Market Returns

Highlights Falling Yields: There have been three main drivers of the latest decline in global bond yields: slower global growth, softer inflation expectations and increased safe-haven demand for bonds given the intensifying U.S.-China trade conflict. The first two are more than fully discounted in current yield levels, but the latter is likely to persist in the near-term with no resolution of the trade conflict in sight. Model Portfolio Adjustments: We are tactically reducing the sizes of the overall strategic tilts in our model bond portfolio – below-benchmark duration exposure and overweight global corporates vs. governments. There is a growing risk of deeper selloffs in global equity and credit markets if the June G-20 meeting produces no positive signals on ending the trade dispute. We do not yet see a case to position more defensively on a medium-term horizon, however, given the pickup in “early” global leading economic indicators. Feature Chart of the WeekYields Discount A Lot Of Bad News Yields Discount A Lot Of Bad News Yields Discount A Lot Of Bad News The investment backdrop at the moment – slowing global growth momentum, softening inflation expectations, an increasingly prolonged U.S.-China trade dispute with no immediate sign of resolution, and a strengthening U.S. dollar– is fairly bond bullish. Unsurprisingly, government bond yields in the developed markets have fallen to levels more consistent with a less certain macro environment. At one point last week, the 10-year U.S. Treasury yield dipped as low as 2.30%, while the 10-year German Bund fell deeper into negative territory at -0.13%. There are now expectations of easier monetary policy discounted in yield curves of several countries, most notably the U.S. where markets are priced for 50bps of Fed rate cuts over the next year – despite no indication from the Fed that cuts are coming anytime soon. From a valuation perspective, bond yields are starting to look a bit stretched to the downside (Chart of the Week). The term premium component of yields has fallen to near post-crisis lows in the majority of countries, while the U.S. dollar has surged despite lower U.S. interest rate expectations – both indications of investors driving up the value of traditional safe-havens at a time of uncertainty. Looking purely at the growth side of the equation, the downward momentum in bond yields should start to fade with the global leading economic indicator now in the process of bottoming out. That does not mean, however, that yields could not fall further in the near-term if the trade headlines get worse and risk assets sell off more meaningfully – an outcome that grows increasingly likely as the two sides in the trade war seem to be digging in for a longer battle. The State Of The World Since The “TTT” Our colleagues at BCA Geopolitical Strategy now believe that there is only a 40% chance of a U.S.-China trade deal by the end of June. This could trigger a deeper selloff in global equity and credit markets if investors begin to price in a larger and more prolonged hit to economic growth and corporate profits from the U.S. tariffs. This would trigger even greater safe-haven flows into government bonds, pushing yields lower through a more negative term premium. The much lower level of U.S. Treasury yields has helped limit the hit to risk asset prices from the elevated uncertainty over global trade. Since the “Trump Tariff Tweet” (TTT) of May 5, when the new round of tariffs on U.S. imports from China was announced which sparked the new leg of the trade war, the fall in benchmark 10-year government bond yields across the developed world can be fully explained by the fall in the term premium (Table 1). For example, the 10-year U.S. Treasury yield has fallen -14bps since the TTT, while our estimate of the term premium on the 10-year Treasury as decreased by -20bps. Over the same time period, 10-year U.S. inflation expectations have also fallen -11bps, but the market has only priced in an additional -5bps of Fed rate cuts over the next year according to our Fed Discounter. Table 1Decomposing 10-Year Government Bond Yield Changes Since The "Trump Tariff Tweet" The Message From Low Bond Yields The Message From Low Bond Yields The big difference between last December and today is the much lower level of U.S. Treasury yields. Lower yields have helped mute the hit to risk asset prices from the elevated uncertainty over global trade since the TTT (Chart 2). The Fed’s more dovish pivot in the early months of 2019 has helped push Treasury yields lower as investors have moved from pricing in rate hikes to discounting rate cuts. Even traditional “risk-off” measures like the VIX, U.S. TED spreads, the price of gold and the Japanese yen have only risen modestly since the TTT compared to the big moves seen back in December when investors feared that the Fed would tighten right into a U.S. recession (Chart 3). Chart 2Risk Assets Remain Relatively Calm Risk Assets Remain Relatively Calm Risk Assets Remain Relatively Calm Chart 3Falling Bond Yields Helping Keep Vol Subdued Falling Bond Yields Helping Keep Vol Subdued Falling Bond Yields Helping Keep Vol Subdued Easier monetary policy, if delivered, can help underwrite a rebound in equity and credit markets. When looking across the array of financial market returns since the TTT (Table 2), the only developed economies that have seen equities appreciate are Australia and New Zealand – countries where rate cuts are being signaled by policymakers (or already delivered, in the case of New Zealand). Table 2Asset Returns By Country Since The "Trump Tariff Tweet" The Message From Low Bond Yields The Message From Low Bond Yields In the case of the U.S., however, numerous Fed officials have stated recently that no changes to U.S. monetary policy are likely without decisive evidence that the new round of China tariffs and trade uncertainty was having a major negative impact on U.S. growth. On that front, forward-looking measures of U.S. economic activity, like the Conference Board leading economic indicator or our models for U.S. employment and capital spending, are not pointing to an imminent sharp slowing of U.S. growth (Chart 4). At the same time, leading indicators like our global LEI diffusion index and the China credit impulse are both signaling that global growth momentum may soon start surprising to the upside (Chart 5). Chart 4No U.S. Recession Signal Yet From These Indicators No U.S. Recession Signal Yet From These Indicators No U.S. Recession Signal Yet From These Indicators Chart 5Some Reasons For Optimism On Global Growth Some Reasons For Optimism On Global Growth Some Reasons For Optimism On Global Growth If the Fed does not see a case to deliver the rate cuts that are now discounted, or even to just signal to the markets that easier policy is coming soon, then there is a greater chance of a deeper pullback in U.S. equity and credit markets from any new negative news on trade. This suggests that the risk-aversion bid for U.S. Treasuries will result in an even more deeply negative U.S. term premium and lower bond yields. Easier monetary policy, if delivered, can help underwrite a rebound in equity and credit markets. Already, we are seeing such increasingly negative correlations between returns on equities and government bonds across the major developed markets. In Charts 6 & 7, we show the rolling 52-week correlation between local government bond and equity returns for the U.S., euro area, Japan, U.K., Canada and Australia. For each country, we also plot that correlation versus our estimate of the term premium on 10-year government bond yields. Chart 6Safe Haven Demand For Bonds ... Safe Haven Demand For Bonds... Safe Haven Demand For Bonds... Chart 7... Helping Drive Down Term Premia ...Helping Drive Down Term Premia ...Helping Drive Down Term Premia It is clear that there is a significant “risk-aversion bid” for government bonds right now, given the increasingly negative stock/bond correlations and falling term premia. One possible interpretation is that falling bond yields are being driven more by fears of a risk-off selloff in global equity and credit markets rather than rational pricing of future monetary policy or inflation expectations because of slowing growth. Interestingly, Australia – where the central bank has been signaling that rate cuts are imminent – is the only exception in this list of countries where the stock/bond correlation is not negative. There, the deeply negative term premium is more about weakening growth and low inflation expectations, which is forcing a dovish response from the Reserve Bank of Australia, rather than a risk aversion bid for safe assets from investors. It is clear that there is a significant “risk-aversion bid” for government bonds right now, given the increasingly negative stock/bond correlations and falling term premia. Net-net, while bond yields discount a lot of bad news and now look too low compared to tentative signs of improving global growth, it is hard to build a case for an imminent rebound in global bond yields without signs that U.S. and China are getting closer to a trade deal. Bottom Line: There have been three main drivers of the latest decline in global bond yields: slower global growth, softer inflation expectations and increased safe-haven demand for bonds given the intensifying U.S.-China trade conflict. The first two are more than fully discounted in current yield levels, but the latter is likely to persist in the near-term with no resolution of the trade conflict in sight. Tactical Risk-Reduction Adjustments To Our Model Bond Portfolio Chart 8Easier Monetary Policy Required In Europe & Australia Easier Monetary Policy Required In Europe & Australia Easier Monetary Policy Required In Europe & Australia Given the growing potential for a larger selloff in global risk assets if no U.S.-China trade deal comes out of next month’s G-20 meeting (where Presidents Trump and Xi will both be in attendance), we think it is prudent to make some tactical adjustments to the recommended weightings within our model bond portfolio. These moves will provide a partial hedge against any near-term widening of global credit spreads or further reduction in government bond yields in the event of a complete breakdown of the trade talks. Specifically, we are making the following changes: Duration Exposure: We are increasing the overall duration of the model bond portfolio by 0.5 years, which still leaves a duration position that is 0.5 years below the custom benchmark index of the portfolio. We are doing this by increasing allocations to the longer maturity buckets in the U.S., Japan and France. Credit Exposure: We are cutting the sizes of our recommended overweight tilts for U.S. corporates in half for both investment grade and high-yield. This is a combined reduction of nearly 4% of the portfolio that will be used to fund the increase in duration on the government bond side. We are making no other changes to our government bond country allocations, staying overweight in core Europe (Germany plus France), Japan and Australia where our Central Bank Monitors are calling for a need for easier monetary policy (Chart 8). We are also staying overweight U.K. Gilts, where yields continue to trade more off Brexit uncertainty than domestic economic growth or inflation pressures. We are not making any changes to the model bond portfolio exposure to euro area corporate debt or Italian governments, riskier spread products where we are already underweight. We are, however, maintaining our weightings for U.S. dollar denominated EM sovereign and corporate debt at neutral. EM debt has performed relatively well versus developed market equivalents since the May 5 “Trump Tariff Tweet” (TTT). We understand that not downgrading EM seems counterintuitive when we are trying to position more defensively in the model portfolio. We prefer to reduce exposure to U.S. credit, however, given that EM debt has performed relatively well versus developed market equivalents since the May 5 TTT (Table 3), and with EM spreads now at more attractive levels relative to U.S. investment grade (Chart 9). In addition, EM credit tends to perform better during periods when Chinese credit growth is accelerating, as is currently the case (bottom panel) – and which may continue if China’s policymakers eventually turn to more domestic stimulus measures to combat the effects of U.S. tariffs, as seems likely. Table 3Credit Market Performance Since The "Trump Tariff Tweet" The Message From Low Bond Yields The Message From Low Bond Yields Chart 9EM Credit Offers Value Versus U.S. Corporates EM Credit Offers Value Versus U.S. Corporates EM Credit Offers Value Versus U.S. Corporates Importantly, these are all only tactical changes to our model portfolio to partially protect against the risk of U.S. credit spread widening in the event of more negative news on the U.S.-China trade front. We still have not changed our strategic (6-12 month) views on global bond yields (higher) and global corporates (outperforming government bonds) given the tentative signs of improving global growth from the leading indicators. Bottom Line: We are tactically reducing the sizes of the overall strategic tilts in our model bond portfolio – below-benchmark duration exposure and overweight global corporates vs. governments. There is a growing risk of deeper selloffs in global equity and credit markets if the June G20 meeting produces no positive signals on ending the trade dispute. We do not yet see a case to position more defensively on a medium-term horizon, however, given the pickup in “early” global leading economic indicators.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Message From Low Bond Yields The Message From Low Bond Yields Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights This report explores the structural potential for the A-share market by reviewing the performance of several MSCI factor indexes, as well as a number of our own factor portfolios. The persistent outperformance of several fundamental factors in China’s domestic equity market may suggest that A-shares are a less efficient market than other emerging or developed markets, but the evidence does not support the idea that A-shares are a “casino” market that is purely driven by speculation. An A-share portfolio formed of industry groups with above-median return on equity and below-median ex-post beta has significantly outperformed over the past decade, and we are comfortable recommending it relative to the MSCI China A Onshore index to global investors who are looking to increase their secular exposure to domestic Chinese stocks. Feature Chart 1Interest In A-Shares Rose Sharply In Q1, In Lockstep With Prices Interest In A-Shares Rose Sharply In Q1, In Lockstep With Prices Interest In A-Shares Rose Sharply In Q1, In Lockstep With Prices Structural interest in domestic Chinese stocks is growing among global investors, which has been heightened somewhat over the past year by MSCI’s decision to progressively include A-shares in the MSCI Emerging Markets Index as well as the ongoing global search for yield/value. BCA’s China Investment Strategy team received many inquiries about the domestic market in Q1 of this year; this was mostly a response to the eye-popping 33% return for the market in the first quarter (Chart 1), but it also reflects a growing recognition of the domestic market and a desire among investors to increase their awareness. The performance of domestic stocks over the past decade has caused some investors to refer to A-shares as a “casino” market; i.e., a highly-volatile and speculative market divorced from fundamental performance, that is primarily driven by momentum-oriented retail investors. But, we have pushed back against the “strong-form” of this view in previous reports,1 arguing that while the A-share market is certainly volatile, it does not appear to be particularly irrational. In this Special Report we explore the structural potential for the A-share market by reviewing the performance of several MSCI factor indexes, both to identify profitable investment opportunities and to further investigate the claim that playing in the A-share market is akin to betting at a casino. We also build several of our own factor portfolios based on similar attributes at the industry group level, and compare the performance of these portfolios to the MSCI factor indexes. Despite obvious near-term risks facing the Chinese economy and equity market, we conclude by recommending a long position in a specific high-performance factor strategy relative to the A-share benchmark, and highlight how the factor performance of Chinese and global stocks challenges the view that the domestic market is driven largely by sentiment rather than fundamentals. The Performance Of MSCI’s Factor Indexes: Onshore China Vs. Global Table 1 presents the six MSCI factor indexes available for both the All Country World and China A Onshore parent indexes, along with a brief description of MSCI’s construction methodology. The methodology for the high dividend yield, size, and value portfolios are relatively straightforward, whereas the construction of the quality, momentum, and low volatility indexes is more involved and definition-dependent. Table 1Description Of MSCI Single Factor Indexes Factor Investing In The A-Share Market Factor Investing In The A-Share Market MSCI defines quality stocks as those having a high return on equity, a low debt/equity ratio, and low earnings variability. Momentum portfolios are build using an average of 6- and 12-month return measures (adjusted for the most recent month’s return to eliminate any short-term reversal effects). Finally, MSCI’s low volatility methodology employs a constrained portfolio optimization approach, where the weight of each constituent stock is set in order to minimize overall portfolio variance. Charts 2 & 3 present the historical price performance of the six factor portfolios for both China A and global, relative to the main benchmark indexes for both regions. We note our observations below: Chart 2The Relative Performance MSCI’s Factor Indexes (Part I) The Relative Performance MSCI's Factor Indexes (Part I) The Relative Performance MSCI's Factor Indexes (Part I) Chart 3The Relative Performance MSCI's Factor Indexes (Part II) The Relative Performance MSCI's Factor Indexes (Part II) The Relative Performance MSCI's Factor Indexes (Part II) Until 2015, the relative price (under)performance of high dividend yielding (“HDY”) stocks had been similar for domestic Chinese and global stocks this cycle.2 Following 2015, high yield stocks continued to underperform at the global level, but massively outperformed in the domestic market to the tune of 11% per year in excess price return. This appears to reflect a shift in domestic Chinese investor sentiment following the 2015 collapse in the A-share market, and has caused a meaningful compression in the average yield of the onshore HDY index relative to the domestic benchmark. It remains unclear whether continued relative outperformance in the domestic market is likely from this factor given how aggressively the strategy has been pursued over the past four years. A low volatility strategy has paid off in the domestic market over the past several years, in contrast to the global market where there has been, at best, a slight uptrend in relative performance over time. Importantly, while the inception date of the MSCI China A Minimum Volatility index is fairly recent, the relative outperformance of the index appears to be much more consistent than that of the HDY index. The apparent success of the low volatility factor within a high volatility equity market is interesting, and serves as the basis of some important investment strategy conclusions to be highlighted later in the report. Similar to the HDY and minimum volatility factors, quality also has outperformed within China’s domestic market. However, this is also true for the global version, in a very consistent fashion over the past decade. The coincident outperformance of quality in both the domestic Chinese and global equity markets is interesting, and also links to some of our later conclusions. In one of the most surprising results of our report, the relative performance of the MSCI momentum index is completely different for the domestic Chinese market than for global stocks. Chart 3 shows that a cyclical momentum strategy has underperformed the MSCI China A onshore index, whereas it has steadily and fairly consistently outperformed at the global level. To us, this finding seems at odds with the common characterization of the A-share market as being driven heavily by momentum-oriented retail investors. In addition, it raises some questions about the efficiency of the global equity market over the past decade. By far, size has exhibited the most impressive potential for outperformance in the A-share market, with domestic small caps having risen three fold relative to large- and mid-cap stocks. However, this massive outperformance has stunningly reversed, with small caps losing 20% per year in relative terms since late-2016. The timing of the collapse appears to be strongly linked with the crackdown on shadow banking by the Chinese government over the past three years (Chart 4), and is consistent with the fact that small firms were disproportionately reliant on alternative financing relative to large firms. This also suggests that at least a portion of the prior massive run-up in small cap performance was boosted by easy access to credit, making it difficult to assess the true underlying impact of size on domestic equity performance. At the global level, small cap stocks have also outperformed the global benchmark, although nearly 80% of the uptrend in relative performance occurred within the first three years of the global expansion. Since mid-2011, global small caps have outperformed the All Country World index by approximately 30 bps per year. Based on MSCI’s indexes, quality and minimum volatility appear to be the most consistently beneficial factors in the A-share market. Finally, the relative performance of value stocks is similar in trend to that of the HDY indexes for both China and global, which is not especially surprising given that the dividend yield is one of three valuation metrics used by MSCI (and many other financial market participants) to define value. However, A-share value has achieved roughly 2/3rds of the annualized outperformance as the HDY factor, in a more consistent fashion that appears to be less influenced by the sentimental shift that occurred in 2015. At the global level, the underperformance of value and HDY stocks likely reflects sector effects, particularly the decade-long underperformance of financials in the aftermath of the global financial crisis (Chart 5). Chart 4Shadow Banking Crackdown = Major Small Cap Underperformance Shadow Banking Crackdown = Major Small Cap Underperformance Shadow Banking Crackdown = Major Small Cap Underperformance Chart 5Globally, Long-Term Underperformance Of HDY And Value Reflects Financial Sector Decline Globally, Long-Term Underperformance Of HDY And Value Reflects Financial Sector Decline Globally, Long-Term Underperformance Of HDY And Value Reflects Financial Sector Decline   Building And Examining New Factor Portfolios CHART 6An Equally-Weighted Industry Group Portfolio Has Outperformed In China And Globally An Equally-Weighted Industry Group Portfolio Has Outperformed In China And Globally An Equally-Weighted Industry Group Portfolio Has Outperformed In China And Globally Given the methodological complexity of some of the factor indexes provided by MSCI, we have created 10 of our own factor portfolios for both the China A onshore and All Country World benchmarks using a simpler approach. Several of these portfolios are conceptually similar to the six MSCI factor indexes, but in practice there are several differences: We identify attributes at the industry group level (GICS level 2), rather than at the individual security level. We use all 24 industry groups at the global level, but owing to certain data limitations, we use a mix of sectors and industry groups for domestic China (for a total of 20 groups). Our approach equally-weights stock groups based on whether the attribute in question is above or below the median of all of the groups. This means that attributes are compared across groups based on their actual current values, not relative to their own history (which is, in practice, what occurs when MSCI calculates a Z-score for a particular attribute). Our equally-weighted group approach means that a portfolio equally-weighted across all groups is the appropriate benchmark to test the performance of our portfolios, rather than the MSCI China A onshore index itself (which is weighted by market capitalization). This is an important difference, because Chart 6 shows that an equally-weighted industry group portfolio has outperformed the main equity benchmark both for global stocks and for A-shares. Thus, outperformance of our factor portfolios versus an equally-weighted industry group portfolio would imply even more outperformance vs the benchmark, value-weighted index. Table 2 describes our 10 factor portfolios, as well as the methodology used to construct them. Besides the general differences between our methodology and MSCI’s noted above, there are also a few specific differences even within factors: Table 2Description of BCA-Calculated Industry-Group Factor Portfolios For Onshore China And Global Stocks (US$) Factor Investing In The A-Share Market Factor Investing In The A-Share Market Our version of a low volatility portfolio allocates to industry groups with below-median beta (rolling 12-month) versus the MSCI China A onshore index. Our momentum portfolio allocates to industry groups based on a simple rolling 12-month return without adjustment, and we include a short-term momentum portfolio for comparison purposes. We specifically test above-median ROE as a factor, rather than building a composite quality index. Our size factor measures whether smaller mid- and large-cap industry groups outperform over time, rather than the impact of size on individual stocks. We use a univariate measure of value, namely a low 12-month trailing P/E ratio. Finally, we include two new factors not explicitly measured by the MSCI indexes: rolling 12-month ex-post alpha (based on a simple regression against benchmark returns), and high 12-month trailing EPS growth. We present two versions of the alpha factor, one portfolio formed on alpha magnitude, and the other on alpha significance. Charts 7-9 present the relative performance of these factor portfolios versus an equally-weighted industry group benchmark, and we list our key findings below: Chart 7The High-Dividend Factor Has Indeed Outperformed Since 2015 The High-Dividend Factor Has Indeed Outperformed Since 2015 The High-Dividend Factor Has Indeed Outperformed Since 2015 Chart 8Momentum Works Better Globally Than In The A-Share Market Momentum Works Better Globally Than In The A-Share Market Momentum Works Better Globally Than In The A-Share Market   Chart 9ROE And Volatility Are Clearly Persistent Factors In China ROE And Volatility Are Clearly Persistent Factors In China ROE And Volatility Are Clearly Persistent Factors In China   Similar to the relative performance of the MSCI factor indexes, our factor portfolios performed better for China than they did for global stocks. With the exception of high (cyclical) momentum, high ROE, and to a lesser extent smaller industry group performance, the factors did not deliver consistently positive excess returns at the global level. Ex-post alpha worked well for global industry groups until 2015, but has since retraced a significant portion of its cumulative excess relative return. Among the domestic China factor portfolios that we created, 7 out of 10 delivered a positive cumulative excess return over the period in question. Size was the worst performing factor, followed closely by short-term momentum and by HDY. Industry groups with a high dividend yield have indeed outperformed substantially since 2015 (consistent with the MSCI China A High Dividend Yield index), but when measured against an equally-weighted industry group portfolio, this outperformance merely made up for a substantial downtrend in relative performance from 2009 to 2015. Among the successful factor portfolios, two stand out as having delivered exceptional relative performance: high ROE, and low beta. Chart 10 shows the performance of a portfolio that averages the industry group weights implied by these two factors, and Table 3 presents whole-period regression results for the portfolio versus both our equally-weighted industry group benchmark and the MSCI China A index. Taken together, Chart 10 and Table 3 make it clear that the combination of high ROE and low beta factors has not only significantly outperformed over time, but has done so with lower volatility. Chart 10High ROE And Low Beta Has Been, And Probably Will Remain, A Winning Combination High ROE And Low Beta Has Been, And Probably Will Remain, A Winning Combination High ROE And Low Beta Has Been, And Probably Will Remain, A Winning Combination Table 3Risk And Excess Return Analysis Of Chinese Onshore High ROE / Low Beta Factor Portfolio* Factor Investing In The A-Share Market Factor Investing In The A-Share Market Investment Conclusions What conclusions can investors draw from the above analysis? In our view, there are three key takeaways. Our factor indexes confirm that ROE and low volatility are persistent factors in the A-share market. First, the persistent outperformance of several fundamental factors in China’s domestic equity market may suggest that A-shares are a less efficient market than other emerging or developed markets. However, to us, the outperformance of legitimate fundamental factors, and the underperformance (or mediocre performance) of momentum is not consistent with the idea that A-shares are a “casino” market that is purely driven by speculation. China’s domestic market is certainly more volatile than others, but we draw a sharp distinction between a stock market that frequently moves in spite of fundamentals and one that moves in an outsized fashion but in a direction that is consistent with fundamental developments. Chart 11Different “Equally-Weighted” Approaches Can Have A Huge Impact On Performance Different "Equally-Weighted" Approaches Can Have A Huge Impact On Performance Different "Equally-Weighted" Approaches Can Have A Huge Impact On Performance Second, an accidental conclusion of our report is that an equally-weighted industry group approach appears to have generated persistently positive excess returns over the past decade, for both domestic China and the global equity benchmark. Chart 11 shows the extreme contrast between the official MSCI equal-weight index for All Country World (which equally weights each component stock), and our equally-weighted industry-group portfolio. Stunningly, buying the latter over the former would have generated 3% extra return per year over the past 10 years. For investors seeking increased secular exposure to the A-share market, these results simply suggest that outsized sector or industry-group weightings should be viewed with caution and avoided if possible. Third, industry groups with high return on equity have persistently outperformed their peers over the past decade, both in China and around the world. However, we think that the joint outperformance of high ROE and low beta stocks in the A-share market carries special significance, one that is linked to China’s enormous increase in corporate and household debt over the past decade. Investors who are familiar with the DuPont approach to decomposing return on equity will recall that ROE (Net Income / Equity) can be broken down into the product of profit margins (Net Income / Sales), asset turnover (Sales / Assets), and financial leverage (Asset / Equity). Since higher financial leverage tends to increase the operating risk of a firm (and thus, presumably, its stock price), and the product of profit margins and asset turnover equals return on assets (ROA), the persistent outperformance of high ROE and low beta industry groups suggest that domestic investors have been focused on buying firms with a high ROA and relatively low financial leverage. Table 4Current High ROE / Low Beta Factor Industry Group Portfolio Weights* Factor Investing In The A-Share Market Factor Investing In The A-Share Market Chart 12A High ROE & Low Beta Portfolio Isn’t Cheap, But Is No More Expensive Today Than In The Past A High ROE & Low Beta Portfolio Isn't Cheap, But Is No More Expensive Today Than In The Past A High ROE & Low Beta Portfolio Isn't Cheap, But Is No More Expensive Today Than In The Past This is a sensible approach, and we are comfortable recommending it to global investors who are looking to increase their secular exposure to A-shares. We are also opening a long relative position in this high ROE / low beta portfolio in our trade book today to track the call, and to provide investors with timely updates on the weights in the portfolio (currently shown in Table 4). While it is true that valuation of this portfolio today is not as attractive as it is for the value-weighted benchmark, Chart 12 highlights that this has been true for the entire sample period, and it has not prevented the substantial outperformance that we have documented. This implies that, while not necessarily widespread, some “cheap” onshore industry groups represent a value trap, rather than true value.   Jonathan LaBerge, CFA Vice President Special Reports jonathanl@bcaresearch.com   Footnotes 1      Please see China Investment Strategy Weekly Report, “A-Shares: Stay Neutral, For Now,” dated March 14, 2018 and “A Shaky Ladder,” dated June 13, 2018, available at cis.bcaresearch.com. 2      While Charts 2 & 3 illustrate relative price instead of total return indexes, our conclusions are generally the same even when showing the latter. Cyclical Investment Stance Equity Sector Recommendations

HighlightsU.S. inflation is on a structural uptrend. Monetary and fiscal policy, populism, and demographics will tend to push inflation higher over the coming decade.How can investors protect portfolios against inflation risk? We look at periods of rising inflation to determine which assets were the best inflation hedge.We find that the level of inflation is very important in determining which assets work best.When inflation is rising and high, or very high, the best inflation hedges at the asset class level are commodities and U.S. TIPS.When inflation is very high, gold is the best commodity to hold and defensive sectors will minimize losses in an equity portfolio.However, hedges have a cost. Allocating a large percentage of a portfolio to inflation hedges will be a drag on returns. Investors should opt for a low allocation to hedges now, and increase to a medium level when inflation rises further.FeatureSome 38 years have passed since the last time the U.S. suffered from double-digit inflation. The Federal Reserve reform of 1979, championed by Paul Volcker, changed the way the Fed approached monetary policy by putting a focus on controlling money growth.1 The reform gave way to almost four decades of relatively controlled inflation, which persists today.But times are changing. While most of today’s investors have never experienced anything other than periods of tame inflation, BCA expects that rising inflation will be a major driving force of asset returns over the coming decade.2 The main reasons behind this view are the following:A rethink in the monetary policy framework: At its most recent meeting, the FOMC openly discussed the idea of a price-level target, implying that it would be open to the economy running hot to compensate for the past 10 years of below-target inflation (Chart I-1A, top panel).Procyclical fiscal policy: The U.S. is conducting expansionary fiscal policy while the economy is at near-full employment (Chart I-1A, middle panel). The last time this happened in the U.S., during the 1960s, high inflation followed, as the fiscal boost made the economy run substantially above capacity.Waning Fed independence: President Trump has openly questioned the hiking campaign undertaken by the Fed. Moreover, he has tried to nominate Fed governors with dovish tendencies. Historically around the world, a lack of central bank independence has often led to higher inflation rates (Chart I-1A, bottom panel).Peak in globalization: Globalization accelerated significantly in the 1990s and 2000s, flooding the global economy with cheap labor (Chart I-1B, top panel). However, we believe that globalization has peaked. Instead, populism and protectionism will be the dominant paradigms for years to come, reducing the cheap pool of workers and goods previously available.Demographics: The population in the U.S. is set to age in coming years (Chart I-1B, middle panel). As the percentage of U.S. retirees increases, the number of spenders relative to savers will begin to rise (Chart I-1B, bottom panel). Higher spending and lower savings in the economy should create upward pressure on inflation. Chart I-1AStructural Forces Point To Higher Inflation In The Coming Decade (I) Structural Forces Point To Higher Inflation In The Coming Decade (I) Structural Forces Point To Higher Inflation In The Coming Decade (I)   Chart I-1BStructural Forces Point To Higher Inflation In The Coming Decade (II) Structural Forces Point To Higher Inflation In The Coming Decade (II) Structural Forces Point To Higher Inflation In The Coming Decade (II)  If our view is correct, how should investors allocate their money?We attempt to answer this question by evaluating the performance of five major asset classes during periods when inflation was rising. Furthermore, we look into sub-asset class performance to determine how investors should position themselves within each asset class to take advantage of an inflationary environment.In our asset-class analysis, we use a data sample starting in 1973 and we limit ourselves to five publicly traded assets that have adequate history: global equities, U.S. Treasuries, U.S. real estate (REITs), U.S. inflation-linked bonds,3 and commodities. We compare asset classes according to their Sharpe ratios: average annualized excess returns divided by annualized volatilities.4 BCA expects that rising inflation will be a major driving force of asset returns over the coming decade.In our sub-asset class analysis, we analyze global equity sectors, international vs U.S. equities, and individual commodities. In some of the sections in our sub-asset class analysis, our sample is slightly reduced due to lack of historical data. Moreover, since in some instances all sectors have negative returns, we compare sub-asset classes according to their excess returns only.We base our analysis on the U.S. Consumer Price Index, given that most of the assets in our sample are U.S. based. We opt for this measure because it tends to track the living expenses for most U.S. citizens and it is the preferred measure to index defined-benefit payments.Finally, we decompose the periods of rising inflation into four quartiles in order to examine whether the level of inflation has any impact on the performance of each asset. Chart I-2 and Table I-1 show the different ranges we use for our analysis as well as a description of the typical economic and monetary policy environments in each of them. Chart I-2 Chart I- Summary Of ResultsTable I-2 shows the summary of our results. For a detailed explanation on how each asset class and sub-asset class behaves as inflation rises, please see the Asset Class section and the Sub-Asset Class section below. Chart I- Which assets perform best when inflation is rising?Rising inflation affects assets very differently, and is especially dependent on how high inflation is.Global equities performed positively when inflation was rising and low or mild, but they were one of the worst-performing assets when inflation was rising and high or very high. Importantly, equities underperformed U.S. Treasuries in periods of both high and very high inflation.Commodities and U.S. TIPS were the best performers when inflation was high or very high.U.S. REITs were not a good inflation hedge.Which global equity sectors perform best when inflation is rising?Energy and materials outperformed when inflation was high.Every single sector had negative excess returns when inflation was very high, but defensive sectors such as utilities, healthcare, and telecommunications5 minimized losses.Which commodities perform best when inflation is rising?With the exception of energy, most commodities had subpar excess returns when inflation was in the first two quartiles.Industrial metals outperformed when inflation was high.Gold and silver outperformed when inflation was very high. Additionally, gold had consistent returns and low volatility.What is the cost of inflation hedging?To answer this question, we construct four portfolios with different levels of inflation hedging:Benchmark (no inflation hedging): 60% equities / 40% bonds.Low Inflation Hedging: 50% equities / 40% bonds / 5% TIPS / 5% commoditiesMedium Inflation Hedging: 40% equities / 30% bonds / 15% TIPS / 15 % commoditiesPure Inflation Hedging: 50% TIPS / 50% commodities. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. Chart I-3Inflation Hedging Comes At A Cost Inflation Hedging Comes At A Cost Inflation Hedging Comes At A Cost  While increased inflation hedging provides better performance when inflation is high and rising, these hedges are costly to hold when inflation is at lower ranges or when it is falling (Chart I-3, panels 1 & 2). However, adding moderate inflation hedging (low or medium) to a portfolio achieved the right balance between cost and protection, and ultimately improved risk-adjusted returns over the whole sample (Chart I-3, panel 3).What about absolute returns? The benchmark outperformed over the whole sample. However, the low and medium inflation hedging did not lag far behind, while avoiding the big drawdowns of high inflation periods (Chart I-3, panel 4).Investment ImplicationsHigh inflation may return to the U.S. over the next decade. Therefore, inflation hedging should be a key consideration when constructing a portfolio. Based on our results, our recommendations are the following:1.  At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation.2.  However, these hedges are costly to hold as they will create a drag on returns in periods when inflation is not high or very high. Therefore, a low allocation to inflation hedges is warranted now.3.  Inflation will probably start to pick up in the 2020s. A medium allocation to inflation hedges will then be appropriate.4.  When inflation is high (3.3%-4.9%), investors should overweight energy and materials in their equity portfolios. Likewise, they should overweight industrial metals and energy within a commodity portfolio.5.  When inflation is very high (4.9% or more), investors should overweight defensive sectors in their equity portfolio to minimize losses. Moreover, investors should overweight gold within a commodity portfolio.Asset ClassesGlobal EquitiesThe relationship between equity returns and rising inflation depends on how high inflation is, with outstanding performance when inflation is rising but low or mild, and poor performance as it gets higher (Chart II-1, top panel). Chart II-1 This relationship can be explained by the interaction between interest rates, inflation, earnings, and valuations:Earnings growth was usually slightly negative when inflation was recovering from low levels. However, given that interest rates were very low in this environment and growth expectations were high, multiple expansion boosted equity returns (Chart II-1, bottom panel).When inflation was mild, the Fed typically started to raise rates, resulting in a declining multiple. However, equities had the best performance in this range thanks to very high earnings growth – a result of the economy growing strongly due to a healthy level of inflation.When inflation climbed into the high or very high range, earnings growth was usually positive but beginning to slow, as high inflation weighed on growth. Meanwhile the multiple started to decline rapidly due to rising interest rates and declining growth expectations.With the exception of the mild inflation range, the return profile of equities during inflationary periods was similar to its normal profile: negative skew and excess kurtosis (Table II-1). However, the consistency of returns decreased at higher levels of inflation, with only 45% of months with positive returns when inflation was rising and in its highest quartile. Chart II- U.S. Treasuries Chart II-2 U.S. Treasuries reacted in a similar fashion to equities when inflation was rising (Chart II-2). However, while Treasuries underperformed equities when inflation was low or mild, they actually outperformed equities when inflation was high or very high. This was in part due to the fact that at higher inflation ranges, U.S. Treasuries offer a higher coupon return when rates are high, at least partially counteracting losses from falling prices.The steady stream of cash flows from the coupons helped Treasuries achieve positive returns roughly two-thirds of the time at the highest levels of inflation (Table II-2). However, this consistency in returns came at a cost: very high inflation resulted in negative skew and high excess kurtosis. Therefore, while Treasuries provided frequent positive returns when inflation was very high, they were prone to violent selloffs. Chart II- U.S. REITs Chart II-3 While REITs had high risk-adjusted returns when inflation was rising but mild, much like equities they had subpar performance in every other quartile and particularly poor performance when inflation was high or very high (Chart II-3). These results confirm our previous research showing that REITs performance is very similar to that of equities.6The return consistency for REITs was generally poor in inflationary periods, with the second-lowest percentage of positive return of any asset class (Table II-3). Moreover, REIT returns had excess kurtosis and negative skew throughout all inflation quartiles. Chart II- Commodity Futures Chart II-4 Commodities performed positively in every quartile, and did particularly well when inflation was mild (Chart II-4, top panel). However, total return and price return were very different due to the behavior of the roll and collateral return:Total risk-adjusted returns were lower than spot risk-adjusted returns when inflation was low and rising. This happened because during these periods, commodity supply was high relative to demand, as the economy was recovering from a deflationary shock. Thus, there was an incentive for producers to conserve inventories, making the futures curve upward-sloping (contango). Thus, roll return was negative (Chart II-4, bottom panel).When inflation was in the upper two quartiles, total risk-adjusted returns were much higher than risk-adjusted spot returns. This was because high inflation was the product of supply shocks. These supply shocks resulted in a downward-sloping futures curve (backwardation), which, in turn, resulted in a positive roll return. Additionally, high rates during these regimes contributed to a high collateral return.Commodities provided good return consistency during inflationary periods, with roughly 60% of positive return months in the upper two inflation quartiles (Table II-4). The skew of returns was neutral or positive in the top two quartiles. This means that although volatility was high for commodities, extreme return movements were normally positive. Chart II- U.S. Inflation-Protected Bonds Chart II-5 While inflation-protected bonds provided meager returns when inflation was rising but in the mild range, they provided excellent performance at the highest levels of inflation (Chart II-5). Moreover, this high Sharpe ratio was not just simply the result of low volatility, since U.S. TIPS had excess returns of 4.6% when inflation was high and 5.7% when inflation was very high.7The return profile of inflation-protected bonds during inflationary periods was also attractive in our testing period. Average skew was positive, while kurtosis was relatively low (Table II-5). The percentage of positive months across all quartiles was also the highest of all asset classes, with a particularly high share of positive returns in the periods of highest inflation. Chart II- Sub-Asset ClassesGlobal Equity Sectors Chart III-1 For the sector analysis, we looked at information technology, financials, energy, materials, utilities, healthcare, and telecommunications. We excluded industrials, consumer discretionary, and consumer staples given that they do not have adequate back data.Once again, we separate rising inflation periods into four quartiles, arriving at the following results:When inflation was low, information technology had the best excess returns while utilities had the worst (Chart III-1, panel 1). This matches our observations at the asset class level, as IT is highly responsive to changes in the valuation multiple.When inflation was mild, energy had the best performance, followed by information technology (Chart III-1, panel 2). Meanwhile, financials had the worst performance, as rates were normally rising in these periods.When inflation was high, sectors highly correlated with commodity prices such as energy and materials outperformed. Meanwhile, IT was the worst performer (Chart III-1, panel 3).When inflation was very high, every sector had negative excess returns. Overall, investing in energy minimized losses (Chart III-1, panel 4). However, this performance was in part attributable to the oil spikes of the 1970s. Alternatively, defensive sectors such as utilities, telecommunications, and healthcare also minimized losses. International vs U.S. Equities Chart III-2 How do equities outside of the U.S. behave when inflation is rising? While the high share of U.S. equities in the global index causes U.S. equities to be the main driver of global stock prices, is it possible to improve returns in inflationary environments by overweighting international equities?The answer once again depends on the level of inflation. When inflation was rising but low, U.S. stocks outperformed global ex-U.S. equities in both common currency and local currency terms (Chart III-2, panel 1). This was in part due to the inherent tech bias in U.S. stocks. Additionally, the low level of inflation was often accompanied by slowing global growth in our sample, helping the U.S. dollar.When inflation was mild, U.S. stocks once again outperformed international stocks in both local and common currency terms, though to a lesser degree (Chart III-2, panel 2). The dollar was roughly flat in this environmentU.S. stocks started to have negative excess returns when inflation was high (Chart III-2, panel 3). On the other hand international equities had positive excess returns in dollar terms, partly because of their energy and material bias and partly because the dollar was generally weak in this period.U.S. equities outperformed global ex-U.S. equities by a small margin when inflation was very high, given that defensive sectors such as telecommunication were over-represented in the U.S. index (Chart III-2, panel 4). The dollar was roughly flat in this period. Individual Commodities Chart III-3 Our analysis above confirmed that commodities were one of the best assets to hold when inflation was rising. However, which commodity performed best?8Total return for every commodity was lower than spot return when inflation was low (Chart III-3, panel 1). This was due to the upward-sloping term structure of the futures curve (contango), resulting in a negative roll yield. In this range, energy had the best performance, followed by industrial metals. Precious metals had negative excess returns.When inflation was mild, energy had the best performance of any commodity by far (Chart III-3, panel 2). Precious and industrial metals had low but positive excess returns in this period.When inflation was high, industrial metals had the highest excess returns, followed by energy (Chart III-3, panel 3).We omit energy for the last quartile since there is not enough data available. Overall, when inflation was very high, both gold and silver had the highest excess returns (Chart III-3, panel 4). However, gold’s return volatility was much lower, while it also had positive returns  64% of the time compared to 52% for silver.Other AssetsU.S. Direct Real Estate Chart IV-1Direct Real Estate Is A Good Inflation Hedge Direct Real Estate Is A Good Inflation Hedge Direct Real Estate Is A Good Inflation Hedge  Our asset-class analysis confirmed that public real estate (REITs) as an asset class offered poor risk-adjusted returns during inflationary periods. But how did direct real estate perform?We analyzed direct real estate separately from all other assets because of a couple of issues:Our return dataset is available only on a quarterly basis, versus a monthly basis for the rest of the assets in our sample. Even when annualized, volatility is not directly comparable when using data with different frequencies.The NCREIF Real Estate Index that we used is a broad aggregate, which is not investable. Individual property prices might differ from this aggregate.Finally, real estate returns are measured on an appraisal basis. Appraisal-based indices are not reflective of real transactions. Moreover, prices tend to be sticky. To attenuate this issue we unsmoothed the capital returns by removing return autocorrelation.Overall, the Sharpe ratio of direct real estate was solid throughout the first three quartiles of rising inflation (Chart IV-1, top panel). There is not enough data available for the fourth quartile. However, judging by the performance of U.S. housing in the 1970s from OECD, risk-adjusted returns when inflation was very high was likely positive (Chart IV-1, bottom panel). Cash Chart IV-2Very High Inflation Erodes The Value Of Cash Very High Inflation Erodes The Value Of Cash Very High Inflation Erodes The Value Of Cash  Cash (investing in a 3-month U.S. Treasury bill) outperformed inflation over our sample. (Chart IV-2, top panel). Moreover, cash provided positive real returns when inflation was mild, or high, or when it was decreasing (Chart IV-2, bottom panel). However, cash was not a good inflation hedge at the highest inflation quartile, with an average annualized real loss of almost 2%. Juan Manuel Correa OssaSenior Analystjuanc@bcaresearch.com Footnotes1      Please see Carl E. Walsh, “October 6, 1979,” FRSBF Economic Letter, 2004:35, (December 3, 2004).2      Please see Global Investment Strategy Special Report, “1970s-Style Inflation: Could it Happen Again? (Part 1), ” dated August 10, 2018, available at gis.bcaresearch.com and Global Investment Strategy Special Report, “1970s-Style Inflation: Could it Happen Again? (Part 2),” dated August 24, 2018, available at gis.bcaresearch.com.3      We use a synthetic TIPS series for data prior to 1997. For details on the methodology, please see: Kothari, S.P. and Shanken, Jay A., “Asset Allocation with Inflation-Protected Bonds,” Financial Analysts Journal, Vol. 60, No. 1, pp. 54-70, January/February 2004. Jay A., “Asset Allocation with Inflation-Protected Bonds,” Financial Analysts Journal, Vol. 60, No. 1, pp. 54-70, January/February 2004.4      Excess returns are defined as asset return relative to a 3-month Treasury bill.5      Sector classification does not take into account GICS changes prior to December 2018. 6      Please see Global Asset Allocation Strategy Special Report "REITS Vs Direct: How To Get Exposure To Real Estate," dated September 15, 2016, available at gaa.bcaresearch.com.7      It is important to note that the synthetic TIPS series does not completely match actual TIPS series for the periods where they overlap. Specifically, volatility is significantly higher in the synthetic series. Thus, results should be taken as approximations.8      We decompose the returns into the same 4 quartiles to answer this question. However, due to lower data availability, we start our sample in 1978 instead of 1973. Moreover, our sample for energy is smaller beginning in 1983. This mainly reduces the amount of data available at the upper quartile.       

Highlights Portfolio Strategy Firming relative demand and input cost dynamics, the Medicare For All (MFA)-induced panic selling in HMOs coupled with 5G euphoria buying in semis have set the stage for an exploitable pair trade opportunity: long S&P managed health care/short S&P semiconductors. Relative supply/demand dynamics, crumbling lumber prices, lower interest rates and compelling valuations and technicals all suggest that the long homebuilding/short home improvement retail pair trade is in the early innings. Recent Changes Initiate a long S&P managed health care/short S&P semiconductors trade today, with a tight stop loss at -7%. Table 1 On Edge On Edge Feature Equities hit a speed bump last week, as President Trump’s trade related tweets instilled some fear back into the markets. Investor complacency reigned supreme and, given the liquidity crunch, risk premia exploded higher with the VIX more than doubling from the recent lows. Historically, a parabolic rise in policy uncertainty is synonymous with an equity market selloff and a widening in risk premia; last week was no different (economic policy uncertainty shown inverted, second panel, Chart 1). Adding insult to injury, given that the forward P/E multiple expansion explained all of the equity market’s advance year-to-date as we highlighted three weeks ago, the trade-related melt up in policy uncertainty caused a mini meltdown in the forward multiple as financial conditions tightened (financial conditions shown inverted, third panel, Chart 1). The implication is that short-term equity market caution is still warranted as we have been writing over the past few weeks, at least until the U.S./China trade dispute dust settles. Chart 1Caution Still Warranted Caution Still Warranted Caution Still Warranted Chart 2Tenuous Trio Tenuous Trio Tenuous Trio The recent simultaneous rise of three asset classes, that we call “the tenuous trio”, warned that something had to give: stocks, bond prices and the trade-weighted U.S. dollar cannot all go up in tandem for an extended period of time. When this happens it is typically a forewarning of an equity market snap (Chart 2). One simple explanation is that a rising greenback comes back and haunts equities via a negative P&L hit, albeit with a lagged effect. Irrespective of where the U.S. dollar will move in the coming months, it will continue to weigh on EPS as the surge in the greenback took root from April to November last year. Thus, with a six-to-nine month lag it will continue to infiltrate EPS and Q2 – which the sell-side already expects to barely breach year ago levels – will also feel the U.S. dollar’s wrath. Were the dollar to continue its ascent from current levels, it would put in jeopardy the back half of this year’s EPS growth numbers, especially Q4/2019 that sell-side analysts forecast to jump to 8%, according to I/B/E/S data. This week we recommend putting on a new pair trade involving an unloved health care subgroup and a mighty tech sector subindex but with a tight stop, and also update an intra-consumer discretionary market-neutral housing-levered pair trade. Importantly, the 12-month forward EPS number is artificially rising. Chart 3 shows that calendar 2019 and 2020 EPS estimates continue to build a base, but the 12-month forward number has been rising since early-February. What explains the increase in the 12-month forward estimate is arithmetic. In other words, despite a multi-month downgrading of calendar 2019 and 2020 EPS, the first two quarters of next year are forecast to come in significantly higher than 2019’s first six months. As the latter roll off and the former get added to the 12-month forward EPS number, a deceiving jump occurs. For next year, we continue to expect $181 EPS, and we would lean against the double-digit EPS growth in 2020 that the sell-side currently forecasts. Our top down macro S&P 500 EPS model softened anew recently, warning that mid-single digit growth, at best, is more likely than low double-digit growth (Chart 4).   Chart 3Artificial EPS Rise Artificial EPS Rise Artificial EPS Rise Chart 4SPX Macro EPS Model Forecasts Softness SPX Macro EPS Model Forecasts Softness SPX Macro EPS Model Forecasts Softness Finally, one of the tech sector’s invincible subgroups is cracking with the S&P semis relative performance hitting a wall both versus the broad market ex-TMT and versus the NASDAQ 100. This is significant not only from a sentiment perspective, but also because semis have high international sales exposure in general and China in particular (Chart 5). Chart 5Vertigo Warning Vertigo Warning Vertigo Warning This week we recommend putting on a new pair trade involving an unloved health care subgroup and a mighty tech sector subindex but with a tight stop, and also update an intra-consumer discretionary market-neutral housing-levered pair trade. New High-Octane Pair Trade Idea While health care and tech stocks started the year on a similar footing, a wide gulf has opened that is likely to, at least partially, reverse in the back half of the year. This dichotomy is most evident at the subsector level where managed health care stocks are still down in absolute terms for the year, whereas chip stocks are up roughly 20% year-to-date (Chart 6). This is an exploitable gap and today we suggest a new pair trade: long S&P managed health care/short S&P semiconductors. Chart 6Exploitable Reversal Looms Exploitable Reversal Looms Exploitable Reversal Looms Bernie Sanders’ revamped MFA bill sent the managed health care group to the ER. While there is heightened uncertainty surrounding MFA and we are working on a joint Special Report with our sister Geopolitical Strategy service due on June 3rd, this is likely a 2022 story. Not only will Sanders have to win the Democratic candidacy and subsequently the Presidential election, but also the GOP would have to lose the Senate. This is an extremely low probability event that has dealt a massive blow to HMO stocks. On the flip side, semis are priced for perfection. The recent catalyst for this group’s stratospheric rise was Apple’s patent settlement with Qualcomm that set in motion a 5G-related euphoria. Again 5G is a late-2021 story and a lot of good news is already priced in to semis stocks. Moreover, historically, semi cycles last four-to-five quarters and investors’ neglect of the semi downcycle is puzzling as we have recently concluded just two down quarters. Explicitly, what is truly baffling is that 12-month forward EPS are slated to contract in absolute terms and forward sales are hovering near the zero line, yet the Philly SOX index recently vaulted to all-time highs. Taken together, we would lean toward health care insurers at the expense of semiconductor stocks. Netting it all out, relative demand and input cost dynamics, the MFA-induced panic selling in HMOs coupled with 5G euphoria buying in semis have set the stage for an exploitable pair trade opportunity: long S&P managed health care/short S&P semiconductors. With regard to relative macro drivers, managed health care has the upper hand. Chart 7 shows that relative demand dynamics clearly favor HMOs and are working against chip stocks. Non-farm payroll growth is trouncing global semi billings. The message from the small business sector is similar with the labor market upbeat compared with declining global semi revenues. Finally, on the relative pricing power gauge front, overall wage inflation is outpacing DRAM prices. On all three fronts, the message is to expect a mean reversion higher in the relative share price ratio. Chart 7Buy Managed Health Care… Buy Managed Health Care… Buy Managed Health Care… Chart 8…At The Expense… …At The Expense… …At The Expense… Input cost/inventory dynamics suggest that HMOs also have the advantage. The health care insurance employment cost index is growing on a par with inflation, but semi industry employment is climbing at a rate over 5%/annum (bottom panel, Chart 8). Taking stock of medical cost inflation, costs are still melting, however global semi inventories are expanding. The upshot is that relative share prices have ample upside (middle panel, Chart 8). Finally, the previous relative valuation overshoot has returned to the neutral zone and, encouragingly, relative technicals are probing multi-year lows near one standard deviation below the historical mean. Importantly, over the past two decades every time our Technical Indicator has hit such a depressed level, a playable rebound in relative share prices has ensued (bottom panel, Chart 9). Chart 9…Of… …Of… …Of… Chart 10…Semis …Semis …Semis Nevertheless, this highly volatile market-neutral trade faces one big risk we previously alluded to: relative profit expectations are extended. In other words, the bombed out S&P semiconductor forward EPS and revenue projections are masking the relative profit and revenue backdrop (Chart 10). Netting it all out, relative demand and input cost dynamics, the MFA-induced panic selling in HMOs coupled with 5G euphoria buying in semis have set the stage for an exploitable pair trade opportunity: long S&P managed health care/short S&P semiconductors. Bottom Line: Initiate a long S&P managed health care/short S&P semis pair trade today with a stop loss at the -7% mark. The ticker symbols for the stocks in the S&P managed health care and S&P semi indexes are: BLBG: S5MANH – UNH, ANTM, HUM, CNC, WCG and BLBG: S5SECO – INTC, AVGO, TXN, NVDA, QCOM, MU, ADI, XLNX, AMD, MCHP, MXIM, SWKS, QRVO, respectively. Homebuilding/Home Improvement Retail Pair Trade Update In late-January we put on a market, sector and subindustry neutral trade preferring homebuilders to home improvement retailers (HIR) as a way to benefit from the increase in residential construction at the expense of residential investment. This trade moved in the black from the get-go and is now generating alpha to the tune of 7% since inception, but more gains are in store in the coming months. President Trump’s hawkish tariff rhetoric should keep interest rates at bay, at least for a short while, and bond market nervousness is more of a boon to homebuilders than to HIR (top panel, Chart 11). The drop in the price of mortgage credit along with minor price concessions from homebuilders are causing sales of new homes to take off versus existing home sales (middle panel, Chart 11). Granted, bankers remain willing extenders of residential loans and the latest Fed Senior Loan Officer Opinion Survey revealed that demand for residential credit is making a comeback following a near yearlong decline (not shown). As a result, relative loan growth metrics also underpin the relative share price ratio (bottom panel, Chart 11). Chart 11Still In Early Innings Still In Early Innings Still In Early Innings In sum, relative supply/demand dynamics, crumbling lumber prices, lower interest rates and compelling valuations and technicals all suggest that the long homebuilding/short HIR pair trade is in its early innings. Importantly, the new/existing home sales–to-inventory ratio is an excellent leading indicator of relative share prices and is currently emitting an unambiguously bullish signal for homebuilders at the expense of HIR (Chart 12). Chart 12Supply/Demand Backdrop Says Stick With This Pair Trade Supply/Demand Backdrop Says Stick With This Pair Trade Supply/Demand Backdrop Says Stick With This Pair Trade Chart 13Relative Sales ##br##Expectations… Relative Sales Expectations… Relative Sales Expectations… Examining the relative demand backdrop reveals that homebuilders will continue to outshine HIR. Current readings in the NAHB home sales survey versus the remodeling survey and future expectations both point to more gains in the relative share price ratio (Chart 13). The felling in lumber prices also represents a benefit to homebuilders to the detriment of HIR. Lumber is a key building input cost in new home construction so any price liquidation is a boon for homebuilding margins. In contrast, HIR makes a set margin on lumber sales, therefore deflating lumber prices cut HIR profits (Chart 14). Chart 14…Felling Lumber Prices And … …Felling Lumber Prices And … …Felling Lumber Prices And … Chart 15…Bombed Out Valuations Signal More Relative Share Price Gains …Bombed Out Valuations Signal More Relative Share Price Gains …Bombed Out Valuations Signal More Relative Share Price Gains Finally, on the relative valuation and technical fronts, there is anything but froth. In fact, the relative price to book ratio is perched near an all-time low and relative momentum has only recently troughed and has yet to reach the neutral zone (Chart 15). In sum, relative supply/demand dynamics, crumbling lumber prices, lower interest rates and compelling valuations and technicals all suggest that the long homebuilding/short HIR pair trade is in its early innings.       Bottom Line: Stick with a long S&P homebuilders/short S&P HIR pair trade. The ticker symbols for the stocks in the S&P homebuilding and S&P HIR indexes are: BLBG: S5HOME – PHM, DHI, LEN and BLBG: S5HOMI – HD, LOW, respectively.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Coming up on the deadline for President Trump’s China – U.S. tariff ultimatum, tariffs on $200 billion of Chinese imports could go to 25% from 10% on Friday – the outlook for base metals remains complicated, particularly for aluminum and copper.1 Of course, the U.S. and China could have a meeting of the minds and agree to resolve the outstanding issues in the trade negotiations. This would be supportive of continued global supply-chain expansion, EM income growth and base metals prices generally. On the downside, an escalation of the Sino – U.S. trade war could retard investment in global supply chains, as firms hunker down for an extended and contentious contraction in global trade.2 This would be bearish for EM income growth, which would translate directly into lower base metals demand and, all else equal, depress prices. Still, a breakdown in trade talks could be bullish for base metals, as China likely would increase its fiscal, monetary and credit stimulus, in an attempt to offset the income-suppressing effects of reduced global trade and investment. As we said, it’s complicated. Two of the three outcomes above are supportive of base metals prices – i.e., a deal is agreed, and increased Chinese stimulus in the event of a breakdown in negotiations. Against this backdrop, we are closing our long tactical trading recommendations in copper and aluminum at tonight’s close, and replacing them with a call spread on July CME COMEX copper, in which we will get long $3.00/lb calls vs. short $3.30/lb calls. The call spreads are a low-risk way of positioning in a volatile market for a likely price-supportive outcome in these talks – the max loss on this position is the net premium paid to get long the spread. Highlights Energy: Overweight. Supply-side fundamentals continue to dominate oil price formation. An unplanned outage in Russia that took ~ 1mm b/d of oil off the market this week, following the contamination of exports with organic chloride left in shipments via Transneft’s European pipeline system. Russia’s Energy Ministry is guiding markets to expect the contamination will be cleared up toward the end of this month.3 Base Metals: Neutral. We are closing our tactical aluminum and copper trade recommendations at tonight’s close. We do see the potential for higher base metals prices – particularly copper – if China expands fiscal and monetary stimulus in the wake of a breakdown in trade talks with the U.S., or both sides can resolve their differences. We expect copper will benefit most from such outcomes. However, we believe a call spread – long July $3.00/lb CME COMEX calls vs. short $3.30/lb calls expiring in July – is a lower-risk way of expressing this view. Precious Metals: Neutral. Gold could rally in the wake of an expanded trade war, if the Fed and the PBOC – along with other systemically important central banks – adopt more accommodative monetary policies in anticipation of a widening trade conflict. Greater fiscal, credit and monetary stimulus by China in response to a breakdown in trade talks also could boost safe-haven demand for gold. Ags/Softs: Underweight. The risk of a wider Sino – U.S. trade war – particularly the likely retaliation by China if U.S. tariffs are raised to 25% on already-targeted exports of $200 billion – would be especially bearish for soybeans and grain exports from the U.S. We remain underweight. Feature In the wake of President Donald Trump’s ultimatum to China to resolve trade talks by tomorrow, BCA Research’s geopolitical strategists give 50% odds to a successful trade deal being concluded by end-June. The odds of an extension of trade talks are 10%; and the odds of no deal on trade, 40% (Table 1). Table 1Updated Trade War Probabilities (May 2019) Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Of these possible outcomes, the no-deal scenario – i.e., an escalation in the trade war including raising tariffs on imports from China to 25% on the $200 billion of goods now carrying a 10% duty – would be the most volatile, and likely would push base metals’ prices lower in the short-term. A trade deal would set markets to estimating the extent of supply-chain investment and trade-flow revival, as the drawn-out uncertainty around the outcome of the Sino – U.S. trade war fades. Given the slim wedge our geopolitical strategists see between the deal and no-deal outcomes to these trade talks, we believe the implications of the latter need to be sorted. An agreement to extend trade talks likely would be welcomed with the same aplomb shown by markets prior to this current level of high drama. In this scenario, markets likely would price in an economically rational outcome to the U.S. – China trade negotiations, which resolves the uncertainty around tariffs and other investment-retarding policies. Given the slim wedge our geopolitical strategists see between the deal and no-deal outcomes to these trade talks, we believe the implications of the latter need to be sorted. In the short term – i.e., following a breakdown in the talks – market sentiment likely would become more negative, as traders priced in the implications for reduced global supply-chain investment and trade flows, particularly re China and EM exporters. In addition, base metals markets would discount the income hit to EM these effects would feed into, raising the likelihood commodity demand growth would slow. News flow would then dictate price action for the metals over the short term. As markets discount these expectations, we believe Chinese policymakers would act to increase the levels of fiscal, credit and monetary stimulus domestically, to counter the hit to domestic income. The lagged effects of this stimulus will have a strong influence on base metals’ price formation, and, depending on the level of stimulus, could be bullish for metals prices. China’s Influence on Base Metals Higher Post-GFC In previous research, we found copper, and to lesser extent aluminum and the LMEX index, which is heavily weighted to both, benefit most from monetary, credit and fiscal stimulus in China.4 Other metals also experience a lift when the level of these Chinese policy variables rises; however, their relationship with EM and China’s industrial production cycle is weaker and time varying (Chart of the Week). Chart 1 In Table 2, we show how different policy and macro factors affect various base metal prices and the LMEX; these models generate the output for the curves in the Chart of the Week. The table show the coefficients of determination for single-variable regressions for each metal on the EM- or China-focused factor shown in the columns for the period 2000 to now, and 2010 to now. Within the base metals complex, copper, the LMEX index and aluminum exhibit the strongest and most reliable relationships with the explanatory variables shown at the top of each column. Table 2Coefficients Of Determination: Base Metals Prices (yoy) Vs. Key Factors Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals The biggest takeaway from this analysis is that, for each individual metal, Chinese economic activity in particular, and EM income dynamics generally dominate price determination. The importance of these factors increased considerably post-Global Financial Crisis (GFC). As was the case with our correlation analysis, this is best captured by our Global Industrial Activity (GIA) Index (Chart 2, panel 1). This is clearly seen in the co-movement of our GIA index and copper prices (Chart 2, panel 2), and EM GDP.5 Chart 3 shows the GIA index disaggregated in its four main components. Chart 2BCA's GIA Index Vs. EM GDP, Copper Prices BCA's GIA Index Vs. EM GDP, Copper Prices BCA's GIA Index Vs. EM GDP, Copper Prices Chart 3BCA GIA Index Components' Performance BCA GIA Index Components' Performance BCA GIA Index Components' Performance Our analytical framework for base metals in China holds the nonferrous “pillar industries” behave as vertically integrated conglomerates. The influence of China’s economy on base metals prices is not unexpected: As China’s relative share of base metals supply and demand versus the rest of the world has grown, the marginal impact of its fiscal, credit, monetary and trade policies increased (Chart 4). The principal effect would be visible in China’s demand-side effects, to which the supply side would respond. That is to say, China’s monetary, credit and fiscal policies post-GFC lifted domestic incomes, which lifted demand domestically. In addition, aggressive export-oriented trade policy contributed to income growth, as well. This prompted increased base metals and bulk (e.g., steel) output on the supply side. Chart 4 A large part of this dynamic likely is explained by the role of state-owned enterprises (SOEs) in the base-metals markets in China. It is important to note these SOEs are strategic government holdings, responding to and directing government policy, as was recently noted in a University of Alberta study on SOEs:      … the government maintains control over a number of economically significant industries, such as the automobile, equipment manufacturing, information technology, construction, iron and steel, and nonferrous metals sectors, which are all considered to be ‘pillar industries’ of the Chinese economy. The government, as a matter of official policy, intends to maintain sole ownership or apply absolute control over only what it considers to be strategic industries, but also maintains relatively strong control over the pillar industries.6 Our analytical framework for base metals in China holds the nonferrous “pillar industries” behave as vertically integrated conglomerates – ranging from firms refining of raw ore to those producing finished products used in infrastructure, construction, etc. In this framework, nonferrous metals in China are not commodity markets per se, but vertically integrated policy-driven industries responding to directives from the Chinese Communist Party’s (CCP) Politburo through to the State Council and the various ministries directing production and consumption.7 At the heart of this is the CCP’s efforts to direct economic growth. Investment Implications The implication of our policy-focused research is investors should focus on metals for which a large share of the variance in y/y prices can be explained by movements in Chinese economic activity. The no-deal outcome could be positive for base metals prices. To get a handle on this, we looked at the variance decomposition of each metal’s price in response to exogenous shocks originating from (1) Chinese economic activity, (2) EM (ex-China) and Complex Economies industrial activity, (3) U.S. industrial activity, and (4) the U.S. trade weighted dollar (Table 3).8 Using this approach, we found that: Copper, aluminum and the LMEX’s variances are mostly explained by China’s economic activity (~ 25%); specifically, shocks to the state’s industrial activity and credit cycle. This corroborates our earlier research, in which we focused on correlations between base metals and these factors. Idiosyncratic factors seem to account for a large part of nickel, lead and zinc’s price formation. This is seen by the large proportion of their variances that is unexplained by our selected explanatory variables. Given the opacity of fundamental data in these markets, we tend to avoid positioning in them. On average, EM ex-China and U.S. industrial activity account for a similar proportion of the variance in metal’s prices (~ 8%). While the U.S. dollar appears to be the second most important variable (~ 14%). Table 3China’s Economic Activity Drives Metals’ Return Variability Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals Our analysis indicates that, as a group, base metals will be supported by the ongoing credit stimulus in China. Each metal is positively correlated with China’s credit cycle and industrial activity. Nonetheless, from our correlation, regression and variance-decomposition analysis, we believe copper and aluminum provide a better and more reliable exposure, as does exposure to the LMEX index, because of its high aluminum and copper weightings. Bottom Line: Approaching the ultimatum set by U.S. President Trump for a resolution to the Sino – U.S. trade war, markets are understandably taut. The odds of a deal vs. no-deal outcome by end-June are close, while the odds trade talks are extended account for the difference. In our estimation, the no-deal outcome could be positive for base metals prices, given our expectation Chinese policymakers will lift the amount of stimulus to the domestic economy to offset the negative effects of an expanded trade war. A deal would remove a lot of the uncertainty currently holding back global supply-chain capex and trade flows, which also would be bullish for base metals.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      For further discussion, please see “U.S. And China Get Cold Feet,” a Special Alert published by BCA Research’s Geopolitical Strategy May 6, 2019. It is available at gps.bcaresearch.com. Our geopolitical strategists give the odds of a successful trade deal being concluded by end-June 50%; that trade talks continue, 10%; and the odds of no deal on trade, 40%. 2      Please see “Global market structures and the high price of protectionism,” delivered at the Jackson Hole central bank conference August 25, 2018, by Agustín Carstens, General Manager, Bank for International Settlements. 3      Please see “Russia sees oil quality normalizing in late May after contamination, output drops,” published May 7, 2019, by reuters.com. 4      Please see our Weekly Report of April 25, 2019, entitled “Copper Will Benefit Most From Chinese Stimulus.” It is available at ces.bcaresearch.com. 5      BCA’s GIA index is heavily weighted toward EM industrial-commodity demand. Please see “Oil, Copper Demand Worries Are Overdone,” where we introduce and discuss the GIA index, published February 14, 2019, in BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 6      Please see “State-Owned Enterprises in the Chinese Economy Today: Role, Reform, and Evolution,” China Institute, University of Alberta, May 2018. 7      Something approximating a pure commodity market is crude oil – the supply and demand curves of many globally distributed sellers and buyers meet and clear the market. As such, a reasonable explanatory model for the evolution of prices can be generated using fundamental inputs (i.e., supply, demand and inventories). Fitting such models to base metals has proved difficult. We have better success explaining base metals prices using macro economic policy variables we believe are important to CCP policymakers – trade, credit, domestic GDP, etc. This is a new avenue of research, which we hope to use to hone in on a good explanatory model to account for ~ 50% of global base metal demand, and, in some instances (e.g., copper and steel, respectively) close to 40% - 50% of supply, as seen in Chart 4. Our current base metals research is focused on trying to disprove the hypothesis these are policy-directed markets within China. This aligns with Karl Popper’s falsifiability condition, which states a theory must be subject to independent, disinterested testing capable of refuting it, to be considered scientific. Please see “Popper, The Logic of Scientific Discovery,” (reprinted 2008), Routledge Classics, particularly Chapter 4. 8      Complex economies are countries ranking at the top of MIT’s Economic Complexity Index (ECI), and which export industrial goods to EM and China. The EM (ex-China) and Complex Economies variable is the first principal component extracted from a group of ~60 series related to industrial production in these countries. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Image Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Image

The Fed that has adopted an abruptly dovish stance and a recently inverted 10-year/fed funds rate yield curve indicates the market’s expectation that the next Fed move will be a cut, corroborated by elevated probabilities of a cut by December. This has driven a marked increase in client requests on positioning if rates are falling. Accordingly, we have updated our research to answer the question: what sectors perform best when the Fed eases? The results of our analysis of the seven Fed loosening cycles since 1965 are presented in the table below. The sector results are telling: defensives lead the pack in advance of a rate cut as market participants smell trouble and a defensive rotation occurs. The key source of funds in this defensive rotation in advance of a loosening cycle is S&P tech which underperforms early and continues to underperform dramatically through the initial stages of the loosening cycle. While we are not forecasting a cut and BCA’s view remains one of no recession for the coming 12 months, the production of this report may well be early. Nevertheless, its use as a sector positioning/return road map is evergreen; please see Monday’s Special Report for more details. Chart 1 ​​​​​​​

Feature Leading indicators of inflation, and hence a hawkish Fed, remain biased to the upside. The S&P 500 is close to all-time highs, the U.S. dollar has been strong this year, and wage growth has been resilient. Almost exactly eight years ago, we published a report examining historical sector performance across the various Fed tightening cycles.1 We now find ourselves on the other side with a Fed that has adopted an abruptly dovish stance and a recently inverted 10-year/fed funds rate yield curve indicating the market’s expectation that the next Fed move will be a cut. Accordingly, we have updated our research to analyze the opposite perspective when rates are falling and answer the question: what sectors perform best when the Fed eases? Such an exercise may seem ill-timed; leading indicators of inflation, and hence a hawkish Fed, remain biased to the upside. The S&P 500 is close to all-time highs, the U.S. dollar has been strong this year, and wage growth has been resilient (Chart 1). Nevertheless, we have been inundated by client requests on this topic and, while we may well be early in its production, its use as a sector positioning/return road map is evergreen and not necessarily to forecast that a Fed cut is nearing. Chart 1Inflation Indicators Still Don’t Point To A Cut Inflation Indicators Still Don’t Point To A Cut Inflation Indicators Still Don’t Point To A Cut The results of our analysis of the seven Fed loosening cycles since 1965 are presented in Table 1. While we highlight the May 1980 iteration as an easing cycle, we have excluded it from our analysis owing to its returns overlap with the March 1981 iteration less than a year later, which offers a cleaner analysis. Table 1Sector Relative Performance And Seven Fed Easing Cycles Sector Performance And Fed Loosening Cycles: A Historical Roadmap Sector Performance And Fed Loosening Cycles: A Historical Roadmap Still, the sector results are telling: defensives lead the pack in advance of a rate cut as market participants smell trouble and a defensive rotation occurs. Some of the results should be taken with a grain of salt. As shown in Table 1, the broad market delivers significant returns 24 months after an easing cycle begins. However, the last two easing cycles (January 2001 and September 2007) witnessed the S&P returning -37% and -31%, respectively, two years post rate cut. Thus, a rate cut does not signal with certainty a positive two year return. The key source of funds in this defensive rotation in advance of a loosening cycle is S&P tech which underperforms early and continues to underperform dramatically through the initial stages of the loosening cycle. Still, the sector results are telling: defensives lead the pack in advance of a rate cut as market participants smell trouble and a defensive rotation occurs (Chart 2). However, the results are not unambiguous as the rate-sensitive defensive S&P utilities and S&P telecoms indexes both underperform early while S&P consumer staples and S&P health care are the top performers of all sectors prior to, and both one and two years post rate cut (Charts 4 & 5). Chart 2 Chart 3 The key source of funds in this defensive rotation in advance of a loosening cycle is S&P tech which underperforms early and continues to underperform dramatically through the initial stages of the loosening cycle (Chart 3). This is an excellent and consistent leading signal that we are monitoring closely. S&P tech’s deep cyclical peer S&P industrials surprisingly does not show advance warning of a loosening cycle, though persistently underperform once the cycle is underway. Also surprising is S&P energy’s outperformance in the early stages of a lower rate environment. Chart 4 Chart 5 The current implied fed funds probabilities are roughly 50-50 for a rate cut at the Fed’s December 2019 meeting and move increasingly towards a rate cut thereafter. While we are not forecasting a cut and BCA’s view remains one of no recession for the coming 12 months, were a Fed cut to materialize, our barbell portfolio approach will likely be able to absorb the Fed shock. We highlight our overweight recommendation on S&P consumer staples and S&P energy along with our neutral recommendation on S&P health care as sector winners in an easing cycle and our underweight recommendation for S&P consumer discretionary as a sector laggard as rates fall. We further note our neutral recommendation on S&P tech. The reference charts below show individual sector relative performance charts along with the fed funds rate (shaded areas depict the initial Fed rate cut).   Chris Bowes, Associate Editor U.S. Equity Strategy ChrisB@bcaresearch.com Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Chart 6 CHART 6 CHART 6 Chart 7 CHART 7 CHART 7 Chart 8 CHART 8 CHART 8 Chart 9 CHART 9 CHART 9 Chart 10 CHART 10 CHART 10 Chart 11 CHART 11 CHART 11 Chart 12 CHART 12 CHART 12 Chart 13 CHART 13 CHART 13 Chart 14 CHART 14 CHART 14 Chart 15 CHART 15 CHART 15   Footnotes 1      Please see BCA U.S. Equity Strategy Special Report, “Sector Performance And Fed Tightening Cycles: An Historical Roadmap” dated April 25, 2011, available at uses.bcaresearch.com.

Highlights In Indonesia, investors are ignoring the weakness in global growth, which is an important driver of the country’s financial markets. The Indonesian currency, equities and local currency bonds all remain vulnerable. We continue to recommend underweighting Indonesian assets for now. In Turkey, additional adjustments in the exchange rate and interest rates are unavoidable. Stay put/underweight Turkish financial markets. In the UAE, the economy is set to improve marginally this year. We recommend overweighting UAE equities and corporate spreads within their respective EM portfolios. Feature Indonesia: The Currency And Bank Stocks Are At Risk  Indonesian financial assets have benefited from the Federal Reserve’s dovish turn and corresponding fall in U.S. bond yields (Chart I-1, top panel). Moreover, the market is cheering President Joko Widodo’s lead in the presidential vote tally. Yet investors are ignoring the budding weakness in industrial metals prices, which has historically been an important driver of Indonesia’s exchange rate (Chart I-1, middle panel). Going forward, the Indonesian currency, equities and local currency bonds all remain vulnerable: Falling global growth in general and Chinese imports in particular will intensify Indonesia’s exports contraction and worsen the country’s already wide current account deficit. In turn, the latter will induce currency depreciation, which will then lead to higher interbank rates (Chart I-2). Chart I-1Global Growth Matters For Indonesian Markets Global Growth Matters For Indonesian Markets Global Growth Matters For Indonesian Markets Chart I-2Falling Current Account Deficit = Higher Local Rates Falling Current Account Deficit = Higher Local Rates Falling Current Account Deficit = Higher Local Rates Upward pressure on local interbank rates will cause a slowdown in domestic private loan growth.   The Indonesian central bank – Bank Indonesia (BI) – has been attempting to lower interbank rates, which have been hovering above the central bank's policy rate (Chart I-3). To achieve this, the central bank has substantially increased excess reserves in the banking system (Chart I-4). It has done so by purchasing central bank certificates from commercial banks, conducting foreign exchange swaps and providing repo lending. Chart I-3A Sign Of Liquidity Strains A Sign Of Liquidity Strains A Sign Of Liquidity Strains Chart I-4Bank Indonesia Is Injecting Liquidity Bank Indonesia Is Injecting Liquidity Bank Indonesia Is Injecting Liquidity   Yet by expanding banking system liquidity so aggressively, BI risks renewed currency depreciation. Like any central bank in a country with an open capital account, BI cannot expect to have full control over the exchange rate while simultaneously targeting local interest rates. The Impossibly Trinity dilemma dictates that a central bank needs to choose between controlling the two. Yet investors are ignoring the budding weakness in industrial metals prices, which has historically been an important driver of Indonesia’s exchange rate. Therefore, if BI continues to inject local currency liquidity to cap or bring down interest rates (interbank rates), the resulting excess liquidity could encourage and facilitate speculation against the rupiah. Scratching below the surface, the recent strong outperformance of Indonesian equities has been entirely due to the surge in the country’s bank share prices (Chart I-5, top panel). Remarkably, the performance of Indonesian non-financial as well as small-cap stocks has been especially dismal (Chart I-5, middle and bottom panels). This is an upshot of poor profitability among Indonesia’s non-financial listed companies (Chart I-6). Chart I-5Indonesian Bank Stocks Are The Only Outperformers Indonesian Bank Stocks Are The Only Outperformers Indonesian Bank Stocks Are The Only Outperformers Chart I-6Falling Non-Financial Corporate Profitability Falling Non-Financial Corporate Profitability Falling Non-Financial Corporate Profitability Furthermore, deteriorating financial health of non-financial corporates, especially small companies, will lead to higher NPLs on banks’ books. Notably, Indonesian banks are more heavily exposed to businesses than to households. As NPLs rise anew, Indonesian commercial banks will need to lift their bad-loan provisioning levels, generating a major profit relapse (Chart I-7). Importantly, Indonesian commercial banks have been boosting their profits by reducing NPL provisions since early 2018. Reversing this will materially affect their earnings. Chart I-7Indonesian Bank Share Prices Are Vulnerable Indonesian Bank Share Prices Are Vulnerable Indonesian Bank Share Prices Are Vulnerable Additionally, bank stocks are vulnerable due to falling net interest income margins. Moreover, their share prices are overbought and not cheap. To be clear, we are not negative on Indonesia’s structural outlook. The above-mentioned alarms are more near-to-medium terms issues. Still, foreign ownership of local currency bonds and stocks – at 38% each – are high, and could be a major source of potential outflows if the rupiah depreciates. This would cause Indonesian stocks and local currency bonds to sell off severely. Bottom Line: The global growth slowdown/commodities downturn and the U.S. dollar upturn are not yet over. Consequently, foreign flows into EM will diminish, which will be particularly negative for Indonesian financial markets. We recommend investors continue underweighting Indonesian equities and avoid Indonesian local currency bonds for now. We continue to recommend a short position in the IDR versus USD. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Turkey’s Foreign Debt Bubble: The Worst Is Not Yet Behind Us Turkish financial assets, and the currency especially, will remain under selling pressure in the coming months. Additional adjustments in the exchange rate and interest rates - as well as in the real economy and current account balance - appear unavoidable. The key imbalance remains the gap between foreign debt obligations (FDOs) and the availability of foreign currency to meet these debt obligations. Turkey’s FDOs in 2019 are equivalent to $180 billion (Chart II-1). FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. This consists of $15 billion in interest payments, $65 billion in debt amortization and $100 billion in maturing short-term (under one year) claims. In theory, these debt obligations can either be rolled over, or the nation should generate current account and capital account surpluses and use these surpluses to pay down FDOs. Even though the current account deficit is shrinking, it is still in a deficit of $18 billion. Net FDI inflows remain weak at US$10 billion. Hence, it appears that Turkey’s only options are either to roll over maturing foreign currency debt or to lure foreign investors into local currency assets and use the surplus in net portfolio inflows to meet these FDOs. The central bank’s foreign currency reserves excluding both commercial banks’ deposits at the Central Bank of Turkey and FX swaps now stand at $13 billion. However, due to a lack of credibility in the Turkish government’s macro policies - in addition to the ongoing deep economic recession and heightened financial market volatility - external creditors will be unwilling to roll over the debt. In fact, net portfolio flows into government debt and equities have tumbled for the same reason. Typically, when foreign funding dries up temporarily, a country can use its foreign exchange reserves to meet its FDOs. However, Turkey’s foreign exchange reserves have already plummeted to extremely low levels (Chart II-2). The central bank’s foreign currency reserves excluding both commercial banks’ deposits at the Central Bank of Turkey and FX swaps now stand at $13 billion. This is negligible compared with the $180 billion FDO figure due in 2019. Chart II-1Turkey: A Large Foreign Debt Servicing Burden Turkey: A Large Foreign Debt Servicing Burden Turkey: A Large Foreign Debt Servicing Burden Chart II-2Foreign Exchange Reserves Are Too Small Foreign Exchange Reserves Are Too Small Foreign Exchange Reserves Are Too Small   The recent plunge in the central bank’s net foreign exchange reserves excluding swaps (i.e. net international reserves) has put many pertinent metrics at record lows. In particular, net international reserves are at a precarious level relative to both total imports and external debt (Chart II-3). Finally, the net international reserves-to-broad money supply ratio has fallen to 7% (from 15% in 2014) despite the fact that the massive lira depreciation reduced the U.S. dollar measure of broad money supply (Chart II-4). Chart II-3FX Reserves Do Not Cover Imports Or External Debt FX Reserves Do Not Cover Imports Or External Debt FX Reserves Do Not Cover Imports Or External Debt Chart II-4Low Coverage Of Broad Money By International Reserves Low Coverage Of Broad Money By International Reserves Low Coverage Of Broad Money By International Reserves The currency will have to depreciate further and interest rates will have to move higher to shrink domestic demand/imports more. This is needed to generate a current account surplus that could be used to service FDOs, or that otherwise entices foreign creditors to be willing to roll over foreign debt or invest in Turkey. Finally, while the adjustment in the real economy is advanced, it is unlikely to be over, due to the large foreign debt bubble. Importantly, with large foreign and local currency debt obligations coming due for both companies and households - in addition to the deterioration in economic activity and higher interest rates - NPLs are bound to rise (Chart II-5). This is especially likely to occur because a lot of borrowing has been used in the property market both for construction and purchases. Notably, real estate volumes are shrinking, and prices are deflating in real terms (Chart II-6). Chart II-5NPLs Will Rise A Lot NPLs Will Rise A Lot NPLs Will Rise A Lot Chart II-6Turkey: Real Estate Is In Free Fall Turkey: Real Estate Is In Free Fall Turkey: Real Estate Is In Free Fall     Bottom Line: The macro adjustment in Turkey is not yet complete. The country still lacks foreign currency supply to service its enormous 2019 FDOs. Further currency depreciation and higher interest rates are required to depress domestic demand/imports and push the current account into surplus. Stay put / underweight Turkish financial markets. The authorities are becoming desperate, and the odds of capital control enforcement are not negligible. While such an outcome is not possible to forecast with any certainty or time frame, investors should consider this very real risk. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Overweight UAE Equities And Corporate Bonds Over the next six to nine months, we believe both UAE equities and corporate spreads will outperform their respective emerging market (EM) benchmarks. The UAE economy is set to improve marginally this year (Chart III-1). It will benefit from expansionary fiscal policy, rising oil output, a buoyant tourism sector, a resilient banking sector and less of a drag from the real estate sector. First, sizable fiscal spending will lead to rising non-oil economic growth. The UAE’s federal budget spending for 2019 will increase by 17.3% from a year ago, much higher than the 5.5% year-on-year growth in 2018. Second, UAE oil output could increase by 15% later this year from current levels (Chart III-2). The U.S. announced on April 22 that all Iran sanction waivers will not be extended beyond the early-May expiration date. The U.S. administration also stated that it has secured pledges from Saudi Arabia and the UAE to increase their oil production in order to offset disrupted supply from Iran. Rising oil output will mitigate the negative impact of potentially lower oil prices on the UAE’s economy. Chart III-1Improving UAE Economy Improving UAE Economy Improving UAE Economy Chart III-2Rising Oil Output Rising Oil Output Rising Oil Output   Third, the outlook for the tourism sector is also positive. The number of tourists is set to rise as Expo 2020 approaches. The government is targeting 20 million visitors in 2020, 26% higher than last year’s levels. The UAE is building theme parks, museums, hotels and infrastructure to attract more tourists. The UAE economy is set to improve marginally this year. Fourth, the UAE’s banking sector will enjoy rising credit growth, robust profitability and improved asset quality this year. The banking system has been in consolidation mode since January 2016, with a 15% reduction in branches and a 14% drop in the number of employees. This has improved the banking sector’s profitability by cutting operating costs and increasing efficiency. The improving growth outlook will lift credit growth. The central bank’s most recent Credit Sentiment Survey suggests banks’ lending standards for both business and personal loans are loosening (Chart III-3). In addition, UAE banks enjoy large capital buffers. Despite rising non-performing loans (Chart III-4), UAE banks still reported a Tier-1 capital adequacy ratio of 17% as of December 2018. Chart III-3Credit Growth Is Likely To Increase Credit Growth Is Likely To Increase Credit Growth Is Likely To Increase Chart III-4Rising NPLs, But Still Large Capital Buffers Rising NPLs, But Still Large Capital Buffers Rising NPLs, But Still Large Capital Buffers   Lastly, the real estate markets in both Dubai and Abu Dhabi have suffered from oversupply (from both mushrooming supply and weaker demand) over the past several years. Property prices have already fallen over 20% in both Dubai and Abu Dhabi from their 2014 peaks (Chart III-5). Odds are high that the most dangerous phase of the property market downturn is behind us. Chart III-5Real Estate Adjustment Is Advanced Real Estate Adjustment Is Advanced Real Estate Adjustment Is Advanced In addition, the government’s efforts to attract people to stay in the country longer will somewhat offset the ongoing exodus of expatriates. Last May, the UAE introduced a new visa system that will allow investors, innovators and talented specialists in the medical, scientific, research and technical fields to stay in the country for up to 10 years. Overall, a potential bottom in property demand and restrained supply will likely make the real estate sector less of a drag on this bourse this year. Finally, the authorities are also more open to increasing the foreign ownership cap in the banking sector, albeit not up to 100%. For example, in early April, the largest UAE lender – First Abu Dhabi Bank – obtained regulatory approval to increase its foreign ownership limit to 40% from 25%. This has boosted foreign equity purchases and has supported the equity index. Bottom Line: We recommend an overweight position in UAE equities within an EM portfolio this year (Chart III-6). For fixed income investors, we recommend overweighting UAE corporate credit in an EM corporate credit portfolio. UAE corporate credit is a lower beta market and will outperform as EM corporate spreads widen (Chart III-7). Most UAE-dollar corporate bonds have been issued by banks. Banks in the UAE do not suffer from structural overhangs, and the cyclical downturn in the property market is well advanced. This is why they have been, and will remain, a lower beta sector within an EM corporate credit portfolio. Chart III-6Overweight UAE Equities Within An EM Portfolio Overweight UAE Equities Within An EM Portfolio Overweight UAE Equities Within An EM Portfolio Chart III-7UAE Corporate Credit Will Likely Outperform EM Benchmark UAE Corporate Credit Will Likely Outperform EM Benchmark UAE Corporate Credit Will Likely Outperform EM Benchmark   Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Portfolio Strategy China’s ongoing reflation trifecta, rising commodity prices, a back-half of the year global growth recovery, favorable balance sheet metrics and neutral valuations and technicals all signal that the cyclical vs. defensive outperformance phase has more running room. New home-related data releases have been a mixed bag lately and there are high odds that homebuilders have discounted all the good housing market news. Be prepared to book profits. Recent Changes There are no changes in our portfolio this week. Table 1 Updating Our SPX Target Updating Our SPX Target Feature The SPX hit fresh all-time closing highs last week, as declining profits were not as bad as previously feared. While economic and profit fundamentals remain soft at best, fear of missing out (FOMO) on the rally and proliferating talk of a melt up in stocks have provided the needed spark to fuel the recent equity breakout (Chart 1). Historically, both of these sentiment/anecdotal-type time series have led or coincided with temporary broad equity market peaks and we continue to believe that some short-term caution is still warranted. In other words, we would not chase this multiple expansion-driven market advance and specifically refrain from putting fresh capital to work (please refer to Charts 1 & 2 from last Monday’s Weekly Report)1. Moreover, the easy money on the “reflation trade” has already been made and now the risk/reward tradeoff is to the downside. Our Reflation Gauge (RG), comprising oil prices, the trade-weighted U.S. dollar and interest rates, is quickly losing steam and warns against extrapolating equity market euphoria far into the future (Chart 2). Chart 1Beware Melt Up And FOMO Narrative Beware Melt Up And FOMO Narrative Beware Melt Up And FOMO Narrative Chart 2Reflation Stalling Reflation Stalling Reflation Stalling As a reminder, crude oil prices are up over 50% from the nadir, the 10-year Treasury yield is up 25bps from the recent lows, and the greenback is on the cusp of a breakout in level terms. The implication from our decelerating RG is also consistent with a cautious equity market stance from a tactical perspective. But, on a cyclical 9-12 month time horizon we continue to have a sanguine equity market view as the U.S. will avoid recession and the Fed will likely stay on the sidelines. We recently updated the S&P 500 dividend payout for calendar 2018 and this week we are introducing our 3,150 SPX target for end-year 2020 derived via three methodologies: SPX dividend discount model (DDM), forward multiple/EPS sensitivity and forward equity risk premium (ERP) analysis. Table 2 summarizes our results. On a side note our end-year 2019 target remains unchanged since our mid-January update at 3,000.2 Table 2SPX Target Using Three Different Methods Updating Our SPX Target Updating Our SPX Target In all three ways we get a value of roughly 3,150 on the SPX, which serves as our end-year 2020 SPX target. In our DDM, we moved the recession to 2021 from 2020 previously, added a year to our 5-year rolling estimates and continue to conservatively assume no buybacks. With regard to the sensitivity analysis, our 2021 EPS estimate is $191, a discount to the $205 currently penciled in by the sell-side, and our base case calls for a 16.5x forward multiple. Finally, the bottom part of Table 2 shows our forward ERP assumptions. We lifted the equilibrium ERP from 200bps to 250bps given the recent setback it suffered and our 10-year Treasury yield also moved down 50bps to 3.5%. Consistent with our sensitivity analysis base case, the starting point is $191 2021 EPS. In all three ways we get a value of roughly 3,150 on the SPX, which serves as our end-year 2020 SPX target. (If you would like to receive our excel spreadsheet in order to adjust our assumptions please email our client requests department here). This week we update our cyclicals/defensives portfolio bent view and a set a stop sell order to an overweight early-cyclical niche subsector. Stick With Cyclicals Over Defensives, For Now Chart 3China… China… China… We were early and right in January when we posited that China’s slowdown was yesteryear’s story and more than discounted in the collapse of the U.S. cyclicals vs. defensives ratio (please refer to Chart 5 from the January 28 Weekly Report). Similarly, in early February when everyone was laser focused on the Fed’s January meeting, our report titled “Don’t Fight The PBoC” highlighted that the Chinese were serious about reflating their economy. The PBoC’s quasi-QE not only recapitalized the banks, but it also injected enormous liquidity into their financial system. The upshot was that U.S. cyclicals would reclaim the upper hand vs. defensives. Now as the story count for “China Slowdown” is coming down fast (story count shown inverted, bottom panel, Chart 3) the question is how much of the looming Chinese recovery is currently priced in the V-shaped cyclical/defensives rebound? Our sense is that while most of the good news is largely reflected in the slingshot recovery in the relative share price ratio, there is some room left for additional gains. Financial variables are upbeat and signal that more gains are in store for the cyclicals/defensives ratio. China’s A-shares year-to-date have trounced the S&P already by a factor greater than 2:1 (in local currency terms, not shown). The MSCI China index is also outperforming the MSCI All-Country World Index (top panel, Chart 4). Sell-side analysts are in synchrony with the markets and they have been upgrading EPS estimates for the MSCI China index (top panel, Chart 5). Chart 4…Signals… …Signals… …Signals… Beyond the stock market, the FX market along with commodities are also underpinning relative share prices. The ADXY index (bottom panel, Chart 4) and the CRB metals index (bottom panel, Chart 5) are both moving in lockstep and suggest that commodity related profits will boost cyclicals at the expense of defensives. Chart 5…More Gains… …More Gains… …More Gains… Similarly, the broad trade-weighted U.S. dollar is no longer appreciating at the late-2018 breakneck pace and, at the margin, suggests that cyclicals profits will get an added boost from positive FX translation gains as they garner a larger slice of their revenue from international markets compared with mostly domestically-exposed defensives (U.S. dollar shown inverted, bottom panel, Chart 6). Soft economic data have taken their cue from higher frequency financial market data and have also turned. China’s CAIXIN manufacturing PMI is above the 50 boom/bust line. The implication is that U.S. cyclicals’ profits will outshine U.S. defensives’ EPS (middle panel, Chart 6). Finally, monetary easing is ongoing on the Chinese front. The banks’ reserve-requirement-ratio is falling and so is the interbank lending rate as per SHIBOR (both shown inverted & advanced, top & middle panel, Chart 7). Given the trifecta of Chinese easing on the monetary, fiscal and credit front, it is inevitable that hard data will also soon turn. Chart 6…Are In Store For Cyclicals… …Are In Store For Cyclicals… …Are In Store For Cyclicals… Chart 7…At The Expense Of Defensives …At The Expense Of Defensives …At The Expense Of Defensives Chart 8Global LEI Diffusion Concurs Global LEI Diffusion Concurs Global LEI Diffusion Concurs Nevertheless, it is not only China that is emitting an unambiguously positive signal for the U.S. cyclicals/defensive ratio. BCA’s global leading economic indicator diffusion index is pushing 65%, underscoring that the majority of the countries we track showcase an improving economic outlook. As a reminder, BCA’s view remains that in the back half of the year global growth will pick up steam. Thus, under such a backdrop, cyclicals will continue to outperform defensives (Chart 8). Stick with a cyclical over defensive portfolio bent, but stay tuned. On the relative operating front, cyclicals are also flexing their muscles and crushing defensives. Since 1980 (the beginning of our dataset), the cyclical/defensive portfolio bent has followed relative return-on-assets (ROA). While over the decades there have been some divergences, this correlation has become extremely tight since early-2000. Currently, following the late-2015/early 2016 manufacturing recession, the relative ROA has jumped 400bps and is signaling that relative share prices are on a solid footing (Chart 9). Chart 9Relative ROA And… Relative ROA And… Relative ROA And… With regard to relative debt dynamics, cyclicals also have the upper hand. Net debt/EBITDA and EBIT/interest expense both show that the relative indebtedness favors cyclicals over defensives. While defensives are degrading their balance sheet, cyclicals are still repairing theirs in the aftermath of the recent manufacturing recession (Chart 10). Despite the year-to-date spike in relative share prices, relative valuations and technicals remain tame. Both our relative Valuation and Technical Indicators are timid, and remain below the respective historical averages (Chart 11). Chart 10…Indebtedness Suggests That Cyclicals Have the Upper Hand …Indebtedness Suggests That Cyclicals Have the Upper Hand …Indebtedness Suggests That Cyclicals Have the Upper Hand In sum, China’s ongoing reflation, rising commodity prices, a back-half of the year global growth recovery, favorable balance sheet metrics and neutral valuations and technicals all signal that the cyclical vs. defensive outperformance phase has more running room. Chart 11No Red Flags No Red Flags No Red Flags Bottom Line: Stick with a cyclical over defensive portfolio bent, but stay tuned. Is The Homebuilding Rally Sustainable? While we were slightly early in our upgrade of homebuilding stocks to overweight in late-September, this recommendation has generated alpha close to 10% for our portfolio. Nevertheless, some soft housing related data compel us to put this index on downgrade alert and, from a risk management perspective in order to protect gains, set a stop sell order near the 10% relative return mark. Just to be clear, this is not a negative call on residential real estate. Quite the opposite, housing market long-term drivers remain upbeat in the U.S. Chart 12 shows that household formation is still running higher than housing starts and building permits. This is a bullish industry supply/demand backdrop. Housing affordability, while not as sky-high as when house prices troughed in 2011/2012, remains above the historical mean and above previous peaks (second panel, Chart 12). Tack on still generationally low interest rates and there good odds that first-time home buyers will return to the residential real estate market. Finally, the labor market is as good as it gets with the unemployment rate plumbing multi-decade lows (unemployment rate shown inverted, bottom panel, Chart 12). Job certainty and rising salaries are a healthy combination for housing market prospects. Beyond the positive structural housing market forces, some recent homebuilder specific data have also been positive. New home sales have surged and are now in expansionary territory (top panel, Chart 13). Similarly, the latest inventory data on new homes showed that newly built house inventories are whittled down, with the months’ supply metric falling by over one month (new house supply shown inverted, second panel, Chart 13). Chart 12Bullish Structural Housing Fundamentals Bullish Structural Housing Fundamentals Bullish Structural Housing Fundamentals Chart 13Select Positive… Select Positive… Select Positive… The 70bps drop in the 30-year fixed mortgage rate since November has shown up in rising mortgage purchase applications that have vaulted to multi-year highs (middle panel, Chart 13). Lumber, a key input cost for new home construction has melted of late and this building material cost relief is a boon for homebuilding margins.  True, new home prices are deflating and are an offset, but from an all-time high level and at a slower pace than lumber prices (fourth & bottom panels, Chart 13). One reason median new single family home prices are falling is that homebuilders are competing aggressively for market share with the existing stock of homes available for sale. Price concessions are paying dividends as relative volumes have spiked i.e. homebuilders are successfully grabbing market share (second & third panels, Chart 14). In absolute terms, S&P homebuilding sales are expanding at a healthy pace and the NAHB’s survey of future sales expectations point to a firming new home demand outlook (bottom panel, Chart 14). However, there are some macro headwinds that homebuilders will have to contend with in the back half of the year. While interest rates have fallen during the past six months, our fixed income strategists expect a selloff in the bond market, which, at the margin, will weigh on housing affordability (mortgage rate shown inverted, top panel,Chart 15). Chart 14…Homebuilding Data… …Homebuilding Data… …Homebuilding Data… Chart 15…But Two Key Risks Remain …But Two Key Risks Remain …But Two Key Risks Remain Netting it all out, housing related data have been a mixed bag of late and homebuilders have likely discounted most of the good housing market news. Thus, in order to protect profits we are setting a stop sell order near the 10% relative return mark. Already, bankers are making it slightly, but steadily, more difficult to get a mortgage loan (third panel, Chart 15). But, what worries us most is that according to the Fed Senior Loan Officer survey, demand for residential real estate loans has collapsed to a level last hit at the depths of the Great Recession. Historically, this bombed out demand indicator has been a precursor of a fall in relative share prices (second panel, Chart 15). Finally, actual mortgage loan origination is quickly decelerating (bottom panel, Chart 15) and short-term momentum is already contracting. Netting it all out, housing related data have been a mixed bag of late and homebuilders have likely discounted most of the good housing market news. Thus, in order to protect profits we are setting a stop sell order near the 10% relative return mark. Bottom Line: Stay overweight the S&P homebuilding index, but we are putting it on our downgrade watch list. Be prepared to monetize gains on a pullback in relative share prices near the 10% return mark since inception. The ticker symbols for the stocks in this index are: BLBG: S5HOME – PHM, DHI, LEN.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com     Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Mixed Signals” dated April 22, 2019, available at uses.bcaresearch.com. 2      Please see BCA U.S. Equity Strategy Weekly Report, “Catharsis” dated January 14, 2019, available at uses.bcaresearch.com.   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights The recent dovish shift in tone from central banks around the world is here to stay this year, providing support for global growth. As a result, stock prices will benefit from a combination of easy policy and rebounding activity, while safe-haven yields will grind higher. The recent deterioration in profit margins is not due to rising costs but reflects weaknesses in pricing power. Pricing power is pro-cyclical: If global growth improves and the dollar weakens, margins should recover. Overweight financials and energy. We are upgrading European equities to neutral, and placing them on a further upgrade watch. Feature Easy Does It The global monetary environment has eased over the past four months. Some major central banks like the Federal Reserve and the Bank of Canada have backed away from tightening. Others, like the Bank of Japan, the Reserve Bank of Australia, the Reserve Bank of New Zealand and the Swedish Riksbank have provided very dovish forward guidance. And one major policy setting institution – the European Central Bank – has even eased policy outright by announcing a large-scale injection of liquidity in the banking sector through its TLTRO-III operation that will begin in September. This phenomenon is not limited to advanced economies. Important EM central banks are also targeting easier liquidity conditions. The Reserve Bank of India has cut interest rates by 50 basis points; the Monetary Authority of Singapore is now targeting a flat exchange rate; and the Bank of Korea has issued a somewhat dovish forward guidance. Most importantly, Chinese policymakers are once again forcing debt through the system, with total social financing flows amounting to RMB 2.9 trillion last quarter, more than the RMB 2.4 trillion pumped through the economy in the first quarter of 2016. These reflationary efforts will bear fruit. Policy easing, especially when it relies as largely on forward guidance as the current wave does, should result in lower forward interest rates. And as Chart I-1 illustrates, when a large proportion of global forward rates are falling, a rebound in global economic activity typically follows. This time will not be different. Chart I-1Monetary Guardians Are Coming To The Rescue Monetary Guardians Are Coming To The Rescue Monetary Guardians Are Coming To The Rescue The S&P 500 and global equities have already rebounded by 18.9% and 17.2%, respectively since late December. Have markets already fully discounted the growth improvement that lies ahead, leaving them vulnerable to disappointments? Or do global stocks have more upside? While a rest may prove necessary, BCA anticipates that global equity prices have more upside over the coming 12 months. Are Central Banks About To Abandon Their Newfound Dovish Bias? We sincerely doubt it. Reversing the recent tone change soon would only hurt the battered credibility that central banks are fighting so hard to maintain. In the case of the U.S., the most recent FOMC minutes were clear: The Fed does not intend to tighten policy soon, even if growth remains decent. The minutes confirmed the idea we espoused last month, that FOMC members are focused on avoiding a Japan-like outcome for the U.S. where low expected inflation begets low realized inflation. Such an outcome would greatly increase the probability that an entrenched deflationary mindset develops in the U.S. in the next recession. As a result, we anticipate that the Fed will refrain from tightening policy until inflation expectations move back up toward their historical range (Chart I-2). Further justifying the Fed’s new stance, a small rebound in productivity is keeping unit labor costs at bay, despite a pick-up in wages. This is likely to put a lid on core inflation for now (Chart I-3). Chart I-2Inflation Expectations: Too Low For The FOMC's Comfort Inflation Expectations: Too Low For The FOMC's Comfort Inflation Expectations: Too Low For The FOMC's Comfort Chart I-3A Whiff Of Disinflation A Whiff Of Disinflation A Whiff Of Disinflation There is little reason for the ECB to adopt a more hawkish stance either. The euro area PMIs have stabilized but are still flirting with the boom/bust line. Realized core inflation is a paltry 0.8% and the ECB’s own forecast is inconsistent with its definition of price stability, which dictates that the inflation rate should be “below but close to 2% over the medium term.” Our ECB Monitor captures these dynamics, remaining in the neutral zone (Chart I-4).   In China, the case for quickly removing credit accommodation is weak. Property developer stocks have rebounded 41% from their October lows, but sales of residential floor space remain soft, keeping real estate speculation in check. Meanwhile, our proxy for the marginal propensity to consume of Chinese households – based on the ratio of demand deposits to time deposits – continues to deteriorate (Chart I-5). The recent pick up in credit growth should put a floor under those trends, but it will take some time before these variables overheat enough to call for policy tightening. Chart I-4Our ECB Monitor Supports An ECB Standing Still Our ECB Monitor Supports An ECB Standing Still Our ECB Monitor Supports An ECB Standing Still Chart I-5Key Domestic Variables Argue Against Tightening Policy In China Key Domestic Variables Argue Against Tightening Policy In China Key Domestic Variables Argue Against Tightening Policy In China   Bottom Line: The three most important policymakers in the world are not set to suddenly slam on the brake pedal. As a result, the global policy backdrop will remain accommodative for at least two to three quarters. The few economic green shoots observed around the world should therefore blossom into a full-fledge global growth pick-up. From Green Shoots To Green Gardens If central banks adopt an easier bias but global growth is slowing sharply without any end in sight, stock prices are unlikely to find a floor. After all, stock prices represent the discounted value of future cash flows. If those cash flows are expected to decline at a faster pace than the risk-free rate, then stock prices can fall – even if policy is becoming more accommodative. However, if economic activity is stabilizing, easier policy should generate substantial equity gains. Stimulative financial conditions will result in an improvement in global activity indicators, including emerging economies (Chart I-6, top panel). This is very important as emerging markets were at the epicenter of the slowdown in global trade, and because they historically lead global industrial activity (Chart I-6, bottom panel). The few economic green shoots observed around the world should therefore blossom into a full-fledge global growth pick-up. Policy easing in China is of particular significance. Our Chinese activity indicator is still slowing, but BCA’s Li-Keqiang Leading Indicator, which mostly tracks developments in the credit sector, has stabilized (Chart I-7, top panel). The rebound in the credit impulse also points to an acceleration in Chinese nominal manufacturing output (Chart I-7, bottom panel). This should lift Chinese imports, resulting in a positive growth impulse for the rest of the world. Chart I-6The Dance Of FCI And Activity The Dance Of FCI And Activity The Dance Of FCI And Activity Chart I-7Chinese Industrial Activity Will Rebound Soon Chinese Industrial Activity Will Rebound Soon Chinese Industrial Activity Will Rebound Soon   At the moment, the euro area remains weak, but it will become a key beneficiary of improving growth. As the top panel of Chart I-8 illustrates, the Eurozone’s exports to China tend to follow the trend in the Chinese Adjusted Total Social Financing impulse. Moreover, European exports to the rest of the world are set to enjoy a recovery, as highlighted by the upturn in the diffusion index of our Global Leading Economic Indicator (Chart I-8, bottom panel). This external-sector improvement is happening as the euro area domestic credit impulse is rebounding, and as the region’s fiscal thrust increases from roughly zero to 0.4% of GDP. In the U.S., it is unlikely that 2019 growth will top that of 2018, but activity should nonetheless rebound from a lukewarm first quarter. Importantly, the fed funds rate is holding below its equilibrium (Chart I-9). Additionally, household fundamentals remain solid. A tight labor market means that wages have upside and household debt levels and debt servicing costs are all well behaved relative to disposable income (Chart I-10). Moreover, housing dynamics are generally stronger than reported by the press, as mortgage applications for purchases are making cyclical highs and the NAHB Homebuilder confidence index is rebounding (Chart I-11). Offsetting some of these positives, capex intentions – a robust forecaster of actual corporate investments – have rolled over from their heady mid-2018 levels. Even so, they remain consistent with positive capex growth. Also, U.S. fiscal policy is becoming increasingly less growth-friendly starting in mid-2019. Netting it all out, U.S. growth should remain above-trend, at about 2.5%. Chart I-8Europe Will Benefit From Stabilizing Growth Elsewhere Europe Will Benefit From Stabilizing Growth Elsewhere Europe Will Benefit From Stabilizing Growth Elsewhere Chart I-9U.S. Policy Remains Accommodative U.S. Policy Remains Accommodative U.S. Policy Remains Accommodative   Chart I-10U.S. Households Are Doing Alright U.S. Households Are Doing Alright U.S. Households Are Doing Alright Chart I-11Forward-Looking Housing Indicators Point To A Pick-Up Forward-Looking Housing Indicators Point To A Pick-Up Forward-Looking Housing Indicators Point To A Pick-Up Bottom Line: While U.S. growth may be weaker than in 2018, it should not fall below trend. Meanwhile, Chinese credit trends suggest that growth there should clearly pick up in the coming months, which should also lead to stronger activity in Europe. In other words, exactly as central banks have removed policy constraints, global growth is set to re-accelerate. This is a positive backdrop for risk assets over the coming 12 months.   What Does It Mean For Asset Prices? Simply put, a dovish shift in policy along with a tentative stabilization in growth should result in both higher stock prices and rising safe-haven bond yields. First, a rebound in global economic activity means that depressed profit growth expectations could easily be bested (Chart I-12, top panel). Bottom-up estimates point to EPS growth of 3.4% in the U.S. and 5.3% in the rest of the world in 2019, using MSCI data. However, profits are extremely pro-cyclical, and a combination of easy financial conditions and improving growth conditions in the second half of the year should result in better-than-expected earnings. Chart I-12Profit Expectations Are Low Profit Expectations Are Low Profit Expectations Are Low Second, the Fed is extending its pause, as other global central banks are also adopting more accommodative policies. This implies that global real interest rates, both at the short- and long-end of the curve, will remain below equilibrium for longer than would have been the case if policy had remained on its previous path. Consequently, not only do lower real rates decrease the discount factor for stocks, they also imply a longer business cycle expansion. This should result in narrower risk premia for stocks and higher multiples. Since they offer cheaper valuations than those in the U.S., international equities may stand to benefit more from policy-led multiple expansion (Chart I-12, bottom panel). Third, the global duration indicator developed by BCA’s Global Fixed Income Strategy service is forming a bottom.1 This gauge – levered to global growth variables like the Global ZEW growth expectations survey, our Global Leading Economic Indicator and the Global LEI’s diffusion index – has perked up in response to green shoots around the globe. An upturn in global safe-haven yields is imminent (Chart I-13). Additionally, the global Policy Uncertainty Index is currently recording very high readings, congruent with depressed yields (Chart I-14). A benign resolution to the Sino-U.S. trade tensions along with the low likelihood of the implementation of a No-Deal Brexit should push this indicator down, lifting yields in the process. Chart I-13Global Dynamics Argue For Fading The Bond Rally Global Dynamics Argue For Fading The Bond Rally Global Dynamics Argue For Fading The Bond Rally Chart I-14Policy Uncertanity Is At An Apex: Look The Other Way Policy Uncertanity Is At An Apex: Look The Other Way Policy Uncertanity Is At An Apex: Look The Other Way   Fourth, while we expect the Fed to stay on pause for the remainder of 2019 and probably through the lion’s share of 2020 as well, this is a more hawkish forecast than what the market is currently pricing in (Chart I-15). As we argued last month, a fed funds rate that turns out to be higher over the next year than what is currently discounted often results in the underperformance of Treasurys relative to cash. Finally, a rebound in global growth, even if the Fed proves more hawkish than the market anticipates, generally pushes the dollar lower (Chart I-16). Since speculators currently hold large net short bets on the euro, the AUD, the CAD, and so on, the probability is high that this historical pattern will assert itself. The recent period of dollar strength is unlikely to last more than a couple of weeks. A weak dollar, easy policy and rebounding growth should boost commodity prices, especially metals and oil. The latter should benefit most from this set up as the end of the waivers of U.S. sanctions on Iran will constrain the availability of crude in international markets. Chart I-15 Chart I-16The Dollar Last Hurrah Will End Very Soon The Dollar Last Hurrah Will End Very Soon The Dollar Last Hurrah Will End Very Soon   Rebounding global growth should also allow equity prices to be resilient in the face of rising bond yields, up to a point. When yields and inflation expectations are low, multiples and equity prices tend to move in tandem. This is because in an environment where central banks are frightened by deflationary risks, monetary authorities do not lift rates as quickly as nominal activity would warrant. Thus, improving nominal growth lifts the growth component of equity multiples more than it raises yields. In other words, we expect yields and stocks to rise together because low but rising inflation expectations, but not surging real rates, will drive the upside in bond yields. Obviously, this cannot last forever. Once the Fed starts suggesting that rates will rise again, and the entire yield curve moves closer to neutral, higher yields will curtail equity advances. This is a constructive cyclical setup; but the tactical environment is murkier. The problem is that equity prices have already moved up significantly over the past four months. With volatility across asset classes having once again plunged toward historical lows, risk assets display a high degree of vulnerability to disappointing economic data. This means that unless growth rebounds strongly and quickly, stocks could experience a short-term correction in the coming months. While staying overweight equities, it is nonetheless prudent to buy some protection. Investors should also wait on the sidelines to deploy any excess cash. Rebounding global growth should also allow equity prices to be resilient in the face of rising bond yields, up to a point. Bottom Line: The current environment is favorable for risk assets on a cyclical basis. Low real rates will not only continue to nurture the nascent improvement in the global economy. They also imply lower discount rates. Meanwhile, improving economic activity and a decline in policy uncertainty will push safe-haven yields higher. Consequently, it remains sensible to be long stocks and underweight bonds for the remainder of the year, even if the risk of a short-term stock correction has risen. Within fixed-income portfolios, a below-benchmark duration makes sense, especially as oil prices are rising, Sino-U.S. trade negotiations should end in a benign outcome, and a No-Deal Brexit remains unlikely. Margins Are The Greatest Risk At the current juncture, the biggest risk for stocks is that profits fall short of depressed analysts’ estimates for 2019 – not because revenue growth disappoints, but because profit margins contract. Our U.S. Equity Sector Strategy service has recently highlighted that the S&P 500 operating earnings margin stands at 10.1% after having peaked at 12% in Q3 2018 (Chart I-17).2 Despite this decline, margins remain both elevated by historical standards and above their long-term upward-sloping trend. As Chart I-18 illustrates, the decline in margins is not an S&P 500-only phenomenon: It is an economy wide one as well, as the pattern is repeated using national accounts data. Chart I-17Will This Margin Deterioration Continue? Will This Margin Deterioration Continue? Will This Margin Deterioration Continue? Chart I-18Margins: All About Labor Costs Versus Selling Prices Margins: All About Labor Costs Versus Selling Prices Margins: All About Labor Costs Versus Selling Prices   At first glance, the Fed’s current pause may undermine profit margins. As Chart I-19 shows, when the unemployment rate stands below NAIRU, on average, wages grow faster than when the labor market is not at full employment. Since the unemployment gap stands as -0.8% today, we are likely to see continued wage pressures in the U.S. economy. Chart I-19Wages Have Upside Wages Have Upside Wages Have Upside The problem with this story is that productivity has been accelerating – from a -0.3% annual rate in the second quarter of 2016 to 1.8% in the fourth quarter of 2018. Because wage inflation did not experience as large a change, unit labor cost inflation is still growing at 1% annually, as they did in Q2 2016. In fact, real unit labor costs are currently contracting at a 0.4% pace. The pick-up in capex over the past three years suggests that productivity can continue to improve over the coming quarters. Consequently, as has been the case over the past two years, rising wages will only have a limited negative impact on margins. The key source of variance in profit margins has been, and will likely remain over the next year or so, corporate pricing power, which today stands at its lowest level since the deflationary episode of 2015-2016 (Chart I-20). As was the case back then, the slowdown in global growth has played a role, since it has resulted in falling global export prices. Not only do they affect foreign revenues for U.S. businesses, they also impact the price of goods sold at home, and thus have a broad impact on aggregate pricing power. Chart I-20Pricing Power Follows The Global Business Cycle Pricing Power Follows The Global Business Cycle Pricing Power Follows The Global Business Cycle Last year’s dollar strength amplified those headwinds. A strengthening dollar affects profitability through four channels. First, it negatively impacts global growth by tightening financial conditions for foreign borrowers who fund themselves in USD. They are thus more financially constrained when the dollar appreciates. Second, a strong dollar hurts commodity prices and industrial goods prices. Third, a strong dollar negatively impacts the competitiveness of U.S. firms, forcing them to cut their prices to stay competitive. Finally, a strong dollar hurts the translation of overseas earnings back into USDs. As a result, a strong dollar weighs on earnings estimates (Chart I-21).   Chart I-21The Dollar Amplified Margins Problems The Dollar Amplified Margins Problems The Dollar Amplified Margins Problems Since we anticipate global growth to improve and the greenback to buckle, the current pricing power problem faced by corporate America should fade and profit margins should rebound in the second half of 2019. This suggests that for now, declining profit margins remain a risk that needs to be monitored – not a base case to embrace. Our U.S. Equity Sector Strategy service has highlighted that the tech sector has the poorest earnings outlook within the S&P 500. An economic upswing could counteract some of the recent declines in tech margins, but the much more pronounced rise in labor costs in Silicon Valley than in other sectors suggests that tech profits could lag behind other heavyweights like financials and energy. Consequently, BCA recommends a neutral allocation to tech stocks. We instead recommend overweighting financials and the energy sector. Financials will benefit from an easy monetary policy setting that should help credit growth. Moreover, net interest margins are at cycle highs of 3.5%, as banks have prevented interest costs on deposits from rising in line with short rates. Finally, buybacks by financial services firms are rising and will likely battle the tech sector’s buybacks for the pole position this year (Chart I-22).3 Chart I-22Why Are We Neutral On Tech? Why Are We Neutral On Tech? Why Are We Neutral On Tech? Our positive stance on energy stems from undue pessimism surrounding the sector. Bottom-up analysts currently pencil in such a large contraction in earnings for this group that, according to their forecasts, energy will curtail 2019 S&P 500 earnings by 18%. With WTI prices back above $65/bbl, rising per-well productivity and easing financing costs, the hurdle to beat is already low. Moreover, the end of U.S. waivers on Iranian sanctions further supports oil prices. In this context, if global growth rebounds and the dollar depreciates, energy stocks could catch fire. Bottom Line: The biggest risk to our positive stance on equities is that earnings are dragged down by declining margins. While the recent softness in margins is concerning, it does not reflect an increase in labor costs. Instead, it is a consequence of eroding pricing power. Falling pricing power is itself a symptom of the slowdown in global growth and a stronger dollar. As both these ills pass, margins should recover in the second half of 2019. Within equities, we prefer financials and energy, as their earnings prospects outshine tech stocks. Upgrading European Equities To Neutral, And Looking For More For equity investors competing against a global benchmark, there is a simple way to express the view that global growth will rebound, safe-haven yields have upside, the dollar will weaken, and that profit margins are a risk to monitor. It is to abandon underweight allocations to European equities and overweight positions to U.S. stocks. This month, we are upgrading European equities to neutral and downgrading U.S. stocks to neutral. Even after this upgrade, we are putting European equities on a further upgrade watch. First, the euro area is much more sensitive than the U.S. to Chinese growth. This also has implication for equities. As Chart I-23 shows, when the ratio of M1 to M2 money supply in China perks up, as it is currently doing, European stocks end up outperforming their U.S. counterparts. This is because the M1-to-M2 ratio ultimately reflects the growth of demand deposits relative to savings deposits in the Chinese banking sector. It therefore informs how spending is likely to evolve. Currently, China’s reflationary efforts point toward a pickup in spending that should lift European exports, and European profits as well. Chart I-23Monetary Dynamics In China Favor Fading Euro Area Bearishness Monetary Dynamics In China Favor Fading Euro Area Bearishness Monetary Dynamics In China Favor Fading Euro Area Bearishness Second, European exports have upside, and unsurprisingly, the bottoming in the BCA Boom/Bust indicator – which captures global growth dynamics beyond just China – is also flagging the end of European equity underperformance (Chart I-24, top panel). Moreover, if the global reflationary period is sustained, the decline in forward interest rates will reverse. This too is consistent with a period of outperformance for European equities (Chart I-24, bottom panel). Third, our overweight stance on financials relative to tech equates to European equities beating their U.S. counterparts. This simply reflects the fact that financials constitute 17.9% of the MSCI euro area index, while tech stocks account for 9.2%. The same sectors represent 12.9% and 26.8% of the U.S. market, respectively. Not only are European banks trading at 0.6-times book value compared to 1.2-times for U.S. lenders, but European banks stand to benefit more than U.S. banks from rising bond yields as they garner a larger share of their income from lending activity. Fourth, European profit margins are toward the bottom third of their distribution relative to U.S. profit margins. As Chart I-25 shows, European profit margins tend to rise when euro area unit labor costs lag U.S. ones. Since the euro area output gap is not as positive as that of the U.S., it is unlikely that European wages will outpace U.S. wages this year. Also, since European stocks are more heavily weighted toward industrials, materials and energy, the sectors that suffered the greatest loss of pricing power during the global economic slowdown, pricing power in Europe could rebound more strongly than in the U.S. This too should flatter European profit margins relative to the U.S. Chart I-24European Equities To Benefit From Rebounding Global Growth European Equities To Benefit From Rebounding Global Growth European Equities To Benefit From Rebounding Global Growth Chart I-25European Profit Margins Can Experience A Further Cyclical Lift European Profit Margins Can Experience A Further Cyclical Lift European Profit Margins Can Experience A Further Cyclical Lift   Finally, even after adjusting for sectoral composition, European equities trade at a discount to U.S. stocks. On an equal-sector basis, the 12-month forward P/E ratio is 14.2, and the price-to-book ratio is 2.0. For the U.S., the same multiples stand at 20.7 and 4.0, respectively. This means that European stocks are not yet pricing in an improving outlook. Be warned: The positive outlook for European equities relative to the U.S. is a cyclical story. As Section II of this report argues, poor demographics and an excessively large capital stock suggest that European rates of return will continue to lag the U.S. As a result, the return from investing in European stocks is unlikely to beat that of the U.S. beyond 12 to 18 months. Bottom Line: Within a global equity portfolio, we are upgrading the euro area from underweight to neutral at the expense of the U.S., which moves to neutral. We are also putting European equities on a further upgrade watch. Mathieu Savary Vice President The Bank Credit Analyst April 25, 2019 Next Report: May 30, 2019 II. Europe: Here I Am, Stuck In A Liquidity Trap An aging population, a banking sector in poor health, and a private sector focused on building up savings are the key factors undermining euro area growth on a structural basis. A large manufacturing sector makes the euro area vulnerable to EM competition. Unlike the U.S., the region’s tech sector is held back by regulatory burdens, taxes and heavy dependence on bank funding. The euro area growth faces decades of low growth and inflation. Euro area rates will stay depressed, but paradoxically, the euro can still experience structural appreciation. Euro area equities are cheap for a good reason, and banks will continue to weigh on performance. Over the past 10 years, the euro area has gone through a sovereign debt crisis, a double-dip recession, persistent below-target inflation, and most recently, yet another major growth slowdown. Moreover, this economic malaise materialized despite highly stimulative monetary policy, including negative interest rates. The ongoing economic weakness has raised the specter that the euro area is the new Japan. Nearly three decades after the bursting of the Nikkei bubble, the Land of the Rising Sun remains mired in low growth and mild but persistent deflation. Consequently, charts showing that European policy rates or bond yields are tracking Japanese developments with a 17-year lag (Chart II-1) have not only become commonplace, they elicit fears that European growth, interest rates and asset valuations will lag the rest of the world for decades to come. Chart II-1Europe Is Following The Japanese Example Europe Is Following The Japanese Example Europe Is Following The Japanese Example In this piece, we discuss the various forces that explain why the euro area economy has been so weak this decade, and why such low interest rates have had so little impact on growth. We also study what sets the U.S. and euro area apart, and whether or not Europe will follow the trail blazed by Japan nearly 30 years ago. The Three Headwinds Three ills have kept European growth particularly depressed this cycle and are likely to remain significant headwinds into the foreseeable future: demographics, the banking sector’s poor health, and nonfinancial private sector balance sheet cleansing. 1)   Demographics This is the most well understood and acknowledged problem impacting Europe today. Since 2008, the European population has grown by 2%, or only 0.2% a year, with the working age population having peaked around that year. Going forward, the picture will only deteriorate: The UN expects Europe’s population to contract by 12% over the next 27 years, and the working age population to fall by 15%. This also means that the dependency ratio – the number of individuals aged less than 15 and above 65 per 100 working-age people – will approximately double over the coming 40 years. This is a clear parallel with Japan. As Chart II-2 illustrates, Europe’s population, the number of working-age individuals and the dependency ratio are all tracking Japan with a 17-year lag. Like Japan, Europe’s trend growth will thus only deteriorate further. Not only will Europe not be able to add as many workers as the U.S. to its total, but it will need to build even fewer schools, malls, office buildings or units of housing. Consequently, both the supply and demand sides of the economy will lag due to this factor alone. 2)   Banking Sector Health The poor health of the euro area banking sector is well known. BCA’s Global Asset Allocation service published an in-depth analysis of the European banking sector last December.4 The piece demonstrated that European banks have been much slower to recognize non-performing loans, curtail credit and rebuild capital than their U.S. counterparts. U.S. bank loans to the private sector fell by 13% in the two years during the crisis, while in Europe, these same loans have only fallen by 2% since 2008. Euro area banks generally remain burdened with significant non-performing loans as a percentage of regulatory capital. Moreover, net interest margins are also dismal, implying that the income cushion against bad loans is thin. Consequently, outside of France, Finland and Germany, European banks have either not grown their loan books to the private sector or, as is the case with Spain, Portugal, and Ireland, these books are continuously shrinking (Chart II-3). Chart II-2Same Demography In Europe Now Than In Japan Then Same Demography In Europe Now Than In Japan Then Same Demography In Europe Now Than In Japan Then Chart II-3Peripheral Banks Continue To Curtail Credit Peripheral Banks Continue To Curtail Credit Peripheral Banks Continue To Curtail Credit   The poor health of the European banking system is now constraining the supply of new credit to the rest of the economy. This is a much bigger problem than is the case in the U.S. given that in Europe, 72% of corporate funding comes from the banking system while 88% of household liabilities are also funded this way. In the U.S., the share of bank funding for these sectors is 32% and 29%, respectively (Chart II-4). A weak euro area banking system prevents the nonfinancial private sector from growing as robustly as it could. Chart II-4 3)   Nonfinancial Private Sector Balance Sheet Cleanse Another major drag on European growth has been the continued efforts of the European private sector to rebuild its balance sheet. To use the terminology developed by our upcoming conference speaker Richard Koo, the euro area has been in the thralls of a powerful balance sheet recession. Households in the euro area, Japan and the U.S. are all accumulating more financial assets than liabilities. However, only in the U.S. is the nonfinancial corporate sector building more liabilities than it is accumulating assets (Chart II-5). In Japan and Europe, the nonfinancial corporate sector is also a source of savings for the economy. Moreover, in Europe, the government runs a much smaller financial deficit. The current account balance tells this story vividly. A country’s current account is equal to the private sector’s savings minus investment and minus government deficits. As Italy, Spain, and other peripheral economies increased their aggregate savings after 2008, their large current account deficits vanished. Meanwhile, the governments of countries like Germany or the Netherlands, which sported healthy public finances, did not increase their spending in a commensurate way. This adjustment transformed an overall euro area current account deficit of 1.5% in 2008 into a surplus of 3.0% of GDP today, sending some of Europe’s excess savings abroad. This mimics the post-1990 Japanese experience. In the U.S., where the private sector savings did not rise as durably as in Europe, the current account stopped improving meaningfully in 2010 (Chart II-6). Chart II-5European Businesses Are Savers, Like In Japan European Businesses Are Savers, Like In Japan European Businesses Are Savers, Like In Japan Chart II-6The Current Account Dynamics Epitomise The Savings Dynamics The Current Account Dynamics Epitomise The Savings Dynamics The Current Account Dynamics Epitomise The Savings Dynamics   A private sector squarely focused on rebuilding its balance sheet liquidity can lead to a liquidity trap. In this state, monetary policy can become ineffective as spending does not respond to lower interest rates. This is where Europe is currently stuck, explaining why the European Central Bank is finding that inflation and growth are not experiencing much lift, despite seemingly incredibly accommodative monetary conditions. Why Such An Urge To Save? The fact that the household sector is a net saver is not surprising, as this is a normal state of affairs across most economies. But why is the European nonfinancial corporate sector still trying to improve its balance sheet liquidity by accumulating more assets than liabilities? Like Japanese businesses 30 years ago, European firms have large debt loads. Another problem is the lack of capex opportunities in Europe. Why do we make this assertion? The return on assets in Europe has been at rock-bottom levels ever since the introduction of the euro (Chart II-7). In the decade from 1998 to 2008, this was a non-issue. Strong global growth flattered European sales, and easy access to credit meant that via rising leverage euro area-listed nonfinancial corporations were able to generate returns on equity comparable to U.S. firms (Chart II-8, top panel). Once European banks got cold feet and European nonfinancial businesses began focusing on deleveraging, the low level of return on assets became more apparent. Part of the problem is that European profit margins are much closer to Japanese than U.S. levels (Chart II-8, middle panel). Even more damning, asset turnover – how much sales are generated by a unit of assets – has been structurally lower in Europe than in both Japan and the U.S. for multiple decades (Chart II-8, bottom panel). Chart II-7Europe Suffers From A Lower RoA Europe Suffers From A Lower RoA Europe Suffers From A Lower RoA Chart II-8DuPont's Decomposition Shows Why The Euro Area RoA Is Poor DuPont's Decomposition Shows Why The Euro Area RoA Is Poor DuPont's Decomposition Shows Why The Euro Area RoA Is Poor   The first factor weighing on the level of asset utilization and returns in Europe is the elevated level of capital stock. As Chart II-9 illustrates, the capital stock as a share of output in Italy, Spain and France dwarfs that of Japan, China or the U.S. Even Germany’s capital stock, which stands well below that of other large euro area economies, is nearly 100 percentage points of GDP larger than the U.S’s. Europe has too large a pool of assets to make any additional investments profitable, especially in light of its poor demographic profile. Chart II-9 The second factor weighing on European asset utilization and returns is the poorer level of labor productivity. From the 1950s to the early 1980s, European GDP per worker rose relative to the U.S., albeit peaking at 92% of the levels across the Atlantic. Due to falling working hours in Europe relative to the U.S. since the 1980s, relative output per hour continued to rise until the mid-1990s, peaking at 105% of the U.S. level. However, since their respective zeniths, both relative productivity measures have collapsed (Chart II-10, top panel). Chart II-10Another Symptom Of Europe's Misallocation Of Capital In The 2000s Another Symptom Of Europe's Misallocation Of Capital In The 2000s Another Symptom Of Europe's Misallocation Of Capital In The 2000s These collapses are in fact worse than Japan’s performance since its lost decades began. As the second panel of the chart shows, since the early 1990s, Japan’s relative output per hour and per worker have flattened – not declined – at around 65% and 72%, respectively, of U.S. levels. Instead, relative European productivity levels are currently converging toward Japanese levels (Chart II-10, third and fourth panels). The particularly poor level of European asset utilization and productivity principally reflects the duality between the peripheral as well as French economies on one side, and Germany as well as the Netherlands on the other side. The exceptionally large capital stock outside of Germany is a legacy of the years directly after the euro’s introduction. Back then, the ECB kept rates low to help Germany, the then-sick man of Europe. These rates were too low for the rest of Europe, encouraging large capital stock build-ups. Moreover, this capital was misallocated, as demonstrated by the tepid growth of output per hour and output per capita in Europe post 2000. Since funds were poorly allocated, the output-to-capital ratio in the periphery collapsed. In other words, the peripheral capital-stock-to-GDP ratios continued rising because the denominator, GDP, lagged. An additional problem for Europe’s asset utilization has been its large manufacturing sector. Even after declining, 20% of Europe’s GDP still comes from the secondary sector versus less than 12% in the U.S. (Chart II-11). This has two consequences for Europe’s asset utilization relative to the U.S. First, a large manufacturing sector requires a much larger asset base than a large service or tech sector. Second, the manufacturing sector is more exposed to competition from emerging markets than the tech sector, or than the domestically-focused service sector. Chart II-11Europe Is Left Exposed To EM Competition Europe Is Left Exposed To EM Competition Europe Is Left Exposed To EM Competition In other words, not only has the U.S. experienced less capital misallocation than a large swath of the European economy, it has also re-aligned its economy to make it more robust in the face of competition from emerging economies, while Europe mostly has not. Consequently, hurt by foreign competition and unable or unwilling to re-invent itself, Europe has been left with dwindling relative productivity levels and poor degrees of asset utilization and returns. Why Did The U.S. Economy Transition Better than Europe To A Globalized World? There are many reasons why the U.S. has maintained higher RoAs and has been more successful at transitioning away from a manufacturing-led economy than the euro area. Europe has too large a pool of assets to make any additional investments profitable, especially in light of its poor demographic profile. First, the level of product and service market regulation in Europe is highly punitive. As Chart II-12 illustrates, like Japan, most euro area countries fare poorly in the World Bank’s Ease of Doing Business survey. In fact, Italy scores even lower than China! Meanwhile, the U.S. ranks near the top, not far from Singapore. This means that starting new businesses, competing, and so on is easier in the U.S. than in Europe, helping foster a greater level of entrepreneurialism. Consequently, established businesses have been able to maintain the status quo longer in Europe than in the U.S., preventing creative destruction from purging the system of bad assets. Chart II-12 Second, most large euro area economies are burdened by heavy taxes. As Chart II-13 shows, while the U.S. public sector extracts taxes equal to 27.1% of GDP, German, Italian and French taxes equal 37.5%, 42.4% and 46.2% of GDP, respectively, well above the OECD average of 34.2%. Such high levels of taxation disincentivize risk-taking. Lower levels of risk taking by individuals further prevented the degree of creative destruction necessary for Europe to better use its capital stock. Chart II-13 Third, and linked to the previous point, government spending equals 34.9% of GDP in the U.S., compared to 48.2% and 56.0% in Italy or France, respectively. A large government has historically stifled innovation and favored the status quo. By no means does this implies that the U.S. system is free of imbalances, but it highlights that compared to two of the three largest European economies, the U.S. public sector has had a less deleterious impact on growth conditions and entrepreneurialism. Moreover, Italy and France have been in deep need of structural reforms that have been lacking. On this front, while the outlook is improving in France under Macron’s presidency, Italy remains mired in immobilism. Fourth, the financing structure in the U.S. favors investing in new businesses and industries, especially when compared to the euro area. Equities represent 78% of the capital structure of nonfinancial corporations in the U.S. while they represent only 61% in the euro area. Moreover, within debt-financing, capital markets account for 68% of sourced funds in the U.S. compared to 28% in the euro area. In fact, junk bond market capitalization only accounts for 2.2% of GDP in Europe compared to 6.0% in the U.S. This suggests that financing risky ventures – and entrepreneurialism is inherently risky – is tougher in Europe than in the U.S. In fact, as a share of GDP, the European venture capital business is less than a sixth the size of the U.S.’s (Chart II-14), a gap that has existed for more than 30 years. Chart II-14U.S. Financing Allows For Greater Risk Taking U.S. Financing Allows For Greater Risk Taking U.S. Financing Allows For Greater Risk Taking With all these hurdles, it is unsurprising that Europe has taken more time to make its economy more dynamic in the globalized economy of the 21st century. It also explains why Europe might be suffering more from EM competition than the U.S. Interestingly, this last point may be changing as U.S. voters seem to want to move back toward a larger manufacturing sector. This transition is unlikely to happen without more protectionism. This is a topic for another report. Is Europe Doomed To Japanification… Or Worse? It is easy to see why Europe cannot hope to grow as fast as the U.S., and therefore why the ECB will not be able to lift rates as high as the Fed and why bund yields are likely to lag Treasurys for years to come. Europe has a much more dire demographic profile than the U.S. It needs to purge its capital stock and invigorate its economy through reforms, a smaller public sector, and more diversified financing channels. But can the euro area fare better than Japan has over the past 30 years? On three fronts, the euro area looks better than Japan. First, as Chart II-15 shows, the overall European nonfinancial private sector entered its crisis in 2008 with lower leverage than Japan’s in the early 1990s. Additionally, European stocks were much cheaper in 2007 than the Nikkei was in 1989 (Chart II-16, top panel). Even Spanish real estate was more reasonably valued in 2007 than Japanese real estate in the early 1990s (Chart II-16, bottom panel). This combination means that now that the acute part of the crisis is over, the hole in the European private sector’s balance sheet is much smaller than the one Japan needed to plug 30 years ago. Thus, from a balance-sheet perspective, the need to rebuild savings is lower in Europe than Japan, and we could expect the current period of elevated savings to be shorter in the euro area than it has been in Japan. Chart II-15 Chart II-16...And European Assets Were Not As Expensive As Japanese Ones At The Onset Of The Crisis ...And European Assets Were Not As Expensive As Japanese Ones At The Onset Of The Crisis ...And European Assets Were Not As Expensive As Japanese Ones At The Onset Of The Crisis   Second, despite former ECB President Jean-Claude Trichet’s policy mistake of raising interest rates in 2011, the ECB was much quicker to implement extreme easing policy measures than the Bank of Japan was in its day. It took 10 years for the BoJ to cut rates to zero after the Nikkei peaked in December 1989. It took one year for the ECB to do so after stock prices peaked in 2007. It took nine years for the BoJ to expand its balance sheet aggressively, but it took less than two years for the ECB to do so. One of the key benefits of this greater European proactivity has been to keep European inflation expectations much higher than in Japan, curtailing real interest rates in the process. Third, Europe purged economic excesses much more quickly than Japan. The Japanese unemployment rate increased from 2% to 6% between 1990 and 2010. In peripheral Europe, where the worst pre-crisis excesses existed, unemployment rose from 7.5% in 2008 to 18% in 2013 (Chart II-17, top panel). Meanwhile, real wages never adjusted in Japan, but fell 27.0% at their worst in Spain and 32.5% in Greece (Chart II-17, bottom panel). Moreover, the Rajoy reforms in Spain and the Macron reforms in France show that outside of Italy, European governments have been reforming their economies faster than Japan did after the bubble burst in 1990. Chart II-17Bigger Labor Market Purge In Europe Than Japan Bigger Labor Market Purge In Europe Than Japan Bigger Labor Market Purge In Europe Than Japan However, on three fronts Europe is faring worse than Japan. First, up until the last 10 years, Japan benefited from a robust global economy where trade grew strongly. Europe is entering its second decade of low growth in an environment where global economic activity is much weaker, as potential U.S. GDP growth has slowed and China is not growing at a double-digit pace anymore. Moreover, budding protectionism in the U.S. is creating another hurdle for European economic output. Second, the excess capital stock in the European periphery is in fact greater than was the case in Japan in 1990. This suggests that the periphery needs to curtail investments by a greater margin than Japan did. Consequently, peripheral growth will continue to exert downward pressure on aggregate European activity for an extended period. Third, the European fiscal response will not match Japan’s. Investors often decry Japan’s large government debt of 238.2% of GDP as a sign of profligacy. It is not. It is mainly a mirror image of the private sector’s savings surplus. The Japanese government’s ability to run large deficits has prevented a larger fall in output – one that would have equaled the annual savings of the private sector. Without the government’s dissaving, the Japanese private sector would have found its debt load even more onerous to service, and the need to curtail spending would have been even greater as economy-wide cash flows would have been even smaller. Europe does not have a unified fiscal authority that can run such large-scale deficits. Instead, each nation’s government has a limited capacity to accumulate debt as investors worry that overly-indebted governments may very well redenominate what they have borrowed in much weaker currencies than the euro. This risk is made even greater by the fact that there is no euro-area wide deposit insurance scheme. Since Italian and Spanish banks hold large amounts of BTPs and Bonos, respectively, a so-called doom-loop exists that links the health of banks in those countries to the health of their governments, further limiting the public sector’s ability to act as a spender of last resort. This makes the efforts of the private sector in Italy, France, and Spain to increase its savings and bring down its excess capital stock more difficult, and thus, likely to last longer. Even if 10 years after the crisis first emerged, Europe has done more to purge its economy from its pre-crisis excesses than Japan had after its first lost decade, a lack of unified fiscal lever in Europe nullifies this positive. Thus, so long as the European integration efforts remain on the backburner, euro area growth, inflation, and interest rates will continue to look more like Japan’s have over the past 30 years than the U.S. This is likely to cause a big problem once the next recession emerges. Europe will enter that slowdown without any ammunition to reflate growth. Therefore, the next recession is likely to prove very deflationary and test the recent improvement in support for the euro seen across all euro area nations (Chart II-18). If the euro area survives this crisis, and we suspect it will, the probability of a fiscal union will only grow.2 After all, it has been through various crises that Europe has moved closer together, and the rise of a multipolar geopolitical environment dominated by large countries makes this imperative ever more vital. Chart II-18Support For The Euro Is Resilient Support For The Euro Is Resilient Support For The Euro Is Resilient Bottom Line: We expect European growth and inflation to continue to lag well behind the U.S. for years to come if not a full decade. Ultimately, bringing down the expensive capital stock in the European periphery will be a slow process, especially if governments remain tight fisted. Investment Implications First, core euro area interest rates are likely to remain well below U.S. levels. As long as the European private sector pares back investments in order to normalize its capital stock-to-GDP ratio - a phenomenon that will be most pronounced in the periphery and France - European growth and inflation will lag behind the U.S. This also means that as long as European governments remain shy spenders and do not compensate for the lack of spending from the private sector, in the euro area periphery, European banks will suffer from depressed net interest margins and be structural underperformers. Second, the euro is likely to experience a structural upward drift. The euro is trading at a 10.5% discount to its purchasing power parity. Moreover, high private sector savings not only weigh on inflation, they will also push Europe’s net international investment position higher via an accumulated current account surplus. Both these factors are long-term bullish for the euro. Moreover, the fact that the euro area will soon become a net creditor nation, along with a lack of room to stimulate growth via monetary easing in times of recessions, means that the euro could increasingly become a counter-cyclical currency like the yen. So long as the European integration efforts remain on the backburner, euro area growth, inflation, and interest rates will continue to look more like Japan’s have over the past 30 years than the U.S. Third, European equities are trading at a discount to U.S. equities, but we do not think this guarantees long-term outperformance. European equities are cheap because European growth prospects are poor. If Japan is any guide, European stocks may be set to continue underperforming. This is especially true as financials are over-represented in European equity benchmarks, and banks stand at the epicenter of the European economic malaise. Fourth, European stocks will remain slaves to the global business cycle. Since the crisis, European growth has become hypersensitive to global growth, making European equities very responsive to the global business cycle. The same phenomenon happened in post-1990 Japan. In other words, the beta of European stocks is likely to continue to rise. This phenomenon could be exacerbated if the euro indeed does become a counter-cyclical currency, in which case the euro and European equities would become negatively correlated, like the yen and the Nikkei. Finally, the period from 1999 to 2005 showed how ECB policy targeted at supporting Germany resulted in imbalances that boosted real estate and equity returns in the periphery – in Spain and Ireland in particular. Today, the periphery is the worst offender when it comes to poor bank health and private sector balance sheet rebuilding. This means that the ECB is likely to keep monetary conditions too accommodative for Germany, where balance sheets are more robust and where the capital stock is not as excessive. As a result, financial market plays linked to German real estate are likely to continue outperforming other European domestic plays. They therefore warrant an overweight within European portfolios. Mathieu Savary Vice President The Bank Credit Analyst III. Indicators And Reference Charts The S&P 500 is retesting its all-time high made last fall. While our indicators suggest that U.S. equity have additional upside, the violence of the rally since December argues that a period of digestion may first be needed. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan continues to improve, while for the euro area, it is flat-lining after a tentative rebound. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The current readings in major advanced economies thus suggest that investors are still inclined to add to their stock holdings. Our Revealed Preference Indicator (RPI) is not echoing this message. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. The pick-up in global growth remains too feeble for the RPI to validate the advance in stocks. This is why we worry that a correction is likely until economic activity around the globe confirms the rally in stocks. According to BCA’s composite valuation indicator, an amalgamation of 11 measures, the U.S. stock market remains slightly overvalued from a long-term perspective. Nonetheless, the S&P 500 is not at nosebleed valuation levels anymore. Hence, we are betting that once global growth picks up, stocks will be able to move even higher and any correction will prove temporary. Moreover, our Monetary Indicator remains into stimulative territory. The Fed has reiterated its dovish message and global central banks have all engaged in dovish talks, thus monetary conditions should stay supportive. As a result, our speculation indicator has also now fully moved out of the “speculative activity” zone. Our Composite Technical indicator for stocks had broken down in December, but it has now moved back above its 9-month moving average. This positive cyclical signal reinforces our confidence that any correction in stocks should prove tactical in nature, and that on a nine- to twelve-month basis equities have upside. According to our model, 10-year Treasurys are slightly expensive. However, we should not read too much into this. Essentially, yields are currently within their neutral range. Moreover, our technical indicator flags a similar picture. That being said, since BCA expects that over the next 24 months, the Fed will lift rates more than the OIS curve anticipates, and since the term premium is incredibly low, once green shoots for global growth fully bloom, bonds could suffer a violent selloff. Since our duration indicator has begun to deteriorate, it is probably a good time to begin moving out of safe-haven bonds. On a PPP basis, the U.S. dollar has only gotten more expensive. Additionally, our Composite Technical Indicator is becoming increasingly overbought. This combination suggests that the greenback could experience further downside this year. However, this downside will only materialize once global growth shows greater signs of strength. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys And Valuations U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1       Please see Global Fixed Income Strategy Weekly Report, “A Sustainable Bottom In Global Bond Yields,” dated April 9, 2019, available at gfis.bcaresearch.com 2       Please see U.S. Equity Strategy Weekly Report, “Have SPX Margins Peaked?” dated March 25, 2019, available at uses.bcaresearch.com 3       Please see U.S. Equity Strategy Weekly Report, “Mixed Signals,” dated April 22, 2019, available at uses.bcaresearch.com 4       Please see Global Asset Allocation Special Report "Euro Area Banks: Value Play Or Value Trap?" dated December 14, 2018, available at gaa.bcaresearch.com 5       The European Commission Eurobarometer Surveys show that Europeans overwhelmingly see Europe as a peace project and as a way to maintain a voice in a world dominated by huge players like the U.S., China, or Russia, a world where France, Germany, or Italy individually are marginal players. In 2016, the U.K. population did not share this opinion. Moreover, even after what amounts to a depression, the support for the euro continues to rise in Greece, showing the growing commitment of Europeans to the euro, and the resilience of this commitment to economic shocks. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY: