Market Returns

In a report published early last August, I wrote that: “The perfect time for equity investing is when markets are cheap, earnings expectations are overly pessimistic and the monetary environment is highly accommodative. Currently, the opposite conditions exist: valuations are stretched, earnings expectations are euphoric and the Fed is in tightening mode. It does not seem a propitious time to be aggressive.” By the end of the year, the MSCI All-Country Index had declined by around 12%, with the S&P 500 down by a similar amount. Against that background, valuations improved, earnings expectations moderated and the Fed adopted a less hawkish tone. And, not surprisingly, investors and traders became much less bullish about the outlook, a positive development from a contrary perspective. As a result, BCA’s equity stance was upgraded to overweight from both a 3- and 12-month perspective. With no recession imminent and the Fed likely to raise rates by less than previously feared, we took the view that the path of least resistance for equities was up. There is no requirement at BCA for strategists to agree on the outlook. In fact, the opposite is true in that we encourage independent thinking and diverse ways of looking at the world. I have no strong reasons to disagree with the view that equities will end this year higher, and thus outperform bonds and cash. However, my concerns about the longer-run outlook, coupled with the potential for further late-cycle volatility, temper my comfort with an overweight position. Of course, this merely cements my reputation amongst colleagues as the resident BCA bear! What Troubles Me There rarely is a shortage of economic, financial or political issues to worry about. Even in the best of times, one can always find some problems and potential threats to the outlook. Contrary to my current reputation within BCA, I am not always bearish – I turned more positive on equities in the spring of 2009 and embraced the rally for most of the subsequent decade. However, notwithstanding the potential for equity prices to move higher this year, I perceive three particular challenges to an optimistic view of the outlook: The outlook for U.S. corporate earnings given the likelihood that labor’s share of income will rise from current unusually low levels. The financial markets’ addiction to easy money and low interest rates that may delay the normalization of monetary policy and encourage financial imbalances and excessive risk-taking. The unprecedented rise in U.S. federal deficits at a time of strong economic growth. There will be a price to pay down the road. Notably absent from this list is any mention of trade wars, Brexit, China, U.S. political dysfunction, recession risks and the many other issues that feature in news headlines. I do care about these things, but the three topics mentioned above are enough reason to be concerned, without piling on other problems. The Extraordinary Performance Of U.S. Profits, But… One of the most remarkable features of the past decade’s economic environment has been the impressive performance of U.S. corporate earnings. Despite the weakest economic recovery on record, profit margins have soared to an all-time peak (Chart 1). How on earth did companies manage that? Let’s start by noting what strong earnings growth did NOT reflect. Chart 1An Impressive Margin Performance An Impressive Margin Performance An Impressive Margin Performance First, there has not been above-trend growth in top-line revenues. The top panel of Chart 2 shows that S&P 500 sales have grown broadly in line with nominal U.S. corporate GDP over the past two decades. Second, related to the above point, there has not been a great environment for corporate pricing power. The corporate sector inflation rate has averaged a measly 1.2% during the past decade. Third, despite ongoing technological innovations, earnings have not benefited from a revival in productivity growth. Corporate sector productivity has grown at only a moderate 1.1% pace during the past 10 years, far below its historical average (third panel of Chart 2). Chart 2No Major Improvements Here! No Major Improvements Here! No Major Improvements Here! Finally, one other popular explanation – low interest rates - also can be ruled out as a major driver of the profit cycle. The large decline in interest rates since the Great Recession has clearly benefited some companies, but interest payments as a share of pre-tax profits have not shown much net change in the decade (final panel of Chart 2). In recent years, the lower level of rates has been offset by an increase in outstanding debt. We are left with two major drivers of the rise in margins: lower tax rates and, more importantly, tight control over labor costs. The effective tax rate paid by domestic non-financial companies averaged 21.7% between 2010 and 2017 compared with 26.7% between 2000 and 2007 (Chart 3). And the rate plunged further in 2018 in response to the large cut in the federal corporate tax rate from 35% to 21%. Had the effective tax rate continued to average 26.7% after 2010, after-tax profits of domestic non-financial companies would have grown at a much-reduced pace during the past eight years. Chart 3Corporate Tax Burdens Have Declined Corporate Tax Burdens Have Declined Corporate Tax Burdens Have Declined We finally come to the main explanation of remarkable earnings growth: the corporate sector’s success in capturing much of the benefits of higher productivity, rather than sharing it with labor. Historically, real employee compensation in the corporate sector rose in line with productivity, allowing both employees and the employers to enjoy the rewards of increased efficiencies. As a result, the shares of income going to capital and labor were among the most mean-reverting series in the economy (Chart 4). Chart 4A Major Divergence in Income Shares A Major Divergence in Income Shares A Major Divergence in Income Shares Everything changed around 2000 when real compensation began to stagnate, even as productivity continued to rise (Chart 5). Labor’s bargaining power was eroded by the combination of globalization and technological innovations, allowing companies to keep a tight grip on wage costs. The returns to capital soared while those to labor collapsed, with both moving to more than four standard deviations away from historical averages – an extraordinary divergence. If real employee compensation had continued to rise in line with productivity after 2000, then EBITD margins1 would be at their historical mean, rather than at a high extreme. Chart 5Labor Gets Left Behind Labor Gets Left Behind Labor Gets Left Behind The corporate sector’s ability to expand at the expense of labor has now come to an end. Wage growth has started to rise against the backdrop of an increasingly tight labor market. As a result, the labor share of income bottomed at the end of 2017 and the capital share peaked. Populist pressures against globalization also argue for an increased labor share.  The payoff to earnings growth from the drop in the corporate tax rate also will end this year. It was a one-off event with no further cuts in prospect. The bottom line is that the major tailwind (weak wage growth) behind strong U.S. earnings has turned into a headwind, while the secondary one (lower taxes) is ending. When it comes to S&P earnings (as opposed to the national income measure of profits), an additional supporting factor has been the decline in outstanding share balances that has boosted earnings per share. Many companies have taken advantage of low interest rates to raise debt and use the proceeds to buy back shares. However, with leverage now high and interest rates off their lows, the incentive for such financial engineering is diminishing. Debt growth has slowed and so should the pace of share buybacks (Chart 6). Chart 6Lots Of Financial Engineering Lots Of Financial Engineering Lots Of Financial Engineering The ever-optimistic analyst community remains unfazed about the above trends. According to IBES data, analysts’ individual company estimates imply long-run earnings growth of more than 16% a year for the S&P 500 universe (Chart 7). That is more than double average historical earnings growth. It was exceeded only by the insane optimism at the peak of the tech bubble in the late 1990s/early 2000, and we know how that ended! There can only be disappointment and an eventual marked downgrading of these earnings expectations. In my view, earnings will be lucky to grow at 3% a year over the long run from current elevated levels. Chart 7Euphoric Long-Run Earnings Estimates Euphoric Long-Run Earnings Estimates Euphoric Long-Run Earnings Estimates Some may argue that these long-term earnings estimates are irrelevant because investors pay them little attention. But there is a loose correlation between valuations and these earnings estimates, and while the price-earnings ratio (PER) has declined from its peak, it remains above its historical average. If long-term earnings estimates come down that should undermine the PER. Perhaps the causality is the other way: high valuations encourage analysts to inflate their earnings projections, but that would not be any more encouraging. Either way, it is a bearish chart. The Addiction To Easy Money The Fed’s gradual retreat from its hyper-easy policy stance was well telegraphed, but still unsettled the markets. That is the problem with addictions – the withdrawal period is always difficult. That has put the Fed in a tricky position as it must balance the need to prevent an overheated economy with the need to maintain financial stability. History suggests that the odds of the Fed getting it just right are slim. Adopting a cautious approach to tightening risks the worst of both worlds: falling behind the curve on inflation while encouraging financial speculation and imbalances. The Fed embraced an extended period of easy policy in the first half of the 2000s after the tech bubble burst, with the fed funds rate kept far below the growth in nominal GDP (Chart 8). If money is unusually cheap, then speculation and financial excesses are inevitable. The easy money period of the 1990s helped fuel the tech bubbles and the more extended period of easy money in the 2000s fueled the housing bubble. Once again, we have interest rates far below the growth in GDP and, not surprisingly, this has fed financial euphoria. Chart 8Monetary Policy Still Looks Accomodative Monetary Policy Still Looks Accomodative Monetary Policy Still Looks Accomodative The Fed has raised the federal funds rate by 225 basis points over the past three years, with nine increases of 25 basis points each. Four of the moves occurred in 2018 and have been blamed for financial problems in emerging economies and volatility in developed equity markets. Yet, all the Fed has done is bring the real fed funds rate out of negative territory. If a real funds rate of only 0.5% is enough to trigger extreme market volatility and threaten the economic expansion, then the system is much more vulnerable than generally assumed. There is much discussion in economic circles about the level of the real equilibrium interest rate – the rate consistent with the economy growing at trend, currently estimated to be around 2% a year. In the past, a simple rule of thumb was that real rates, over time, would have some approximation to the real growth in the economy. However, some studies (including by the Fed) argue that the real equilibrium rate may now be close to zero, far below the trend growth of the economy. If real rates close to zero are all that the economy can tolerate then that raises interesting questions. Does it mean that the economy’s growth potential could be much lower than 2%? Does it mean that if real rates have to be kept close to zero, then speculative activities in the markets will continue to build, ultimately threatening financial stability? Either way, it does not seem to be a positive story. Some worry that the Fed is making a mistake in both raising rates and unwinding its bloated balance sheet (aka QT or quantitative tightening). I believe this concern is hugely overstated. Contrary to popular opinion, the expansion in the Fed’s balance sheet did not lead to a surge of liquidity that drove asset prices sharply higher. Of course, the Fed’s bond purchases lowered yields and that forced money into riskier assets. However, there was no increased flood of money in the broader financial system. Quantitative easing (QE) led to a dramatic rise in bank reserves at the Fed, but there was no corresponding sustained surge in M2 – the measure of money supply that is more reflective of money available for economic and/or financial transactions. In other words, the money multiplier (the ratio of M2 to the narrow money) collapsed (Chart 9). This is because the credit system was impaired after the 2007-09 meltdown and the Fed was largely pushing on a string in its attempts to bring it back to life. The main way that Fed policy drove asset prices higher was keeping short rates close to zero because that gave investors a massive reason to take on more risk. Chart 9The Monetary Plumbing Has Blockages The Monetary Plumbing Has Blockages The Monetary Plumbing Has Blockages If QE was not the driving factor behind the bull market in stocks, then we should not be overly concerned about QT. Yes, investors will be forced to absorb more bond issuance as the Fed ceases to be a buyer. However, it is interesting to note that the current 10-year Treasury yield of 2.7% is no higher than five years ago, even though the Fed’s balance sheet has begun to shrink and the Fed has hiked rates nine times over the period (Chart 10). Chart 10Monetary Policy And Bond Yields Monetary Policy And Bond Yields Monetary Policy And Bond Yields The bottom line is that the Fed should continue on its path of reducing its balance sheet and not be timid about raising rates if the economy continues to grow in excess of a 2% pace. At some point there will be another recession and the Fed may well be blamed. But that is a lesser evil than feeding the addiction to easy money by prolonging the period of excessively low rates. Fiscal Profligacy The federal deficit is expected to reach around $1 trillion this year, around 5% of GDP. There is no precedent for such a large peacetime deficit during the late stage of an economic expansion (Chart 11). And, assuming current policies remain in place, the Congressional Budget Office (CBO) expects the deficit to rise rather than fall over the next few decades given the aging population’s impact on entitlement programs. Chart 11Fiscal Policy Has Become Pro-Cyclical Fiscal Policy Has Become Pro-Cyclical Fiscal Policy Has Become Pro-Cyclical There is no strong support for fiscal discipline in Congress. Neither party has the stomach to tackle the problem of entitlements, those on the right want more spending on defense, while those on the left want more spending on social programs. One should never be surprised that politicians prefer fiscal profligacy to austerity. It is no fun and is injurious to re-election prospects to advocate spending cuts and tax increases. When things start to get of hand, the burden of imposing fiscal discipline falls on the markets. Currently, markets do not appear fazed by fiscal trends. The 10-year Treasury bond yield remains below 3% and the gap between 30- and 10-year yields is low. If markets are worried about government finances, that gap tends to widen as investors demand a fiscal premium to hold longer-duration bonds (Chart 12). Chart 12Bond Investors Unfazed By The Deficit...For Now Bond Investors Unfazed By The Deficit...For Now Bond Investors Unfazed By The Deficit...For Now Presumably, investor complacency about the grim fiscal picture reflects a list of other more important economic and financial concerns that are suppressing yields. There will be a limit to this fiscal tolerance, but we just don’t know exactly where it is. Japan’s gross government debt has exceeded 200% of GDP throughout the past decade without a financial crisis, but that is a poor model for what the U.S. can manage. Japan does not need to borrow from abroad and thus finances its deficits internally. In contrast, the U.S. current account deficit is still running at around $500 billion a year and the country is, by far, the world’s largest international debtor. Yes, the dollar is the international reserve currency of choice and the U.S. receives the exorbitant privilege from that. However, that will not protect the U.S. currency or markets from an eventual loss of investor confidence. I accept that a fiscal-related bond/currency market crisis could be years away, and timing is everything! Nonetheless, the current lack of fiscal discipline does pose a threat to markets because it could limit the authorities’ room to enact stimulus in the next recession. How I Could Be Wrong I have strong convictions about the views I expressed, but that does not mean I will be proved right. Let’s examine some counter arguments. On earnings, my pessimism will be unfounded if the corporate sector manages to keep a tight grip on wages and/or there is a sustained marked improvement in productivity. Of course, we need to exclude subdued wages that arise because of an economic slowdown as that would undermine sales growth. It would be remarkable if the nascent upturn in wage growth suddenly reverses without a renewed rise in unemployment so I would put low odds on that. As far as productivity is concerned, there are lots of interesting innovations these days, but none seem to be game changers within a five-year horizon. Autonomous vehicles will certainly be huge for several sectors but widespread adoption is still some time away. However, it is important to keep an open mind on this and I will certainly change my view if the data improve meaningfully. Turning to monetary policy, I suppose it is possible that the Fed will miraculously calibrate policy to achieve a soft economic landing and maintain financial stability. They have never been able to do this in the past but there is a first time for everything. Needless to say, I am hugely skeptical but time will tell. Finally, on fiscal policy, you would have to be an extreme optimist to believe that politicians will suddenly enact the politically painful measures required to restore order to government finances. The current Administration has shown no signs of fiscal responsibility and the opposition have not raised this as an issue. If anything, there are calls for even more spending. History shows that governments generally skirt to the edge of a severe crisis before they reluctantly embrace austerity. In other words, I do not see much case to be optimistic here. Concluding Thoughts On average, the stock market is more likely to rise than fall. Since 1950, the S&P has recorded monthly gains 60% of the time. In other words, it generally has paid to be bullish. This was particularly true between end-1982 and end-2018 with the S&P 500 delivering above-average compound annual returns of around 11% a year (8% a year in real terms), despite two 50%+ market declines during the period. This was the greatest 36-year period for financial assets in history, driven by falling inflation and interest rates, major corporate restructuring that boosted profit margins, rising equity multiples and a huge expansion in credit growth. Looking ahead, the environment will be very different. Inflation and interest rates are more likely to rise than fall, profit margins will be under pressure, it would imprudent to expect sustained gains in multiples, and broad credit growth will not return to its earlier rapid pace. Thus, future returns will be a pale shadow of the past performance. Against the above background, I don’t think I am being overly pessimistic. However, I understand that many investors do not have the luxury of taking a long-term view. For those who are in a competition to beat their peers, it can be disastrous to stand on the sidelines while the market marches higher. Moreover, if returns are going to be modest by past standards, it puts a premium on market timing, as difficult as that may be. So I do not recommend ignoring the BCA view that equities will outperform bonds and cash this year. My concerns are for the long run. The obvious question is: how should one invest in a world of low returns? I doubt that piling into alternative investments will be the solution as these assets will be affected by the same macro forces as conventional assets. The answer is a rather boring and obvious one. In the absence of being a market-timing and stock/sector-selection genius or investing with such a person, capital preservation has become more important. When returns are low, it takes longer to recover from market losses. This means one should maintain a conservative portfolio bias with higher-than-normal levels of cash.   Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com Footnotes 1 EBITD = earnings before interest, taxes and depreciation. This measure best reflects the performance of earnings as it relates to output, wages, prices and productivity.

OPEC 2.0 is building physical optionality, to deal with different possible moves the U.S. can make on Iranian oil export sanctions and waivers. This comes despite an apparent break in the sense of urgency Saudi Arabia and Russia feel re production cuts. The coalition’s market monitoring committee meets in April, followed by a full gathering in May, when U.S. waivers expire. If the U.S. extends waivers, OPEC 2.0 can extend production cuts; if it doesn’t, it can add supply as needed.1 On the demand side, markets appear to be overly concerned about a sharper-than-expected slowdown in China, which, if borne out, would restrain EM growth. We believe these fears are overdone, and expect a slight improvement in EM demand generally this year and next. In our new balances estimates, we see the OECD commercial oil inventory overhang clearing in 1H19, on the back of resilient demand, OPEC 2.0 discipline, and a more moderate level of growth in U.S. shale oil output. This keeps Brent on track to average $80/bbl this year and $85/bbl next year, with WTI trading $74/bbl this year, and $82/bbl next year. Highlights Energy: Overweight. Mandatory cuts of 325k b/d, coupled with additional exports of ~ 190k b/d due to additional train and pipeline capacity out of Canada, will drain the 35mm barrels of excess crude oil inventories targeted by the Alberta government in December by 1H19. The WCS – WTI spread narrowed to -$10/bbl from -$50/bbl on these mandatory cuts. By 2H19, we expect Canadian production cuts to average 95k b/d. Base Metals: Neutral. Aluminum output in China surged 11.3% y/y in December, hitting 3.05mm MT, according to Metal Bulletin. Total output for 2018 was 35.8mm MT, a 7.4% y/y increase. Precious Metals: Neutral. Gold is holding its recent gains, as markets become more comfortable with the Fed pausing on its rates-normalization policy until 2H19. Agriculture: Underweight. Hot and dry weather in Brazil is threatening crop yields there. The unfavorable weather is expected to affect three-quarters of cotton-growing regions, half of sugar areas, a third of first-crop corn acreage, and a quarter of soy regions. Feature The first signs of fraying in the relationship between the putative leaders of OPEC 2.0 – the Kingdom of Saudi Arabia (KSA), which cut production ~ 450k b/d m/m in December, and Russia, which raised output – are emerging, as world leaders meet in Davos. While this casts doubt on the leadership’s carefully cultivated amity, and their shared willingness to abide by the recently agreed output cuts, we do not believe it signals the end of the historic cooperation between these states. Total OPEC output – estimated by production-tracking sources outside the Cartel – stood at 31.6mm b/d in December, a prodigious 751k b/d reduction m/m. We expect continued oil production cuts from core OPEC states and decline-curve losses among non-Gulf OPEC and non-OPEC states within the coalition this year to remove at least 1.2mm b/d from the market, per the quotas agreed by members in December (Chart of the Week, Table 1). On top of this, mandatory Canadian production cuts of 325k b/d in 1H19 and 95k b/d in 2H19 will keep average production cuts at ~ 1.4mm b/d this year. Chart of the WeekOPEC 2.0 Will Resume Production Cuts OPEC 2.0 Will Resume Production Cuts OPEC 2.0 Will Resume Production Cuts Table 1OPEC 2.0 Production Cuts Could Exceed Quotas OPEC Starts Cutting Oil Output; Demand Fears Are Overdone OPEC Starts Cutting Oil Output; Demand Fears Are Overdone OPEC 2.0’s cuts could persist into 2020, depending on how the U.S. deals with Iranian oil-export sanctions and waivers. Even though KSA and Russia apparently do not share the same sense of urgency re production cuts right now, we believe OPEC 2.0 is committed to draining oil inventories, particularly in the OECD.2 To do so, they’re increasing their operational flexibility – creating physical options, in a manner of speaking – to deal with a range of uncertain outcomes when U.S. waivers on Iranian export sanctions expire in May. Sanctions And OPEC 2.0’s Physical Options Despite the waivers granted to its eight top consumers shortly after U.S. sanctions took effect in November, Iranian exports plunged below 0.5mm b/d in December. As of December, China had substituted almost all of its Iranian imports for alternative barrels.3 This coincided with a production surge by OPEC 2.0 at the behest of the U.S. leading up to the November sanctions deadline of November 4, 2018, which swelled OECD inventories and took them above their rolling 5-year average level (Chart 2). India retained 30% of its May import levels from Iran, while Europe complied at 100% with U.S. sanctions (Table 2). Chart 3 shows the decrease in exports in preparation for the sanctions over the course of 2018. Chart 2OECD Inventory Overhang Will Draw As OPEC 2.0 Cuts and Losses Kick In OECD Inventory Overhang Will Draw As OPEC 2.0 Cuts and Losses Kick In OECD Inventory Overhang Will Draw As OPEC 2.0 Cuts and Losses Kick In Table 2Iran Exports By Destination 2018 (‘000 b/d) OPEC Starts Cutting Oil Output; Demand Fears Are Overdone OPEC Starts Cutting Oil Output; Demand Fears Are Overdone Chart 3 Whether or not the waivers are extended is anyone’s guess. It is possible waivers will be extended for 90 or 180 days, as a way to counter OPEC 2.0 production cuts, and to offset the lag between filling new pipeline takeaway capacity in the Permian. We expect importers to queue up for Iranian barrels as the market tightens in 1H19. OPEC 2.0’s market monitoring committee will meet in April, followed by a ministerial meeting in May, just ahead of the expiration of the waivers.4 If the U.S. extends them, OPEC 2.0 can extend production cuts after it meets in May; if waivers are not extended, the Cartel can calibrate an appropriate supply response. Either way, we expect OPEC 2.0 will closely align its production schedule with any U.S. action on the sanctions and waivers. This will, we believe, keep change in the overall market’s supply side relatively constant, except for the month or two required to adjust OPEC 2.0 output. Permian Will Drive OPEC 2.0 Policy The larger issue for OPEC 2.0 comes in 4Q19, when ~ 2mm b/d of new pipeline takeaway capacity comes on line in the Permian Basin in West Texas. With additional takeaway capacity due to come on in 2020, the Cartel will have its work cut out for it next year.5 Our models show a slight decrease then flattening in U.S. rig counts over the coming months, as a result of the 4Q18 sell-off in WTI, with a rebound around mid-year (Chart 4). This is because rig count lags oil prices by ~4 months. Chart 4U.S. Shales Continue to Drive Lower 48 Production Growth (ex GOM) U.S. Shales Continue to Drive Lower 48 Production Growth (ex GOM) U.S. Shales Continue to Drive Lower 48 Production Growth (ex GOM) We are expecting production in the Big 5 shale basins to average 8.4mm b/d in 2019 and 9.0mm b/d next year, a somewhat higher level than projected by the EIA. Growth in the shales accounts for close to 80% of the 2.3mm b/d of growth in the U.S. over 2019 – 2020. Globally, U.S. shales will continue to provide the bulk of y/y crude oil production growth, accounting for 73% of the 2.5mm b/d of growth we will see over the next two years. Given the near-death experience OPEC 2.0 member states had in the price collapse of 2014 – 2016, we remain convinced OPEC 2.0 member states will once again have to embark on a strategy to backwardate the Brent forward curve as they did in 1H18, to moderate the growth of shale-oil production in the U.S. (Chart 5). Reducing production in the short term will force refiners to draw inventories to supply their units and produce products like gasoline, diesel, jet fuel and a wide range of petrochemicals. Chart 5OPEC 2.0 Needs Backwardated Brent Forwards OPEC 2.0 Needs Backwardated Brent Forwards OPEC 2.0 Needs Backwardated Brent Forwards This will backwardate the Brent forward curve – i.e., prompt-delivery barrels will be more expensive than deferred-delivery barrels. A backwardated forward curve means OPEC 2.0 member states with term contracts indexed to spot prices receive higher prices for their oil than shale producers hedging 2 years forward, all else equal. The trick for OPEC 2.0 will be to keep the Brent forwards backwardated when the Permian takeaway capacity starts to fill, and exports from the U.S. rise in the early 2020s, as deep-water harbors are brought on line. If OPEC 2.0 is successful in keeping the Brent forwards in backwardation, this will, over time, moderate the growth of shale production: Hedgers’ revenue is constrained by lower forward prices.6 We would not be surprised if OPEC 2.0 states started announcing final investment decisions on select investments in spare capacity to augment existing resources, so they are able to quickly bring production to market in the event of unplanned outages that could lift the entire forward curve and incentivize hedging at higher prices. Demand Still Looks Good Oil markets continue to fret over a possible hard landing in China – resulting either from an internal policy error or a ratcheting up of tensions in the Sino – U.S. trade war. This is causing markets to extrapolate into the wider EM space, and take oil-demand projections lower on an almost-daily basis. In a word, markets are overwrought. Chinese policymakers are sensitive to the tight financial conditions that prevailed in 2H18, which, along with the trade war with the U.S., slowed growth and fostered uncertainty among households and firms in China. We agree with our Geopolitical Strategy and China Investment Strategy groups that presidents Trump and Xi are pragmatists dealing with restive populations, and want to deliver a deal ahead of U.S. elections and the 100th anniversary of the founding of the Chinese Communist Party in 2021.7 We’ve been expecting the government to deploy a modest amount of stimulus in 1H19, which will begin having an effect on the Chinese economy in the second half of this year. Toward the end of the year and into 2020, we expect the larger stimulus to be deployed in the run-up to put a bid under industrial commodities – oil, base metals and bulks in particular. Overall, we are seeing signs global growth may be reviving over the next few months via an apparent bottoming in our Global LEI Diffusion index (Chart 6). The diffusion index measures the proportion of countries where Leading Economic Indicators (LEIs) are rising relative to those in which LEIs are falling. As is apparent in Chart 6, the diffusion index suggests the downturn in the global LEI has bottomed. The index leads the global LEI by a few months. Chart 6BCA's Global LEI Likely Bottoming BCA's Global LEI Likely Bottoming BCA's Global LEI Likely Bottoming In our latest supply-demand balances, we are expecting Chinese oil demand to average 14.3mm b/d this year, and 14.8mm b/d next year. Along with India – expected to consume 5.0mm b/d this year, and 5.2mm b/d next year – these two states account for 36% of the total 54.3mm b/d of EM demand we expect in 2019 and 2020 (Table 3).8 Table 3BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) OPEC Starts Cutting Oil Output; Demand Fears Are Overdone OPEC Starts Cutting Oil Output; Demand Fears Are Overdone Overall EM demand, the powerhouse of global oil-demand growth led by China and India, is expected to increase 1.1mm b/d this year – slightly more than we estimated last month – and 1.3mm b/d in 2020. DM demand growth, as always, comes in lower, at 390k b/d this year and 280k b/d next year. Oil Supply-Demand Balances Will Tighten We expect global oil production to average 100.9mm b/d this year and 102.9mm b/d in 2020. Consumption is expected to average 101.8mm b/d this year and 103.4mm b/d next year, respectively (Chart 7). This puts OECD inventories back on a downward trajectory, as storage draws resume (Chart 2). Chart 7Global Oil Balances Will Resume Tightening Global Oil Balances Will Resume Tightening Global Oil Balances Will Resume Tightening On the back of these estimates, we expect Brent to average $80/bbl this year and $85/bbl next year, with WTI averaging $74/bbl and $82/bbl, respectively. Given our expectation for higher prices in Brent and WTI, we continue to favor being long crude oil exposure. We are long outright WTI spot futures; long July 2019 Brent vs. short July 2020 Brent; long call spreads along the 2019 forward Brent curve, and long the S&P GSCI. Bottom Line: Markets will continue to tighten as a combination of lower supply growth and rising consumption allows OECD commercial oil inventories to resume their downward trajectory. The apparent lack of a shared sense of urgency by OPEC 2.0’s leaders – KSA and Russia – will be resolved, in our view. OPEC 2.0 will once again focus on backwardating the Brent forward curve, in order to gain some control over the rate at which U.S. shale oil production grows. We continue to favor long exposures to the crude oil futures.   Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Pavel Bilyk, Research Analyst Commodity & Energy Strategy PavelB@bcaresearch.com Footnotes 1      In last week’s Commodity & Energy Strategy we noted these upcoming meetings, and OPEC 2.0’s resolve to drain the market.  Please see “Fed’s Capitulation Will Boost Oil,” published by BCA Research January 17, 2019.  It is available at ces.bcaresearch.com. 2      Bloomberg reported this week KSA’s and Russia’s oil ministers cancelled a planned meeting in Davos, following al-Falih’s criticism of the pace at which Russian oil production is being cut.  Please see “Saudi, Russian Energy Ministers Cancel Planned Davos Meeting,” published by bloomberg.com January 22, 2019.  KSA cut its crude oil output 450k b/d m/m in December to 10.64mm b/d from 11.09mm b/d in November.  Russia increased crude and liquids production to a record 11.65mm b/d in December, an 80k b/d increase m/m, according to OPEC Monthly Oil Market Report published January 17, 2019.  OPEC expects Russian oil output to average 11.47mm b/d in 1H19, and 11.49mm b/d in 2019.  We are carrying something close to this in our balances (11.51mm b/d) for 2019 and 2020. 3      China imported 10.3mm b/d of crude oil in December after posting a record 10.4mm b/d of imports in November 2018, just as sanctions were kicking in. 4      In our base case estimate, we assume Iran’s crude oil output will average ~ 2.8mm b/d, down ~ 1.0mm b/d from its 3.8mm b/d production level in 1H18, which was prior to the U.S.’s announcement it intended to re-impose export sanctions.  One way or another, we expect OPEC 2.0 to adjust production to compensate for whatever production is lost due to sanctions.  5      Please see “Permian tracker: Production growth slowing as pipeline race still on,” published by S&P Global Platts July 2, 2018, for a discussion of the new takeaway capacity planned for the Permian Basin by midstream companies in 2019 and 2020. 6      The Permian basin is closely tied to hedging activity in the WTI futures market.  It is the only basin for which WTI commercial short open interest is an explanatory variable for rig counts in our modeling.  Commercial short open interest in the WTI futures also Granger causes Permian rig counts. 7      Please see the Special Report entitled “Is China Already Isolated,” published by BCA Research’s Geopolitical Strategy and China Investment Strategy January 23, 2019.  It is available at gps.bcaresearch.com and cis.bcaresearch.com. 8      Our EM demand assumptions are driven by the IMF and World Bank EM GDP forecasts. This week the IMF lowered its global growth forecast for 2019 and 2020 by 0.2 and 0.1 percentage points to 3.5% and 3.6%, respectively. This is only slightly down from our lower estimate last month, but still above the World Bank’s expectation. We are using these variables directly in regressions to estimate prices and EM consumption. This replaced our earlier income-elasticity models used to calculate EM oil consumption.  We proxy EM demand with non-OECD oil consumption. We discuss this in “Fed’s Capitulation Will Boost Oil,” published by BCA Research January 17, 2019.  It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 4q18 Image Commodity Prices and Plays Reference Table Insert table images here Summary Of Trades Closed In 2018 Image

Highlights The Eurostoxx600’s short bursts of outperformance require either global technology to underperform or the euro to underperform. EM’s short bursts of outperformance usually coincide with the global healthcare sector’s short bursts of underperformance. Remain tactically overweight to Europe and EM, but expect to reverse position later in the year. The ECB is justified in setting an accommodative monetary policy, but it is not justified in setting an ultra-accommodative monetary policy. Soft inflation prints will cap the extent to which bond yields can rise in the near term. Italian BTPs are an attractive long-term proposition, especially relative to other euro area bonds. Feature Chart of the WeekEuro Area Inflation Appears To Be Underperforming... Euro Area Inflation Appears To Be Underperforming... ...But Adjusted For Its 'Negative Space' It Is Not Euro Area Inflation Appears To Be Underperforming... ...But Adjusted For Its 'Negative Space' It Is Not ...But Adjusted For Its 'Negative Space' It Is Not Euro Area Inflation Appears To Be Underperforming... ...But Adjusted For Its 'Negative Space' It Is Not Euro Area Inflation Appears To Be Underperforming... ...But Adjusted For Its 'Negative Space' It Is Not     “The music is not in the notes, but in the silence between”  – Wolfgang Amadeus Mozart As Mozart pointed out, true awareness lies not in appreciating what is there, but in appreciating what is not there. This is the concept of ‘negative space’: to understand an object, you have to understand the empty space that defines it. This week’s report extends the concept of negative space into the fields of investment and economics to make more sense of Europe’s recent past and its future. The Negative Space In Stock Markets Picking stock markets is a relative game. This means that what a stock market does not contain – its negative space – is often more important than what it does contain (Table I-1). This is not an abstract proposition, it is a mathematical truth. When a major global sector is strongly outperforming, a stock market’s zero or near-zero exposure to that sector will create a strong headwind to relative performance. And when the major sector is underperforming, its absence in the stock market will necessarily create a strong tailwind to relative performance. Chart I- For the European stock market, the negative space is technology, a sector in which European equities have a near-zero exposure. But there is another factor to consider: the currency. The technology sector’s global profits are mostly translated into shares quoted in dollars, while European equities’ global profits are mostly translated into shares quoted in euros. It follows that the Eurostoxx600’s short bursts of outperformance require at least one of the following two conditions (Chart I-2): Chart I-2The Eurostoxx600 Usually Outperforms When Technology Underperforms The Eurostoxx600 Outperforms When Technology Underperforms The Eurostoxx600 Outperforms When Technology Underperforms Technology to underperform. Or: The euro to underperform. For emerging market (EM) equities, the negative space is healthcare, a sector in which EM has a near-zero exposure. Therefore unsurprisingly, EM’s short bursts of outperformance usually coincide with the healthcare sector’s short bursts of underperformance (Chart I-3). Sceptics will raise an obvious question: what is the cause and what is the effect? The answer is that sometimes EM is the driver of healthcare relative performance, and at other times vice-versa. Chart I-3EM Usually Outperforms When Healthcare Underperforms EM Outperforms When Healthcare Underperforms EM Outperforms When Healthcare Underperforms A sharp slowdown emanating from emerging economies would undoubtedly drag down global equities. In the ensuing bear market, the more defensive healthcare sector would almost certainly outperform the financials. Under these circumstances the direction of causality would clearly be from EM to healthcare’s relative performance. On the other hand, absent a major bear market, in a common or garden reassessment of sector relative valuations versus their growth prospects, the causality would run in the other direction: sector rotation would drive the relative performance of equity markets: healthcare’s underperformance would help EM to outperform; and technology’s underperformance would help European equities to outperform. As we have explained in recent reports, the major sectors – and therefore the major stock markets – are now in this latter configuration in a brief countertrend burst before reverting to their structural trends later this year (Chart I-4 and Chart I-5). So for the time being, remain tactically overweight to Europe and to EM.1 Chart I-4The Eurostoxx600 Outperformance Is A Countertrend Burst The Eurostoxx600 Outperformance Is A Countertrend Burst The Eurostoxx600 Outperformance Is A Countertrend Burst Chart I-5The EM Outperformance Is A Countertrend Burst The EM Outperformance Is A Countertrend Burst The EM Outperformance Is A Countertrend Burst The Negative Space In European Inflation And Unemployment On the face of it, inflation is structurally underperforming in the euro area versus the U.S. But on closer examination this is only because of what the euro area harmonised index of consumer prices (HICP) does not contain: owner occupied housing costs – which tend to rise faster than other items in the price basket. Adjusting for this negative space in the HICP, the euro area and the U.S. have both achieved the exact same modest structural inflation, which their central banks define as ‘price stability’ (Chart of the Week).   In a similar vein, the unemployment rate disregards changes in the labour participation rate. When people join the labour force – as they are in their tens of millions in Europe (Chart I-6) – the joining cohort tends to have a slightly higher unemployment rate given its inexperience in the formal labour market. So the joiners tend to lift the overall unemployment rate too. The paradox is that the percentage of the working age (15-74) population in employment also rises at the same time. Looking at this alternative measure of labour market health, the euro area employment market is in a structural uptrend and much healthier than it was at the peak of the last cycle in 2008 (Chart I-7). Chart I-6Europeans Are Joining The Labour Force In Their Tens Of Millions Europeans Are Joining The Labour Force In Their Tens Of Millions Europeans Are Joining The Labour Force In Their Tens Of Millions   Chart I-7The European Employment To Population Ratio Is In A Structural Uptrend The European Employment To Population Ratio Is In A Structural Uptrend The European Employment To Population Ratio Is In A Structural Uptrend Hence, once we adjust for what is missing in euro area inflation and the euro area unemployment rate, neither inflation nor employment market performance appear to be too cold or too hot. This means that the ECB is justified in setting an accommodative monetary policy, but it is not justified in setting an ultra-accommodative monetary policy. The Negative Space In Monetary Policy The negative space in monetary policy is literally the negative space, by which we mean that interest rates cannot go deeply into negative territory. With the deposit rate already at -0.4 percent, the ECB’s room for manoeuvre in the dovish direction is limited. On the other hand, neither can monetary policy get meaningfully hawkish in the near term. The simple reason is that the ECB, like other central banks, is now even more wedded to ‘data-dependency’. The problem with this is that the data on which the central banks depend is always backward-looking. So policy will reflect what was happening one or two months ago, rather than what is happening now. Specifically, the plunge in the price of crude oil will depress both headline and core inflation rates (Chart I-8). And the recent wobble in risk-asset prices has weighed down some sentiment surveys (Chart I-9). Having promised to be data-dependent, the central banks have effectively created ‘an algorithm’ for their policy setting, an algorithm which everyone can see and read. It follows that the data, especially soft inflation prints, will cap the extent to which bond yields can rise in the near term. Chart I-8The Plunge In The Price Of Crude Will Subdue Inflation The Plunge In The Price Of Crude Will Subdue Inflation The Plunge In The Price Of Crude Will Subdue Inflation Chart I-9The Stock Market Sell-Off Hurt Sentiment The Stock Market Sell-Off Hurt Sentiment The Stock Market Sell-Off Hurt Sentiment However, core euro area bonds are an unattractive long-term proposition. When yields are so close to their lower bound, there is little scope for a capital gain, even in a crisis. Whereas the scope for a capital loss is considerably greater. By contrast, Italian BTPs are an attractive long-term proposition, especially relative to other euro area bonds. Almost all of the 2.75 percent yield on 10-year BTPs is a premium for euro break-up risk. Yet the populists in Italy do not want to break up the euro. And despite their rhetoric, neither do the populists in the core countries. To understand why, we must explain the negative space of ECB QE. When the ECB bought BTPs from Italian investors, what the Italian investors did not do was deposit the cash in Italian banks. Instead, they deposited it in German banks – something that we can see very clearly in the euro area’s mirror-image Target2 imbalances (Chart I-10). Chart I-10ECB QE Has Exacerbated The Target2 Imbalances ECB QE Has Exacerbated The Target2 Imbalances ECB QE Has Exacerbated The Target2 Imbalances In effect, the core countries, through their equity in the Eurosystem, are holding a huge quantity of Italy’s €2.7 trillion of BTPs. Meaning that if the euro broke up, the core countries would be the ones picking up the tab. For the euro area’s future, this is the most important negative space of all. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System* There are no new trades this week. But all four of our open trades – long PKR/INR, industrials versus utilities, litecoin and ethereum, and MIB versus Eurostoxx – are in profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Footnotes 1 Please see the European Investment Strategy Weekly Report, “Why 2019 Is The Mirror-Image Of 2018”, dated January 10, 2019, available at eis.bcaresearch.com. Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Portfolio Strategy Vibrant and broad-based bank credit growth, pristine credit quality, pent up bank buyback demand and a V-shaped recovery in bank ROE more than offset the risk of 10/2 yield curve inversion, and suggest that the path of least resistance is higher for the S&P banks index. Rising residential construction versus stalling residential investment, easing interest rates, cheapened lumber prices, and alluring valuations and technicals all signal that more gains are in store for homebuilders at the expense of home improvement retailers. Recent Changes Initiate a long S&P homebuilding/short S&P home improvement retail pair trade today. Table 1 Dissecting 2019 Earnings Dissecting 2019 Earnings Feature Equities have retraced 50% of the peak-to-trough losses, and are still consolidating the post December Fed meeting tremor. Chart 1 shows that the VIX has been cut in half and the high-yield corporate bond option-adjusted spread has dropped 105bps. Retrenching volatility and deflating junk spreads suggest that the equity risk premium (ERP) remains uncharacteristically high. The path of least resistance is for the ERP to narrow in the coming months as we do not foresee recession in 2019. As a reminder, the ERP and the economy are inversely correlated. Chart 1Risk Premia Renormalization Risk Premia Renormalization Risk Premia Renormalization Nevertheless, in order for the reflex rebound since the late-December lows to morph into a durable rally, the macro/policy backdrop has to turn from a headwind to a tailwind. We are closely monitoring three potential positive catalysts: A definitively more dovish Fed, which would help restrain the greenback A positive U.S./China trade resolution A continuation of the earnings juggernaut With regard to the macro related catalysts, an update to our reflation gauge (RG) is in order. The trade-weighted U.S. dollar has been depreciating since early November, the 10-year U.S. Treasury yield has come undone since the early November peak and oil prices are 33% lower than the early-October peak. These three variables comprise our RG and the signal is unambiguously bullish. In other words, a reflationary impulse looms in the months ahead which should pave the way for a rebound in both plunging investor sentiment and the gloomy economic surprise index (RG shown advanced, Chart 2). Chart 2Reflating Away Reflating Away Reflating Away On the earnings front, last week we trimmed our end-2020 SPX EPS forecast to $181 while we sustained the multiple at 16.5 times which resulted in a 3,000 SPX target.1 Drilling beneath the surface and analyzing the composition of SPX profits is revealing. Table 2 highlights sell side analysts’ profit levels and growth projections on a per GICS1 sector basis and also their contribution to overall earnings along with each sector’s projected earnings weight and most recent market capitalization weight. Table 2S&P 500 Earnings Analysis Dissecting 2019 Earnings Dissecting 2019 Earnings Chart 3 shows that financials, health care and industrials are responsible for 61% of the SPX’s profit growth in 2019. Interestingly, technology’s contribution has fallen to a mere 7.2% and even if we add the new communication services sector’s 9.6% contribution it still falls well shy of the tech sector’s market cap and earnings weight. Another worthwhile observation is that energy profits are no longer off the charts, as base effects since the early-2016 $25/bbl oil trough have filtered out of the dataset. Chart 3 While the risk of disappointment surrounds financials, health care and industrials, there are high odds that tech surprises to the upside as it has borne the brunt of recent negative earnings revisions (Charts 4 & 5). In addition, if our Commodity & Energy Strategy service’s bullish oil forecast pans out this year, the negative energy sector contribution to SPX profit growth will get a sizable upward revision (please look forward to our GICS1 sector EPS growth models updates and profit margin analysis in next week’s report). Chart 4Earnings Revisions... Earnings Revisions... Earnings Revisions... Chart 5...Really Weigh On Tech ...Really Weigh On Tech ...Really Weigh On Tech ​​​​​​​ In sum, if the Fed pauses its hiking cycle through at least the first half of the year, we see a positive U.S./China trade resolution and SPX profits sustain their upward trajectory, then the SPX budding recovery will morph into a durable rally. This week we are updating an interest rate sensitive index that is highly levered to the surging U.S. credit impulse (Chart 6) and are initiating an early cyclical intra-sector and intra-industry pair trade. Chart 6Heed The U.S. Credit Impulse Signal Heed The U.S. Credit Impulse Signal Heed The U.S. Credit Impulse Signal Stick With Banks While our overweight call in the S&P banks index suffered a setback last month, since inception it has moved laterally, and we continue to recommend an above benchmark allocation to this key financials sub group. Not only are the odds of recession low for this year, but narrowing credit spreads and a reversal in financial conditions are also waving the green flag (junk spread shown inverted & advanced, bottom panel, Chart 7). Chart 7Bank On Banks Bank On Banks Bank On Banks Unlike the previous three reporting seasons when banks revealed blowout numbers and stocks subsequently fell, this season some profit and top line growth misses have been greeted with rising bank stocks prices. Such a reaction suggests that the worst is behind this sector and a sustainable recovery looms. Importantly, on the loan growth front, our credit impulse diffusion index is reaccelerating (Chart 6) and the overall credit impulse is expanding (middle panel, Chart 7). Our total loans & leases growth model and BCA’s C&I loan growth model both corroborate this encouraging credit backdrop (second & bottom panels, Chart 8). The latter is significant given that C&I loans are the single biggest credit category in bank loan books (Chart 9). Importantly, C&I loans have gone vertical recently topping the 10.5% growth mark despite softening capex intentions and CEO confidence. Chart 8Credit Models Flashing Green Credit Models Flashing Green Credit Models Flashing Green Chart 9Credit Models Flashing Green C&I Loans Leading The Pack C&I Loans Leading The Pack Multi-decade highs in consumer confidence are offsetting the Fed’s tightening cycle and suggest that consumer loans, another key lending category, will also gain traction (third panel, Chart 8). The outlook for the second largest credit category, residential real estate, remains upbeat in spite of last quarter’s soft housing related data releases. The recent easing in monetary conditions has breathed life back into the mortgage purchase applications index and also house prices continue to expand at a healthy pace (Chart 10). The upshot is that first-time home buyers will show up this spring selling season. Chart 10Residential Loans Also On Solid Footing Residential Loans Also On Solid Footing Residential Loans Also On Solid Footing Beyond positive credit growth prospects, credit quality remains pristine. BCA’s no recession in 2019 view remains intact, thus NPLs and chargeoffs should stay muted. As a reminder, U.S. banks are the best capitalized banks in the world,2 and their reserve coverage ratio has returned to 124%, a level last seen in 2007 (Chart 11). Chart 11Pristine Credit Quality Pristine Credit Quality Pristine Credit Quality Another important source of support is equity retirement. Banks have been late to the buyback game as the GFC along with the new strict bank regulatory body, the Fed, really tied their hands with regard to shareholder friendly activities. In fact, according to flow of funds data, the financial sector is still a net equity issuer, albeit at a steeply decelerating pace especially relative to the non-financial corporate sector (Chart 12). Pent up financial sector buyback demand is a boon for bank EPS growth. Chart 12Pent Up Buyback Demand Getting Unleashed Pent Up Buyback Demand Getting Unleashed Pent Up Buyback Demand Getting Unleashed This is significant at a time when analysts have been swiftly downgrading EPS growth figures for the SPX. Encouragingly, our bank EPS growth model captures all these positive forces and while it is decelerating it still suggests that profit growth will be stellar in 2019 and easily outpace the overall market (Chart 13). Chart 13Banks EPS Growth Will Outpace The Market Banks EPS Growth Will Outpace The Market Banks EPS Growth Will Outpace The Market Despite all this enticing news, bank valuations remain anchored near rock bottom levels and a resurgent ROE is signaling that a re-rating phase looms (Chart 14). Chart 14Rerating In Still In The Early Innings Rerating In Still In The Early Innings Rerating In Still In The Early Innings Nevertheless, there is one headwind banks face as the business cycle is long in the tooth and on track to become the longest expansion on record: the price of credit. One reason for the deflating relative stock price ratio since the January 2018 peak has been the yield curve slope flattening (Chart 15), as it suppresses bank net interest margins. Banks have been fighting this off partly by keeping their source of funding ultra-low judging by still anemic CD rates, according to Bankrate’s national average (bottom panel, Chart 15). Chart 15One Minor Headwind One Minor Headwind One Minor Headwind While yield curve inversions have widened all the way out to the 7/1 slope, the key 10/2 slope has yet to invert. Were the 10-year U.S. treasury to resume its selloff, even a mild yield curve steepening will go a long way, as BCA’s bond strategists expect. Clearly a flattening curve is a risk to our sanguine bank view, but the rest of the positives we outlined above more than offset the yield curve blues. Adding it all up, vibrant and broad-based bank credit growth, pristine credit quality, pent up bank buyback demand and a V-shaped recovery in bank ROE more than offset the risk of the 10/2 yield curve inversion, and suggest that the path of least resistance is higher for the S&P banks index. Bottom Line: Maintain the overweight stance in the S&P banks index. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB, FRC, . Buy Homebuilders/Sell Home Improvement Retailers While we reiterate our recent overweight call on the S&P homebuilding index3 and the high-conviction underweight call on the S&P home improvement retail (HIR) group,4 it also makes sense to initiate a market neutral trade: long homebuilders/short HIR. This pair trade is levered on the swings of residential construction compared with residential investment. Currently the former is significantly outpacing the latter and suggests that relative share prices have ample room to run (top panel, Chart 16). Chart 16A Play On Residential Construction Vs. Investment A Play On Residential Construction Vs. Investment A Play On Residential Construction Vs. Investment Put differently, this share price ratio moves in tandem with homebuilders breaking new ground versus home owners renovating their existing house. Chart 17 shows the NAHB’s homebuilder sales expectations survey compared with the remodeling expectations survey. This relative sentiment gauge has ticked up recently, confirming the message from national accounts that residential construction has the upper hand over residential investment. The upshot is that the bull market in relative share prices is in the early innings. Chart 17Relative Survey Expectations... Relative Survey Expectations... Relative Survey Expectations... Keep in mind that housing starts and building permits are extremely sensitive to interest rates, depend on first time home buyers and move in lockstep with the homeownership rate. Currently, interest rates are easing, the homeownership rate is coming out of its GFC funk and first time home buyers are slated to make a comeback this spring selling season. This is a boon for homebuilders at the expense of HIR (middle & bottom panels, Chart 16). More specifically on the interest rate front, while both groups move with the oscillation of lending rates, new home sales are more sensitive than HIR sales to the price of credit. Our proxy of mortgage application purchase to refinance index does an excellent job in capturing this relative interest rate sensitivity and the recent jump signals that a catch up phase looms in the relative share price ratio (top panel, Chart 18). Chart 18...Easing Interest Rates... ...Easing Interest Rates... ...Easing Interest Rates... Relative loan growth activity also corroborates that demand for residential real estate is outpacing demand for home renovation (bottom panel, Chart 18). Beyond these macro tailwinds for this intra-sector trade, the price of lumber is a key determinant of relative profitability: lumber represents an input cost to homebuilders whereas it is an important selling item in Big Box building & supply retailers that make a set margin on it. In other words, rising lumber prices are a boon for HIR and a bane to homebuilders and vice versa. The recent drubbing in lumber prices should ease margin pressures on homebuilders but eat into HIR profits (Chart 19). Chart 19...And Cheapened Lumber Prices Favor Homebuilders Over HIR ...And Cheapened Lumber Prices Favor Homebuilders Over HIR ...And Cheapened Lumber Prices Favor Homebuilders Over HIR Finally, oversold relative technicals, depressed valuations and extreme sell side analysts’ relative profit pessimism, offer a very compelling entry point in the pair trade for fresh capital (Chart 20). Chart 20Oversold And Unloved Oversold And Unloved Oversold And Unloved Netting it all out, rising residential construction versus stalling residential investment, easing interest rates, cheapened lumber prices, and relative alluring valuations and technicals all signal that more gains are in store for homebuilders at the expense of home improvement retailers. Bottom Line: Initiate a new long S&P homebuilding/short S&P home improvement retail pair trade today. The ticker symbols for the stocks in these indexes are: BLBG: S5HOME – DHI, LEN and PHM, and BLBG: S5HOMI – HD and LOW, respectively.   Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com footnotes 1 Please see BCA U.S. Equity Strategy Report, “Catharsis” dated January 14, 2019, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, “Top 10 Reasons We Still Like Banks” dated March 5, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Report, “Indurated” dated September 24, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Report, “2019 Key Views: High-Conviction Calls” dated December 3, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights 2018 Performance Breakdown: Our recommended model bond portfolio generated a modest outperformance versus the custom benchmark index of +6bps for all of 2018. Winners & Losers: The outperformance of our model bond portfolio in 2018 mostly came from country selection on our government bond portfolio (underweight U.S. Treasuries, overweight the U.K. and Australia). However, our below-benchmark overall duration stance, as well as our bias favoring U.S. credit over non-U.S. corporates, were drags on performance during the risk-off moves at the end of 2018. Scenario Analysis For 2019: The tactical upgrade to global corporates that we initiated last week is projected to generate outperformance versus the model portfolio benchmark index in the next six months - both from below-benchmark duration positioning and higher exposure to U.S. corporates. Feature 2019 has gotten off to a very busy start, with significant news and market moves forcing us to devote our first two Weekly Reports of the year to analysis and even changes to our views. This week, we belatedly take care of one final piece of housekeeping for 2018 – reporting the performance of the BCA Global Fixed Income Strategy (GFIS) model bond portfolio for the fourth quarter and for the entire calendar year. We also present an updated scenario return analysis for the next six months after the tactical upgrade to global corporate bonds that we initiated last week.1 As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. This is done by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. A Quick Summary Of The Full Year Performance For 2018 The 2018 performance of the model portfolio can really be broken up into two periods: the first ten months of the year and November/December. This is an unsurprising consequence of the severe market moves around year-end that went contrary to our two most significant recommendations – maintaining a below-benchmark stance on overall portfolio duration and overweighting U.S. investment grade corporate debt versus non-U.S. equivalents in Europe and emerging markets (EM). The overall portfolio return in 2018 was +1.10% (hedged into USD), which outperformed our custom benchmark index by +6bps (Chart of the Week).2 That outperformance was considerably higher before the year-end plunge in global bond yields, reaching a peak of +32bps on November 20. In terms of the breakdown of outperformance, our recommended positioning on government bonds (duration and country allocation) contributed +22bps, while our credit tilts (by country and broadly defined credit sectors) were a drag on performance to the tune of -16bps. Chart of the WeekA Small Gain For 2018 After A Q4 Round-Trip A Small Gain For 2018 After A Q4 Round-Trip A Small Gain For 2018 After A Q4 Round-Trip The full breakdown of the full-year 2018 performance can be found in the Appendix tables and charts on Pages 14-16. For the government bond portion of the portfolio the full-year outperformers by country were the U.S. (+18bps), Germany (+10bps), Australia (+4bps) and the U.K. (+3bps). These are in line with our long-standing underweight position on the U.S. versus Germany, and our recommended overweights on Australia and the U.K. The laggards were relatively modest, led by our overweight stance on Japan (-4bps) and underweights on France (-3bps) and Italy (-3bps). For the credit portion of the portfolio, the winners were EM USD-denominated corporates (+7bps), U.S. B-rated high-yield (HY) corporates (+3bps) and U.S. Caa-rated high-yield (HY) corporates (+2bps). This was in line with our long-standing bias to favor U.S. junk bonds over EM credit. The losers were our overweights on U.S. investment grade (IG) financials (-15bps), U.S. IG industrials (-8bps), U.S. Ba-rated HY (-4bps), and euro area IG corporates (-2bps). Our overweight tilts on U.S. IG were the issue here. Q4/2018 Model Portfolio Performance Breakdown: A “Risk-Off” Hit To Our Core Recommendations The detailed data on our model bond performance for Q4/2018 only can be found in Table 1. Table 1GFIS Model Bond Portfolio Q4/2018 Overall Return Attribution 2018 GFIS Model Bond Portfolio Performance Review: Fading At The Finish Line 2018 GFIS Model Bond Portfolio Performance Review: Fading At The Finish Line The total return of the GFIS model bond portfolio was +1.5% (hedged into USD) in Q4, which underperformed the custom benchmark index by a mere -1bp. The main cause for the slight underperformance is from our below-benchmark duration positioning with the Bloomberg Barclays Global Treasury Index yield falling by 20bps over the full quarter. In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -2bps of underperformance versus our custom benchmark index while the latter outperformed by just +1bp. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. Chart 2   Chart 3 The main individual sectors of the portfolio that drove the excess returns were the following: Biggest outperformers Underweight U.S. government bonds with maturities between 5-7 years (+12bps) Overweight Japanese government bonds (JGBs) with maturities between 7-10 years (+5bps) Underweight Germany government bonds with maturities between 7-10 years (+3bps) Overweight U.K. government bonds with maturities between 5-7 years (+2bps) Biggest underperformers Overweight Japanese government bonds (JGBs) with maturities beyond 10 years (-15bps) Underweight U.S. government bonds with maturities beyond 10 years (-8bps) Underweight Italy government bonds with maturities beyond 10 years (-3bps) Underweight France government bonds with maturities beyond 10 years (-2bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q4/2018. The returns are hedged into U.S. dollars (we do not take active currency risk in this portfolio) and are adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color-coded the bars in each chart to reflect our recommended investment stance for each market during Q4/2018 (red for underweight, blue for overweight, gray for neutral). Chart 4 Government bonds are dominating the left half of the chart, as yields declined in the final months of 2018. This was a drag on our model portfolio performance. However, the best performing sector was U.K. government bonds, generating a total return of 4.7% in Q4/2018 (on a currency-hedged and duration-matched basis). The GFIS model portfolio benefited from this move, given our long-standing overweight bias for U.K. Gilts. The right side of Chart 4 is occupied by global spread product, where currency-hedged returns were flat-to-negative in Q4. This was due to credit spread widening as investors feared both slower global growth and additional Fed tightening. The riskier parts of the corporate bond universe – high-yield, EM corporates – suffered the largest losses. The total return of Bloomberg Barclays U.S. High-Yield Index (currency-hedged into USD) for Q4 was -2.7%, as the option-adjusted spread (OAS) widened by +206bps. Unfortunately for our model portfolio, our preference for U.S. corporate bonds over European and EM credit hurt performance, although not by as much as the below-benchmark duration stance. We are disappointed by the final result for the year, although we are still pleased to generate even a small positive outperformance given the ferocity of the market moves seen at the end of 2018. We can attribute that to lingering gains from good calls made earlier in 2018, but also from our recommended cautious stance on overall portfolio risk (i.e. tracking error) in a more-volatile investment environment. Bottom Line: The outperformance of our model bond portfolio in 2018 mostly came from country selection on our government bond portfolio (underweight U.S. Treasuries, overweight the U.K. and Australia). However, our below-benchmark overall duration stance, as well as our bias favoring U.S. credit over non-U.S. corporates, were drags on performance during the risk-off moves at the end of 2018. Future Drivers Of Portfolio Returns Looking ahead, the performance of the model bond portfolio will benefit from two main factors: our below-benchmark duration bias and our underweight stance on global government bonds versus corporate debt. In terms of specific weighting in the GFIS model bond portfolio, we now have a tactical bias favoring global corporate debt over government debt coming on top of our below-benchmark duration stance (Chart 5). We are sticking with the latter position, about one full year short of the duration of our benchmark index, with global yield curves priced for inflation expectations that are too low and with no rate hikes discounted for 2019 in all major developed markets. Chart 5Portfolio Duration: Staying Below-Benchmark Portfolio Duration: Staying Below-Benchmark Portfolio Duration: Staying Below-Benchmark However, we are also keeping our current country allocations on the government bond side of the model portfolio, even after our tactical credit upgrade. That means staying underweight countries where policymakers are only pausing on rate hiking cycles (U.S. and Canada), while overweighting countries that are likely to keep rates on hold for all of 2019 (Japan, U.K., Australia). Our decision to upgrade global credit exposure helps boost the yield of our model portfolio (Chart 6). However, the portfolio is still yielding less than the benchmark thanks to our bear-steepening bias on government yield curves that involves underweights to longer-maturity bonds with higher yields. Chart 6Portfolio Yield: Credit Upgrade Helps Offset Defensive Duration Tilt Portfolio Yield: Credit Upgrade Helps Offset Defensive Duration Tilt Portfolio Yield: Credit Upgrade Helps Offset Defensive Duration Tilt Importantly, all the changes that were made to our portfolio allocations last week – raising weights on all global corporate bond markets, cutting exposure to government debt in the U.S., Germany and France – did not materially change the tracking error (relative volatility versus the benchmark) of the model portfolio. We do not see the current backdrop as being conducive to taking high levels of overall portfolio risk, even given our tactical view that the U.S. monetary policy will be on hold for the next 3-6 months. We prefer to recommend more relative value positioning via country and credit allocations that help dampen overall portfolio risk and reduce exposure to the kind of volatility spikes that became more frequent in 2018. Thus, we will continue to target a tracking error for the model portfolio of 40-60bps, well below our self-imposed 100bps ceiling (Chart 7). Chart 7Portfolio Risk Budget Usage: Staying Cautious Portfolio Risk Budget Usage: Staying Cautious Portfolio Risk Budget Usage: Staying Cautious Scenario Analysis & Return Forecasts In April 2018, we introduced a framework for estimating total returns for all government bond markets and spread product sectors, based on common risk factors.3 For credit, returns are estimated as a function of changes in the U.S. dollar, the Fed funds rate, oil prices and market volatility as proxied by the VIX index (Table 2A). For government bonds, non-U.S. yield changes are estimated using historical betas to changes in U.S. Treasury yields (Table 2B). This framework allows us to conduct scenario analysis of projected returns for each asset class in the model bond portfolio by making assumptions on those individual risk factors. Chart   Chart In Tables 3A & 3B, we present three differing scenarios, with all the following changes occurring over a six-month horizon. Note that this differs from how we have typically presented these scenario analyses, with projections over the subsequent twelve months. Given that the changes to our recommended allocations introduced last week were tactical in nature (i.e. up to six months), we are shortening our forecast window for this particular scenario analysis to line up with that shorter investment horizon. Chart   Chart The scenarios are all driven by what we believe will be the most important driver of market returns in 2019 – the path of U.S. monetary policy. Our Base Case: the Fed stays on hold, the U.S. dollar remain flat, oil prices rise by +10%, the VIX index falls to 15, and there is a bear-steepening of the U.S. Treasury curve. This scenario is the one we laid out in last week’s report, with the Fed taking a pause through at least the March FOMC meeting, allowing market volatility to drift lower as U.S. monetary and financial conditions ease. A Very Hawkish Fed: the Fed does a surprise +25bps rate hike in March, the U.S. dollar rises by +5%, oil prices increase +20%, the VIX index climbs to 25 and there is a sharp bear-flattening of the U.S. Treasury curve. This would be the case if the U.S. economy maintains firm growth, the global growth downturn stabilizes, U.S. inflation expectations increase and market volatility increases from a surprisingly hawkish Fed. A Very Dovish Fed: the Fed cuts the funds rate by -25bps, the U.S. dollar falls by -5%, oil prices decline -20%, the VIX index increases to 35 and there is a sharp bull steepening of the U.S. Treasury curve. This is a scenario where U.S./global growth slows rapidly from the current pace and the Fed has no choice but to ease monetary policy as market volatility surges alongside elevated recession risks. The model bond portfolio is expected to outperform the custom benchmark index by +19bps in our Base Case scenario. This comes from the relative outperformance of credit versus government bonds in an environment of rising bond yields (which also benefits our below-benchmark duration stance), and tighter credit spreads. In the Very Hawkish Fed scenario, our model portfolio is expected to outperform the benchmark by +29bps. This is not only due to our duration tilt and our corporates-versus-governments bias. As in the Base Case, the relative stance favoring U.S. corporates over EM credit would benefit from a backdrop of tightening U.S. monetary conditions and rising market volatility (Chart 8) – both of which are worse for EM credit. Chart 8Risk Factors Assumptions For The Scenario Analysis Risk Factors Assumptions For The Scenario Analysis Risk Factors Assumptions For The Scenario Analysis In the Very Dovish Fed scenario, our portfolio is projected to underperform the benchmark index by -26bps, with falling bond yields (Chart 9) hitting both our defensive duration bias and the overweight on corporates relative to governments. Chart 9UST Yield Assumptions For The Scenario Analysis UST Yield Assumptions For The Scenario Analysis UST Yield Assumptions For The Scenario Analysis In all three scenarios, there is a drag on expected performance from the relative carry of the model portfolio versus the benchmark (-17bps). This comes mostly from the below-benchmark overall duration stance that involves reduced exposure to longer-maturity government bonds with higher yields. The drag on carry also comes from the underweight positioning on high-yielding EM debt. We are maintaining that tilt given our concerns that China’s policymakers will be unable to provide enough stimulus to benefit EM economies through greater Chinese demand. Importantly, our recommended allocations win in scenarios that do not involve Fed rate cuts, a very low probability outcome in 2019, in our view. Thus, we expect our current allocations to generate alpha in the first half of the year, even if the Fed returns to a hawkish bias faster than we currently anticipate. Bottom Line: The tactical upgrade to global corporates that we initiated last week is projected to generate outperformance versus the model portfolio benchmark index in the next six months - both from below-benchmark duration positioning and higher exposure to U.S. corporates.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “Enough With The Gloom: Upgrade Global Corporates On A Tactical Basis”, dated January 15th 2019, available at gfis.bcareseach.com. 2 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 3 Please see BCA Global Fixed Income Strategy Weekly Report, “GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start”, dated April 10th 2018, available at gfis.bcareseach.com. Appendix Image   Image   Image Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index 2018 GFIS Model Bond Portfolio Performance Review: Fading At The Finish Line 2018 GFIS Model Bond Portfolio Performance Review: Fading At The Finish Line Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

The Fed’s near-term capitulation on its rates-normalization policy highlighted by our fixed-income desks will provide a tailwind for EM oil demand this year by weakening the USD. This will reduce refined-products’ costs in local-currency terms ex-U.S., as it buoys EM growth prospects.1 If, as we expect, Chinese policymakers also deploy modest stimulus, global oil demand still will remain on track to grow 1.4mm b/d this year, per our forecast. We are mindful of potential upside surprises on the demand side, particularly, if, as we noted in our last balances update, the 100th anniversary of the Chinese Communist Party in 2021 provokes policymakers to deploy large-scale stimulus in 2H19 or 2020.2 The odds of this occurring before 2H19 are low, and we are not yet raising our demand estimates. A partial defusing of the Sino – U.S. trade war is possible, as the 90-day negotiating window agreed at the December G20 meeting starts to close next month. This could trigger a short-term rally in commodities, but, absent durable agreements on the technology front, this potential thawing will be transitory. Highlights Energy: Overweight. China’s crude oil imports surged 30% y/y in December 2018, which helped lift total 2018 imports by 10% vs. 2017 levels. This partly was the result of independent refiners scrambling to use up 2018 import quotas at year-end, so that they could retain those levels this year, according to S&P Global’s Platts.3 Base Metals: Neutral. China’s copper ore and concentrate imports were down 11.5% y/y in December – the largest y/y decline since May 2017 – in line with slowing growth there. Precious Metals: Neutral. We expect gold to continue to rally over the next 3 – 6 months on the back of a weaker USD in 1H19, as the Fed likely pauses on its rate-hiking schedule. Ags/Softs: Underweight. Grains likely will get a short-term price lift as the Fed dials back its rates-normalization policy. Feature For the moment, the Fed’s apparent capitulation on its rates-normalization policy reduces the risk the U.S. central bank will err on the side of being overly aggressive, which would have thrown a spanner into EM growth prospects this year. An easier Fed monetary policy will buoy EM GDP and weaken the USD over the short term, which will, support oil prices via stronger demand (Chart of the Week). Chart of the WeekEM GDP Growth On Track, Keeping Oil Demand Growth On Track EM GDP Growth On Track, Keeping Oil Demand Growth On Track EM GDP Growth On Track, Keeping Oil Demand Growth On Track On the supply side, we remain convinced OPEC 2.0 is resolved to drain the global inventory overhang as quickly as possible. This unintended inventory accumulation resulted from OPEC 2.0’s production surge and the granting of waivers on U.S. export sanctions against Iran by the Trump administration in November (Chart 2). This conviction was strengthened earlier this week, following the announcement of a proposed earlier-than-expected meeting of the coalition’s market monitoring committee in Baku, Azerbaijan, in mid-March to assess global supply and demand conditions. This could be followed by a full OPEC 2.0 meeting in Vienna in mid-April, following up on their December meeting in Vienna, according to S&P Global Platts.4 Chart 2OPEC 2.0 Is Resolved To Drain Inventory Overhang OPEC 2.0 Is Resolved To Drain Inventory Overhang OPEC 2.0 Is Resolved To Drain Inventory Overhang Pieces Of The Price Puzzle Falling Into Place The Fed is signaling it has put its rates normalization policy on hold, given indications global economic growth is slowing in a manner similar to what occurred in 2014 – 15. Then, the U.S. central bank was attempting to escape the zero lower bound of its monetary policy, following the end of its QE program. In the event, the Fed only raised rates once in December 2015, as the slowdown in growth stayed its hand. Our colleagues at BCA’s Global Fixed Income Strategy note, “the downturn in cyclical growth indicators like manufacturing purchasing managers indices (PMI) and the global leading economic indicator (LEI) … reached levels last seen after that 2014/15 episode” as 2019 unfolded (Chart 3).5 The slowdown in global growth could stabilize, as the LEI diffusion index suggests, but the Fed, at least for now, appears to be comfortable waiting for clear evidence this is the case. Chart 3Global Growth Slowdown Provokes Fed Restraint Global Growth Slowdown Provokes Fed Restraint Global Growth Slowdown Provokes Fed Restraint In and of itself, the Fed’s near-term capitulation to the market will not be sufficient to reverse the “darkening prospects” foreseen by the World Bank in its most recent forecast, but it will be supportive of oil prices.6 On the back of our expectation the Fed will take a break from its rate-normalization, we are expecting a weaker USD over the short term, which will support oil demand and EM GDP growth. All else equal, this will create a tailwind for oil prices, given EM is the main driver of demand growth (Chart 4). Chart 4USD Near-Term Trajectory Will Support Oil Prices USD Near-Term Trajectory Will Support Oil Prices USD Near-Term Trajectory Will Support Oil Prices The Chart of the Week introduces a new model we developed to understand the effect of EM GDP growth on oil prices. The level of EM demand is mean reverting to a linear trend, and anchors other variables – oil prices and FX rates, for example – that oscillate randomly with the arrival of new information to the market. Our modeling indicates Brent and WTI prices can be expected to increase (decrease) 94bp and 73bp for every 1 percent increase (decrease) in EM GDP, assuming the broad trade-weighted index (TWIB) for the USD remains unchanged. A 1 percent decrease (increase) in the USD TWIB (holding EM GDP constant) translates into an increase (decrease) in Brent and WTI prices of ~ 4.0% and 3.6%, respectively. We have found EM GDP levels to be as useful an explanatory variable for Brent and WTI prices as non-OECD oil consumption, our proxy for EM demand. Indeed, it is perhaps even cleaner, since using it directly in our models does not require us to estimate an income elasticity of demand for EM economies, in order to forecast prices.7 We are not raising our expectation for demand growth on the back of the Fed’s apparent moderation in its rates policy. We are keeping our 2019 demand growth estimate at 1.4mm b/d, with 1.0mm b/d of that coming from EM and the remainder from DM. Should the Fed signal a further pause in its rates-normalization policy – extending perhaps deep into 2H19 – we would be inclined to raise our demand-growth estimates. Additional Stimulus Coming From China? China is not the be-all and end-all of EM growth. All the same, next to the U.S., it is the second-largest consumer in the world, accounting for ~ 14% of the 103.75mm b/d of global demand we expect this year. Next in line is India, which accounts for ~ 5% of global demand. The news coming out of China at the moment is confusing. While the Xi administration prosecutes its “Three Tough Battles” – i.e., deleveraging, pollution and poverty – it also is pulling policy levers to counter the economic damage inflicted by its trade war with the U.S.8 Government policymakers are signaling fiscal and monetary stimulus will be forthcoming via tax cuts and bond issuance this year, to counter these headwinds.9 However, we do not expect a massive deployment of stimulus. More than likely, the big stimulative measures arrive in 2H19 or next year. The key target dates for policymakers are further in the future, and are focused on the upcoming 100th Anniversary of the Communist Party in 2021. By 2020, the Xi administration is targeting a doubling of real GDP vs. 2010 levels, and a doubling of rural and urban incomes (Chart 5). Chart 5China Keeping Powder Dry For 2021 "Centenary Goal" China Keeping Powder Dry For 2021 "Centenary Goal" China Keeping Powder Dry For 2021 "Centenary Goal" So the real stimulus out of China likely comes later this year or next year. As our Geopolitical Strategy service notes: “If China launches a large-scale stimulus now, peak output will occur in 2020 and the economy will be decelerating into 2021. This would be bad timing for the centenary. It would make more sense for China to save some dry powder for 2019 or 2020 to ensure a positive economic backdrop in 2021.” There is, as we noted in our last balances update, a low-probability chance stimulus could surprise to the upside if growth – particularly employment – falls precipitously. For now, we are comfortable with our House view that the more extensive fiscal and monetary stimulus will be saved for later this year or next in the run-up to the Communist Party’s anniversary.10 Bottom Line: The Fed appears to have capitulated to markets in the short term, and likely will hold off on another rate hike in 1H19. All else equal, this will weaken the USD and buoy EM GDP over the short term. Together, these effects will keep oil demand on track to growth 1.4mm b/d, per our forecast. Markets are reacting to news of fiscal and monetary stimulus coming out of China. We have been expecting modest stimulus to be deployed this year, most likely in 2H19. We continue to expect a larger package of fiscal and monetary stimulus later in the year and next year in the run-up to the Communist Party’s 100th anniversary.   Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      Please see “Enough With the Gloom: Upgrade Global Corporates On A Tactical Basis,” published January 15, 2019, by BCA Research’s Global Fixed Income Strategy. It is available at gfis.bcaresearch.com. See also “Buy Corporate Credit,” published by BCA’s U.S. Bond Strategy January 15, 2019. It is available at usbs.bcaresearch.com. 2      Please see “Oil Volatility Will Persist; 2019 Brent Forecast Lowered to $80/bbl,” published January 3, 2019, by BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 3      Please see “China’s 2018 crude oil imports rise 10% to 9.28 mil b/d,” published by S&P Global Platts January 14, 2019, online. 4      OPEC 2.0 ministerial meetings usually are held in May/June and again November/December. Please see “OPEC eyes mid-March monitoring committee meeting, mid-April full ministerial,” published by S&P Platts Global January 14, 2019. The cartel also will meet in early February to put the finishing touches on a charter formalizing the coalition. We will be delving deeper into the supply side next week, when we update our balances. 5      Please see footnote 1 above. 6      The World Bank’s most recent forecast can be found in its Global Economic Prospects, published January 8, 2019. The lead article is entitled “Darkening Skies.” 7      We use forecasts of EM GDP and GDP growth published by the World Bank and IMF in our modeling. This is useful for us for a number of reasons, particularly since it is calculated externally by well-regarded global institutions tasked with this function. Like other estimates and projections – e.g., the EIA’s, IEA’s and OPEC’s supply/demand estimates – we can take a view on these data relative to our House view or our own Commodity & Energy Strategy view. NB: Because these are cointegrated systems, regressions in levels is appropriate. 8      This campaign is discussed in depth in “China Sticks To The ‘Three Battles’,” published by BCA Research’s Geopolitical Strategy October 24, 2018. It is available at gps.bcaresearch.com. 9      Please see “China signals more stimulus as economic slowdown deepens,” published by uk.reuters.com January 15, 2019. 10     Please see footnote 2 above. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 4Q18 Image Commodity Prices and Plays Reference Table   Trades Closed in 2019 Summary of Trades Closed in 2018 Image

Highlights Portfolio Strategy The budding recovery in Chinese infrastructure outlays and easing in monetary conditions, a pause in the U.S. dollar’s rally on the back of a more dovish Fed and improving domestic steel final-demand dynamics along with compelling valuations and technicals, all suggest it no longer pays to be bearish the S&P 1500 steel index. Boost to overweight. A marginally improving China monetary backdrop, a de-escalation in the U.S./China trade tussle, recovering EM market internals and a brightening profit backdrop, all signal that a re-rating phase looms in the S&P materials sector. Upgrade to a modest overweight. Recent Changes Boost the niche S&P 1500 Steel Index to overweight today. This move also lifts the S&P Materials Index to a modest overweight. Table 1 Catharsis Catharsis Feature The S&P 500 convulsed following the December 19th Fed meeting and suffered a cathartic 450 point peak-to-trough fall last month. The Fed likely made a policy error, and Fed Chair Powell’s resolve is getting tested as has happened with every Chair since Volcker (Chart 1).1 Chart 1Powell's Resolve Getting Tested Powell's Resolve Getting Tested Powell's Resolve Getting Tested The top panel of Chart 2 shows that the 2018 peak in the SPX occurred one week prior to the September Fed meeting. That meeting, when the Fed raised rates for the third time that year, was the straw that broke the camel's back. Indeed, the bond market has been signaling that the U.S. economy has reached the neutral rate last year, as the 10-year UST yield stalled near the 3.10% mark on several occasions (middle panel, Chart 2). Chart 2Fed Policy Mistake Fed Policy Mistake Fed Policy Mistake Our recent research also suggests that the Fed’s tightening cycle (from trough-to-peak) is now above the historical median and at least a pause is warranted.2 To put last year’s discount rate increases into further perspective, bottom panel of Chart 2 shows that a 100bps increase in the fed funds rate caused a roughly 30% collapse in the forward P/E. Not only is this multiple compression overdone, but prices also corrected 19% from peak-to-trough, likely paving the way for a smart recovery. Our running assumption remains that the U.S. economy will avoid recession this year and EPS will continue to expand. True, the yield curve inversions have widened beyond the 5/3 and 5/2 slopes to the 7/1, and we heed the bond market’s message (Chart 3). However, as we highlighted last month, yield curve inversions occur before stock market peaks. Keep in mind that the most important yield curve slope, the 10/2, has not yet inverted. The upshot is that the SPX has yet to peter out for the cycle.3 Chart 3Yield Curve Inversion Is Spreading Yield Curve Inversion Is Spreading Yield Curve Inversion Is Spreading With regard to our end-2019 SPX target we are revising our base case scenario to 3,000 (from 3,150 previously),4 based on a 2020 EPS revision to $181 (from $191 previously),5 but we are sustaining the multiple at 16.5 times (Table 2). Assuming 2018 EPS end near $162, this represents a 6% EPS CAGR, in line with the still mid-single digit expansion signal from our EPS growth model (Chart 4). Table 2SPX EPS & Multiple Sensitivity Catharsis Catharsis Chart 4EPS Growth Model Still Expects Mid-Single Digit Expansion EPS Growth Model Still Expects Mid-Single Digit Expansion EPS Growth Model Still Expects Mid-Single Digit Expansion Adding it up, stocks hit rock bottom late-last year and a pause in the Fed tightening cycle, at least for the first half of the year, will likely serve as a welcome catalyst; any positive news on the trade tussle front with China will also act as a tonic for stocks, especially beaten down deep cyclicals. This week we are upgrading a U.S./China trade war GICS1 sector victim to a modest overweight position, via boosting a niche deep cyclical sub-index to an above benchmark allocation. Made Of Steel We are booking gains of 2.3% in the niche S&P 1500 steel index and boosting it from underweight all the way to an overweight stance. Beyond the contrary buy signal that bombed out technicals and depressed valuations are sending (Chart 5), there are high odds that relative profit outperformance is in the early innings. Chart 5Steel Is A Steal Steel Is A Steal Steel Is A Steal While U.S. steel stocks should have benefitted enormously from the U.S./China trade war and steel import tariffs, China macro dictates the fate of the S&P 1500 steel index. China’s waning fiscal and credit impulses have weighed heavily on U.S. steel stocks (top panel, Chart 6). Chinese authorities have been trying to engineer a soft landing, but the Chinese manufacturing PMI has now dipped below the boom/bust line (middle panel, Chart 6). Chart 6Mixed China Signals... bca.uses_wr_2019_01_14_c6 bca.uses_wr_2019_01_14_c6 Nevertheless, the recovering Li KEQIANG index is sending a positive signal (bottom panel, Chart 6). In addition, recent news of a mini fiscal package centered on high speed rail infrastructure spending is a step in the right direction. Historically, Chinese infrastructure outlays and relative share prices have been joined at the hip (middle panel, Chart 7). Chart 7...But Monetary And Fiscal Taps Are Opening ...But Monetary And Fiscal Taps Are Opening ...But Monetary And Fiscal Taps Are Opening On the monetary front, the easing in the banks’ reserve-requirement-ratio (RRR), albeit with a delayed effect, should also aid infrastructure spending uptake (RRR shown inverted, bottom panel, Chart 7). Similarly, the steepening in the Chinese yield curve underscores that easing financial conditions are conducive to a pickup in capital outlays (top panel, Chart 7). The U.S. dollar is another important macro variable driving U.S. steel stocks performance. The greenback’s steep appreciation since April 2018 has dealt a dual blow to domestic steel producers: not only is the underlying commodity quoted globally in U.S. dollars, but also FX translation losses have dented sector profitability. Despite the grim U.S. dollar news, there is light at the end of the tunnel. Were the Fed to pause its hiking cycle, at least in the front half of the year, the greenback’s advance may go on hiatus. Importantly, J.P. Morgan’s EM FX index is staging a comeback and steel prices are holding their own (top and bottom panels, Chart 8). Chart 8Bright Profit Drivers Bright Profit Drivers Bright Profit Drivers On the domestic front, news is also encouraging. Ever since President Trump came into power, blast furnaces have been running around the clock. Industry resource utilization rates are in a V-shaped recovery since 2016 and only recently returned to levels last seen prior to the Great Recession (middle panel, Chart 8). Steel new order growth is running at a healthy clip and is even surpassing inventory accumulation. This bright demand backdrop is a boon for steelmaking earnings (Chart 9). Chart 9Domestic Operating Backdrop... Domestic Operating Backdrop... Domestic Operating Backdrop... With regard to the domestic demand front, while automobile sales have been flirting with the zero growth line for the better part of the past three years, non-residential construction has been a primary beneficiary from the easing in fiscal policy (bottom panel, Chart 10). Fiscal thrust will continue to goose the U.S. economy in 2019, according to the IMF’s October 2018 World Economic Outlook update, and a new infrastructure spending bill, however modest, will, at the margin, buoy steel profits. Finally, according to the Fed’s latest Senior Loan Officer Survey, bankers are far from constricting the flow of credit toward the key end-demand segments, autos and commercial real estate. Chart 10...And Domestic Demand Will Buoy Steel Profits ...And Domestic Demand Will Buoy Steel Profits ...And Domestic Demand Will Buoy Steel Profits In sum, compelling valuations and technicals, the budding recovery in Chinese infrastructure outlays and easing in monetary conditions, a pause in the U.S. dollar’s rally on the back of a more dovish Fed and improving domestic steel final-demand dynamics, all suggest that it no longer pays to be bearish the S&P 1500 steel index. Bottom Line: Lift the S&P 1500 steel index from underweight to overweight and lock in gains of 2.3%. The ticker symbols for the stocks in the S&P 1500 steel index are: BLBG: S15STEL – NUE, STLD, RS, X, ATI, CMC, CRS, WOR, AKS, SXC, TMST, HAYN and ZEUS. Time To Dip Into Materials Raising the S&P 1500 steel index to an above benchmark allocation shifts the S&P materials sector into the overweight column. China macro dominates the direction of U.S. materials stocks. On the monetary front, the easing cycle continues unabated and the near 150bps year-over-year drop in the 10-year Chinese Treasury yield will soon start to bear fruit (yield change shown inverted and advanced, bottom panel, Chart 11). Chart 11Buy Materials As China's Monetary Spigots Are Loosening Buy Materials As China's Monetary Spigots Are Loosening Buy Materials As China's Monetary Spigots Are Loosening The renminbi also moves in lockstep with relative share prices. The apparent de-escalation in the U.S./China trade tensions has boosted the CNYUSD and is signaling that a playable reflation trade is in the offing in the S&P materials sector (top panel, Chart 11). Beyond the budding recovery in some key Chinese data (bottom panel, Chart 12), the troughing in emerging markets (EM) currencies versus the greenback also suggests that U.S. materials stocks have put in a bottom (top panel, Chart 12). Chart 12Shifting EM Internals Are A Boon For Materials Shifting EM Internals Are A Boon For Materials Shifting EM Internals Are A Boon For Materials The EM stock outperformance compared with the global benchmark (second panel, Chart 12) along with EM market internals corroborate the EM FX message. In more detail, EM Latin American equities have been significantly outperforming EM Asian bourses. This real time proxy of commodity producers versus consumers has been an excellent indicator of relative share prices and the current message is to expect more relative gains in the S&P materials sector (third panel, Chart 12). On the earnings front, while last year’s trade dispute related collapse in relative share prices is signaling profit trouble in the coming months, our EPS growth model (comprising the U.S. dollar, interest rates and commodity prices) has ticked up. Similar to the 2012 and 2016 lows, there are good odds that our model is picking up a soft landing in profits (second panel, Chart 13). Chart 13Profit Growth Model Has Troughed Profit Growth Model Has Troughed Profit Growth Model Has Troughed S&P materials sub-sector EPS breadth has slingshot higher compared with the overall market and relative long-term EPS growth forecasts are trying to bottom near the 2016 nadir (third & bottom panels, Chart 13). With regard to the sector’s financial health, materials’ indebtedness profile remains in recovery mode, still in the aftermath of the late-2015/early-2016 manufacturing recession with net debt-to-EBITDA in a free fall and a steeply accelerating interest coverage ratio. Capital outlays are also expanding smartly and are now on an even keel with sales growth (Chart 14). Given this improvement in corporate health, there are low odds of debt-related materials sector deflation. Chart 14Clean Bill Of Corporate Health Clean Bill Of Corporate Health Clean Bill Of Corporate Health Taking the pulse of investor sentiment toward this niche deep cyclical sector reveals that technical conditions are as oversold as can be; in fact our Technical Indicator sits at one standard deviation below the historical mean, a level that has preceded previous recovery rallies (Chart 15). Chart 15Contrary Buy Alert: Under-owned... Contrary Buy Alert: Under-owned... Contrary Buy Alert: Under-owned... Finally, according to our Valuation Indicator, relative valuations have crumbled to the lowest level since the GFC, and even relative EV/EBITDA has also corrected to the historical mean (Chart 16). Chart 16...And Unloved ...And Unloved ...And Unloved Netting it out, a marginally improving China monetary backdrop along with a de-escalation in the U.S./China trade tussle, recovering EM market internals and a brightening profit backdrop, all signal that a re-rating phase looms in the S&P materials sector. Bottom Line: Lift the S&P materials sector to a modest overweight position.   Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Will The Market Test Powell?” dated November 13, 2017, available at uses.bcaresearch.com. 2      Please see BCA U.S. Equity Strategy Weekly Report, “Manic Market” dated November 19, 2018, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise” dated December 17, 2018, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Weekly Report, “Lifting SPX Target” dated April 30, 2018, available at uses.bcaresearch.com. 5      Ibid. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

The oil rout that began in October appears to have run its course, based on positioning, sentiment and technicals. All the same, several cross-market gauges we designed to assess investors’ conviction on global macro conditions continue to support a cautious view over the short term. This dichotomy in the markets’ internal dynamics supports our view volatility will remain elevated over the next month or two. After that, we expect clear evidence the global oil market is tightening, as strong OPEC 2.0 compliance with production cuts and robust demand – albeit weaker than that of the past two years – drains inventories in 1H19. This is the basis of our $80/bbl Brent forecast for this year. Highlights Energy: Overweight. Our oil recommendations made last week in the wake of the oil-price vs. fundamentals disconnect – long spot WTI and long July 2019 Brent vs. short July 2020 Brent spread – are up 5.7% and 0.7%. Base Metals: Neutral. Asia trade-volume growth likely will move lower in the short term, even if Sino – U.S. trade talks are fruitful. With or without such an outcome, precautionary inventories built on both sides will have to be drawn down, an outcome we believe is priced into base metals prices. A rapprochement would be supportive for these markets, but these inventories still have to be worked through. Precious Metals: Neutral. Gold’s rally is intact, as markets gain conviction the Fed will deliver one rate hike this year. We are aligned with our House view calling for three hikes, which would present a headwind. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. Insiders report China made three large purchases of soybeans from the U.S. over the past month, as trade negotiators met in Beijing this week. Optimism on the trade front is buoying optimism in ag markets.1 Feature The rout in oil prices over the course of 4Q18 appears to have run its course, based on a composite indicator we created to assess technical and sentiment information in the crude oil market, and other metrics designed to gauge internal market dynamics (Chart of the Week). Chart of the WeekBCA's WTI Composite Indicator Flags Oversold Condition for Crude BCA's WTI Composite Indicator Flags Oversold Condition for Crude BCA's WTI Composite Indicator Flags Oversold Condition for Crude The individual components of the composite at the end of last year all had taken a sharp down leg, indicating investors were seriously concerned about a global slowdown and perhaps even an unexpectedly early recession (Chart 2).2 This concern also was noted by the World Bank, which this week revised its EM growth outlook – the key driver of commodity demand – for 2018 lower, and shaved its global 2019 growth estimate as well.3 Chart 2Sharp Down Leg In Composite's Components Sharp Down Leg In Composite's Components Sharp Down Leg In Composite's Components Ordinarily, there is not a lot of econometric support for technical indicators. Nonetheless, we found this composite indicator does a good job of explaining y/y changes of Brent crude oil prices, and vice versa. That’s right: there is two-way Granger-causality between the BCA WTI Composite indicator and y/y crude prices (Chart 3).4 Chart 3Composite Indicator, WTI Crude Form A Feedback Loop Composite Indicator, WTI Crude Form A Feedback Loop Composite Indicator, WTI Crude Form A Feedback Loop Given this two-way relationship, it is plausible speculative positioning, investor sentiment and price momentum can help forecast short-term price movements. In turn, the movement in prices feeds back to the components of our composite indicator, and can help anticipate positioning, sentiment and momentum. Indeed, it is likely the fundamental supply-side shock arising from the higher-than-expected waivers on Iranian imports granted by the Trump administration in November – separate and apart from the selling pressure in October – set off one of these feedback loops. Given the paucity of data at the time, market participants had to guess the extent of the physical surplus arising from the waivers as OPEC 2.0 rapidly increased production and filled inventories ahead of U.S. sanctions, and at the same time fears over the strength of demand were becoming more pronounced.5 As we noted last week, we do not think the oil price rout was evidence of an as-yet undetected collapse in demand or run-away supply. OPEC 2.0 and Canadian producers will cut ~ 1.4mm b/d of production; decline-curve losses of ~ 200k b/d from states that cannot maintain or increase their supply will persist, and slower U.S. shale growth resulting from price-induced capex declines will reduce output growth there. These supply cuts, plus still-strong demand growth of 1.4mm b/d, are driving our forecast the physical oil overhang will clear in 1H19, and that Brent prices will average $80/bbl this year, with WTI trading $6/bbl below that.6 Based on the most recent “oversold” reading of the BCA WTI Composite indicator, we believe the oil rout has run its course, given the indicator is in deeply oversold territory. By now, we think the negative sentiment and spec positioning components of prices have been exhausted. Unless we see a fundamental shock – a truly unexpected collapse in demand, e.g., or a complete breakdown in OPEC 2.0 production discipline – it is difficult to foresee another sell-off.  As the uncertainty clears and inventory starts to draw, speculators will re-enter the market (allowing producers to hedge), and sentiment will turn more bullish as visible evidence of lower inventories continues to be reported in weekly and monthly data. Some Indicators Still Urge Caution While the case can be made the oil rout has run its course, there still are cautionary signals flashing in our other indicators that assess internal market dynamics within and across EM and commodities. This likely will keep volatility high over the short term (Chart 4). Chart 4Conflicting Signals Will Keep Oil Vol Elevated Conflicting Signals Will Keep Oil Vol Elevated Conflicting Signals Will Keep Oil Vol Elevated BCA’s Emerging Market strategists’ Risk-on vs. Safe-Haven currency ratio has rolled over. This ratio picked up the degradation of demand expectations and rise in recession fears, which then spilled into global bond yields. With the benefit of hindsight, the case can be made this presaged a rise in global risk aversion in currency markets (Chart 5).7 Chart 5Warning Signs Flashing bca.ces_wr_2019_01_10_c5 bca.ces_wr_2019_01_10_c5 In addition, our gold ratios, which serve as growth-versus-safe-haven indicators – i.e., the copper/gold and oil/gold ratios – sagged, as industrial commodities weakened and gold rallied by 7% since November 2018.8 Together, these indicate markets were revising down their growth expectations, and reducing their risk in 4Q18. Even with the recent pick up in EM trade volume – a proxy for EM income growth – our short-term models suggest this likely will not be sustained, and that import volume growth will contract in 2H19 (Chart 6). Chart 6Expect Weaker Trade Volumes In 2H19 Expect Weaker Trade Volumes In 2H19 Expect Weaker Trade Volumes In 2H19 Our EM trade-volume models are driven by the broad trade-weighted USD (TWIB) and other FX and financial variables.9 The USD had been rallying as the U.S. domestic economy outperformed the rest of the world, and markets remained concerned over the Fed’s rates-normalization policy, which was pressuring expectations for EM trade growth lower. With the oil-price collapse of 4Q18 in the rear-view mirror, it is not inconceivable the Fed will not feel compelled to raise rates in 1H19, as inflation expectations are re-calibrated in the wake of this most important expectations driver. If this takes some of the steam out of the USD, or even causes it to retreat from its recent highs, oil – and commodities generally – will rally on the tailwind. Indeed, a depreciation in the USD of 5% from current levels could lift prices by ~18%, holding everything else constant (Chart 7). Chart 7USD's Path Will Be Important As Oil Supply and Demand Rebalance USD's Path Will Be Important As Oil Supply and Demand Rebalance USD's Path Will Be Important As Oil Supply and Demand Rebalance Bottom Line: Our intra- and inter-market indicators are throwing off conflicting signals regarding the current state of global oil markets. On the one hand, our WTI Composite indicator shows oil is oversold, which supports our bullish outlook. On the other hand, markets currently are signaling a larger decline in global growth than we currently have in our oil forecast models. A larger-than-expected slowdown in oil demand growth – e.g., an additional loss of 200k b/d that took growth to 1.2mm b/d – would push our Brent forecasts down by ~ $4/bbl to $76/bbl this year. Nevertheless, uncertainty about the future path of oil supply and demand is elevated, and the distribution of possible price outcomes is wide, as our most recent forecast illustrates (Chart 8). We believe the combination of OPEC 2.0 production discipline and robust demand support a rebound in oil prices in 2019. We are keeping our 2019 Brent price target at $80/bbl. Chart 8Elevated Volatility Keeps Range of Expected Prices Wide Elevated Volatility Keeps Range of Expected Prices Wide Elevated Volatility Keeps Range of Expected Prices Wide Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Pavel Bilyk, Research Analyst Commodity & Energy Strategy PavelB@bcaresearch.com Footnotes 1      Please see “China buys more U.S. soy as officials meet for trade talks,” published by reuters.com January 7, 2019.com. 2      Each of the individual components is standardized to create the WTI composite indicator. We lack CFTC open-interest data to update the open-interest series, due to the U.S. government’s shutdown. 3      This is in line with our expectation, which is contained in our most recent balances and forecast update published last week.  Please see “Oil Volatility will Persist; 2019 Brent Forecast Lowered to $80/bbl.”  It is available at ces.bcaresearch.com.  The World Bank’s latest forecast can be found in its Global Economic Prospects, which is titled “Darkening Skies.”  It can be found at http://www.worldbank.org/en/publication/global-economic-prospects. 4      Clive Granger used standard statistics to show information contained in past realizations of one variable can be used to predict another variable’s value. Two-way causality indicates lagged values of both variables contain statistically significant information that allows past realizations of both to be used to predict the other’s value.  There is a huge literature on this topic.  For an excellent intuitive explanation of Granger causality, please see the discussion beginning on p. 365 of “Time Series Analysis, Cointegration, and Applications,” Clive Granger’s Nobel lecture delivered December 8, 2003 (https://www.nobelprize.org/uploads/2018/06/granger-lecture.pdf). 5      Please see “All Fall Down: Vertigo In The Oil Market ... Lowering 2019 Brent Forecast To $82/bbl,” published by BCA Research’s Commodity & Energy Strategy November 15, 2018.  It is available at ces.bcaresearch.com. 6      We would not be at all surprised if OPEC 2.0 overdelivered on production cuts, as it did in 2017 – 1H18. 7      Relative total return (carry included) of four equally weighted EM (ZAR, RUB, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc. 8      These gold ratios are discussed in detail in “Gold Ratios Wave Off ‘Red October’ … Iran Export Waivers Highlight Tight Market,” published by BCA Research’s Commodity & Energy Strategy November 8, 2018.  It is available at ces.bcaresearch.com. 9      For in-depth discussions of these models and our general approach to modeling EM trade volumes, please see “Trade, Dollars, Oil & Metals … Assessing Downside Risk,” published by BCA Research’s Commodity & Energy Strategy August 23, 2018.  It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Trade Recommendation Performance In 4Q18 Image Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2018 Image ​​​​​​​

Highlights EM equity and credit outperformance versus the U.S. in the past three months was an aberration in the cyclical and structural downtrend. Hence, the recent outperformance of EM assets provides a good entry point for investors to short EM/China assets against their U.S. counterparts. In our opinion, this strategy will work in the coming months regardless of whether global risk assets rebound or sell off – i.e., they are not dependent on market direction. Feature The fourth quarter of 2018 was marked by a precipitous plunge in global equities, led by the U.S. In the meantime, EM stocks have outperformed the global equity benchmark in the past three months. Will EM and U.S. stocks trade places again, or will EM continue to outperform U.S. and DM equities? By the end of December, global share prices had become extremely oversold, and investor sentiment was downbeat. A trifecta of confidence-boosting developments – the rapprochement between the U.S. and China in trade negotiations, the announcement of more policy stimulus in China and reassurances from Federal Reserve Chairman Jerome Powell that monetary policy tightening is not predetermined – have since led to a rebound in global stocks. A key question for asset allocators heading into 2019 is: Will EM continue to outperform the global equity index in this rebound? We do not think so. The odds are considerable that EM will resume its underperformance versus DM in general and the U.S. in particular. The fundamental rationale for staying bearish on EM is that global trade and manufacturing remain on a downward trajectory. Chart I-1 illustrates that EM risk assets sell off when global trade is slowing, especially when the weakness stems from China. Chart I-1EM Selloff Has Been Due To Slowdown In China EM Selloff Has Been Due To Slowdown In China EM Selloff Has Been Due To Slowdown In China Chinese policymakers are easing both fiscal and monetary policies, but the impact of their efforts on the economy is yet to be seen. Declining interest rates in China do not constitute a sufficient condition to buy EM risk assets. Importantly, EM stocks often drop when Chinese interest rates are falling, as that reflects a deteriorating growth outlook (Chart I-2). Chart I-2Lower Interest Rates In China Is Not A Reason To Buy EM Lower Interest Rates In China Is Not A Reason To Buy EM Lower Interest Rates In China Is Not A Reason To Buy EM In short, monetary and fiscal stimulus in China are not yet sufficient to revive the mainland’s business cycle. The latter is critical to the performance of EM risk assets. We will explore China’s fiscal and credit stimulus efforts in much more detail in the coming weeks. Finally, EM equity valuations are no better than those in the U.S. In particular, our EM/U.S. relative stock valuation indicator based on a 20% trimmed mean is currently neutral (Chart I-3). This valuation measure strips out the top and bottom 10% for EM as well as U.S. sub-sectors and computes an equally weighted average of the other 80%. Hence, it eliminates the outliers that for structural or industry specific reasons trade at much lower or higher multiples. Consequently, contrary to the common narrative in the investment industry, EM equities are not cheap versus U.S. ones. Chart I-3EM Equities Are Not Cheaper Than U.S. Ones bca.ems_wr_2019_01_10_s1_c3 bca.ems_wr_2019_01_10_s1_c3 Given our high conviction on the view that U.S. will outperform EM over the coming several months, we are reiterating a few of our long-standing strategic recommendations/pair trades: Short EM stocks / long the S&P 500; Short EM banks / long U.S. banks; Short EM high-yield corporate credit / long U.S. high-yield corporate credit; Short Chinese property developers / long U.S. homebuilders. In all four cases, the recent outperformance of EM assets provides a good entry point for investors who do not yet have these positions. In our opinion, these recommendations will work in the coming months regardless of whether global risk assets rebound or sell off – i.e., they are not dependent on market direction. No Turnaround In Global Trade/Manufacturing Global cyclical equity sectors have plunged significantly and their prices may be recovering/stabilizing due to oversold conditions. Yet there are few signs of improvement in global trade and manufacturing, and no indication of a significant turnaround in financial markets that are most sensitive to global trade and Chinese growth. Our Risk-On-to-Safe-Haven (RSH) currency ratio1 has relapsed again following a failed rebound attempt (Chart I-4, top panel). Interestingly, this ratio seems to be forming a head-and-shoulders pattern, suggesting the next big move could be to the downside. As we have shown in past reports, EM share prices correlate strongly with this indicator, and a major downleg in this indicator would be consistent with a major drop in EM stocks. Chart I-4No Buy Signal For EM From The Global Currency Markets bca.ems_wr_2019_01_10_s1_c4 bca.ems_wr_2019_01_10_s1_c4 Furthermore, the annual rate of change on this currency ratio leads the EM manufacturing PMI, and it presently foreshadows more downside in the latter (Chart I-4, bottom panel). Korean and Taiwanese exports contracted slightly in December from a year ago. As frontloading from U.S. import tariffs wanes, their exports will shrink further. Chips prices are falling, signaling that the slump of the global tech hardware sector is not yet over (Chart I-5). Chart I-5Chip Prices Are Still Plunging Chip Prices Are Still Plunging Chip Prices Are Still Plunging Continued deterioration in global trade and manufacturing is bad news for emerging Asia. The technical profile of Asian stock markets is also poor, raising the odds of a meltdown as cyclical economic conditions in the region deteriorate further. The region’s relative equity performance versus global and Latin American indexes is relapsing, having failed to break above long-term moving averages (Chart I-6). Chart I-6Underweight Emerging Asian Stocks Versus Both World And Latin America Underweight Emerging Asian Stocks Versus Both World And Latin America Underweight Emerging Asian Stocks Versus Both World And Latin America Odds are that emerging Asian stocks will drop in absolute terms, underperforming both the EM and global equity benchmarks. This will drag the EM index down further. We continue to recommend the following strategy: long Latin American stocks / short emerging Asian equities. The U.S. manufacturing leading indicator – the ISM manufacturing new orders-to-inventory ratio – remains in a downtrend (Chart I-7). Chart I-7The U.S. Selloff Has Been Partially Due To Manufacturing Slowdown The U.S. Selloff Has Been Partially Due To Manufacturing Slowdown The U.S. Selloff Has Been Partially Due To Manufacturing Slowdown The average of new and backlog orders from the Chinese manufacturing PMI survey has plunged to its previous lows (Chart I-8, top panel). The domestic orders component of the People’s Bank of China’s latest 5000 industrial enterprise survey is also in a free fall (Chart I-8, bottom panel). Chart I-8China: No Sign Of Bottom In Industrial Sectors China: No Sign Of Bottom In Industrial Sectors China: No Sign Of Bottom In Industrial Sectors Meanwhile, the impact of Chinese domestic demand on the rest of the world occurs via mainland imports. The leading indicator for imports – the manufacturing PMI import sub-component – has plunged to 46, well below the 50 boom-bust line (see Chart I-1, bottom panel on page 1). Within the investable Chinese equity universe, cyclical sectors exposed to capital spending are making new lows in absolute terms (Chart I-9, top and middle panels). At the same time property stocks are relapsing again (Chart I-9, bottom panel). Chart I-9China: Not Much Rebound In Cyclical Equity Sectors China: Not Much Rebound In Cyclical Equity Sectors China: Not Much Rebound In Cyclical Equity Sectors While the authorities are once again boosting infrastructure spending by allowing local governments to issue more special bonds, the mainland’s real estate market has ground to a halt. The latter will likely offset the former. Finally, the MSCI China All Shares index – which incorporates all Chinese stocks trading inside and outside the country – has not rebounded much, despite being oversold (Chart I-10, top panel). Chart I-10China All Share Index: Poor Performance Continues China All Share Index: Poor Performance Continues China All Share Index: Poor Performance Continues Notably, this index’s relative performance versus both DM and EM equity indexes has failed to break above its 200-day moving average, despite the announced policy stimulus (Chart I-10, middle and bottom panels). These are negative technical signposts that bode ill for the outlook for Chinese share prices. Bottom Line: Odds are high that the global trade/manufacturing or related equity sectors/segments will continue struggling in the months ahead. What About The U.S. Dollar? The trade-weighted U.S. dollar has been going sideways for several months. While lower U.S. interest rate expectations have weighed on the greenback, the global manufacturing slowdown and risk-off sentiment in financial markets have put a floor under its value. The dollar is a countercyclical currency, and it does well when global growth is weakening, and vice versa (Chart I-11). Chart I-11The U.S. Dollar Is A Counter-Cyclical Currency The U.S. Dollar Is A Counter-Cyclical Currency The U.S. Dollar Is A Counter-Cyclical Currency It is impossible to know how long this standstill phase in the currency markets will last. What we do know is that when it breaks one way or another, the move will be violent and large. We believe risks to the U.S. currency are to the upside. First, U.S. consumer spending growth remains robust, and the labor market is very tight. Unless the rest of the world plunges into a major growth slump, pulling the U.S. down with it, U.S. interest rate expectations should recover, lifting the dollar. Second, a further downshift in U.S. interest rate expectations will likely occur only if the global economic slowdown is so severe that it leads the market to price in Fed rate cuts. In this scenario, the greenback will rally violently as well. The basis is that the dollar tends to appreciate during global slumps and sell off amid global growth recoveries, as illustrated in Chart I-11. Third, the only scenario where the dollar could plunge is where global trade recovers briskly, driven by growth outside the U.S. in general and in China/EM in particular. This is the least-likely scenario at the current juncture, in our opinion. The trend in the dollar is critical to the relative performance between EM and U.S. stocks. Chart I-12 demonstrates that periods of EM equity underperformance versus the U.S. typically coincide with an appreciation in the trade-weighted greenback, and vice versa. Chart I-12When EM Stocks Outperform The Global Benchmark, U.S. Underperforms And Dollar Weakens And Vice Versa When EM Stocks Outperform The Global Benchmark, U.S. Underperforms And Dollar Weakens And Vice Versa When EM Stocks Outperform The Global Benchmark, U.S. Underperforms And Dollar Weakens And Vice Versa Bottom Line: The next big move in the U.S. dollar will likely be up, not down. Investment Considerations Global equity prices are already reflecting a lot of bad news; they are oversold, and investor sentiment on global growth has become downbeat (Chart I-13). This could create a window for global equities to rebound on a tactical basis. Chart I-13U.S./Global Stocks Are Oversold U.S./Global Stocks Are Oversold U.S./Global Stocks Are Oversold The majority of our colleagues at BCA believe global equities are primed for a cyclical rally. We within BCA’s EM team agree with the equity rebound narrative but on a tactical basis and believe that any rebound will be led by U.S. stocks – and that EM will lag. We are not convinced that global equities are in a cyclical bull market yet. The main difference between BCA’s house view and the EM team’s outlook is the risks related to China’s economy and their impact on global cyclical equity sectors. The U.S. is relatively unexposed to Chinese growth, EM economies, commodities producers, Japan and Germany. Therefore, U.S. stocks will outperform and the dollar will do well if Chinese growth continues disappointing. Ongoing trade talks between China and the U.S. may bring about some positive results, and the Fed may continue to sound more dovish. However, we contend that the main culprit behind the global equity selloff in 2018 was neither the trade war nor the Fed, but the slowdown in global trade/manufacturing (please refer to Chart 1 and 7 on pages 1 and 6, respectively). On this front, we do not foresee an imminent reversal, as argued above. The latest underperformance of the U.S. has created a good entry point for our relative strategies/trades to be short EM / long U.S. We reiterate the following strategies/trades (Chart I-14): Chart I-14Reiterating Four EM Vs. U.S. Strategies/Trades Re-iterating Four Strategies/Trades for EM Vs. U.S. Re-iterating Four Strategies/Trades for EM Vs. U.S. Short EM stocks / long the S&P 500; Short EM banks / long U.S. banks; Short EM HY corporate credit / long U.S. HY corporate credit; Short Chinese property developers / long U.S. homebuilders. Within the EM equity space, we continue to recommend underweighting emerging Asia while overweighting Latin America, Russia and Central Europe. In particular, we are reiterating our long Latin America / short Emerging Asian equities trade initiated on October 11, 2018 (please refer to Chart I-6 on page 5). The complete list of our country equity allocations is presented on page 12. Finally, the path of least resistance for the dollar is up. We continue to recommend shorting a basket of the following EM currencies against the dollar: ZAR, IDR, MYR, KRW, COP and CLP. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Footnotes 1      Average of CAD, AUD, NZD, BRL, CLP & ZAR total return indices relative to average of JPY & CHF total returns (including carry). Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights All of our recent investment recommendations have performed very strongly but have further to go: 1.   Own a combination of European banks plus U.S. T-bonds. 2.   Overweight EM versus DM. 3.   Overweight European versus U.S. equities. 4.   Overweight Italian assets versus European assets. 5.   Overweight the JPY. Feature Chart of the WeekBank Outperformance Corroborates A Growth Rebound Bank Outperformance Corroborates A Growth Rebound Bank Outperformance Corroborates A Growth Rebound 2019 will be the investment mirror-image of 2018. Last year started with growth fading and inflation on the cusp of picking up, both in Europe and around the world. This year has started with the European and global economies in the mirror-image configuration: growth likely to rebound, albeit modestly, and inflation set to fade (Chart I-2). Chart I-2Why 2019 Is The Mirror-Image Of 2018 Why 2019 Is The Mirror-Image Of 2018 Why 2019 Is The Mirror-Image Of 2018 However, as 2019 unfolds, the configuration will reverse, requiring a flip from a pro-cyclical to a pro-defensive investment tilt later in the year. This contrasts with 2018 which started pro-defensive and ended pro-cyclical. In this regard, the economic and investment shape of 2019 will be the mirror-image of 2018. Growth To Rebound, Inflation To Fade A tell-tale sign of a growth rebound is the recent outperformance of banks. Around the world, yield curves have flattened – or even inverted – meaning that banks’ net interest margins have compressed. This compression of bank profit margins is normally bad news for bank equities. Yet banks have been outperforming, not just in Europe but globally (Chart I-3). If margins are compressing, the plausible explanation for outperformance would be an improved outlook for asset growth, reflecting both a reduction in bad debt provisioning and a pick-up in bank credit growth. Chart I-3Banks Have Been Outperforming Since October Banks Have Been Outperforming Since October Banks Have Been Outperforming Since October Independently and reassuringly, our proprietary credit impulse analysis supports this thesis (Chart of the Week). Six-month credit impulses have been rebounding not only in Europe, but also in the United States and very impressively in China (Chart I-4).   Chart I-46-Month Credit Impulses Have Rebounded Everywhere 6-Month Credit Impulses Have Rebounded Everywhere 6-Month Credit Impulses Have Rebounded Everywhere At the same time, inflation is set to disappoint as the recent near-halving of the crude oil price feeds into both headline and core consumer price indexes. With central banks now promising even greater “dependence on the incoming data”, this unfolding dynamic will force them to temper any hawkish intentions and rhetoric, limiting the extent of upside in bond yields. In this configuration, the combination of European banks plus U.S. T-bonds which we first recommended in November is still appropriate (Chart I-5). The position is up 3 percent in little more than a month and has further to go.1 Chart I-5Own A Combination Of Banks And Bonds Own A Combination Of Banks And Bonds Own A Combination Of Banks And Bonds Europe’s largest economy, Germany, should benefit from another support to growth. Last year, the auto sector – a major engine of the German economy – spluttered as it absorbed the new WLTP emissions testing standard. Through the middle of 2018 German motor vehicle exports suffered a €20 billion hit which shaved 0.6 percent from Germany’s €3.4 trillion economy (Chart I-6). Now, if auto exports stabilize, this drag will disappear. And if auto exports recover to the pre-WLTP level after this one-off and temporary shock, Germany will receive a 0.6% mirror-image boost to growth.2 Chart I-6German Auto Exports Suffered A WLTP Hit German Auto Exports Suffered A WLTP Hit German Auto Exports Suffered A WLTP Hit Regional Allocation Is Always And Everywhere About Sectors The European equity earnings cycle is tightly connected with global growth oscillations (Chart I-7). The simple reason is that the European equity market is over-exposed to classically growth-sensitive sectors such as banks and industrials. Chart I-7The European EPS Cycle Is Tightly Connected With Global Growth Oscillations The European EPS Cycle Is Tightly Connected With Global Growth Oscillations The European EPS Cycle Is Tightly Connected With Global Growth Oscillations The emerging market earnings cycle is also connected with global growth oscillations (Chart I-8) because emerging markets have a very high exposure to banks. But the much less understood reason is that emerging markets have a near-zero exposure to healthcare (Table I-1). In sharp contrast, the U.S. equity earnings cycle has almost no connection with global growth oscillations (Chart I-9) because the U.S. equity market is over-exposed to technology and healthcare, neither of which are classically cyclical sectors. Chart I-8The EM EPS Cycle Is Also Connected With Global Growth Oscillations... The EM EPS Cycle Is Also Connected With Global Growth Oscillations... The EM EPS Cycle Is Also Connected With Global Growth Oscillations... Chart I-9...But The U.S. EPS Cycle Is Not Connected With Global Growth Oscillations ...But The U.S. EPS Cycle Is Not Connected With Global Growth Oscillations ...But The U.S. EPS Cycle Is Not Connected With Global Growth Oscillations Chart I- Hence the allocation to emerging market (EM) versus developed market (DM) equities, and to Europe versus the U.S. reduce to simple equity sector calls. A quick glance at Chart I-10 and Chart I-11 will reveal two fundamental and inescapable truths: Chart I-10EM Outperforms DM When Global Banks Outperform Healthcare EM Outperforms DM When Global Banks Outperform Healthcare EM Outperforms DM When Global Banks Outperform Healthcare Chart I-11European Equities Outperform U.S. Equities When Global Banks Outperform Technology 11. European Equities Outperform U.S. Equities When Global Banks Outperform Technology 11. European Equities Outperform U.S. Equities When Global Banks Outperform Technology EM outperforms DM when global banks outperform global healthcare. European equities outperform U.S. equities when global banks outperform global technology. But is this just about so-called ‘beta’? No, banks can outperform in a rising market by going up more or, as recently, in a falling market by going down less. So this is always and everywhere about head-to-head sector relative performances. My colleague Arthur Budaghyan, our chief emerging market strategist, remains steadfastly pessimistic on the structural outlook for EM versus DM. We agree with Arthur, albeit we arrive at the structural conclusion from a completely different perspective. To reiterate, for EM to outperform DM global banks must outperform global healthcare. However, over an extended period this will prove to be an extremely tall order. As detailed in European Banks: The Case For And Against, blockchain is a long-term extinction threat to banks’ business models and profitability. Whereas healthcare is still a major growth sector as people focus more spending on improving the quality and quantity of their lifespans.3  Nevertheless, from a purely tactical perspective, the growth up-oscillation phase that started in October can continue for a little while longer allowing the recent countertrend moves to persist – especially as the recent decline in bond yields could further spur credit growth in the near term. So for the moment stay overweight: EM versus DM. European equities versus U.S. equities. Italian assets versus European assets. Bargain Basement Currencies Another of my colleagues Doug Peta, our chief U.S. strategist, has coined a lovely metaphor: “you cannot get hurt falling out of a basement window”. The metaphor beautifully captures the asymmetry when you are near the floor or ‘zero-bound’. Doug uses it to explain that small contributors to an economy have a limited capacity to damage economic growth because they cannot fall very far. We think the metaphor applies equally to interest rates when they are at or near their lower bound, which is to say, in the basement. This begs the obvious question: if interest rates are in the basement, then what is it that cannot get hurt much? The answer is: the exchange rate. The payoff profile for exchange rates just tracks expected long-term interest rate differentials. This means that when the expected interest rate is in or near the basement, the currency possesses a highly attractive payoff profile called positive skew. In essence, for any central bank already at the realistic limit of ultra-loose policy – such as the BoJ and ECB – policy rate expectations are effectively in the basement. They cannot go significantly lower. In contrast, policy rate expectations for the Federal Reserve are somewhere between the seventh and twelfth storey of the building (Chart I-12). From which you can get seriously hurt if you fall out of the window! Chart I-12You Cannot Get Hurt Falling Out Of A Basement Window You Cannot Get Hurt Falling Out Of A Basement Window You Cannot Get Hurt Falling Out Of A Basement Window The upshot is that currency investors should always own at least one currency whose interest rate is in the basement against one whose interest rate is high up in the building, susceptible to fall out at some point, and get seriously hurt. The near term complication is the risk, albeit low, of a no-deal Brexit which would hurt European economies and currencies to a greater or lesser extent. Until the Brexit fog shows some signs of clearing, we would prefer the currency whose interest rate is in the basement to be a non-European currency. So for the moment, our favourite major currency remains the JPY. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System* We are pleased to report that the 50:50 combination of Litecoin and Ethereum has surged by 42 percent in just two weeks! Also, long EUR/NZD achieved its 2.5 percent profit target and is now closed. This week’s trade is in line with the recommendation in the main body of this report to become pro-cyclical. Go long global industrials versus global utilities with a profit target of 3 percent and a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-13 Long Global Industrials Vs. Global Utilities Long Global Industrials Vs. Global Utilities The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions.   *  For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Footnotes 1 The European banks position is relative to the broader equity market, and the recommended combination is 25 cents in the banks and 75 cents in the bonds. 2 German auto net exports and GDP are quoted at annualized rates. The Worldwide Harmonized Light Vehicle test Procedure (WLTP) is a new standard for auto emissions that took effect on September 1, 2018. 3 Please see the European Investment Strategy Special Report “European Banks: The Case For And Against”, November 8, 2018 available at eis.bcaresearch.com. 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