive to global growth. While this could be a long-term advantage, in the short-term the current global growth soft patch represents a potent handicap for the kiwi. In the end, we judge Australia's problems as deeper than New Zealand's. Since valuations are also in the NZD's favor, the only exposure we like to the kiwi is to buy it against the AUD. The Swiss Franc Chart 8The SNB's Problem The SNB's Problem The SNB's Problem On purchasing power parity metrics, the Swiss franc is expensive, and the meteoric rise of Swiss unit labor costs expressed in euros only confirms this picture. The problem is that this expensiveness is justified once other factors are taken into account, namely Switzerland's gargantuan net international investment position of 128% of GDP, which exerts an inexorable upward drift on the franc's fair value. Once this factor is incorporated, the Swiss franc currently looks cheap (Chart 8). The implication of this dichotomy is that the Swiss franc could experience upward pressure, especially when global growth slows, which is the case right now. However, the Swiss National Bank remains highly worried that an indebted economy like Switzerland, which also suffers from a housing bubble, cannot afford the deflationary pressures created by a strong franc. As a result, we anticipate that the SNB will continue to fight tooth and nail against any strength in the franc. Practically, we are currently short EUR/CHF on a tactical basis. Nonetheless, once we see signs that global growth is bottoming, we will once again look to buy the euro against the CHF as the SNB will remain in the driver's seat. The Swedish Krona Chart 9What The Riksbank Wants What The Riksbank Wants What The Riksbank Wants The Swedish krona is quite cheap (Chart 9), but in all likelihood the Riksbank wants it this way. Sweden is a small, open economy, with total trade representing 86% of GDP. This means that a cheap krona is a key ingredient to generating easy monetary conditions. However, this begs the question: Does Sweden actually need easy monetary conditions? We would argue that the answer to this question is no. Sweden has an elevated rate of capacity utilization as well as closed unemployment and output gaps. In fact, trend Swedish inflation has moved up, albeit in a choppy fashion, and the Swedish economy remains strong. Moreover, the country currently faces one of the most rabid housing bubbles in the world, which has caused household debt to surge to 182% of disposable income. This is creating serious vulnerabilities in the Swedish economy - dangers that will only grow larger as the Riksbank keep monetary policy at extremely easy levels. A case can be made that with large exposure to both global trade and industrial production cycles, the current slowdown in global growth is creating a risk for Sweden. These risks are compounded by the rising threat of a trade war. This could justify easier monetary policy, and thus a weaker SEK. When all is said and done, while the short-term outlook for the SEK will remained stymied by the global growth outlook, we do expect the Riksbank to increase rates this year as inflation could accelerate significantly. As a result, we recommend investors use this period of weakness to buy the SEK against both the dollar and the euro. The Norwegian Krone Chart 10The NOK Is The Cheapest Commodity Currency In The G-10 The NOK Is The Cheapest Commodity Currency In The G-10 The NOK Is The Cheapest Commodity Currency In The G-10 The Norwegian krone has experienced a meaningful rally against the euro and the krona this year - the currencies of its largest trading partners - and as such, the large discount of the real trade-weighted krone to its equilibrium rate has declined. On a long-term basis, the krone remains the most attractive commodity currency in the G-10 based on valuations alone (Chart 10). While we have been long NOK/SEK, currently we have a tactical negative bias towards this cross. Investors have aggressively bought inflation protection, a development that tends to favor the NOK over the SEK. However, slowing global growth could disappoint these expectations, resulting in a period of weakness in the NOK/SEK pair. Nonetheless, we believe this is only a short-term development, and BCA's bullish cyclical view on oil will ultimately dominate. As a result, we recommend long-term buyers use any weakness in the NOK right now to buy more of it against the euro, the SEK, and especially against the AUD. The Yuan Chart 11The CNY Is At Equilibrium The CNY Is At Equilibrium The CNY Is At Equilibrium The fair value of the Chinese yuan has been in a well-defined secular bull market because China's productivity - even if it has slowed - remains notably higher than productivity growth among its trading partners. However, while the yuan traded at a generous discount to its fair value in early 2017, this is no longer the case (Chart 11). Despite this, on a long-term basis we foresee further appreciation in the yuan as we expect the Chinese economy to continue to generate higher productivity growth than its trading partners. Moreover, for investors with multi-decade investment horizons, a slow shift toward the RMB as a reserve currency will ultimately help the yuan. However, do not expect this force to be felt in the RMB any time soon. On a shorter-term horizon, the picture is more complex. Chinese economic activity is slowing as monetary conditions as well as various regulatory and administrative rules have been tightened - all of them neatly fitting under the rubric of structural reforms. Now that the trade relationship between the U.S. and China is becoming more acrimonious, Chinese authorities are likely to try using various relief valves to limit downside to Chinese growth. The RMB could be one of these tools. As such, the recent strength in the trade-weighted dollar is likely to continue to weigh on the CNY versus the USD. Paradoxically, the USD's strength is also likely to mean that the trade-weighted yuan could experience some upside. The Brazilian Real Chart 12More Downside In The BRL More Downside In The BRL More Downside In The BRL Despite the real's recent pronounced weakness, it has more room to fall before trading at a discount to its long-term fair value (Chart 12). More worrisome, the equilibrium rate for the BRL has been stable, even though commodity prices have rebounded. This raises the risk that the BRL could experience a greater decline than what is currently implied by its small premium to fair value if commodity prices were to fall. Moreover, bear markets in the real have historically ended at significant discounts to fair value. The current economic environment suggests this additional decline could materialize through the remainder of 2018. Weak global growth has historically been a poison for commodity prices as well as for carry trades, two factors that have a strong explanatory power for the real. Moreover, China's deceleration and regulatory tightening should translate into further weakness in Chinese imports of raw materials, which would have an immediate deleterious impact on the BRL. Additionally, as we have previously argued, when the fed funds rate rise above r-star, this increases the probability of an accident in global capital markets. Since elevated debt loads are to be found in EM and not in the U.S., this implies that vulnerability to a financial accident is greatest in the EM space. The BRL, with its great liquidity and high representation in investors' portfolios, could bear the brunt of such an adjustment. The Mexican Peso Chart 13The MXN Is A Bargain Once Again The MXN Is A Bargain Once Again The MXN Is A Bargain Once Again When we updated our long-term models last September, the peso was one of the most expensive currencies covered, and we flagged downside risk. With President Trump re-asserting his protectionist rhetoric, and with EM bonds and currencies experiencing a wave of pain, the MXN has eradicated all of its overvaluation and is once again trading at a significant discount to its long-term fair value (Chart 13). Is it time to buy the peso? On a pure valuation basis, the downside now seems limited. However, risks are still plentiful. For one, NAFTA negotiations are likely to remain rocky, at least until the U.S. mid-term elections. Trump's hawkish trade rhetoric is a surefire way to rally the GOP base at the polls in November. Second, the leading candidate in the polls for the Mexican presidential elections this summer is Andres Manuel Lopez Obrador, the former mayor of Mexico City. Not only could AMLO's leftist status frighten investors, he is looking to drive a hard bargain with the U.S. on NAFTA, a clear recipe for plentiful headline risk in the coming months. Third, the MXN is the EM currency with the most abundant liquidity, and slowing global growth along with rising EM volatility could easily take its toll on the Mexican currency. As a result, to take advantage of the MXN's discount to fair value, a discount that is especially pronounced when contrasted with other EM currencies, we recommend investors buy the MXN versus the BRL or the ZAR instead of buying it outright against the USD. These trades are made even more attractive by the fact that Mexican rates are now comparable to those offered on South African or Brazilian paper. The Chilean Peso Chart 14The CLP Is At Risk The CLP Is At Risk The CLP Is At Risk We were correct to flag last September that the CLP had less downside than the BRL. But now, while the BRL's premium to fair value has declined significantly, the Chilean peso continues to trade near its highest premium of the past 10 years (Chart 14). This suggests the peso could have significant downside if EM weakness grows deeper. This risk is compounded by the fact that the peso's fair value is most sensitive to copper prices. Prices of the red metal had been stable until recent trading sessions. However, with the world largest consumer of copper - China - having accumulated large stockpiles and now slowing, copper prices could experience significant downside, dragging down the CLP in the process. An additional risk lurking for the CLP is the fact that Chile displays some of the largest USD debt as a percent of GDP in the EM space. This means that a strong dollar could inflict a dangerous tightening in Chilean financial conditions. This risk is even more potent as the strength in the dollar is itself a consequence of slowing global growth - a development that is normally negative for the Chilean peso. This confluence thus suggests that the expensive CLP is at great risk in the coming months. The Colombian Peso Chart 15The COP Is Latam's Cheapest Currency The COP Is Latam's Cheapest Currency The COP Is Latam's Cheapest Currency The Colombian peso is currently the cheapest currency covered by our models. The COP has not been able to rise along with oil prices, creating a large discount in the process (Chart 15). Three factors have weighed on the Colombian currency. First, Colombia just had elections. While a market-friendly outcome ultimately prevailed, investors were already expressing worry ahead of the first round of voting four weeks ago. Second, Colombia has a large current account deficit of 3.7% of GDP, creating a funding risk in an environment where liquidity for EM carry trades has decreased. Finally, Colombia has a heavy USD-debt load. However, this factor is mitigated by the fact that private debt stands at 65% of Colombia's GDP, reflecting the banking sector's conservative lending practices. At this juncture, the COP is an attractive long-term buy, especially as president-elect Ivan Duque is likely to pursue market-friendly policies. However, the country's large current account deficit as well as the general risk to commodity prices emanating from weaker global growth suggests that short-term downside risk is still present in the COP versus the USD. As a result, while we recommend long-term investors gain exposure to this cheap Latin American currency, short-term players should stay on the sidelines. Instead, we recommend tactical investors capitalize on the COP's cheapness by buying it against the expensive CLP. Not only are valuations and carry considerations favorable, Chile has even more dollar debt than Colombia, suggesting that the former is more exposed to dollar risk than the latter. Moreover, Chile is levered to metals prices while Colombia is levered to oil prices. Our commodity strategists are more positive on crude than on copper, and our negative outlook on China reinforces this message. The South African Rand Chart 16The Rand Will Cheapen Further The Rand Will Cheapen Further The Rand Will Cheapen Further Despite its more than 20% depreciation versus the dollar since February, the rand continues to trade above its estimate of long-term fair value (Chart 16). The equilibrium rate for the ZAR is in a structural decline, even after adjusting for inflation, as the productivity of the South African economy remains in a downtrend relative to that of its trading partners. This means the long-term trend in the ZAR will continue to point south. On a cyclical basis, it is not just valuations that concern us when thinking about the rand. South Africa runs a deficit in terms of FDI; however, portfolio inflows into the country have been rather large, resulting in foreign ownership of South African bonds of 44%. Additionally, net speculative positions in the rand are still at elevated levels. This implies that investors could easily sell their South African assets if natural resource prices were to sag. Since BCA's view on Chinese activity as well as the soft patch currently experienced by the global economy augur poorly for commodities, this could create potent downside risks for the ZAR. We will be willing buyers only once the rand's overvaluation is corrected. The Russian Ruble Chart 17The Ruble Is At Fair Value The Ruble Is At Fair Value The Ruble Is At Fair Value There is no evidence of mispricing in the rubble (Chart 17). Moreover the Russian central bank runs a very orthodox monetary policy, which gives us comfort that the RUB, with its elevated carry, remains an attractive long-term hold within the EM FX complex. On a shorter-term basis, the picture is more complex. The RUB is both an oil play as well as a carry currency. This means that the RUB is very exposed to global growth and liquidity conditions. This creates major risks for the ruble. EM FX volatility has been rising, and slowing global growth could result in an unwinding of inflation-protection trades, which may pull oil prices down. This combination is negative for both EM currencies and oil plays for the remainder of 2018. Our favorite way to take advantage of the RUB's sound macroeconomic policy, high interest rates and lack of valuation extremes is to buy it against other EM currencies. It is especially attractive against the BRL, the ZAR and the CLP. The only EM commodity currency against which it doesn't stack up favorably is the COP, as the COP possesses a much deeper discount to fair value than the RUB, limiting its downside if the global economy were to slow more sharply than we anticipate. The Korean Won Chart 18Despite Its Modest Cheapness, The KRW Is At Risk Despite Its Modest Cheapness, The KRW Is At Risk Despite Its Modest Cheapness, The KRW Is At Risk The Korean won currently trades at a modest discount to its long-term fair value (Chart 18). This suggests the KRW will possess more defensive attributes than the more expensive Latin American currencies. However, BCA is worried over the Korean currency's cyclical outlook. The Korean economy is highly levered to both global trade and the Chinese investment cycle. This means the Korean won is greatly exposed to the two largest risks in the global economy. Moreover, the Korean economy is saddled with a large debt load for the nonfinancial private sector of 193% of GDP, which means the Bank of Korea could be forced to take a dovish turn if the economy is fully hit by a global and Chinese slowdown. Moreover, the won has historically been very sensitive to EM sovereign spreads. EM spreads have moved above their 200-day moving average, which suggests technical vulnerability. This may well spread to the won, especially in light of the global economic environment. The Philippine Peso Chart 19Big Discount In The PHP Big Discount In The PHP Big Discount In The PHP The PHP is one of the rare EM currencies to trade at a significant discount to its long-term fair value (Chart 19). There are two main reasons behind this. First, the Philippines runs a current account deficit of 0.5% of GDP. This makes the PHP vulnerable in an environment where global liquidity has gotten scarcer and where carry trades have underperformed. The second reason behind the PHP's large discount is politics. Global investors remain uncomfortable with President Duterte's policies, and as such are imputing a large risk premium on the currency. Is the PHP attractive? On valuation alone, it is. However, the current account dynamics are expected to become increasingly troubling. The economy is in fine shape and the trade deficit could continue to widen as imports get a lift from strong domestic demand - something that could infringe on the PHP's attractiveness. However, on the positive side, the PHP has historically displayed a robust negative correlation with commodity prices, energy in particular. This suggests that if commodity prices experience a period of relapse, the PHP could benefit. The best way to take advantage of these dynamics is to not buy the PHP outright against the USD but instead to buy it against EM currencies levered to commodity prices like the MYR or the CLP. The Singapore Dollar Chart 20The SGD's Decline Is Not Over The SGD's Decline Is Not Over The SGD's Decline Is Not Over The Singapore dollar remains pricey (Chart 20). However, this is no guarantee of upcoming weakness. After all, the SGD is the main tool used by the Monetary Authority of Singapore to control monetary policy. Moreover, the MAS targets a basket of currencies versus the SGD. Based on these dynamics, historically the SGD has displayed a low beta versus the USD. Essentially, it is a defensive currency within the EM space. The SGD has historically moved in tandem with commodity prices. This makes sense. Commodity prices are a key input in Singapore inflation, and commodity prices perform well when global industrial activity and global trade are strong. This means that not only do rising commodity prices require a higher SGD to combat inflation, higher commodity prices materialize in an environment where this small trading nation is supported by potent tailwinds. Additionally, Singapore loan growth correlates quite closely with commodity prices, suggesting that strong commodity prices result in important amounts of savings from commodity producers being recycled in the Singaporean financial system. To prevent Singapore's economy from overheating in response to these liquidity inflows, MAS is being forced to tighten policy through a higher SGD. Today, with global growth softening and global trade likely to deteriorate, the Singaporean economy is likely to face important headwinds. Tightening monetary policy in the U.S. and in China will create additional headwinds. As a result, so long as the USD has upside, the SGD is likely to have downside versus the greenback. On a longer-term basis, we would expect the correction of the SGD's overvaluation to not happen versus the dollar but versus other EM currencies. The Hong Kong Dollar Chart 21The HKD Is Fairly Valued The HKD Is Fairly Valued The HKD Is Fairly Valued The troughs and peaks in the HKD follow the gyrations of the U.S. dollar. This is to be expected as the HKD has been pegged to the USD since 1983. Like the USD, it was expensive in early 2017, but now it is trading closer to fair value (Chart 21). Additionally, due to the large weight of the yuan in the trade-weighted HKD, the strength in the CNY versus the USD has had a greater impact on taming the HKD's overvaluation than it has on the USD's own mispricing. Moreover, the HKD is trading very close to the lower bound of its peg versus the USD, which has also contributed to the correction of its overvaluation. Even when the HKD was expensive last year, we were never worried that the peg would be undone. Historically, the Hong Kong Monetary Authority has shown its willingness to tolerate deflation when the HKD has been expensive. The most recent period was no different. Moreover, the HKMA has ample fire power in terms of reserves to support the HKD if the need ever existed. Ultimately, the stability created by the HKD peg is still essential to Hong Kong's relevance as a financial center for China, especially in the face of the growing preeminence of Shanghai and Beijing as domestic financial centers. As a result, while we could see the HKD become a bit more expensive over the remainder of 2018 as the USD rallies a bit further, our long-term negative view on the USD suggests that on a multiyear basis the HKD will only cheapen. The Saudi Riyal Chart 22The SAR Remains Expensive The SAR Remains Expensive The SAR Remains Expensive Like the HKD, the riyal is pegged to the USD. However, unlike the HKD, the softness in the USD last year was not enough to purge the SAR's overvaluation (Chart 22). Ultimately, the kingdom's poor productivity means that the SAR needs more than a 15% fall in the dollar index to make the Saudi economy competitive. However, this matters little. Historically, when the SAR has been expensive, the Saudi Arabia Monetary Authority has picked the HKMA solution: deflation over devaluation. Ultimately, Saudi Arabia is a country that imports all goods other than energy products. With a young population, a surge in inflation caused by a falling currency is a risk to the durability of the regime that Riyadh is not willing to test. Moreover, SAMA has the firepower to support the SAR, especially when the aggregate wealth of the extended royal family is taken into account. Additionally, the rally in oil prices since February 2016 has put to rest worries about the country's fiscal standing. On a long-term basis, the current regime wants to reform the economy, moving away from oil and increasing productivity growth. This will be essential to supporting the SAR and decreasing its overvaluation without having to resort to deflation. However, it remains to be seen if Crown Prince Mohamed Bin Salman's ambitious reforms can in fact be implemented and be fruitful. Much will depend on this for the future stability of the riyal. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com 2 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Yen: QQE Is Dead! Long Live YCC!", dated January 12, 2018, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary

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

Three macro "policy puts" are in jeopardy of disappearing or, at the very least, being repriced. Fed Put: Rising inflation has made the Fed more reluctant to back off from rate hikes at the first hint of slower growth or falling asset prices. China Put: Worries about high debt levels, overcapacity, and pollution all mean that the bar for fresh Chinese stimulus is higher than in the past. Draghi Put: Bailing out Italy was a no-brainer in 2012 when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. These factors, along with additional risks such as mounting protectionism, warrant a more cautious 12-month stance towards global equities and other risk assets. The fact that valuations are stretched across most asset classes only adds to our concern. A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase over the balance of the year, with the next big move for global equities probably being to the downside. Buckle Up One of BCA's key ongoing themes is that policy and markets are on a collision course. We are starting to see this impending crash play out across the world. Higher Inflation Is Tying The Fed's Hands A slowdown in global growth caused the Fed to abort its tightening plans for 12 months starting in December 2015. Global growth is faltering again, but this time around the Fed is less eager to hit the pause button. In contrast to 2015, the U.S. economy has run out of spare capacity. The unemployment rate fell to a 48-year low of 3.75% in May. For the first time in the history of the Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS), there are more job vacancies than unemployed workers (Chart 1). Average hourly earnings surprised on the upside in May, while the Employment Cost Index for private-sector workers - the cleanest and most reliable measure of U.S. wage growth - rose at a robust 4% annualized pace in the first quarter. Labor market surveys, which generally lead wage growth by three-to-six months, are pointing to a further acceleration in wages (Chart 2). Chart 1There Are Now More ##br##Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers Chart 2U.S. Wage Growth Is Set To Accelerate U.S. Wage Growth Is Set To Accelerate U.S. Wage Growth Is Set To Accelerate The Dollar Rally Can Keep Going Rising wages will put more income into workers' pockets, who will then spend it. Stronger demand can be partly satisfied by imports, but it will take a change in relative prices for that to happen. U.S. imports account for only 16% of GDP. Unless the prices of foreign-made goods decline in relation to the prices of domestically-produced goods, the bulk of any additional household income will be spent on goods produced in the U.S. This means that the dollar needs to strengthen. The Fed's broad trade-weighted dollar index is up 8% since the start of February. While we are not as bullish on the dollar as we were a few months ago, we still believe that the path of least resistance for the greenback is up. Our long DXY trade recommendation has gained 12.1% inclusive of carry since we initiated it. We are raising the target price from 96 to 98. A stronger dollar can help deflect some additional spending towards imports, but this won't be enough to fully cool the economy. Services, which generally cannot be imported, account for nearly two-thirds of GDP. Since it takes time to shift resources from goods-producing sectors to service sectors, any rising aggregate demand will boost service prices. Outside of housing, service-sector inflation is already running at 2.4%, a number that is likely to rise further over the coming year (Chart 3). This will keep the Fed on edge. Hard Times For Emerging Markets The combination of rising U.S. rates and a stronger dollar is bad news for emerging markets. Eighty percent of EM foreign-currency debt is denominated in dollars. Outside of China, EM dollar debt is now back to late-1990s levels both as a share of GDP and exports (Chart 4). Chart 3Faster Wage Growth Will Push ##br##Up Service Inflation Faster Wage Growth Will Push Up Service Inflation Faster Wage Growth Will Push Up Service Inflation Chart 4EM Dollar Debt Back To Late-1990s Levels EM Dollar Debt Back To Late-1990s Levels EM Dollar Debt Back To Late-1990s Levels The wave of EM local-currency debt issued in recent years only complicates matters. If EM central banks raise rates to defend their currencies, this could imperil economic growth and make it difficult for local-currency borrowers to pay back their loans. Rather than hiking rates, some EM central banks may simply choose to inflate away debt. Consider the case of Brazil. Ninety percent of Brazilian sovereign debt is denominated in reais. The Brazilian government won't default on its debt per se. However, if push comes to shove, Brazil's central bank can always step in to buy government bonds, effectively monetizing the fiscal deficit. The specter of trade wars only adds to the risks facing emerging markets. A larger U.S. budget deficit will drain national savings, leading to a bigger trade deficit. Rather than blaming his own macroeconomic policies, President Trump will blame America's trading partners. Global trade has already been flatlining for over a decade (Chart 5). Trump's trade agenda will further undermine the global trading system. Emerging markets will bear the brunt of that development. Chart 5Global Trade Has Crested Global Trade Has Crested Global Trade Has Crested Chinese Stimulus To The Rescue? When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive new stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. Today, Chinese growth is slowing again. May data on industrial production, retail sales, and fixed asset investment all disappointed. Property prices in tier 1 cities are down year-over-year. Our leading indicator for the Li Keqiang index, a widely followed measure of economic activity, is in a clear downtrend (Chart 6). So far, the policy response has been fairly muted. Reserve requirements have been cut and some administrative controls loosened, but the combined credit and fiscal impulse has plunged (Chart 7). Onshore and offshore corporate bond yields have increased to multi-year highs. Bank lending rates are rising, while loan approvals are dropping (Chart 8). Chart 6Chinese Growth Is Slowing Anew Chinese Growth Is Slowing Anew Chinese Growth Is Slowing Anew Chart 7China: Policy Response To Slowdown ##br##Has Been Muted So Far China: Policy Response To Slowdown Has Been Muted So Far China: Policy Response To Slowdown Has Been Muted So Far Chart 8China: Credit Tightening China: Credit Tightening China: Credit Tightening We have no doubt that China will stimulate again if the economy appears to be heading for a deep slowdown. However, the bar for a fresh round of stimulus is higher today than it was in the past. Elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities can respond with the usual barrage of infrastructure spending and increased bank lending. The economy needs to feel more pain before policymakers come to its aid. Draghi's Dilemma The Italian economy was showing signs of weakness even before bond yields exploded higher. Domestic demand slowed to a mere 0.3% qoq in Q1. The PMIs, consumer confidence, and the Bank of Italy's Ita-Coin cyclical indicator all decelerated (Chart 9). Italy would benefit from a more competitive cost structure, but the political will to undertake the sort of reforms Germany implemented in the late 1990s, and that Spain implemented after the Great Recession, has been sorely lacking (Chart 10). Unwilling to take tough actions to improve competitiveness, the Five Star-Lega coalition government has proposed loosening fiscal policy to support demand. Chart 9Italy's Economy Is Weakening... Again Italy's Economy Is Weakening... Again Italy's Economy Is Weakening... Again Chart 10Italy: More Work Needs To Be Done On ##br##The Labor Competitiveness Front Italy: More Work Needs To Be Done On The Labor Competitiveness Front Italy: More Work Needs To Be Done On The Labor Competitiveness Front Italy's shift towards populism is arriving at the same time that the ECB is looking to wind down its asset purchase program. This means that a key buyer of Italian debt is stepping back just when it may be needed the most. Getting the ECB to bail out Italy will not be as straightforward this time around. Recall that Mario Draghi and Jean-Claude Trichet penned a letter to the Italian government in 2011 outlining a series of reforms they wanted to see enacted as a condition of ongoing ECB support. The contents of the letter were so explosive that they precipitated the resignation of then-PM Silvio Berlusconi when they were leaked to the public. One of the reforms that Mario Draghi demanded - and the subsequent government led by Mario Monti ultimately undertook - was the extension of the retirement age. Italy's current government has explicitly promised to reverse that decision much to the consternation of the ECB and the European Commission. It was one thing for Mario Draghi to promise to do "whatever it takes" to protect Italy when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. Investment Conclusions The outlook for global risk assets is likely to be more challenging over the coming months. With that in mind, we are downgrading our 12-month recommendation on global equities and credit from overweight to neutral. A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase again over the balance of the year, with the next big move for global equities probably being to the downside. Although Treasurys could rally in the near term, higher U.S. inflation will push bond yields up over a 12-month horizon. Given that yields are positively correlated across international bond markets, rising U.S. yields will put upward pressure on yields in the rest of the world. As such, we recommend shifting equity allocations towards cash rather than long-duration bonds. We would also reduce credit exposure. Within the commodity complex, the backdrop for crude remains more favorable than for economically-sensitive metals. Investors should underweight EM equities, credit, and currencies relative to their developed market peers. The Fed needs to tighten U.S. financial conditions to prevent the economy from overheating. Chart 11 shows that EM equities almost always fall when that is happening. Chart 11Tighter U.S. Financial Conditions Do Not Bode Well For EM Stocks Tighter U.S. Financial Conditions Do Not Bode Well For EM Stocks Tighter U.S. Financial Conditions Do Not Bode Well For EM Stocks A stronger dollar will hurt the profits of U.S. multinationals. That said, the sector composition of the U.S. stock market is a bit more defensive than it is elsewhere. On balance, we no longer have a strong view that euro area and Japanese equities will outperform the U.S. in local-currency terms, and hence we are closing our trade recommendation to this effect for a loss of 5.4%. If macro developments evolve as we expect, we will shift to an outright bearish stance on risk assets later this year or in early 2019 in anticipation of a global recession in 2020. That said, we would consider moving our 12-month recommendation temporarily back to overweight if global equities were to sell off by more than 15% over the next few months or the policy environment becomes markedly more market friendly. But at current prices, the risk-reward trade-off no longer justifies a high degree of bullishness. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights BCA's Geopolitical Power Index (GPI) confirms that we live in a multipolar world; Most of President Trump's policies are designed to strike out against this structural reality; Trade war with China is real and presents the premier geopolitical risk in 2018; President Trump's aggression towards G7 allies boils down to greater NAFTA risk; We remain bullish USD, bearish EM, maintain our short U.S. China-exposed equities and closing all our "bullish" NAFTA trades; Remain short GBP/USD, Theresa May's days appear numbered. Feature "We're going to win so much, you're going to be so sick and tired of winning." Candidate Donald Trump, May 26, 2016 In 2013, BCA's Geopolitical Strategy introduced the concept of multipolarity into our financial lexicon.1 Multipolarity is a term in political science that denotes when the number of states powerful enough to pursue an independent and globally relevant foreign policy is greater than one (unipolarity) or two (bipolarity). At the time, the evidence that U.S. global hegemony was in retreat was plentiful, but the idea of a U.S. decline was still far from consensus. By late 2016, however, President Donald Trump was overtly campaigning on it. His campaign slogan, "Make America Great Again," promised to reverse the process by striking out at the perceived causes of the decline: globalization, unchecked illegal immigration, and the ineffective foreign policy of the D.C. establishment. How can we quantitatively prove that the world is multipolar? We recently enhanced the classic National Capability Index (NCI) with our own measure, the Geopolitical Power Index (GPI). The original index, created for the Correlates of War project in 1963, had grown outdated. Its reliance on "military personnel" and "iron and steel production" harkened back to the late nineteenth century and overstated the power of China (Chart 1). Chart 1The National Capability Index Overstates China's Power The National Capability Index Overstates China's Power The National Capability Index Overstates China's Power Our own index avoids these pitfalls, while retaining the parsimony of the NCI, by focusing on six key factors: Population: We adapted the original population measure by penalizing countries with large dependency ratios. Yes, having a vast population matters, but having too many dependents (the elderly and youth) can strain resources otherwise available for global power projection. Global Economic Relevance: The original index failed to capture a country's relevance for the global economy. Designed at the height of the Cold War, the NCI did not foresee today's globalized future. As such, we modified the original index by introducing a measure that captures a country's contribution to global final demand. The more an economy imports, the greater its bargaining power in terms of trade and vis-à-vis its geopolitical rivals. Arms Exports: Having a large army is no longer as relevant now that wars have become a high-tech affair. To capture that reality, we replaced the NCI's focus on the number of soldiers with arms exports as a share of the global defense industry. We retained the original three variables that measure primary energy consumption, GDP, and overall military expenditure. Chart 2 shows the updated data. As expected, the U.S. is in decline, having lost nearly a third of its quantitatively measured geopolitical power since 1998. Over the same period, China has gone from having just 30% of U.S. geopolitical power to over 80%. Other countries, like Russia, India, Turkey, Iran, and Pakistan, have also seen an increase in geopolitical power over the same period, confirming their roles as regional powers (Chart 3). Chart 2BCA's Geopolitical Power Index Illustrates A Multipolar World BCA's Geopolitical Power Index Illustrates A Multipolar World BCA's Geopolitical Power Index Illustrates A Multipolar World Chart 3China Was Not The Only EM To Rise Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? President Trump was elected with the mandate of changing the trajectory of American power and getting the country back on a "winning" path. Investors can perceive nearly all the moves by the administration - from protectionist actions against China and traditional allies, to applying a "Maximum Pressure" doctrine against North Korea and Iran - as a fight against the structural decline of U.S. power. Isn't President Trump "tilting at windmills"? Fighting a vain battle against imaginary adversaries? Yes. The decline of the U.S. is a product of classic imperial overstretch combined with the natural lifecycle of any global hegemon. U.S. policymakers have made decisions that have hastened the decline, but the overarching American geopolitical trajectory would have been negative regardless: Global peace brought prosperity which strengthened Emerging Markets (EM), particularly China, relative to the U.S. That said, Trump is not as crazy as the media often imply. Chaos is not necessarily bad for a domestically driven economy secured by two oceans. The U.S. tends to outperform the rest of the world - economically, financially, and geopolitically - amid turbulence. Our own updated GPI shows that both World Wars were massively favorable for U.S. hegemony (Chart 4), although this time around the chaos is mostly self-inflicted. Chart 4America Profits From Chaos America Profits From Chaos America Profits From Chaos Similarly, Trump's economic populism at home is buoying sentiment and assuaging the negative consequences - real or imagined - of his protectionism. Meanwhile, the threat of tariffs is souring the mood abroad. This policy mix is causing U.S. assets to outperform (Chart 5). Most importantly, the U.S. dollar is now up 2.7% since the beginning of the year, putting pressure on EM assets. When combined with continued counter-cyclical structural reforms in China, we maintain that the overall macro and geopolitical context remains bearish for global risk assets. This is not the first time that an American president has deployed both an aggressive trade policy and an aggressive foreign policy. The difference, this time around, is that the world is multipolar. A defining feature of multipolarity is that it is less predictable and more likely to produce inter-state conflict (Chart 6). As more countries matter - geopolitically, economically, financially - the number of "veto players" rises, making stable equilibria more difficult to produce. As such, bullying as a negotiating tactic worked when used by Presidents Nixon, Reagan, Bush Jr., and Clinton, but may not work today. Investors should therefore prepare for a long period of uncertainty this summer as the world responds to a U.S. administration focused on "winning." Chart 5U.S. Assets Outperform U.S. Assets Outperform U.S. Assets Outperform Chart 6Multipolarity Produces Uncertainty Multipolarity Produces Uncertainty Multipolarity Produces Uncertainty Bottom Line: There is a clear logic behind President Trump's foreign and trade policy. He is trying to reverse a decline in U.S. hegemony. The problem is that his policy decisions are unlikely to address the structural causes of America's decline. What is much more likely is that his policy will cause the rest of the world to react in unpredictable ways. The U.S. may benefit, but that is not a forgone conclusion. Investors should position themselves for a volatile summer. Below we review three key issues, two negative and one positive. The U.S. Vs. China: The Trade War Is Real The Trump administration has announced that it will go ahead with tariffs on $50 billion worth of Chinese imports in retaliation for forced technology transfer and intellectual property theft under Section 301 of the 1974 Trade Act. The tariffs will come in two tranches beginning on July 6. China will respond proportionately, based on both its statements and its response to the steel and aluminum tariffs (Chart 7). If the two sides stop here, then perhaps the trade war can be delayed. But Trump is already saying he will impose tariffs on a further $200 billion worth of goods. At that point, if Beijing re-retaliates, China's proportionate response will cover more goods than the entire range of U.S. imports (Chart 8). Retaliation will have to occur elsewhere. Chart 7Trump's Steel/Aluminum Tariffs Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Chart 8Trump's Tariffs On China Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? We would expect the CNY/USD to weaken as negotiations fail. We would also expect tensions to continue spilling over into the South China Sea and other areas of strategic disagreement.2 The South China Sea or Taiwan could produce market-moving "black swan" geopolitical events this year or next.3 Chart 9Downside Risks Continue Downside Risks Continue Downside Risks Continue It is critical to distinguish between the U.S. trade conflict with China and the one with the G7. In the latter case, the U.S. political establishment will push against the Trump administration, encouraging him to compromise. With China, however, Congress is becoming the aggressor and we certainly do not expect the Defense Department or the intelligence community to play the peacemaker with Beijing. In particular, members of Congress are trying to cancel Trump's ZTE deal while expanding the powers of the Committee on Foreign Investment in the United States (CFIUS) to restrict Chinese investments.4 These congressional factors underscore our theme that U.S.-China tensions are structural and secular.5 Would China stimulate its economy to negate the effects of tariffs? We see nothing yet on the policy side to warrant a change in our fundamental view, which holds that any stimulus will be limited due to the agenda of containing systemic financial risk. Credit growth remains weak and fiscal spending has not yet perked up (Chart 9), portending weak Chinese imports and negative outcomes for EM. The risk to Chinese growth remains to the downside this year (and likely next year) as the government continues with the reforms. Critically, stimulus is not the only possible Chinese response to trade war. A trade war with the United States will provide Xi with a "foreign devil" on whom he can blame the pain of structural reforms. As such, it is entirely possible that Beijing doubles-down on reforms in light of an aggressive U.S. Bottom Line: The U.S.-China trade war is beginning and will cause additional market volatility and, potentially, a "black swan" event, especially ahead of the U.S. midterm elections. We do not expect 2015-style economic stimulus from Beijing. Stay long U.S. small caps relative to large caps; short U.S. China-exposed equities; and remain short EM equities relative to DM. The U.S. Vs. The G6: This Is About NAFTA There was little rhyme or reason to President Trump's smackdown of traditional U.S. allies at the G7 summit in Quebec. As our colleague Peter Berezin recently pointed out, the U.S. is throwing stones while living in a glass house.6 While the overall level of tariff barriers within developed countries is low, the U.S. actually stands at the top end of the spectrum (Chart 10). The decision to launch an investigation into whether automobile imports "threaten to impair the national security" of the U.S. - under Section 232 of the Trade Expansion Act of 1962 - falls into the same rubric of empty threats. The U.S. has had a 25% tariff on imported light trucks since 1964, a decision that likely caused its car companies to become addicted to domestic pickup truck demand to the detriment of global competitiveness. Meanwhile, only 15% of U.S. autos shipped to the EU were subject to the infamous European 10% surcharge on auto imports. This is because U.S. autos containing European parts are exempt from the tariff. Many foreign auto manufacturers have already adjusted to the U.S. market, setting up manufacturing inside the country (Chart 11). Tariffs would hurt luxury brands like BMW, Daimler, Volvo, and Jaguar.7 As such, we doubt the investment-relevance of Trump's threat against autos. Either way, the investigation is unlikely to be completed until the tail-end of Q1 2019. Chart 10Tariffs: Who Is Robbing The U.S.? Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Chart 11Car Imports? What Imports? Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Instead, investors should take Trump's aggressive comments from the G7 in the context of the ongoing NAFTA negotiations and the closing window for a deal. President Trump wants to get a NAFTA deal ahead of the U.S. midterms in November and prior to the new Mexican Congress being inaugurated on September 1.8 This means that a deal has to be concluded by late July, or early August, giving the "old" Mexican Congress enough time to ratify it before the new president - likely Andrés Manuel López Obrador - comes to power on December 1. This would conceivably give the U.S. Congress enough time to ratify a deal by December, assuming Republicans can remove some procedural hurdles before then. The rising probability of no resolution before the U.S. midterm election will increase the risk that Trump will trigger Article 2205 and announce the U.S.'s withdrawal. Trump has always had the option of triggering the six-month withdrawal period as a negotiating tactic to increase the pressure on Canada and Mexico. Withdrawing might fire up the base, while major concessions from Canada or Mexico might be presented as "victories" to voters. Anything short of these binary outcomes is useless to Trump on November 6. Therefore, if Canada and Mexico do not relent in the next month or two, the odds of Trump triggering Article 2205 will shoot up. The key is that Trump faces limited legal or economic constraints in withdrawing: Legal Constraints: Not only can Trump unilaterally withdraw from the agreement, triggering the six-month exit period, but Congress is unlikely to stop him. Announcing withdrawal automatically nullifies much of the 1993 NAFTA Implementation Act.9 Some provisions of NAFTA under this act may continue to be implemented, but the bulk would cease to have effect, and the White House could refuse to enforce the rest. Economic Constraints: The U.S. economy has far less exposure to Canada and Mexico than vice- versa (Chart 12). Certain states and industries would be heavily affected - ironically, the U.S. auto industry would be most severely impacted (Chart 13) - and they would lobby aggressively to save the agreement. But with the American economy hyper-charged with stimulus, the drag from leaving NAFTA is not prohibitive to Trump. Voters will feel any pocketbook consequences about three months late i.e., after the election. Chart 12U.S. Economy:##br## Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA Chart 13NAFTA Has Made U.S. Auto ##br##Manufacturing More Competitive Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? The potential saving grace for Canada is the Canada-U.S. Free Trade Agreement (CUSFTA), which took effect in 1989 and was incorporated into NAFTA. The U.S. and Canada agreed through an exchange of letters to suspend CUSFTA's operation when NAFTA took effect, but the suspension only lasts as long as NAFTA is in effect. However, reinstating CUSFTA is not straightforward. The NAFTA Implementation Act suspends some aspects of the CUSFTA and amends others (for instance, on customs fees), so there will not be an easy transition from NAFTA to a fully operational CUSFTA.10 Trump may well walk away from both CUSFTA and NAFTA in the same proclamation, or he could walk away from NAFTA while leaving CUSFTA in limbo. The latter would mitigate the negative impact on Canada, but it would still see rising tariffs, customs fees, and rising policy uncertainty. Bottom Line: We originally assigned a high probability to the abrogation of NAFTA.11 Subsequently, we lowered the probability due to positive comments from the White House and Trump's negotiating team. This was a mistake. As we initially posited, there are few constraints to abrogating NAFTA, particularly if President Trump intends to renegotiate the deal later, or conclude two separate bilateral deals that effectively maintain the same trade relationship. We are closing our trade favoring an equally-weighted basket of CAD/EUR and MXN/EUR. We are also closing our trade favoring Mexican local government bonds relative to EM. North Korea: A Geopolitical Opportunity, Not A Risk Not every move by the Trump administration is increasing geopolitical volatility. Trump's Maximum Pressure doctrine may have elevated risks on the Korean Peninsula in 2017, but it ultimately worked. The media is missing the big picture on the Singapore Summit. Diplomacy is on track and geopolitical risk - namely the risk of war on the peninsula - is fading. It is false to claim that President Trump got nothing in return for the summit. Since November 28, North Korea has moderated its belligerent threats, ceased conducting missile tests, released three U.S. political prisoners, and largely blocked off access to the Punggye-ri nuclear testing site. Now, North Korean leader Kim Jong-un has held the summit with Trump, reaffirmed his longstanding promise of "complete denuclearization," reaffirmed the peace-seeking April 2018 Panmunjom Declaration with South Korea, and pledged to dismantle a ballistic missile testing site and continue negotiations. In response, President Trump has given security guarantees to the North Korean regime and has pledged to discontinue U.S.-South Korea military drills for the duration of the negotiations. Trump has not yet eased economic sanctions and his administration has ruled out troop withdrawals from South Korea for now. There is much diplomatic work to be done. But the summit was undoubtedly a positive sign, dialogue is continuing at lower levels, and Kim is expected to visit the White House in the near future. Table 1 shows that the Singapore Summit is substantial when compared with major U.S.-North Korea agreements and inter-Korean summits - and it is unprecedented in that it was agreed between American and North Korean leaders. Table 1How The Singapore Summit Stacks Up To Previous Pacts With North Korea Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Because Trump demonstrated a credible military threat, and China enforced sanctions, the foundation is firmer than that of President Barack Obama's April 2012 agreement to provide food aid in payment for a cessation of nuclear and missile activity. It is much more similar to that of President Clinton and the "Agreed Framework" of 1994, which lasted until 2002, despite many serious failures on both the U.S. and North Korean sides. We should also bear in mind that it was originally U.S. Congress, not North Korea, which undermined the 1994 agreement. Aside from removing war risk, Korean diplomacy is of limited global significance. It marginally improves the outlook for South Korean industrials, energy, telecoms, and consumer staples relative to their EM peers (Chart 14). In the long run it should also be positive for the KRW. Chart 14Winners And Losers Of Inter-Korean Engagement Winners And Losers Of Inter-Korean Engagement Winners And Losers Of Inter-Korean Engagement We maintain that a U.S.-China trade war will not be prevented because of a Korean deal. But we do not expect China to spoil the negotiations. Geopolitically, China benefits from reducing the basis for U.S. forces to be stationed in South Korea. Bottom Line: Go long a "peace dividend" basket of South Korean equity sectors (industrials, energy, consumer staples, and telecoms) and short South Korean "loser" sectors (financials, IT, consumer discretionary, and health care), both relative to their EM peers. Stick to our Korean 2-year/10-year sovereign bond curve steepener trade. Brexit Update: A New Election Is Now In Play Prime Minister Theresa May is fending off a revolt within her Conservative Party this week that could set the course for a new election this year. May reneged on a "compromise" with soft-Brexit/Bremain Tory backbenchers on an amendment that would have given the House of Commons a meaningful vote on the final U.K.-EU Brexit deal. According to the press, the compromise was killed by her own Brexit Secretary, David Davis. There is a fundamental problem with Brexit. The current path towards a hard Brexit, pushed on May by hard-Brexit members of her cabinet and articulated in her January 2017 speech, is incompatible with her party's preferences. According to their pre-referendum preferences, a majority of Tory MPs identified with the Bremain campaign ahead of the referendum (Chart 15). That would suggest that a vast majority prefer a soft Brexit today, if not staying in the EU. We would go further. The current trajectory is incompatible with the democratic preferences of the U.K. public. First, polls are showing rising opposition to Brexit (Chart 16). Second, most voters who chose to vote for Brexit in 2016 did so under the assumption that the Conservative Party would pursue a soft Brexit, including continued membership in the Common Market. Boris Johnson, the most prominent supporter of Brexit ahead of the vote and now the foreign minister, famously stated right after the referendum that "there will continue to be free trade and access to the single market."12 Chart 15Westminster MPs Support Bremain! Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Chart 16Bremain On The Rise Bremain On The Rise Bremain On The Rise So what happens now? We expect the government to be defeated on the crucial amendment giving Westminster the right to vote on the final EU-U.K. deal. If that happens, PM May could be replaced by a hard-Brexit prime minister, most likely Davis. Given the lack of support for an actual hard-Brexit outcome - both in Westminster and among the public - we believe that a new election remains likely by March 2019. Bottom Line: Political risk remains elevated in the U.K. A new election could resolve this risk, but the potential for a Jeremy Corbyn-led Labour Party to win the election could add additional political risk to U.K. assets. We remain short GBP/USD. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013; and "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Pyongyang's Pivot To America," dated June 8, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Taiwan Is A Potential Black Swan," dated March 30, 2018, available at gps.bcaresearch.com. 4 The Senate has passed a version of the National Defense Authorization Act with a rider that would boost CFIUS and maintain stringent restrictions on ZTE's business with the U.S. These restrictions have crippled the company but would have been removed under the Trump administration's snap deal in June. The White House claims it will remove the rider when the House and Senate hold a conference to resolve differences between their versions of the defense bill, but it is not clear that the White House will succeed. Congress could test Trump's veto. If Trump does not veto he will break a personal promise to Xi Jinping and escalate the trade war further than perhaps even he intended. 5 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 6 Please see BCA Global Investment Strategy Weekly Report, "Piggy Bank No More? Trump And The Dollar's Reserve Currency Status," dated June 15, 2018, available at gis.bcaresearch.com. 7 We do not include Porsche in this list as we would gladly pay the 25% tariff on top of its current price. 8 Mexican elections for both president and Congress will take place on July 1, but the new Congress will sit on September 1 while the new president will take office on December 1. 9 Please see Lori Wallach, "Presidential Authority to Terminate NAFTA Without Congressional Approval," Public Citizen's Global Trade Watch, November 13, 2017, available at www.citizen.org. 10 The National Customs Brokers and Forwarders Association of America, "Issues Surrounding US Withdrawal From NAFTA," available from GHY International at www.ghy.com. See also Dan Ciuriak, "What if the United States Walks Away From NAFTA?" C. D. Howe Institute Intelligence Memos, dated November 27, 2017, available at www.cdhowe.org. 11 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 12 Please see "U.K. will retain access to the EU single market: Brexit leader Johnson," Reuters, dated June 26, 2016, available at uk.reuters.com. Geopolitical Calendar

Three macro "policy puts" are in jeopardy of disappearing or, at the very least, being repriced. Fed Put: Rising inflation has made the Fed more reluctant to back off from rate hikes at the first hint of slower growth or falling asset prices. China Put: Worries about high debt levels, overcapacity, and pollution all mean that the bar for fresh Chinese stimulus is higher than in the past. Draghi Put: Bailing out Italy was a no-brainer in 2012 when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. These factors, along with additional risks such as mounting protectionism, warrant a more cautious 12-month stance towards global equities and other risk assets. The fact that valuations are stretched across most asset classes only adds to our concern. A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase over the balance of the year, with the next big move for global equities probably being to the downside. Buckle Up One of BCA's key ongoing themes is that policy and markets are on a collision course. We are starting to see this impending crash play out across the world. Higher Inflation Is Tying The Fed's Hands A slowdown in global growth caused the Fed to abort its tightening plans for 12 months starting in December 2015. Global growth is faltering again, but this time around the Fed is less eager to hit the pause button. In contrast to 2015, the U.S. economy has run out of spare capacity. The unemployment rate fell to a 48-year low of 3.75% in May. For the first time in the history of the Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS), there are more job vacancies than unemployed workers (Chart 1). Average hourly earnings surprised on the upside in May, while the Employment Cost Index for private-sector workers - the cleanest and most reliable measure of U.S. wage growth - rose at a robust 4% annualized pace in the first quarter. Labor market surveys, which generally lead wage growth by three-to-six months, are pointing to a further acceleration in wages (Chart 2). Chart 1There Are Now More ##br##Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers Chart 2U.S. Wage Growth Is Set To Accelerate U.S. Wage Growth Is Set To Accelerate U.S. Wage Growth Is Set To Accelerate The Dollar Rally Can Keep Going Rising wages will put more income into workers' pockets, who will then spend it. Stronger demand can be partly satisfied by imports, but it will take a change in relative prices for that to happen. U.S. imports account for only 16% of GDP. Unless the prices of foreign-made goods decline in relation to the prices of domestically-produced goods, the bulk of any additional household income will be spent on goods produced in the U.S. This means that the dollar needs to strengthen. The Fed's broad trade-weighted dollar index is up 8% since the start of February. While we are not as bullish on the dollar as we were a few months ago, we still believe that the path of least resistance for the greenback is up. Our long DXY trade recommendation has gained 12.1% inclusive of carry since we initiated it. We are raising the target price from 96 to 98. A stronger dollar can help deflect some additional spending towards imports, but this won't be enough to fully cool the economy. Services, which generally cannot be imported, account for nearly two-thirds of GDP. Since it takes time to shift resources from goods-producing sectors to service sectors, any rising aggregate demand will boost service prices. Outside of housing, service-sector inflation is already running at 2.4%, a number that is likely to rise further over the coming year (Chart 3). This will keep the Fed on edge. Hard Times For Emerging Markets The combination of rising U.S. rates and a stronger dollar is bad news for emerging markets. Eighty percent of EM foreign-currency debt is denominated in dollars. Outside of China, EM dollar debt is now back to late-1990s levels both as a share of GDP and exports (Chart 4). Chart 3Faster Wage Growth Will ##br##Push Up Service Inflation Faster Wage Growth Will Push Up Service Inflation Faster Wage Growth Will Push Up Service Inflation Chart 4EM Dollar Debt Back To Late-1990s Levels EM Dollar Debt Back To Late-1990s Levels EM Dollar Debt Back To Late-1990s Levels The wave of EM local-currency debt issued in recent years only complicates matters. If EM central banks raise rates to defend their currencies, this could imperil economic growth and make it difficult for local-currency borrowers to pay back their loans. Rather than hiking rates, some EM central banks may simply choose to inflate away debt. Consider the case of Brazil. Ninety percent of Brazilian sovereign debt is denominated in reais. The Brazilian government won't default on its debt per se. However, if push comes to shove, Brazil's central bank can always step in to buy government bonds, effectively monetizing the fiscal deficit. The specter of trade wars only adds to the risks facing emerging markets. A larger U.S. budget deficit will drain national savings, leading to a bigger trade deficit. Rather than blaming his own macroeconomic policies, President Trump will blame America's trading partners. Global trade has already been flatlining for over a decade (Chart 5). Trump's trade agenda will further undermine the global trading system. Emerging markets will bear the brunt of that development. Chart 5Global Trade Has Crested Global Trade Has Crested Global Trade Has Crested Chinese Stimulus To The Rescue? When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive new stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. Today, Chinese growth is slowing again. May data on industrial production, retail sales, and fixed asset investment all disappointed. Property prices in tier 1 cities are down year-over-year. Our leading indicator for the Li Keqiang index, a widely followed measure of economic activity, is in a clear downtrend (Chart 6). So far, the policy response has been fairly muted. Reserve requirements have been cut and some administrative controls loosened, but the combined credit and fiscal impulse has plunged (Chart 7). Onshore and offshore corporate bond yields have increased to multi-year highs. Bank lending rates are rising, while loan approvals are dropping (Chart 8). Chart 6Chinese Growth Is Slowing Anew Chinese Growth Is Slowing Anew Chinese Growth Is Slowing Anew Chart 7China: Policy Response To Slowdown ##br##Has Been Muted So Far China: Policy Response To Slowdown Has Been Muted So Far China: Policy Response To Slowdown Has Been Muted So Far Chart 8China: Credit Tightening China: Credit Tightening China: Credit Tightening We have no doubt that China will stimulate again if the economy appears to be heading for a deep slowdown. However, the bar for a fresh round of stimulus is higher today than it was in the past. Elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities can respond with the usual barrage of infrastructure spending and increased bank lending. The economy needs to feel more pain before policymakers come to its aid. Draghi's Dilemma The Italian economy was showing signs of weakness even before bond yields exploded higher. Domestic demand slowed to a mere 0.3% qoq in Q1. The PMIs, consumer confidence, and the Bank of Italy's Ita-Coin cyclical indicator all decelerated (Chart 9). Italy would benefit from a more competitive cost structure, but the political will to undertake the sort of reforms Germany implemented in the late 1990s, and that Spain implemented after the Great Recession, has been sorely lacking (Chart 10). Unwilling to take tough actions to improve competitiveness, the Five Star-Lega coalition government has proposed loosening fiscal policy to support demand. Chart 9Italy's Economy Is Weakening... Again Italy's Economy Is Weakening... Again Italy's Economy Is Weakening... Again Chart 10Italy: More Work Needs To Be Done On ##br##The Labor Competitiveness Front Italy: More Work Needs To Be Done On The Labor Competitiveness Front Italy: More Work Needs To Be Done On The Labor Competitiveness Front Italy's shift towards populism is arriving at the same time that the ECB is looking to wind down its asset purchase program. This means that a key buyer of Italian debt is stepping back just when it may be needed the most. Getting the ECB to bail out Italy will not be as straightforward this time around. Recall that Mario Draghi and Jean-Claude Trichet penned a letter to the Italian government in 2011 outlining a series of reforms they wanted to see enacted as a condition of ongoing ECB support. The contents of the letter were so explosive that they precipitated the resignation of then-PM Silvio Berlusconi when they were leaked to the public. One of the reforms that Mario Draghi demanded - and the subsequent government led by Mario Monti ultimately undertook - was the extension of the retirement age. Italy's current government has explicitly promised to reverse that decision much to the consternation of the ECB and the European Commission. It was one thing for Mario Draghi to promise to do "whatever it takes" to protect Italy when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. Investment Conclusions The outlook for global risk assets is likely to be more challenging over the coming months. With that in mind, we are downgrading our 12-month recommendation on global equities and credit from overweight to neutral. A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase again over the balance of the year, with the next big move for global equities probably being to the downside. Although Treasurys could rally in the near term, higher U.S. inflation will push bond yields up over a 12-month horizon. Given that yields are positively correlated across international bond markets, rising U.S. yields will put upward pressure on yields in the rest of the world. As such, we recommend shifting equity allocations towards cash rather than long-duration bonds. We would also reduce credit exposure. Within the commodity complex, the backdrop for crude remains more favorable than for economically-sensitive metals. Investors should underweight EM equities, credit, and currencies relative to their developed market peers. The Fed needs to tighten U.S. financial conditions to prevent the economy from overheating. Chart 11 shows that EM equities almost always fall when that is happening. Chart 11Tighter U.S. Financial Conditions Do Not Bode Well For EM Stocks Tighter U.S. Financial Conditions Do Not Bode Well For EM Stocks Tighter U.S. Financial Conditions Do Not Bode Well For EM Stocks A stronger dollar will hurt the profits of U.S. multinationals. That said, the sector composition of the U.S. stock market is a bit more defensive than it is elsewhere. On balance, we no longer have a strong view that euro area and Japanese equities will outperform the U.S. in local-currency terms, and hence we are closing our trade recommendation to this effect for a loss of 5.4%. If macro developments evolve as we expect, we will shift to an outright bearish stance on risk assets later this year or in early 2019 in anticipation of a global recession in 2020. That said, we would consider moving our 12-month recommendation temporarily back to overweight if global equities were to sell off by more than 15% over the next few months or the policy environment becomes markedly more market friendly. But at current prices, the risk-reward trade-off no longer justifies a high degree of bullishness. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com

Highlights As interest rates rise, investors are looking for the leveraged pressure points in the global economy to identify the sectors most likely to show strain. We previously identified the U.S. corporate bond market as a definite candidate. In this report, we look at European corporates. European corporations are still well behind the U.S. in the leveraging cycle. Relative trends in corporate financial health have generally favored European credit quality relative to U.S. issuers. Below the surface, balance sheet repair in the Eurozone has been concentrated in domestic issuers; financial trends among foreign issuers have resembled those in the U.S. market. Foreign issuers are much more vulnerable to higher interest rates and an economic downturn. Interest- and debt-coverage ratios are likely to fall to levels that will spark a raft of downgrades for foreign firms issuing into the Eurozone market, in the event that interest rates rise and a recession follows. Investors should concentrate their European corporate bond portfolios in domestic securities. Feature That said, trends in financial health are unlikely to be the key driver of corporate bond relative returns this year. More important will be the end of the ECB's asset purchase program. We recommend an underweight position in Eurozone IG and HY relative to Eurozone government bonds, and relative to U.S. corporates. Risk assets remain on a collision course with monetary policy, which is the main reason why the "return of vol" was a key theme in the BCA 2018 Outlook. In the U.S., rising inflation is expected to limit the FOMC's ability to cushion soft patches in the economic data or negative shocks from abroad. We expect that ECB tapering will add to market stress, especially now that Eurozone breakup risks are again a concern. We also believe that geopolitics will remain a major source of uncertainty and volatility. All this comes at a time when corporate bond spreads offer only a thin buffer against bad news. On a positive note, we remain upbeat on the earnings outlook in the major countries. The U.S. recession that we foresaw in 2019 has been delayed into 2020 by fiscal stimulus. The longer runway for earnings to grow keeps us nervously overweight corporate bonds, at least in the U.S. That said, corporates are no more than a carry trade now that the lows in spreads are in place for the cycle. We are keeping a close eye on a number of indicators that will help us to time the next downgrade to our global corporate bond allocation. Profitability is just one, albeit important, aspect of the financial backdrop. What about the broader trends in other measures of corporate health, like leverage? Do they justify wider spreads even if the economy and profits hold up over the next year? We reviewed U.S. corporate financial health in the March 2018 monthly Bank Credit Analyst, using our bottom-up sample of companies. We also stress-tested these companies for higher interest rates and a medium-sized recession.1 We concluded that the U.S. corporate sector's heavy accumulation of debt in this expansion will result in rampant downgrade activity during the next economic downturn. In this report, we extend the analysis to the European corporate sector. The European Corporate Health Monitor The bottom-up version of our European Corporate Health Monitor (CHM) is a complement to our top-down CHM, which uses macro data from the European Central Bank (ECB) to construct an index of six financial ratios for the non-financial corporate sector. While useful as an indicator of the overall trend in corporate financial health in the Eurozone, the top-down CHM does not shed light on underlying trends across credit quality, countries and sectors. It also fails to distinguish between domestic versus foreign issuers in the Eurozone market. To allow those comparisons, we built bottom-up versions of the CHM using actual individual company financial data that are then aggregated up to the sector level, etc. A number of features of the European market limit the bottom-up analysis to some extent relative to what we are able to do for the U.S.: the Eurozone market is significantly smaller and company data typically do not have as much history; foreign issuers comprise almost 50% of the market, a much higher percentage than in the U.S.; and the Financial sector features more prominently in the Eurozone index, but we exclude it in our CHM calculations because financial firms are structurally different than non-financial firms (i.e. financials sustainably operate with much higher leverage and much lower returns on capital). We analyzed only domestic issuers in our study of U.S. corporate health. However, we decided to include foreign issuers in our Eurozone analysis in order to maximize the sample size. Moreover, it is appropriate for some bond investors to consider the whole picture, given that important benchmarks such as the Bloomberg Barclays corporate bond indexes include both foreign and domestic issuers. The relative composition of domestic versus foreign, investment grade versus high-yield, and industrial sectors in our sample are comparable with the weights used in the Bloomberg Barclays index. The CHM is calculated using the median value for each of six financial ratios (Table 1). We then standardize2 the median values for the six ratios and aggregate them into a composite index using a simple average. The result is an index that fluctuates between +/- 2 standard deviations away from a medium-term trend. A rising index indicates deteriorating health, while a downtrend signals improving health. Table 1Definitions Of Ratios That Go Into The CHMs Leverage And Sensitivity To Rising Rates: The Eurozone Corporate Sector Leverage And Sensitivity To Rising Rates: The Eurozone Corporate Sector We defined it this way in order to facilitate comparison with trends in corporate spreads (i.e. a rising CHM means worsening credit quality, justifying wider credit spreads). One has to be careful in interpreting our Eurozone CHM. The bottom-up version only dates back to 2005. Thus, while both the level and change in the U.S. CHM provide important information regarding balance sheet health, for the Eurozone CHM we focus more on the change. Whether it is a little above or below the zero line is less important than the trend. Top-Down Versus Bottom-Up Chart 1 compares the top-down and bottom-up Eurozone CHMs for the entire non-financial corporate sector.3 The levels are different, although the broad trends are similar. Key differences that help to explain the divergence include the following: the top-down CHM defines leverage to be total debt as a percent of the market value of equity, while our bottom-up CHM defines it to be total debt as a percent of the book value of the company. The second panel of Chart 1 highlights that the two measures of leverage have diverged significantly since 2012; the top-down CHM defines profit margins as total cash flow as a percent of sales. For data availability reasons, our bottom-up version uses operating income/total sales; most importantly, the top-down CHM uses ECB data, which includes only companies that are domiciled in the Eurozone. Thus, it excludes foreign issuers that make up a large part of our company sample and the Bloomberg Barclays index. When we recalculate the bottom-up CHM using only domestic investment grade issuers, the result is much closer to the top-down version (Chart 2). Both CHMs have been in 'improving health' territory since the end of the Great Financial Crisis. The erosion in the profitability components during this period was offset by declining leverage, rising liquidity and improving interest coverage for domestic issuers. Chart 1Top-Down Vs. Bottom-Up Top-Down Vs. Bottom-Up Top-Down Vs. Bottom-Up Chart 2Top-Down Vs. Domestic Bottom-Up Top-Down Vs. Domestic Bottom-Up Top-Down Vs. Domestic Bottom-Up It has been a different story for foreign investment grade issuers (Chart 3). These firms have historically enjoyed higher returns on capital, operating margins, interest coverage, debt coverage and liquidity. Nonetheless, heavy debt accumulation has undermined their interest- and debt-coverage ratios in absolute terms and relative to their domestic peers until very recently. In other words, while domestic issuers have made an effort to clean up their balance sheets since the Great Recession, financial trends among foreign issuers look more like the trends observed in the U.S. No doubt, this is in part due to U.S. companies issuing euro-denominated debt, but there are many other foreign issuers in our sample as well. Some analysts prefer total debt/total assets to the leverage measure we use in constructing our CHMs. However, the picture is much the same; leverage among investment grade domestic and foreign firms has diverged dramatically since 2010 (Chart 4). Over the past year or so there has been some reversal in the post-Lehman trends; domestic health has stabilized, while that of foreign issuers has improved. Leverage among foreign companies has leveled off, while margins and the liquidity ratio have bounced. The results for high-yield issuers must be taken with a grain of salt because of the small sample size. Chart 5 highlights that the high-yield CHM is improving for both domestic and foreign issuers. Impressively, leverage is declining for both the domestic and foreign components. The return on capital, interest coverage, and debt coverage have also improved, although only for foreign issuers. Chart 3Bottom-Up: Domestic Vs. Foreign IG Bottom-Up: Domestic Vs. Foreign IG Bottom-Up: Domestic Vs. Foreign IG Chart 4Diverging Leverage Trends Diverging Leverage Trends Diverging Leverage Trends Chart 5Bottom-Up: Domestic Vs. Foreign HY Bottom-Up: Domestic Vs. Foreign HY Bottom-Up: Domestic Vs. Foreign HY Corporate Sensitivity The bottom line is that, while there have been some relative shifts below the surface, the European corporate sector's finances are generally in good shape in absolute terms and relative to the U.S. This is particularly the case for domestic issuers that have yet to catch the debt-financed equity buyback bug. However, the threat of less accommodative ECB monetary policy and rising borrowing rates raises potential concerns over future Eurozone corporate bond performance - especially if the economy suffers a prolonged slump. Corporate bond yields and spreads remain near historically low levels in Europe. Thus, it is important to estimate the potential impact of higher borrowing rates, weaker economic growth, or both, on Eurozone corporate financial health and, by association, corporate bond spreads. We estimated the change in the interest coverage ratio for the companies in our bottom-up European sample for a 100 basis-point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt (i.e. the coupons reset only for the bonds, notes and loans that mature in the next three years). We make the simplifying assumptions that all debt and loans maturing in the next three years are rolled over, but that companies do not take on net new obligations. We also assume that earnings before interest and taxes (EBIT) are unchanged in order to isolate the impact of higher interest rates. The 'x' in Chart 6 denotes the result of the interest rate shock only. The 'o' combines the interest rate shock with a recession scenario, in which EBIT contracts by 15%. The interest coverage ratio declines sharply when rates rise by 100 basis points, but the ratio moves to a new post-2000 low only for foreign issuers. The ratio for domestic issuers falls back to the range that existed between 2009 and 2013. The median interest coverage ratio drops further when we combine this with a 15% earnings contraction in the recession scenario. Again, the outcome is far worse for foreign issuers than for domestic issuers. Chart 7 presents a shock to the median debt coverage ratio. Since debt coverage (cash flow divided by total debt) does not include interest payments, we show only the recession scenario result that reflects the decline in profits. Once again, foreign issuers appear to be far more exposed to an economic downturn than their domestic brethren. Chart 6Interest Coverage Shocks Interest Coverage Shocks Interest Coverage Shocks Chart 7Debt Coverage Shock Debt Coverage Shock Debt Coverage Shock Indeed, the results for Eurozone foreign issuers are qualitatively similar to the shocks we previous published for our bottom-up sample of investment grade corporates in the U.S. (Charts 8 and 9). In both cases, higher interest rates and contracting earnings will take the interest coverage and debt coverage ratios down into uncharted territory. Chart 8U.S. Interest Coverage Shocks U.S. Interest Coverage Shocks U.S. Interest Coverage Shocks Chart 9U.S. Debt Coverage Shock U.S. Debt Coverage Shock U.S. Debt Coverage Shock Conclusions European corporations are still well behind the U.S. in the leveraging cycle. Relative trends in corporate financial health have generally favored European credit quality relative to U.S. issuers, where balance sheet activity has focused on lifting shareholder value since the last recession. Below the surface, balance sheet repair in the Eurozone has been concentrated in domestic issuers; financial trends among foreign issuers have resembled those in the U.S. market. There has been a small convergence of financial health between Eurozone domestic and foreign issuers over the past year or so, but the latter are still much more vulnerable to higher interest rates and an economic downturn. Interest- and debt-coverage ratios are likely to fall to levels that will spark a raft of downgrades for foreign firms issuing into the Eurozone market, in the event that interest rates rise and a recession follows. Investors should concentrate their European corporate bond portfolios in domestic securities. That said, trends in financial health are unlikely to be the key driver of corporate bond returns relative to European government bonds or to U.S. corporates this year. More important will be the end of the ECB's asset purchase program later in 2018. We expect spreads to widen as this important liquidity tailwind fades. For the moment, our Global Fixed Income Strategy service recommends an underweight position in Eurozone investment grade and high-yield corporates relative to Eurozone government bonds, and relative to U.S. corporates. Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see Section II of the March 2018 edition of The Bank Credit Analyst, "Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector", available at bca.bcaresearch.com. 2 Standardizing involves taking the deviation of the series from the 18 quarter moving average and dividing by the standard deviation of the series. 3 Note that a rising CHM indicates deteriorating health to facilitate comparison with quality spreads.

Highlights Fed: The Fed delivered a confidently hawkish rate hike last week, but its projections for growth and, more importantly, inflation appear too cautious. With the market still not fully priced to the Fed's interest rate "dots", and with inflation expectations likely to continue rising to levels consistent with the Fed's inflation target, Treasury yields will remain under upward pressure. Maintain a defensive, below-benchmark U.S. duration stance. ECB: The ECB finally signaled the end of its current Asset Purchase Program, while sticking with its message that interest rate hikes are not likely until at least September 2019. The ECB's optimistic growth and inflation forecasts for the next couple of years may not be realized, but that will not prevent euro area bond yields from drifting higher as the ECB stops buying. Stay below-benchmark on euro area duration exposure. Feature Chart Of the WeekFed Vs. ECB: Still Diverging Fed vs. ECB: Still Diverging Fed vs. ECB: Still Diverging Central bank watching used to be a fairly black and white endeavor for investors and analysts. Policies were either "hawkish", "dovish" or perhaps "neutral". New buzzwords have entered the lexicon in the post-crisis era, however, as central banks have often struggled to adjust policy settings without upsetting financial markets. Now, the combination of action on interest rates and central bank communications can create additional types of policy moves, like a "hawkish hold" or a "dovish hike". With the Federal Reserve and the European Central Bank (ECB) announcing policy moves last week, we dedicate this Weekly Report to our assessment of the actions taken by each bank, while trying to throw a few more monetary policy buzzwords into the mix to describe their decisions. Our conclusion is that while there is a need to see tighter monetary conditions on both sides of the Atlantic, the Fed is still delivering a combination of rate changes and language that is creating more upside for bond yields in the U.S. than in Europe (Chart of the Week). The Fed: Hawkishly Hawkish The Fed sounded a confident tone at last week's policy meeting, delivering another 25bp rate hike while also upgrading its growth and inflation forecasts for 2018. In the press conference following the FOMC meeting, Fed Chairman Jerome Powell expressed a very upbeat view on the state of the economy and even sounded a bit surprised as to how resilient growth has been. Yet it appears that the Fed is still erring a bit on the cautious side when it comes to its economic growth projections and, by association, its inflation forecast. The Fed now expects U.S. real GDP growth of 2.8% in 2018, up a mere 0.1 percentage point from its projection from last March. Yet the economy has accelerated in the recent months and the Atlanta Fed's GDPNow model is calling for growth to hit a whopping 4.8% in the second quarter. While that model tends to over-predict actual growth outcomes, it does underscore how strong the current run of U.S. data has been and how the risks on the economy are tilted to the upside. That strength is also manifesting itself in robust business confidence, as evidenced by the latest read on small business optimism from the National Federation of Independent Business (NFIB) that was released last week.1 The overall NFIB Optimism Index reached the second highest level in its 45-year history in May, while a record number of respondents felt that now was a "good time to expand" (Chart 2). Reports of positive earnings trends also hit a record high, while reports of positive sales growth were the highest since 1995. At the same time, concerns about labor quality hit the second highest level in the history of the NFIB survey, while reports of compensation increases hit a record high. This booming economy is also impacting price-setting behavior, with reports of actual and planned price increases hitting the highest levels in a decade. Against this backdrop of very robust growth, the Fed did lower its forecast for the unemployment rate for 2018 (now 3.6%), 2019 (3.5%) and 2020 (3.5%). Yet its 2018 projections for headline and core PCE inflation were only nudged up by 0.2 percentage points (to 2.1%) and 0.1 percentage points (to 2.0%), respectively. Inflation is expected to remain around those levels in 2019 and 2020. Does the Fed still believe that NAIRU in the U.S. is 4.5%? If so, there is a serious disconnect between its unemployment and inflation forecasts - one that is more likely to be resolved via higher inflation, especially if those readings from the NFIB data are to be taken at face value. The FOMC did send a mildly hawkish message last week through its interest rate projections (the "dots"). They added one more expected rate increase to 2018, which would bring the total amount of hikes this year to 100bps. However, no cumulative additional increases were added beyond 2018, which means that the Fed merely pulled forward a rate hike that would have occurred in 2020. We still anticipate that a 25bps-per-quarter pace of hikes is the most likely outcome for the Fed over the next year, especially now that the inflation-adjusted funds rate is hovering around the Fed's own estimate of the neutral "r-star" level. That path of rates is still not fully discounted in U.S. money markets (Chart 3), however, which suggests that Treasury yields will remain under upward pressure from a higher front-end of the yield curve. Chart 2U.S. Economy Is On Fire U.S. Economy Is On Fire U.S. Economy Is On Fire Chart 3Market Still Not Fully Converged To Fed Dots Market Still Not Fully Converged To Fed Dots Market Still Not Fully Converged To Fed Dots The Fed will likely err on the side of caution regarding the pace of rate increases, however, given the fact that a) wage growth is still relatively subdued given how tight the labor market is; b) TIPS breakevens are not yet at levels consistent the with the market believing that the Fed has achieved its inflation target; c) the rising U.S. dollar is tightening monetary conditions at the margin; and d) the growing threat of a U.S.-vs-The-World trade war may pose a more serious risk to global growth. Yet all those factors are likely not enough to derail the booming U.S. growth locomotive. Only a move to an outright restrictive Fed monetary policy will make that happen. However, at the moment, the Fed seems more willing to tolerate a potential overshoot of its inflation target than to try and slow an overheating economy. This means that Treasury yields will likely rise through higher inflation expectations, as well as through a convergence of market pricing to the Fed's interest rate projections. Stay below-benchmark on U.S. Treasury market duration exposure. Bottom Line: The Fed delivered a confidently hawkish rate hike last week, but its projections for growth and, more importantly, inflation appear too cautious. With the market still not fully priced to the Fed's interest rate "dots", and with inflation expectations likely to continue rising to levels consistent with the Fed's inflation target, Treasury yields will remain under upward pressure. Maintain a defensive, below-benchmark U.S. duration stance. The ECB: Dovishly Hawkish The ECB announced last week what had widely been expected by the market - that there would be no net new bond buying in its Asset Purchase Program (APP) after December of this year. Yet at the same time, the central bank was able to convey a dovish signal on the timing and pace of rate hikes after the bond purchases stop. Financial markets latched onto the latter message, triggering a rally in euro area bond markets and a daily decline of two big figures on EUR/USD. The central bank sounded a very confident tone - perhaps, surprisingly so - on both the growth and inflation outlook. ECB President Mario Draghi described the deceleration of the euro area economy in the first quarter as a "soft patch" and that the 0.4% (non-annualized) growth in real GDP was "still high growth". Draghi went even further in his description of the strong economy seen last year, and the slowing seen so far in 2018, as being largely driven by external demand: "Basically, it's a pullback from the very high levels of growth in 2017, mostly justified by an extraordinary pickup in exports, which is unlikely to repeat itself now, compounded by an increase - an undeniable increase in uncertainty - and for a variety of reasons really, mostly geopolitical reasons, and some temporary and supply-side factors at both the domestic and the global level as well as weaker impetus from external trade." That assessment for the cause of the Q1/2018 growth slowdown is accurate, as the peak in euro area data such as the manufacturing PMI, industrial confidence and the OECD's leading economic indicator all occurred alongside a slowing of export growth (Chart 4). Yet the ECB may be too optimistic in thinking that the softening in export demand will prove to be "temporary". In the ECB's updated macroeconomic projections, the forecast for real GDP growth in 2018 was revised down from 2.4% to 2.1%, largely due to a reduction in expected export growth from 5.3% to 4.2%. Yet the GDP forecasts for 2019 (+1.9%) and 2020 (+1.7%) were unchanged, and the export growth projection for 2019 was upgraded from 4.1% to 4.4%. That is a view that may prove to be too optimistic. Global trade activity is slowing fast at the moment, primarily on the back of diminished Chinese demand (bottom panel), and leading economic indicators (outside of the U.S.) have rolled over. With U.S. President Donald Trump now turning his protectionist trade rhetoric into actual tariff actions - aimed not just at China but also Europe - the risks are all to the downside for the ECB's growth projections. We find it a bit surprising that the market reacted so strongly to the ECB's indication that interest rates would be kept at current levels "at least through the summer of 2019".2 That language is consistent with the message that the ECB had been signaling prior to last week that any rate hikes would not take place soon after the net new bond purchases end. Taking the ECB's statement at face value, it would suggest that September 2019 is the first possible "live" meeting where a rate hike could occur. According to a survey of economists taken in early June by Bloomberg, the consensus view was that the net bond purchases would stop in December, the ECB would raise the deposit rate in the second quarter of 2019, and then raise the main refinancing rate (the ECB's primary policy rate) from 0% in the third quarter of 2019.3 This is broadly consistent with the pricing we see in our own "months-to-hike" indicator for the euro area, which shows that a 10bp rate increase is priced into the euro Overnight Index Swap (OIS) curve by August 2019, but with a full 25bps of increases not discounted until March 2020 (Chart 5). That date for the 10bp hike was at June 2019 on the day prior to last week's policy meeting, so the market repriced more or less in line with the ECB's messaging on the potential timing of that first hike. Chart 4Is The ECB Too Optimistic On Growth? Is The ECB Too Optimistic On Growth? Is The ECB Too Optimistic On Growth? Chart 5Market & ECB Are In Agreement Market & ECB Are In Agreement Market & ECB Are In Agreement Draghi gave no specific indication as to which of the ECB's policy rates would be moved first - when the ECB finally does decide to move - nor what the size of that first move could be. Yet even if the ECB "goes small" on that first move and does not move in 25bp increments like the Fed has been doing, that outcome has now been largely been discounted in the money market yield curve. Our view remains that there will be no rate hikes from the ECB until euro area core inflation and, more importantly, inflation expectations are much higher (Chart 6). As a rough rule of thumb, the ECB's previous rate hikes during the mid-2000s tightening cycle, and even the much-criticized hikes in 2011 that played a role in triggering the European Debt Crisis, did not occur until market-based inflation expectations measures like the 5-year CPI swap, 5-years forward were above 2% (bottom panel). Realized core euro area inflation was pushing toward 1.5-2% during those prior two episodes, which the ECB is not projecting to occur until later in 2019. So with core inflation only at 1.1%, and with inflation expectations still mired at 1.7%, the market is correct to take the ECB at its word that it will not even consider raising rates until next September. So why did bond yields and the euro decline after last week's ECB meeting? Perhaps it was Draghi mentioning in his press conference that bond purchases could be restarted, if needed: "[...] APP is not disappearing; it remains part of the toolbox. It's a new instrument of monetary policy that will be used for contingencies that we don't see now, and that's what we anticipate. But it remains now as a normal instrument to monetary policy." This is not a provocative statement, of course. The Bank of England did exactly that - restarting its quantitative easing (QE) program after the shock of the 2016 Brexit vote - while the Fed has also stated that it could do more rounds of QE in the future if the situation required it (but only after the funds rate had been cut back to the zero once again). Perhaps by leaving the door open a crack to ramping up the APP again, at a time when euro area growth is decelerating and core inflation remains well below target, the ECB was seen by the market to be hedging its bets with regards to exiting the current extraordinarily accommodative monetary policy settings. The ECB has been trying to communicate consistently over the past few months that the decisions on stopping bond purchases and hiking interest rates should be treated separately. In other words, a decision on the former would not have any sort of immediate implications for the latter. We discussed the possibility of the ECB avoiding a Fed-style Taper Tantrum when it exited its APP program back in March.4 Our conclusion was that while the ECB had been absorbing a greater share of government bond issuance than the Fed ever did during its QE programs, the "flow effect" of the ECB buying fewer bonds as it exited the APP would still push up euro area bond yields through the normalization of negative term premia (Chart 7). The ECB has been arguing that the "stock effect" of it owning such a large share of the euro area bond market has created a scarcity of risk-free assets that will keep yields subdued. Yet as was shown in the U.S. experience, the bigger impact on U.S. Treasury yields from its QE program was the signaling effect on the expected path of interest rates post QE. That can be seen by the very tight correlation between the term premium on 10-year U.S. Treasury yields and our measure of the market's expectation for the neutral rate fed funds rate - the 5-year U.S. OIS rate, 5-years forward minus the 5-year U.S. CPI swap rate, 5-years forward (Chart 8). A similarly tight correlation exists in the euro area interest rate markets (bottom panel), suggesting that the ECB may have a tougher time keeping a lid on bond yields than they expect if the market starts to raise the expected path of interest rates at a faster pace than the ECB would like to see. Chart 6ECB Will Not Hike Until Inflation ##br##Expectations Are Much Higher ECB Will Not Hike Until Inflation Expectations Are Much Higher ECB Will Not Hike Until Inflation Expectations Are Much Higher Chart 7The 'Flow Effect' Of Less ECB Buying##br## Will Boost Bond Yields The 'Flow Effect' Of Less ECB Buying Will Boost Bond Yields The 'Flow Effect' Of Less ECB Buying Will Boost Bond Yields Chart 8Markets Do Not Treat Tapering ##br##& Rate Hikes Separately Markets Do Not Treat Tapering & Rate Hikes Separately Markets Do Not Treat Tapering & Rate Hikes Separately For now, the uncertainty of the current state of euro area economic growth, combined with core inflation that is still undershooting the ECB's target, suggests that euro area bond yields will remain subdued in the near term. Yet as the ECB begins to cut its pace of asset purchases after September of this year, a slow drift higher in euro area bond yields is still the most likely outcome. If the euro area economy rebounds as the ECB expects, then the risk of an even bigger move higher in yields would increase as the market reprices the ECB rate hike cycle, although only if accompanied by an acceleration in core inflation and inflation expectations. We are maintaining our strategic recommendation to stay below-benchmark on duration risk within euro area bond portfolios. In terms of country allocation, we are sticking with our modest underweight stance, however, although we do still prefer owning core European bonds over U.S. Treasuries (especially on a currency hedged basis into U.S. dollars), as the risks of higher bond yields are still much greater in the U.S. than in Europe. Bottom Line: The ECB finally signaled the end of its current Asset Purchase Program, while sticking with its message that interest rate hikes are not likely until at least September 2019. The ECB's optimistic growth and inflation forecasts for the next couple of years may not be realized, but that will not prevent euro area bond yields from drifting higher as the ECB stops buying. Stay below-benchmark on euro area duration exposure. ­­ Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 https://www.nfib.com/surveys/small-business-economic-trends/ 2 http://www.ecb.europa.eu/press/pressconf/2018/html/ecb.is180614.en.html 3 https://www.bloomberg.com/news/articles/2018-06-07/draghi-s-bond-buying-era-seen-ending-as-ecb-gears-up-for-talks 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Bond Markets Are Suffering Withdrawal Symptoms", dated March 20th 2018, available at gfis.bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Hawks & Doves And Everything In Between Hawks & Doves And Everything In Between Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns