Market Returns

Highlights Our antennae are twitching wildly, as the Kingdom of Saudi Arabia (KSA) walks back a widely telegraphed commitment to surge production. This occurs against the backdrop of a possible loss of as much as 2mm b/d in exports from Iran and Venezuela next year, with demand expected to remain fairly strong. U.S. President Donald Trump remains silent. We believe the proximate cause of KSA's reversal boils down to one or all of the following: President Trump told KSA to expect an SPR release ahead of November mid-terms; KSA found it difficult to maintain higher production; or Short-term demand for KSA's output is falling, so they reduced production. We have questioned the ability of KSA to sustain production above 10.5mm b/d for an extended period in the past. However, we believe July's 200k b/d cut was produced by a combination of No. 1 and No. 3. We expect KSA to build storage ahead of Iran sanctions. On the back of our updated balances modeling we are maintaining our 2H18 Brent ensemble forecast of $70/bbl, and raising our 2019 forecast to $80/bbl from $75/bbl (Chart of the Week): The front-loaded production increase we expected from OPEC 2.0 could be less than expected. Highlights Energy: Overweight. The U.S. EIA reported U.S. crude and product inventories rose 17.4mm barrels for the week ended August 10, 2018. Markets traded sharply lower as a result, falling more than 3% in WTI and 2% in Brent. As we went to press, October Brent was trading just above $70/bbl. We are maintaining our $70/bbl Brent forecast for 2H18. Base Metals: Neutral. Union leaders at BHP's Escondida mine in Chile, the largest in the world, will take proposed contract terms to members this week.1 We were stopped out of our tactical Dec18 copper call spread with a 10.2% loss. Precious Metals: Neutral. Gold remains under pressure as the broad trade-weighted USD rises. We remain long as a portfolio hedge. Ags/Softs: Underweight. USDA export data show year-to-date wheat and soybean exports are down 20% and 10% y/y in the Oct17 - Jun18 period. Feature Forward guidance from OPEC 2.0's leadership and its predecessor, the regular old OPEC, has not been helpful of late.2 This complicates our balances assessment this month (Chart of the Week), and raises the odds volatility will increase sooner than we expected. Chart of the Week2H18 Brent Forecast Stays At $70/bbl, 2019 Moved Up To $80/bbl 2H18 Brent Forecast Stays At $70/bbl, 2019 Moved Up To $80/bbl 2H18 Brent Forecast Stays At $70/bbl, 2019 Moved Up To $80/bbl KSA's reversal in July of its earlier, widely telegraphed decision to sharply raise production in response to aggressive tweeting from U.S. President Donald Trump beginning in May - to as much as 11mm b/d from just over 10mm b/d in the first five months of this year - was followed by an abrupt output cut of ~ 200k b/d last month. Last month, we expected KSA's crude production to average 10.60mm b/d in 2H18, and 10.50mm b/d next year. In our current balances estimate (Table 1), we now expect the Kingdom's output to average 10.28mm b/d in 2H18 and 10.35mm b/d in 2019, down 300k b/d and 150k b/d, respectively. Table 1BCA Global Oil Supply - Demand Balances (MMb/d) (Base Case Balances) OPEC 2.0 Sailing Close To The Wind OPEC 2.0 Sailing Close To The Wind Russia, OPEC 2.0's other putative leader, also is complicating assessments of liquids production by the producer coalition. Given the signaling it and KSA were providing over the past couple of months, we expected Russia to raise production 80k b/d in 2H18 to 11.27mm b/d, and by 160k b/d in 2019 to 11.35mm b/d. We still expect Russia to raise its production and revised our baseline estimates to 11.32mm b/d and to 11.43mm b/d for this year and next, respectively. However, it is difficult to reconcile our expectation with the 11.13mm b/d 2H18 liquids production expected by OPEC for Russia in its August Monthly Oil Market Report (MOMR), as we are highly confident Russia signed off on that estimate before it was published. Chart 2Physical Deficit Worsens Physical Deficit Worsens Physical Deficit Worsens Our global liquids supply estimate for 2H18 now stands at 101.08mm b/d, down 680k b/d from last month's estimate. For 2019, we lowered our supply estimate by 800k b/d to 101.01mm b/d. But this could end up overstating supply, given what we're seeing from OPEC 2.0 presently. On the demand side, we've lowered our 2018 and 2019 expectations slightly - to 1.67mm b/d and 1.62mm b/d, respectively, or ~ 50k b/d on average versus our previous estimates. This is still relatively stout demand growth - supported by still-strong global trade, particularly in the EM economies - which means storage will be forced to draw harder next year than we expected even a month ago (Chart 2). Physical Deficit Worsens In 2019 We expected OPEC 2.0's supply increase would persist at a higher level during 2H18, which would allow refiners to build precautionary inventories going into next year. This no longer is a tenable assumption, given what is being reported for OPEC 2.0's largest producers - KSA and Russia. In addition, we have amended our base case supply model, to reflect the loss of 1mm b/d of Iranian exports to U.S. sanctions for most of next year; we have this occurring in 250k b/d increments in the Nov18 - Feb 19 period, leaving production from March 2019 on at 2.8mm b/d. This replaces our earlier assumption of a 500k b/d by the end of 1H19. We took this action on the back of the increasingly strident rhetoric from the U.S. administration, and press reports indicating widespread compliance with the sanctions is expected - particularly reports suggesting China and India will not be looking to increase purchases of Iranian crude. Offsetting the higher Iranian export losses we foresee, our base case includes a re-start of Neutral Zone production in 2Q19.3 We expect KSA and Kuwait to each bring 175k b/d back on line, for a total of 350k b/d. It is not clear this is counted in both countries' spare capacity, but if it is, then spare capacity will become tighter within OPEC 2.0 next year. In our scenario analysis, we continue to give a relatively high weight to the loss of Venezuela's exports - anywhere from 800k to 1mm b/d - as that country's oil industry continues to degrade. Our ensemble analysis indicates OECD storage will draw more than previously estimated (Chart 3), on the back of these higher assumed Iranian export losses, and a reduction in OPEC 2.0's front-loaded production increases, particularly in 2019. As storage draws, days-forward-cover (DFC) also will contract (Chart 4). In addition to steepening the backwardation in crude forward curves, we expect implied option volatility to increase in 2019 (Chart 5). Chart 3Storage Will Draw##BR##Harder Next Year Storage Will Draw Harder Next Year Storage Will Draw Harder Next Year Chart 4Days-Forward-Cover##BR##Will Fall In 2019 Days-Forward-Cover Will Fall In 2019 Days-Forward-Cover Will Fall In 2019 Chart 5Implied Volatilities Will Rise,##BR##As OECD Storage Falls OPEC 2.0 Sailing Close To The Wind OPEC 2.0 Sailing Close To The Wind Ensemble Forecast Update In addition to moving the 1mm b/d loss of Iranian exports from a scenario and into our base case - offset somewhat by higher Neutral Zone production - we expect transportation bottlenecks in the Permian Basin to slow production growth in the U.S. shales even more. We have lowered our expected U.S. production growth to 1.21mm b/d this year and 1.22mm b/d in 2019, versus earlier estimates of 1.30mm b/d and 1.34mm b/d, as a result (Chart 6 shows the trajectory we expect from this scenario).4 Coupled with the lower-than-expected production increase from OPEC 2.0 and still-strong demand growth globally, this will lead to tighter markets in 2019. Chart 6Higher Volatility = Wider Expected Price Range Higher Volatility = Wider Expected Price Range Higher Volatility = Wider Expected Price Range We also are including a scenario showing a slowdown in demand growth, which takes y/y growth to 1.43mm b/d in 2018 and 2019, versus our current estimates of average growth of 1.64mm b/d over the two-year interval. Bottom Line: Numerous conflicting data have entered the oil pricing picture over the past month, which greatly complicates our analysis and forecasting. The fact that OPEC 2.0's leadership - KSA and Russia - is providing little in the way of forward guidance does not make this any easier. We admit to being puzzled by KSA's apparent decision to walk back its production increase going into 2019, when the likelihood of losing close to 2mm b/d of exports from Iran and Venezuela becomes markedly higher. Based on our current modeling we expect higher prices next year ($80/bbl vs. our earlier estimate of $75/bbl for Brent), and a steepening of the Brent and WTI backwardations next year. We continue to expect WTI to trade $6/bbl below Brent in 2H18 and 2019. The steepening backwardation will lift implied volatility, particularly next year. We remain long call option spreads along the Brent forward curve in 2019, in expectation prices and volatility will move higher. We continue to believe the balance of price risk is to the upside. However, as the lower-demand scenario in our ensemble forecast shows, an unexpected slowdown in growth can have profound effects on prices. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see "Chile's Escondida union to take new labor proposal to members," published by reuters.com August 15, 2018. 2 OPEC 2.0 is the name we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. At the end of June, the coalition's member states agreed to increase production to bring it into line with the originally agreed deal to remove 1.8mm b/d of output from the market. 3 Please see "Kuwait, Saudi to resume output from Neutral Zone in 2019 - Toyo Engineering," published by reuters.com July 2, 2018. 4 We place our scenarios within the context of a market-generated confidence interval, which we calculate using implied volatilities derived from Brent and WTI options markets. Please see Ryan, Bob and Tancred Lidderdale (2009), "Energy Price Volatility and Forecast Uncertainty," particularly Appendix 1 beginning on p. 18, for a derivation of the confidence intervals. The article was published by the U.S. EIA. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table OPEC 2.0 Sailing Close To The Wind OPEC 2.0 Sailing Close To The Wind Trades Closed in 2018 Summary of Trades Closed in 2017 OPEC 2.0 Sailing Close To The Wind OPEC 2.0 Sailing Close To The Wind

Highlights Seasonal capacity restrictions in China during the winter heating months - when pollution from steel mills is particularly high - and continued efforts to limit particulate emissions in major cities will drive steel prices higher. The steel rebar market in China is backwardated, indicating physical markets are tight; inventories have been falling since mid-March. We expect prices to remain elevated going into the winter months, when capacity restrictions kick in. Ongoing capacity reductions in steelmaking will favor higher-grade iron ores, which will widen price differentials versus lower-grade ores. We are recommending a long China rebar futures on the SHFE in 1Q19 vs short 62% Fe iron ore futures on the Dalian DCE in 1Q19 at tonight's close, based on our research. Energy: Overweight. Loadings of Iranian crude are expected to be curtailed beginning this month, as the November 4 deadline for the imposition of U.S. secondary sanctions kick in. Our base case calls for the loss of 500k b/d of exports from Iran; our ensemble forecast includes an estimate of 1mm b/d. Base Metals: Neutral. BHP asked the Chilean government to intervene in the strike called by unions at its Escondida mine. Union officials delayed strike action while talks are being held. Negotiators have until August 14 to reach an agreement. Reuters reported Chile's copper production was up 12.3% y/y in 1H18 to 2.83mm MT.1 Precious Metals: Neutral. U.S. sanctions on trading gold and precious metals with Iran went into effect earlier this week. Ags/Softs: Underweight. Chinese imports of U.S. soybeans could fall 10mm MT over the next year, if pig and chicken farmers switch to lower-protein feed and substitutes like sunflower seeds, and boost local production of the legume, state-run news service Xinhua reported.2 The USDA expects U.S. exports of 55.52mm MT of soybeans in the 2018 - 19 crop year, down 1.22mm MT from last year. Feature Steel prices have performed exceptionally since the beginning of 2Q18, seemingly oblivious to Sino - U.S. trade tensions, a stronger USD, and risks to China's economy roiling other metal markets (Chart of the Week). The MySteel Composite Index we use to track steel prices is up 7% since the beginning of April. With demand growth leveling off, steel's price dynamics highlight the continued relevance of the market's supply-side developments. Most notably, Beijing's battle for blue skies: Winter capacity curbs, and, to a lesser extent, ongoing efforts to retire older, highly polluting capacity will keep prices elevated over the next 9 months. Winter Curbs: China's New Normal As we highlighted in our April 12 weekly, despite the much-ballyhooed reductions in China's steel capacity over the 2017 - 18 winter months, markets in China and globally remained relatively well supplied over the winter.3 However, several key changes this year suggest the impact of these measures will intensify this time around, keeping producers constrained in their ability to ramp up production of the metal. For one, the data suggest strong production levels amid the anti-pollution curbs last winter were a result of an increase in output from regions unaffected by the capacity restrictions (Chart 2). This went a long way in muting the impact of the restrictions in the heavily industrialized Beijing-Tianjin-Hebei region of northern China. Chart of the WeekSteel Oblivious To Pessimism Steel Oblivious To Pessimism Steel Oblivious To Pessimism Chart 22017/18 Winter Cuts: A Net Non-Event Blue Skies Drive China's Steel Policy Blue Skies Drive China's Steel Policy This year's curbs will broaden the regions targeted by anti-pollution restrictions. The campaign will encompass 83 cities, up from last year's 28, thereby reducing the potential production ramp up from regions not covered by these measures (Chart 3). This coming winter's closures will cover regions where producers traditionally account for 68% of China's steel output (Chart 4). Chart 3Second Annual Winter Capacity ##br##Restrictions Will Broaden Coverage... Blue Skies Drive China's Steel Policy Blue Skies Drive China's Steel Policy Chart 4...And##br## Impact Blue Skies Drive China's Steel Policy Blue Skies Drive China's Steel Policy The anti-pollution campaign is one of the three battles prioritized in Xi Jinping's plan for the coming years. These curbs will be implemented during the October 1, 2018 to March 31, 2019 heating season, extending the duration from last year's mid-November to Mid-March period. Because the minimal effect observed per last year's closures was due to specifying too narrow a range of plants and regions, not to non-compliance, we expect the measures announced for this coming winter to be fully implemented. These measures come amid already-tight market conditions. The steel rebar market in China is in backwardation - meaning a physical shortage is pushing up prompt prices relative to those further out the curve. Inventories have been falling since mid-March, reflecting supply-demand dynamics in other steel product markets. Thus, we expect prices to remain elevated going into the winter months. Capacity Impacts Are Difficult To Gauge Opaqueness and discretionary authority in the new rules clouds the outlook on how anti-pollution reforms will impact the steel market. This makes it difficult to estimate their impact with precision. This time around, China's State Council announced that curbs will be implemented in a more scientific and targeted approach, ensuring maximum efficiency to attain the targets. This means the constraints this year will depend on emissions in each region, which will be set at the discretion of local authorities.4 For example, steel mills in six key cities including Tianjin, Shijiazhuang, Tangshan, Handan, Xingtai and Anyang will be asked to keep capacity below 50% this winter, while producers in the rest of the Beijing-Tianjin-Hebei region will keep production running at less than 70% of capacity. Furthermore, a draft plan by the city of Changzhou - which planned to implement the curbs beginning August 3 - suggests production curbs may vary by company, depending on operational situations and emission levels.5 These restrictions are applied to capacity, rather than production. Without up-to-date and accurate information on crude steel-making capacity across the different regions, it is extremely difficult to accurately quantify the impact. Specifics of the plans are up to the discretion of local authorities. Thus, these restrictions can be applied to different stages in the steel-making process (Diagram 1), impacting furnaces, pig iron or sintering plants. In some cases, the output curbs are not only restricted to the winter heating months. Several regions have been implementing curbs throughout the year on an as-needed basis. The cities of Tangshan and Changzhou are two such examples, implementing restrictions during the summer months as well. Furthermore, all industrial plants in the city of Xuzhou remain shut. High profit margins at steel mills may incentivize the shuttered illegal furnaces to restart. The industry ministry acknowledges this threat, and claims it will carry out checks on these producers to ensure they do not come back online. Diagram 1Steelmaking Production Process: Restrictions Can Be Applied To Different Stages Blue Skies Drive China's Steel Policy Blue Skies Drive China's Steel Policy Without full knowledge of these details, quantifying the impact of these restrictions is a challenge. Morgan Stanley estimates the impact of these curbs on steel output to be 78mm MT during the winter period by assuming capacity utilization is restricted to 50% in the key cities, while the rest of the areas cut capacity by 30%. The estimated production loss from these restrictions accounts for 9% of China's 2017 crude steel output.6 China's Ongoing Capacity-Reduction Reforms Most of the planned permanent capacity shutdowns have already taken place. Of the targeted 150mm MT of cuts between 2016 and 2020, 115mm MT have already taken place over the past two years. Furthermore, 1H17 witnessed the closure of all illegal induction furnaces producing sub-par quality steel, estimated to account for 140mm MT of crude steel capacity (Table 1).7 Table 1De-Capacity Reforms Still Ongoing Blue Skies Drive China's Steel Policy Blue Skies Drive China's Steel Policy We expect the magnitude of cutbacks to slow considerably. Even though the industry ministry issued a statement in February that it plans to meet steel capacity reduction targets this year - two years ahead of schedule. Furthermore, mills face restrictions on new steel capacity. China's State Council announced it intends to prevent new steel capacity additions in the Beijing-Tianjin-Hebei, Guangdong province, and Yangtze River Delta regions, and a cap set at 200mm MT in Hebei by 2020. The capacity replacement plan, which allows a maximum of 0.8 MT of new capacity for each MT of eliminated capacity, will ensure capacity does not grow going forward. In fact, not all mills are eligible to take advantage of the replacement policy. Among others, now-shuttered induction furnace capacity, as well as producers that previously benefited from cash and policy support will not meet the requirements for this program. Steel And Iron Ore Prices Will Not Reconverge As a result of China's reform policies in the steel industry, iron ore prices have diverged from steel. Reduced steel production lowers demand for raw materials, including iron ore. This is reflected in falling Chinese iron ore imports amid contracting production (Chart 5). Chart 5Weak Demand For Iron Ore Weak Demand For Iron Ore Weak Demand For Iron Ore Chart 6EAF Penetration In China: Still Some Catching Up To Do Blue Skies Drive China's Steel Policy Blue Skies Drive China's Steel Policy China's reform and anti-pollution campaigns have had serious consequences on iron ore markets. For starters, China is encouraging the adoption of electric arc furnaces (EAF), rather than additional new blast furnaces.8 While the latter primarily uses iron ore, the former uses scrap steel. EAF penetration in China's steel industry significantly lags the rest of the world (Chart 6). This means that even if the capacity-replacement program allows eliminated furnaces to be replaced with newer, more up-to-date capacity, this will not spur demand for iron ore. Instead, we expect to see higher scrap steel prices (Chart 7). Furthermore, as we first highlighted in our January report, China's anti-pollution campaign coupled with high steel profit margins has incentivized the use of higher grade iron ore and iron ore pellets, widening the price spread between high- and low- grade ores (Chart 8).9 Chart 7EAFs Support Scrap Steel Demand EAFs Support Scrap Steel Demand EAFs Support Scrap Steel Demand Chart 8IO Grade Premiums Will Remain Elevated IO Grade Premiums Will Remain Elevated IO Grade Premiums Will Remain Elevated While high-grade ores are more expensive, they emit less pollution in the steelmaking process. Similarly, unlike fines, pellets which are direct charge feedstock, are not required to undergo the highly polluting sintering stage and can be fed directly into the furnace. China's Steel Dynamics Overshadow Global Markets The ongoing supply-side reforms in China are overshadowing events in other markets. Globally, steel is expected to remain in physical deficit this year (Chart 9). This is largely on the back of an increase in world ex-China demand, and the decline in Chinese supply, despite expectations of weaker Chinese demand, and increased supply from the rest of the world (Table 2). Chart 9Physical Steel Deficit Will Persist... Blue Skies Drive China's Steel Policy Blue Skies Drive China's Steel Policy Table 2...Despite Weaker Chinese Demand And Stronger RoW Supply Blue Skies Drive China's Steel Policy Blue Skies Drive China's Steel Policy These figures do not consider the impact of the ongoing Sino - U.S. trade dispute, which could evolve into a full-blown trade war, weighing on EM incomes and demand. In such a scenario, global demand for steel would take a hit, potentially shifting global markets into surplus. In theory, trade barriers on U.S. steel imports could lead to weaker domestic supply for American users and at the same time, leave more of the metal for use by the rest of the world. The net effect of that would be a higher price for American steel relative to the rest of the world. However, since May, 20,000 requests for steel tariff exemptions have been filed in the U.S., of which the Commerce Department has denied 639. To the extent that American steel users are able to obtain tariff exemptions, the impact of the barriers on global steel markets will be muted. Bottom Line: We expect China's steel market to tighten as we go into the winter season, during which capacity cuts will be broadened to 82 cities, from last year's 28. This will keep steel prices elevated. At the same time, we expect prices of 62% Fe material and lower iron ore grades to weaken, as appetite for the steelmaking raw material contracts during these months. Mills still running in the mid-November to mid-March period will have a preference for higher-grade ores and pellets, keeping premiums on these grades elevated. Barring a significant demand-side shock, expect more upside to steel prices and downside to iron ore prices over the coming 9 months. Based on our research, we are recommending a long China rebar futures on the SHFE in 1Q19 vs. short 62% Fe iron ore futures on the Dalian DCE in 1Q19 at tonight's close. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see "BHP asks for government mediation in talks at Chile's Escondida," published August 6, 2018, by uk.reuters.com. 2 Please see "Economic Watch: China can cut soybean imports in 2018 by over 10 mln tonnes," published August 5, 2018, by xinhuanet.com. 3 Please see Commodity & Energy Strategy Weekly Report titled "Chinese Steel, Aluminum Markets Well Supplied Despite Winter Capacity Cuts," dated April 12, 2018, available at ces.bcaresearch.com. 4 Please see "Chinese steel output cuts to vary from mill to mill next winter," dated July 21, 2018, available at reuters.com. 5 The restrictions will not only apply to the city's steel mills, but also to copper smelters, chemical makers as well as cement producers. Please see "China's Changzhou plans to enforce output curbs in steel, chemical plants," dated July 30, 2018, available at reuters.com. 6 Please see "Shanghai steel resumes rise, coke rallies as China eyes winter curbs," dated August 2, 2018, available at reuters.com. 7 Low-quality steel produced by induction furnaces, also referred to as ditiaogang, is made by melting scrap steel using induction heat, preventing sufficient control over the quality of the steel. Platts estimates ditiaogang production in 2016 to be 30-50mm MT. As we explain in our September 7, 2017 Weekly Report titled "Slow-Down In China's Reflation Will Temper Steel, Iron Ore In 2018," given that ditiaogang is illegal, these closures are not reflected in official steel production figures. Thus the closures of these mills have no impact on actual steel production, but instead raise the capacity utilization rates for Chinese steel producers. 8 China launched a carbon trading system in January 2018, which penalizes blast furnace operators with higher environmental taxes relative to EAF processes. 9 Please see Commodity & Energy Strategy Weekly Report titled "China's Environmental Reforms Drive Steel & Iron Ore," dated January 11, 2018, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Blue Skies Drive China's Steel Policy Blue Skies Drive China's Steel Policy Trades Closed in 2018 Summary of Trades Closed in 2017 Blue Skies Drive China's Steel Policy Blue Skies Drive China's Steel Policy

Highlights Chart 1Yield Curve Suggests GDP Growth Has Peaked Yield Curve Suggests GDP Growth Has Peaked Yield Curve Suggests GDP Growth Has Peaked Last month we learned that the U.S. economy grew 4.1% in the second quarter, the fastest pace since 2014. The gap between year-over-year nominal GDP growth and the fed funds rate - a reliable recession indicator - also widened considerably (Chart 1). However, our sense is that this might be as good as it gets for the U.S. economy. With fewer unemployed workers than job openings and businesses reporting difficulties finding qualified labor, strong demand will increasingly translate into higher prices rather than more output. Higher interest rates and a stronger dollar will also start to weigh on demand as the Fed responds to rising inflation. For bond investors, it is still too soon to position for slower growth by increasing portfolio duration. Markets are priced for only 83 basis points of Fed tightening during the next 12 months, below the current "gradual" pace of +25 bps per quarter. Maintain below-benchmark portfolio duration and a neutral allocation to spread product. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 133 basis points in July, bringing year-to-date excess returns up to -50 bps. The index option-adjusted spread tightened 14 bps on the month, and currently sits at 109 bps. Corporate bonds remain expensive with 12-month breakeven spreads for both the A and Baa credit tiers near their 25th percentiles since 1989 (Chart 2). Further, with inflation now close to the Fed's target, monetary policy will provide much less support for corporate bond returns going forward. These are two main reasons why we downgraded our cyclical corporate bond exposure to neutral near the end of June.1 Recent revisions to the U.S. National Accounts reveal that gross nonfinancial corporate leverage declined in Q4 2017 and Q1 2018, though from an elevated starting point (panel 4). While strong Q2 2018 profit growth should lead to a further decline when the second quarter data are reported in September, the downtrend in leverage will probably not last through the second half of the year. A rising wage bill and stronger dollar will soon drag profit growth below the rate of debt growth. At that point, leverage will rise. Historically, rising gross leverage correlates with rising corporate defaults and widening corporate bond spreads. The Fed's Senior Loan Officer Survey for the second quarter was released yesterday, and it showed that banks continue to ease standards on commercial & industrial loans (bottom panel). Rising corporate defaults tend to coincide with tightening lending standards (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Peak Growth? Peak Growth? Table 3BCorporate Sector Risk Vs. Reward* Peak Growth? Peak Growth? High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 128 basis points in July, bringing year-to-date excess returns up to +205 bps. The average index option-adjusted spread tightened 27 bps on the month, and currently sits at 334 bps. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses is currently 213 bps, below its long-run mean of 247 bps (Chart 3). This tells us that if default losses during the next 12 months are in line with our expectations, we should expect excess high-yield returns of 213 bps over duration-matched Treasuries, assuming also that there are no capital gains/losses from spread tightening/widening. However, we showed in a recent report that the default loss expectations embedded in our calculation are extremely low relative to history (panel 4).2 Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.2% during the next 12 months. The only historical period to show significantly lower default losses was 2007, a time when corporate balance sheets were in much better shape than today. While most indicators suggest that default losses will in fact remain low for the next 12 months, historical context clearly demonstrates that the risks are to the upside. It will be critically important to track real-time indicators of the default rate such as job cut announcements, which declined last month but remain above 2017 lows (bottom panel), for signals about whether current default forecasts are overly optimistic. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 20 basis points in July, bringing year-to-date excess returns up to -4 bps. The conventional 30-year zero-volatility MBS spread tightened 3 bps on the month, driven by a 2 bps decline in the compensation for prepayment risk (option cost) and a 1 bp tightening of the option-adjusted spread (OAS). The excess return Bond Map shows that MBS offer a relatively poor risk/reward trade-off, particularly compared to Aaa-rated non-Agency CMBS, High-Yield and Sovereigns. However, our Bond Map analysis does not account for the macro environment, which remains very favorable for the sector. In a recent report we showed that the two main factors that influence MBS spreads are mortgage refinancing activity and residential mortgage bank lending standards.3 Refi activity is tepid (Chart 4) and will likely stay that way for the foreseeable future. Only 5.8% of the par value of the Conventional 30-year MBS index carries a coupon above the current mortgage rate, and even a drop in the mortgage rate to below 4% (from its current 4.6%) would only increase the refinanceable percentage to 38%. As for lending standards, yesterday's second quarter Senior Loan Officer Survey showed that they continue to ease (bottom panel), though banks also reported that they remain at the tighter end of the range since 2005. The still-tight level of lending standards suggests that further gradual easing is likely going forward. That will keep downward pressure on MBS spreads. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 37 basis points in July, bringing year-to-date excess returns up to +2 bps. Sovereign debt outperformed the Treasury benchmark by 179 bps on the month, bringing year-to-date excess returns up to -35 bps. Foreign Agencies outperformed by 24 bps on the month, bringing year-to-date excess returns up to -22 bps. Local Authorities outperformed by 33 bps on the month, bringing year-to-date excess returns up to +61 bps. Supranationals outperformed by 6 bps on the month, bringing year-to-date excess returns up to +13 bps. Domestic Agency bonds broke even with duration-matched Treasuries in July, keeping year-to-date excess returns steady at -1 bp. The strengthening U.S. dollar is a clear negative for hard currency Sovereign debt (Chart 5) and valuation relative to U.S. corporates remains negative (panel 2). Maintain an underweight allocation to Sovereigns. In contrast, the Foreign Agency and Local Authority sectors continue to offer a favorable risk/reward trade-off compared to other fixed income sectors (please see the Bond Maps on page 15). Maintain overweight allocations to both sectors. The Bond Maps also show that while the Supranational and Domestic Agency sectors are very low risk, expected returns are feeble. Both sectors should be avoided. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 66 basis points in July, bringing year-to-date excess returns up to +187 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio fell 3% in July to reach 83% (Chart 6). This is more than one standard deviation below its post-crisis mean and only slightly higher than the average of 81% that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. The total return Bond Map shows that municipal bonds still offer an attractive risk/reward profile for investors who are exposed to the top marginal tax rate. For investors who cannot benefit from the tax exemption there are better alternatives - notably Supranationals, Domestic Agency bonds and Agency CMBS. While value is dissipating, the near-term technical picture remains positive. Fund inflows are strong (panel 2) and visible supply is low (panel 3). Fundamentally, revisions to the GDP data reveal that state & local government net borrowing has been fairly flat in recent years, and in fact probably increased in the second quarter (bottom panel). At least so far, ratings downgrades have not risen alongside higher net borrowing, but this will be crucial to monitor during the next few quarters. Stay tuned. Treasury Curve: Buy The 5/30 Barbell Versus The 10-Year Bullet Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve's bear flattening trend continued in July. The 2/10 Treasury slope flattened 4 bps and the 5/30 slope flattened 2 bps, as yields moved higher. Despite the curve flattening, our position long the 7-year bullet and short the 1/20 barbell returned +8 bps on the month and is now up +30 bps since inception.4 The trade's outperformance is due to the extreme undervaluation of the 7-year bullet versus the 1/20 barbell. As of today, the bullet still plots 12 bps cheap on our model (Chart 7), which translates to an expected 42 bps of 1/20 flattening during the next six months. We view that much flattening as unlikely.5 Table 4 of this report shows that curve steepeners are also cheap at the front-end of the curve, particularly the 2-year bullet over the 1/5 and 1/7 barbells. Meanwhile, barbells are more fairly valued relative to bullets at the long-end of the curve. The 5/30 and 7/30 barbells look particularly attractive relative to the 10-year bullet. We recommend adding a position long the 5/30 barbell and short the 10-year bullet. The 5/30 barbell is close to fairly valued on our model (panel 4), which implies that the 5/10/30 butterfly spread is priced for relatively little change in the 5/30 slope during the next six months. This trade should perform well in the modest curve flattening environment we anticipate, and it provides a partial hedge to our 1/7/20 trade that is geared toward curve steepening. Table 4Butterfly Strategy Valuation (As Of August 3, 2018) Peak Growth? Peak Growth? TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 10 basis points in July, bringing year-to-date excess returns up to +139 bps. The 10-year TIPS breakeven inflation rate increased 1 bp on the month and currently sits at 2.12%. The 5-year/5-year forward TIPS breakeven inflation rate increased 8 bps on the month and currently sits at 2.24% (Chart 8). Both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates remain below the 2.3% to 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed's 2% target. We expect breakevens will return to that target range as investors become increasingly convinced that the risk of deflation has faded. Consistent inflation prints at or above the Fed's 2% target will be the deciding factor that eventually leads to this upward re-rating of inflation expectations. In that regard, core PCE inflation was relatively weak in June, growing only 0.11% month-over-month. That pace is somewhat below the monthly pace of 0.17% that is necessary to sustain 2% annualized inflation (panel 4). Nevertheless, 12-month core PCE inflation at 1.9% is only just below the Fed's target, and the 6-month rate of change is above 2% on an annualized basis. These readings are confirmed by the Dallas Fed's trimmed mean PCE inflation measure (bottom panel). Maintain an overweight allocation to TIPS relative to nominal Treasury securities for now. We will reduce exposure to TIPS once both the 10-year and 5-year/5-year forward breakeven rates reach our target range of 2.3% to 2.5%. ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in July, bringing year-to-date excess returns up to +9 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 5 bps on the month and now stands at 38 bps, only 11 bps above its pre-crisis low. The Bond Maps show that consumer ABS continue to offer relatively attractive return potential compared to other low-risk spread products. However, we maintain only a neutral allocation to this space because credit quality trends have started to move against the sector. Despite the large upward revision to the personal savings rate that accompanied the second quarter GDP report, the multi-year uptrend in the household interest coverage ratio remains intact (Chart 9). This will eventually translate into more frequent consumer credit delinquencies, and indeed, the consumer credit delinquency rate appears to have put in a bottom. The Fed's Senior Loan Officer Survey for Q2 was released yesterday and it showed that average consumer credit lending standards tightened for the ninth consecutive quarter (bottom panel). Credit card lending standards tightened for the fifth consecutive quarter, while auto loan standards eased after having tightened in each of the prior eight quarters. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 37 basis points in July, bringing year-to-date excess returns up to +98 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 5 bps on the month and currently sits at 71 bps (Chart 10). In a recent report we showed that the macro picture for CMBS is decidedly mixed.6 A typical negative environment for CMBS is characterized by tightening bank lending standards for commercial real estate loans and falling demand. Yesterday's Q2 Senior Loan Officer Survey reported that both lending standards and demand for nonresidential real estate loans were very close to unchanged (bottom two panels). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 24 basis points in July, bringing year-to-date excess returns up to +31 bps. The index option-adjusted spread tightened 5 bps on the month and currently sits at 47 bps. The Bond Maps show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this defensive sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of August 3, 2018) Peak Growth? Peak Growth? Chart 12Total Return Bond Map (As Of August 3, 2018) Peak Growth? Peak Growth? Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem", dated July 17, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem", dated July 17, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights U.S. Investment Strategy is getting back to basics: We follow last week's report outlining our stance on interest rates with a review of the credit cycle and its current position. The credit cycle is not just about borrowers: Lender willingness is inversely related to loan performance over a five-year horizon, but it amplifies near-term performance swings. Our bond strategists use three broad indicators to track the credit cycle...: Valuation, monetary conditions and credit quality all offer insight into corporate bond performance. ... and we also consider the fed funds rate cycle: The way that lenders interact with the monetary policy backdrop is discouraging for the course of human evolution, but it follows a well-defined pattern that helps demarcate the credit cycle. The cycle is in its latter stages, and investors should be in the process of dialing down credit exposures: Our bond strategists downgraded spread product to neutral in mid-June, and we won't return to overweight until the next recession is well underway. Feature U.S. Investment Strategy is meant to provide analyses and forecasts of financial markets and the economy for the purpose of helping our clients make asset-allocation decisions. This report continues our focus on going back to the basics of meeting that mandate. Next week's Special Report will present a simple indicator for anticipating the onset of a recession and the end of the equity bull market. After Labor Day, we will publish a Special Report updating, and expanding upon, our work on the fed funds rate cycle. By the unofficial end of the summer, then, we will have outlined our positions on rates, credit, the business cycle, and the state of monetary policy. That will provide us with a framework for evaluating incoming data and engaging in an ongoing investment-focused dialogue. It will also hopefully put us in position to identify the first set of major cyclical inflection points since 2007-8 in a timely fashion. 2019 is shaping up as a pivotal year for asset allocation, and we look forward to navigating it alongside our clients. Lenders Never Learn, Part I: Lending Standards Investors typically think of the credit cycle exclusively in terms of borrower performance. After all, cycle peaks and troughs are defined by default-rate troughs and peaks. There are two parties to every loan, though, and a narrow focus on debtors precludes a full understanding of the landscape. The credit cycle encompasses lender willingness as well as borrower performance. Bad loans are made in good times, just as surely as good loans are made in bad times. Skepticism and gloom carry the day in a recession and its immediate aftermath, and the loans that manage to get made early in the credit cycle are tightly underwritten, insulated with a margin of safety that would warm Benjamin Graham's heart. As the cycle stretches on, however, lenders forget about the trauma of the last downturn and focus more on market share than standards. The fact that standards impact performance with a lag much longer than the annual bonus cycle obscures their importance and helps them persist. Like the rest of us, loan officers and their managers learn best when they receive immediate feedback that clearly results from their decisions. Over the three-decade history of the Federal Reserve's senior loan officer survey the last three cycles, however, it appears that lending standards impact loan performance with as much as a five-year lag. The Chart Of The Week shows the net percentage of loan officers tightening standards for commercial and industrial (C&I) loans to large and mid-sized companies, inverted and advanced by 20 quarters. Easy standards line up with peak defaults, and tight standards align with default troughs. Chart of the WeekLending Standards Are Negatively Correlated With Intermediate-Term Loan Performance ... Lending Standards Are Negatively Correlated With Performance In The Intermediate-Term ... Lending Standards Are Negatively Correlated With Performance In The Intermediate-Term ... The lag between loan approval and loan performance is far too long to reinforce learning, however. Over the course of five years, factors that could not have been foreseen at origination may well end up precipitating a default. Lenders' response to that long-term uncertainty may help explain the positive short-term correlation (Chart 2). Partially goaded by pro-cyclical loan-loss reserve standards, lenders react to surging default rates by getting more conservative, nudging default rates higher in a feedback loop that plants the seeds for strong intermediate-term performance. Chart 2... But They March In Lockstep With Loan Performance In The Near Term ... But They March In Lockstep With Loan Performance In The Near Term ... But They March In Lockstep With Loan Performance In The Near Term Bottom Line: 2014's cyclical bottom in standards suggests that rising default rates will not peak until late 2019 or 2020. Increased near-term lender caution will reinforce the upward move. Tracking The Credit Cycle: Default Rates When the economy is expanding, borrowers in the aggregate find it easier to service their debts, just as recessions make debt service more onerous. The pro-cyclicality of inflation, which eases debt burdens, helps reinforce the relationship. There is more to tracking the credit cycle than tracking the business cycle, however. While defaults have peaked within five months after the end of the last three recessions, default-rate troughs have varied wildly, occurring anywhere from six years before the recession to the month it began (Chart 3). Our credit strategists try to identify the point at which defaults begin to take off by tracking lending standards, monetary conditions, and credit quality. None of these factors suggests that default rates can make new lows. The loan officer survey could improve, but tight spreads leave almost no room for the bond market to become more receptive (Chart 4). Monetary conditions are steadily becoming less accommodative, helped along by the rate-hike/dollar-strength loop (Chart 5). Our bond strategists expect that credit quality will weaken as soon as upward wage pressure snuffs out pre-tax corporate profits'1 ability to keep up with double-digit debt growth. It's hard to say just when default rates will begin to erode total returns in a meaningful way, but our bond strategists are of a mind that risk is rapidly catching up with reward. Chart 3The Business Cycle Reliably Calls Peaks,##BR##But It's No Help With Troughs The Business Cycle Reliably Calls Peaks, But It's No Help With Troughs The Business Cycle Reliably Calls Peaks, But It's No Help With Troughs Chart 4Little Room##BR##For Improvement Little Room For Improvement Little Room For Improvement Chart 5Tightening,##BR##But Not Yet Tight Tightening, But Not Yet Tight Tightening, But Not Yet Tight Tracking The Credit Cycle: Corporate Spreads Chart 6Spreads Aren't Ready To Blow Out Yet Spreads Aren't Ready To Blow Out Yet Spreads Aren't Ready To Blow Out Yet High-yield data only exist for the last two spread-widening episodes, but what they lack in quantity they make up for in consistency. Heading into both the dot-com bust and the financial crisis, spreads did not widen in earnest (Chart 6, top panel) until the Fed had completed its tightening cycle (Chart 6, second panel), BCA's proprietary Corporate Health Monitor (CHM) began to deteriorate (Chart 6, third panel), and lenders tightened their standards (Chart 6, bottom panel). That template suggests that spreads are not poised to blow out anytime soon, as we expect the Fed will not be finished tightening before the end of 2019 (or later), and lenders are still actively easing their standards for commercial borrowers. As noted above, we expect that deterioration in the CHM will pick up again, once runaway profit growth ceases to paper over surging leverage. All in all, our bond strategists do not think it is anywhere near time to panic. As with defaults, they think it is still too soon to expect the beginning of sustained spread widening. On balance, however, the indicators suggest that return expectations should be modest, and limited to coupon yields. It is too late to buy bonds with the expectation of realizing capital gains, and prudent return projections should pencil in some minor capital losses. Lenders Never Learn, Part II: The Fed Funds Rate Cycle The fed funds rate cycle has been a U.S. Investment Strategy pillar, informing many of our views on cycles and asset markets. We will publish a Special Report delving into it more fully the first week of September, but a quick summary is sufficient to illustrate its relevance to the credit cycle. We divide the fed funds rate cycle into four phases based on whether the Fed is hiking rates or cutting them, and whether or not the fed funds exceeds our estimate of the equilibrium rate. Per our stylized representation of the cycle (Chart 7), we are currently in Phase I (the Fed is hiking, but policy remains accommodative) and are likely to remain there until the second half of 2019, when we expect that policy will turn restrictive, ushering in Phase II. While we have found that the level of the fed funds rate trumps its direction when it comes to explaining equity and bond returns, loan growth is more sensitive to the direction of rates. Banks expand their loan books more rapidly when the Fed is tightening than they do when it's easing. The effect is most pronounced for C&I loans, which grow five times faster during rake-hiking campaigns than they do during rate-cutting campaigns (Table 1). The conclusion may seem counter-intuitive on its face, but one must remember that the Fed is charged with leaning against the cycle: it tightens when times are good to keep them from becoming too good, and its eases when times are bad to get the economy back on its feet. Chart 7The Fed Funds Rate Cycle Taking Stock Of The Credit Cycle Taking Stock Of The Credit Cycle Table 1An Example Of What Not To Do Taking Stock Of The Credit Cycle Taking Stock Of The Credit Cycle Lenders who take a countercyclical tack operate with the policy wind at their back. Those who follow the cycle are actually fighting the Fed. Most lenders short-sightedly follow the crowd aping the cycle, basing future projections on the most recent data samples and hewing to career incentives that encourage herding. Bankers who load up on loans when the cycle is demonstrably old and approaching its peak make two errors: they ignore a well-established cyclical pattern (tightening leads recessions, which lead defaults and higher losses given default), and they deploy capital when it's widely available in the marketplace, but husband it when it's scarce. Bottom Line: Banks reinforce the credit cycle by avidly deploying capital when conditions are about to take a turn for the worse, and withholding it when they're about to get better. We recommend investors reject their example, and limit their exposure to spread product. Investment Implications If our view that the Fed is going to hike rates more than the consensus expects is correct, all bonds will have to contend with a persistent headwind. Thanks to positive carry, and high-yield bonds' structurally shorter duration, spread product will be less vulnerable than Treasuries. Our bond strategists are nonetheless lukewarm on the risk-reward offered by investment-grade and high-yield bonds. The cycle is clearly in its latter stages and spreads are historically tight. We remain constructive on both the business cycle and the monetary policy cycle, and we are not yet ready to throw in the towel on the equity bull market. Although our equity take is more sanguine than the BCA consensus, our optimism does not extend to the credit cycle, which has clearly passed its peak. While neither modest spread widening nor a mild pickup in defaults is likely to wipe out all of spread product's excess returns, we do not expect that they will be large enough to merit more than benchmark weighting in balanced portfolios. Our sister Global ETF Strategy service's model portfolios hold benchmark spread-product positions (while underweighting Treasuries, maintaining below-benchmark duration across all bond categories, and overweighting cash) and that is the way we intend to be positioned in the small basket of ETFs we will recommend once we've completed our review of the most impactful macro drivers. A Note On Payrolls Friday's Goldilocks employment situation report for July reinforced our views on the economy and rates, but it was mixed enough to have satisfied anyone's preconceived notions. July's net payroll gains fell shy of the consensus expectation, but revisions to May and June pushed the 3-month moving average of net gains to over 224,000, slightly above expectations. Neither hours worked nor average hourly earnings set off any alarm bells, but the "hidden" unemployment rate slid 30 basis points to 7.5%, the lowest level since May 2001. We see the seeds of future inflation pressures in the continued absorption of slack, and believe that the Fed does as well. We continue to expect four hikes this year and next, two more than the money market is currently discounting. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Annualized profit growth calculated with data from the BEA's National Income and Profit Accounts.

Highlights The eye of the storm is passing over the oil market. OPEC 2.0's recent production increase will temporarily halt the sharp decline in OECD commercial oil inventories, allowing stocks of crude oil and refined products in member states to level off ahead of the sharp drawdowns we expect next year (Chart of the Week).1 This will keep the front of Brent's forward curve in a modest contango going into 4Q18, and suppress short-term price volatility. Thereafter, reduced OPEC 2.0 output post-U.S. midterm elections, and lower Iranian and Venezuelan exports will force OECD inventories to resume drawing sharply, backwardating Brent's forward curve and raising oil price volatility (Chart 2).2 Chart of the WeekOECD Inventories Rebuild Slightly,##BR##Then Resume Falling Next Year OECD Inventories Rebuild Slightly, Then Resume Falling Next Year OECD Inventories Rebuild Slightly, Then Resume Falling Next Year Chart 2Brent, WTI Implied Volatility Vs. Curve Shape:##BR##Implied Vol Is Higher At Storage Extremes Calm Before The Storm In Oil Markets Calm Before The Storm In Oil Markets Chart 3Physical Oil Deficit Returns##BR##To Oil Market Next Year Physical Oil Deficit Returns To Oil Market Next Year Physical Oil Deficit Returns To Oil Market Next Year Highlights Energy: Overweight. The U.S. EIA revised its estimate of OPEC spare capacity down slightly for this year - to 1.7mm b/d from 1.8mm b/d. Spare capacity for next year was raised to 1.3mm b/d from just over 1mm b/d previously. At ~1.5% of global consumption this year and next, spare capacity is chronically low. Base Metals: Neutral. Chinese policymakers could sanction new infrastructure spending and easier credit to counter slower growth related to trade tensions, Reuters reported.3 Precious Metals: Neutral. We were stopped out of our tactical long silver position with a 10% loss. Ags/Softs: Underweight. There is more evidence that U.S. ags are finding new markets. EU imports of U.S. soybeans almost quadrupled in recent weeks. This comes amid the June plunge in prices and a thawing in trade tensions, following talks between EU Commission President Juncker and President Trump late last week.4 Feature The oil market sits in the eye of a pricing storm we expect to hit later this year. Following highly vocal - and twitter-textual - jawboning by U.S. President Donald Trump, OPEC's Gulf Arab producers lifted production in June and again in July.5 Reuters survey data indicate the OPEC Cartel (including new member Congo) lifted production by 70k b/d in July, bringing output to its highest level this year (32.64mm b/d).6 KSA boosted its output to 10.6mm b/d in June, up from less than 10mm b/d in the January - May period. This likely was a combination of higher production and inventory draws. OPEC's compliance level fell to 111% of the 1.2mm b/d of cuts agreed in November 2016, versus compliance levels exceeding 150% earlier this year. This is attributed to sharp declines in Venezuela's output, sporadic losses from Libya and Nigeria, and ongoing declines in non-Gulf OPEC states. We expect Russia, the putative co-head of the OPEC 2.0 coalition, will increase production by 200k b/d in 2H18 (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Calm Before The Storm In Oil Markets Calm Before The Storm In Oil Markets Global Oil Market Will Tighten Again Post-U.S. mid-term elections in November - just when the U.S. sanctions are re-imposed against Iranian crude exports - we expect OPEC 2.0 to dial back production increases made at the behest of President Trump. Continued declines in non-Gulf OPEC output, led by ongoing and deep losses in Venezuelan output, and random unplanned production outages also will contribute to a tightening on the supply side going into 2019. Rising geopolitical tensions in the Gulf will keep markets on edge, with a predisposition to push higher. This supply-side tightness will once again come up against strong global oil demand, which we estimate will grow at a 1.7mm b/d rate this year and next. We are not expecting a repeat of the evolution of prices observed following OPEC 2.0's January 2017 agreement, which cut production to reverse the massive accumulation of inventories brought about by the original cartel's market-share war launched in November 2014. This evolution is depicted in the price-decomposition model for Brent shown in Chart 4. We segmented the fundamental price drivers - i.e. demand, supply and inventories - into distinct factors, and estimated an econometric model that allows us to track whether the evolution of prices is consistent with our expectations for these factors. Chart 4Factor Decomposition For Brent Prices Calm Before The Storm In Oil Markets Calm Before The Storm In Oil Markets Our modeling indicates the 2014 - 15 decline in oil prices was driven by a not-often-seen combination of every single factor, with our OPEC Supply-and-Inventory factor accounting for the largest negative contribution to the evolution of prices during this period. Since 2017, our factor model shows Brent prices have been supported by two factors acting simultaneously together: (1) the strong compliance of OPEC 2.0 members to the coalition's production-cutting agreement, which reduced the OPEC Supply-and-Inventory factor's role, and (2) the pickup in global oil demand, particularly in EM economies, which pushed our Global Demand factor up. These effects were partly counterbalanced by the rise in our Non-OPEC Supply factor, which became the largest negative contributor to price movements, driven by strong U.S. shale production growth. Return Of Backwardation Will Spur Volatility Our ensemble forecasts for Brent in 2H18 and 2019 are $70 and $75/bbl, with WTI expected to trade $6/bbl below these levels (Chart 5). The supply-side tightening we expect, coupled with continued demand growth, will once again lead to sharp draws in OECD inventories beginning in 4Q18 and continuing into 2019, as seen in the Chart of the Week. This will steepen the backwardations in the Brent and WTI forward curves (Chart 6). Chart 5BCA Brent And##BR##WTI Forecasts BCA Brent And WTI Forecasts BCA Brent And WTI Forecasts Chart 6Backwardation Will Return##BR##To Brent's Forward Curve Backwardation Will Return To Brent's Forward Curve Backwardation Will Return To Brent's Forward Curve Our research shows that as the slope of the Brent and WTI forward curves steepen - i.e., backwardations become more positive in percentage terms (or contangoes become more negative) - the implied volatility of options written on these crude oil futures increases, as can be seen in Chart 2.7 All else equal, higher volatility makes options written on these crude futures more valuable. Higher Vol ... Higher Prices ... In the different scenarios we use to produce our ensemble forecast, we view the balance of risks to be on the upside. This can be seen in the different paths our scenarios cover over the next year and a half, which include physical and geopolitical variables affecting price expectations (Chart 7).8 Chart 7Higher Volatility = Wider Expected Price Range Higher Volatility = Wider Expected Price Range Higher Volatility = Wider Expected Price Range Our base case assumes the supply and demand estimates shown in Table 1, which include the loss of 500k b/d due to the re-imposition of U.S. sanctions against Iran. However, we also model the loss of 1mm b/d of Iranian exports. Furthermore, we account for the loss of ~ 800k b/d of Venezuelan exports in the event that country collapses and nothing but the 250k b/d of output required to produce refined products for the local market remains online. Lastly, we account for the Permian transportation bottlenecks preventing all of the crude produced in the Basin from getting to refiners or to export markets. In this week's publication, we also include an estimate of the 95% confidence interval derived from Brent and WTI options' implied volatilities, so that our scenarios can be placed in the context of market-derived assessments of the range in which prices will trade. ... Lower Prices ... ? In modeling these risks, we also must account for downside price risks. Most prominent among these is a resolution of the long-simmering U.S. - Iran conflict, which, from time to time, results in physical confrontation. This is an outcome markets were forced to consider earlier this week when President Trump offered to meet Iranian President Rouhani without any preconditions. Among other things, Trump suggested he would have interest in working on a nuclear-arms deal to replace the one negotiated under President Obama's watch, which he scuppered in May. Secretary of State Mike Pompeo walked this remark back later. We believe the odds of such a meeting are extremely low. The odds such meeting would lead to a resolution of animosities - or at least a working understanding between the two sides - are even lower. Even so, investors need to account for this tail risk, which, if realized could take $5 to $10/bbl out of the current oil price structure. That is, until KSA and Russia muster the OPEC 2.0 member states to again reduce production to keep prices at levels that work best for their economies. Bottom Line: Our modeling and the forecasts point to higher prices and a steepening of the backwardation in Brent and WTI forward curves. This will lead to an increase in implied volatilities for options written on these crude oil futures. For this reason, we suggest investors remain long call spreads further out the Brent forward curve in 2019, which can be found in the Strategic Recommendations table on page 10 of this publication. That said, downside risks have emerged, even if, at present, the likelihood of a diplomatic breakthrough that triggers them is remote. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 OPEC 2.0 is the name we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. At the end of June, the coalition's member states agreed to increase production, which we estimate will raise its output ~ 275k b/d in 2H18 (vs. 1H18). We expect a physical deficit of ~ 430k b/d in 1H19 (vs 1H18, Chart 3). 2 "Contango" and "backwardation" are terms of art in commodity markets. In oil trading, when prompt-delivery crude is priced below deferred-delivery material markets are in contango; vice versa for backwardation. 3 Please see "Exclusive: China eyes infrastructure boost to cushion growth as trade war escalates - sources," published by uk.reuters.com July 27, 2018. 4 We discussed this possibility under Option 1 in our July 26, 2018, Commodity & Energy Strategy lead article entitled "Policy Uncertainty Could Trump Ag Fundamentals." It is published by BCA Research, and is available at ces.bcaresearch.com. 5 Please see our Special Report entitled "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," published jointly July 19, 2018, by BCA Research's Commodity & Energy Strategy and Geopolitical Strategy. It is available at ces.bcaresearch.com. 6 Please see "OPEC July oil output hits 2018 peak, but outages weigh: Reuters survey," published July 30, 2018, by uk.reuters.com. 7 Chart 2 shows the V-shaped mapping of implied volatility as a function of the slope of the forward curve - , i.e., the difference between the 1st- and 12th-nearby futures divided by the 1st -nearby future (to get the number in %) - against the at-the-money Implied Volatilities of 3rd-nearby Brent and WTI options (also in %). Our findings extend results published in Kogan et al (2009), who show realized volatilities calculated using historical settlements of crude oil futures have a similar V-shaped mapping with the slope of crude oil futures conditioned on 6th- vs. 3rd-nearby futures returns (in %). Please see Kogan, L., Livdan, D., & Yaron, A. (2009). "Oil Futures Prices in a Production Economy With Investment Constraints." The Journal of Finance, 64 (3), 1345-1375. Strictly speaking, volatility is the standard deviation of percent returns, usually measured on a per annum basis. Realized volatility uses futures prices to calculate returns and standard deviations; options' implied volatility is a parameter of an option-pricing model that is solved for once an option's premium, or price, is known (i.e., clears the market). This makes implied volatility a forward-looking market-cleared parameter, provided market participants agree the model used to calculate its value. Research shows implied volatilities do a better job of forecasting actual volatility than historical volatilities constructed using futures prices. See Ryan, Bob and Tancred Lidderdale (2009). "Energy Price Volatility and Forecast Uncertainty." U.S. Energy Information Administration. 8 We do not try to model a closure of the Strait of Hormuz or its prices implications. We do, however, consider this in our Special Report published July 19, 2018, "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," referenced above. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Calm Before The Storm In Oil Markets Calm Before The Storm In Oil Markets Trades Closed in 2018 Summary of Trades Closed in 2017 Calm Before The Storm In Oil Markets Calm Before The Storm In Oil Markets

The Golden Rule: During the next 12 months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market? In this report we demonstrate that an investor who can correctly answer that question will very likely make the right bond market call. We call this framework for market analysis the golden rule of bond investing. Exceptions: We identify a few periods when applying the golden rule correctly would not have led to the right market call. Such periods are rare, but they tend to occur when the market "fights the Fed". One such episode occurred as recently as 2017. Total Return Forecasts: We use the golden rule framework to generate total return forecasts for Treasury indexes of all different maturities and many different spread product indexes. It's easy to get lost in the sea of financial market news. Last week alone saw the suggestion of additional tariffs, weak housing data, strong consumer data, falling commodity prices and steep Chinese currency depreciation. It's not always obvious what's important for bond markets and what isn't. While there is no miracle solution to this problem, we propose one helpful question that investors should always ask themselves to help discern the signal from the noise. During the next 12 months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market? If you are able to answer that question correctly you will make the correct bond market call most of the time, and any new piece of information should be judged on how it impacts your answer. In fact, the framework of viewing everything through the lens of answering the above question works so well that we call it the golden rule of bond investing. In this Special Report we illustrate the empirical success of the golden rule. We also draw on historical evidence to consider periods when the rule failed. Finally, we translate the golden rule into a method for forecasting total returns, and we generate total return forecasts for many different bond indexes, encompassing both Treasuries and spread product. Testing The Golden Rule's Performance Chart 1 on page 1 shows how well the golden rule has worked during the past 28 years. The top panel shows the 12-month fed funds rate surprise - the difference between the expected change in the fed funds rate that was priced into the market at the beginning of the 12-month investment horizon and the change in the fed funds rate that was ultimately delivered. A reading above zero indicates that the market expected a larger increase (or smaller decrease) than actually occurred, a reading below zero indicates that the market expected a smaller increase (or larger decrease) than actually occurred. The bottom panel shows 12-month excess returns from the Bloomberg Barclays Treasury Master Index relative to a position in cash. Chart 1The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record If the golden rule works, then dovish fed funds rate surprises (positive values in Chart 1, shown shaded) will coincide with positive Treasury excess returns, and vice-versa. Chart 1 shows that this has indeed generally been the case. Digging a little deeper, we find a strong positive relationship between 12-month Treasury excess returns and the 12-month fed funds rate surprise (Chart 2) and a similarly strong relationship using Treasury index price return instead of the excess return versus cash (Chart 3). Dovish fed funds rate surprises coincide with positive 12-month Treasury excess returns 87% of the time for an average excess return of +3.9%. They also coincide with positive Treasury price returns 76% of the time for an average price return of +2.1%. Hawkish surprises coincide with negative 12-month Treasury excess returns 61% of the time for an average excess return of -0.3%. They also coincide with negative Treasury price returns 72% of the time for an average price return of -1.9% (Table 1). Chart 2Treasury Index Excess Return & ##br##Fed Funds Rate Surprises (1990 - Present) The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Chart 3Treasury Index Price Return & ##br##Fed Funds Rate Surprises (1990 - Present) The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Table 112-Month Treasury Index Returns And Fed Funds Rate Surprises (1990 - Present) The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Total Treasury returns also factor in coupon income, and are therefore often positive even when the price return is negative. Still, Table 1 shows that Treasury index total returns average +7.1% in periods with a dovish fed funds rate surprise and only +3.4% in periods with a hawkish surprise. Further, 65% of negative total return periods occurred when there was a hawkish fed funds rate surprise. Of course, the golden rule is no panacea. The results presented above are impressive, but they assume that investors are able to correctly predict whether the market is over- or under-pricing the Fed. Making that determination remains a tall order. The key insight to be gleaned from the golden rule is that if a piece of information does not alter your opinion about the future path of the fed funds rate relative to expectations, then it should probably be ignored. The golden rule is certainly not the "be all and end all", but it is a very useful first step. Learning From Failures While Table 1 shows that correctly determining the 12-month fed funds rate surprise allows us to make the correct bond market call most of the time, it also shows that it doesn't always work. To understand why the golden rule might fail, it is useful to think about why it works in the first place. To do this, let's first consider that any Treasury yield can be thought of as consisting of three components: Treasury Yield = Fed Funds Rate + Expectations For Future Change In The Fed Funds Rate + Term Premium Based on this formula, it is obvious that if rate expectations and the term premium are held constant, a higher fed funds rate translates directly into a higher Treasury yield, and vice-versa. This is one reason why the fed funds rate surprise correlates with Treasury returns. The second reason that the fed funds rate surprise correlates with Treasury returns is that the expectations component of the above formula also tracks the fed funds rate surprise. In other words, investors are more likely to revise their rate expectations higher when the Fed is already in the process of delivering hawkish surprises. They are also more likely to revise their rate expectations lower when the Fed is delivering dovish surprises. This dynamic is illustrated in Chart 4. The top panel shows the correlation between the 12-month fed funds rate surprise and changes in rate expectations as measured by our 12-month fed funds discounter. The two lines are mostly positively correlated, though they do occasionally diverge. The largest divergences appear near inflection points in monetary policy - e.g. when the Fed switches from hiking rates to cutting. Such inflection points are often prompted by economic recession. Chart 4When The Golden Rule Doesn't Work When The Golden Rule Doesn't Work When The Golden Rule Doesn't Work The bottom panel of Chart 4 shows the much tighter correlation between the 12-month fed funds rate surprise and the change in the average yield on the Treasury Master index. These two lines also occasionally diverge, but only during periods when rate expectations move strongly in the opposite direction of what is suggested by the rate hike surprise. Crucially, the abnormal change in rate expectations has to be so large that it more than offsets the impact from the change in the fed funds rate itself. Such periods are rare, though we did experience one as recently as last year. Chart 5The 2017 Example The 2017 Example The 2017 Example The 2017 Episode Treasury returns in 2017 provide a textbook example of one of the rare periods when the golden rule failed. The Treasury Master Index returned +1.5% in excess of cash, even though the Fed lifted rates 25 bps more than the market expected at the beginning of the year. The reason for the divergence is that even though the Fed was in the process of lifting rates by more than what the market anticipated, the market continued to doubt the Fed's resolve and revised its expectations lower. At the beginning of 2017 the market was priced for 51 bps of rate hikes for the year. Then, just as the Fed started to lift rates more quickly than that expectation would suggest, core inflation plunged (Chart 5). The market started to price-in that the Fed would react to falling inflation by turning more dovish, but as it revised its expectations lower the Fed continued to hike. The end result is that the impact of the downward revision to rate hike expectations more than offset the upward pressure on yields from Fed rate hikes, and the Treasury index outperformed cash for the year. Forecasting Total Returns One final application of the golden rule is that it can be used as a framework for generating total return forecasts for different bond indexes. To illustrate how this is achieved we will walk through how we calculate such a forecast for the Treasury Master Index. First, we note that the current reading from our 12-month fed funds discounter is 79 bps. This means that the market expects 79 bps of Fed rate hikes during the next 12 months. If we assume that the Fed will lift rates by 100 bps during the next 12 months, then we have a hawkish fed funds rate surprise of 21 bps. As an aside, Chart 6 shows that we have consistently witnessed hawkish fed funds rate surprises since mid-2017, and our 12-month discounter has increased, as is typically the case. But this also means that the bar for further hawkish rate surprises is now much higher. Chart 6Market Has Underestimated ##br##The Fed In Recent Years Market Has Underestimated The Fed In Recent Years Market Has Underestimated The Fed In Recent Years We already demonstrated the strong correlation between the 12-month fed funds rate surprise and the 12-month change in the average yield from the Treasury index (see Chart 4). This allows us to translate our assumed fed funds rate surprise into an expected change in the index yield. In this case, that expected change in yield is +19 bps. With an expected yield change in hand, it is relatively simple to calculate an expected total return using the index's yield, duration and convexity: Expected Total Return = Yield - (Duration*Expected Change In Yield) + 0.5*Convexity*E(ΔY2) E(ΔY2) = 1-year trailing estimate of yield volatility In our scenario where we assume the Fed lifts rates by 100 bps during the next 12 months, the above formula spits out an expected total return of +1.60% for the Treasury Master Index. Table 2 shows total return forecasts using this same method but with many different rate hike assumptions. For example, if we assume only 50 bps of Fed rate hikes during the next 12 months we get an expected Treasury Index total return of +3.37%. Table 2 also displays total return forecasts for different maturity buckets within the Treasury Master index. These forecasts are all generated using the same method, but we correlate the 12-month fed funds rate surprise with different Treasury yields in each case. One caveat here is that the correlation between the fed funds rate surprise and the change in Treasury yield declines as we move into longer maturities (Appendix A). This is because long-dated yields are less directly connected to near-term changes in the fed funds rate. As such, there is more uncertainty surrounding the total return forecasts for long maturity sectors. Table 2Treasury Index Total Return Forecasts The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Spread Product Total Return Forecasts With one additional assumption we can also apply our return forecasting method to different spread product indexes. That additional assumption is for the expected change in the average index spread. Using Table 3, you can simply pick a column based on the number of Fed rate hikes you expect during the next 12 months and pick a row based on whether you think spreads will remain flat, widen or tighten. Table 3Spread Product Total Return Forecasts The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing For example, if the Fed lifts rates by 100 bps during the next 12 months and investment grade corporate bond spreads stay flat, we would expect investment grade corporate bond index total returns of +2.9%. For each sector, the spread widening scenario assumes that the average index spread widens to its highest level since the beginning of 2016 and the spread tightening scenario assumes the average index spread tightens to its lowest level since the beginning of 2016. All the spread scenarios are depicted graphically in Appendix B. For the High-Yield sector we make the additional adjustment of subtracting expected 12-month default losses from the average index yield. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Appendix A Chart 7Change In 1-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Corporate Bond Spread Scenarios Corporate Bond Spread Scenarios Chart 8Change In 2-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Government-Related Spread Scenarios Government-Related Spread Scenarios Chart 9Change In 3-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Structured Product Spread Scenarios Structured Product Spread Scenarios Chart 10Change In 5-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Chart 11Change In 7-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Chart 12Change In 10-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Chart 13Change In 30-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Appendix B Chart 14Corporate Bond Spread Scenarios Corporate Bond Spread Scenarios Corporate Bond Spread Scenarios Chart 15Government-Related Spread Scenarios Government-Related Spread Scenarios Government-Related Spread Scenarios Chart 16Structured Product Spread Scenarios Structured Product Spread Scenarios Structured Product Spread Scenarios

Highlights Many investors remain overweight equities; BCA recommends a neutral stance. Investors should position portfolios for rising rates. Fed Chair Powell weighed in last week on yield curve, the impact of the Trump administration's trade policies, financial stability and the level of the neutral Fed funds rate. More evidence of trade policy-related uncertainty, rising labor costs and deteriorating margins in the latest Beige Book. Feature The S&P 500 finished the week little changed, as investors braced for a wave of Q2 earnings reports this week and next. The S&P financials sector, which tends to lead the overall market, rose more than 1% last week, as the banks reported healthy Q2 results. The dollar sold off late last week after President Trump grumbled about the Fed's rate policy. BCA's view is that Fed Chair Powell will ignore Trump's comments on monetary policy and adhere to the central bank's mandate of low and stable inflation and full employment. Gold fell 1% on the week. BCA recommends monitoring the price of gold for clues about the neutral rate of interest. Fed Chair Powell's semiannual policy testimony to Congress dominated the headlines last week. Powell discussed trade policy, the yield curve, the neutral rate and financial stability. The week's economic data was robust, suggesting that Q2 GDP will be well above the Fed's view of potential GDP. Housing starts were soft in June, but the weakness was due to supply issues, not tepid demand. Widespread supply constraints were prevalent in the Fed's latest Beige Book. The strong economic data, along with a 23-year high in the number of inflation words in the Beige Book pushed the 10-year Treasury yield up 6 bps to 2.88%. BCA's U.S. Bond Strategy team notes that the Fed's gradual pace of rate hikes toward a 3% equilibrium fed funds rate would be consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%. In late June, BCA downgraded its 12-month recommendation on global equities and credit from overweight to neutral. We still expect that the U.S. stock-to-bond ratio will grind higher in the next year, as U.S. stocks move sideways and Treasury yields climb. We recommend that investors put proceeds from the sale of equity positions into cash. Not all investors are being risk averse. The National Association of Active Investment Managers (NAAIM) says that active managers have increased their equity risk tolerance since the start of the year (Chart 1). At 89%, the average exposure of institutional investors is close to the cycle high reached in March 2017, which was the greatest since the S&P 500 zenith in October 2007. Furthermore, BCA's Equity Speculation Index remains elevated (Chart 2). Moreover, the asset allocation survey from AAII shows that investors' allocation to equites (at 69% in June) are in line with the 2007 market top (Chart 3). However, equity holdings based on this survey were higher before the peak in equity prices in 2000. Moreover, consumers' expectations for stock price returns in the next 12 months remain close to cycle highs (U of Michigan) and near 24-year extremes based on the Conference Board surveys (Chart 4). Despite the optimism, individual sentiment toward equities remains muted in some surveys (Chart 4, panel 3). Chart 1Active Managers Have Increased Equity Exposure This Year Active Managers Have Increased Equity Exposure This Year Active Managers Have Increased Equity Exposure This Year Chart 2Equity Speculation##BR##Is Elevated Equity Speculation Is Elevated Equity Speculation Is Elevated Chart 3Equity Allocations##BR##On The Rise... Equity Allocations On The Rise... Equity Allocations On The Rise... Chart 4Households Expect Higher Stock##BR##Prices In The Next 12 Months Households Expect Higher Stock Prices In The Next 12 Months Households Expect Higher Stock Prices In The Next 12 Months Individuals, banks and other financial institutions hold more equities today than at the height in 2007. However, insurance companies and pension funds' holdings of equites are not as elevated as they were in 2007 (Table 1). Somewhat surprisingly, households' cash positions are below the 2007 level and at a cycle low. However, the cash positions of financial institutions are four times as large as in 2007, partly due to the Fed's vigilance on financial stability. Pension funds and insurance companies have roughly the same allocation to cash today as earlier in the cycle (2012) and in 2007, just before the financial crisis. Table 1Asset Allocation: Comparison With Early 1990s Powell Tells All Powell Tells All Bottom Line: BCA's view is that the risk/reward balance for holding equities is much less attractive than it was at the start of the bull market in 2009. The economy is in the late stages of an expansion and is running beyond full employment. The Fed is raising rates. Moreover, equity valuations are elevated and forward earnings estimates are at their most optimistic in 20 years (not shown). The good news is already priced into the equity market. If macro developments evolve as expected, then we will shift to an outright bearish stance on risk assets later this year or early in 2019 in anticipation of a global recession in 2020. Absent a recession, we would move to underweight stocks if a wider trade war develops. We would consider temporarily moving our 12-month recommendation back to overweight if global equities sell off by more than 15% in the next few months. This shift would also be favored if our economic indicators remain constructive and the Fed either cuts rates or signals that it is on hold. 10-Year Treasuries: An Update BCA's U.S. Bond Strategy service recommends that investors remain below benchmark in duration. However, at 2.84%, the 10-year Treasury yield is 27 bps below its 2018 zenith of 3.11%, which was reached in mid-May. Chart 5 shows that the drop in yields since that time reflects both slower economic growth prospects and weaker inflation. Investors are concerned about the impact of Trump's trade policies on global growth and those fears have been stoked by the recent run of poor economic data in the U.S. Oil prices and inflation breakevens moved up in tandem earlier this year, and both are currently rolling over (not shown). U.S. inflation is back to the Fed's 2% target and the central bank remains on course to raise rates two more times in 2018 and another four times next year. The market is pricing in only three more hikes in the next 18 months. The economy is at full employment. Moreover, at 3.6%, the average of the New York Fed and Atlanta Fed's Nowcasts for Q2 GDP growth implies that the GDP expanded well above the Fed's projection of potential GDP (1.8%) in the first half of the year (Chart 6). Moreover, the lagged effect of easier financial conditions suggests that GDP growth in the second half of the year will also be far above potential (Chart 7). Chart 5Inflation Breakevens##BR##Rolling Over Again Inflation Breakevens Rolling Over Again Inflation Breakevens Rolling Over Again Chart 6U.S. Economy Poised For Above##BR##Potential Growth in 2018 U.S. Economy Poised For Above Potential Growth in 2018 U.S. Economy Poised For Above Potential Growth in 2018 Inflation breakevens (Chart 5) are falling again despite mounting inflation pressures. The New York Fed's Underlying Inflation Gauge (Chart 8, panel 4) climbed to 3.33% in June, its highest point since 2005. Moreover, wage inflation is trending up and the economy is beset with shortages and constraints.1 Chart 7Lagged Effect Of Easier Financial##BR##Conditions Will Boost Growth Lagged Effect Of Easier Financial Conditions Will Boost Growth Lagged Effect Of Easier Financial Conditions Will Boost Growth Chart 8Inflation Is##BR##Accelerating Inflation Is Accelerating Inflation Is Accelerating Bottom Line: Investors should position their portfolios for escalating rates. Global growth should bottom in the second half of the year and the U.S. economic activity reports will begin to outpace lower expectations. Moreover, with inflation at the Fed's target and mounting, inflation breakevens will adjust upward. BCA's position is that the Fed's gradual pace of rate hikes toward a 3% equilibrium fed funds rate would be consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%, well above current forward rates.2 Leading The Way S&P Financials provide a long lead time for market peaks. Table 2 shows that since the mid-1970s, a peak in the Financials sector relative to the S&P 500 occurs an average of 16 months before a peak in the overall index. The Bank (Industry Group) sector provides a similar warning (18 months), while the Investment Banking index's relative performance peaks 20 months before the S&P 500 tops out (Chart 9). Note that the leads times are slightly shorter in the last 15 years than in the 1976-2000 period (Table 2). Table 2Financial Stocks' Relative Performance Provides Early Warning Of Market Tops Powell Tells All Powell Tells All Chart 9Financials Lead The Broad Market Financials Lead The Broad Market Financials Lead The Broad Market In a recent report,3 BCA's U.S. Equity Strategy service noted that cyclicals and interest rate-sensitive sectors, including financials, perform well when U.S. fiscal policy is loose and monetary policy is tight. Furthermore, our equity strategists found that rising rates boost top-line growth for banks, while the impact of fiscal stimulus via lower taxes should support business and consumer demand for capital. Moreover, our U.S. Equity Strategy team examined sector performance in late cycles, defined as the period between the peak in the ISM Manufacturing Index and the next recession.4 Financials outperform the S&P 500 in late-cycle environments; in the early stages (peak in the ISM's index to peak in the S&P 500) financials underperform the broad market, but they outperform after the peak in the S&P 500 and the next recession. Bottom Line: Our equity strategists recommend that investors remain overweight financials relative to the S&P 500. The late-cycle environment, along with the favorable regulatory climate, suggest that financials still have some room to run. The implication is that the peak in the overall U.S. equity market is still over a year away. Until then, the Fed will continue to remain vigilant on the financial sector and financial stability. Staying The Course At his semiannual Congressional testimony last week, Fed Chair Powell reaffirmed that the Fed will maintain its gradual pace of rate hikes. Following his presentation, Powell met with legislators and discussed the yield curve, the impact of the Trump administration's trade policies, financial stability and the level of the neutral Fed funds rate. Powell repeated his June statement that the yield curve can be considered an indicator of monetary stance. Like Powell, BCA's position is that a steep curve signals that policy is stimulative and short-term rates will need to climb. The opposite holds if the yield curve inverts. A flat yield curve indicates that the policy stance is neutral. The 2/10-year curve has flattened to about 25 bps. Our view is that if the curve inverts with a few more Fed rate hikes, it would suggest that the neutral rate is lower than what the Fed believes and policy is becoming restrictive. Furthermore, BCA's U.S. Bond Strategy team anticipates that curve flattening will occur as the Fed lifts rates, but some flattening pressure will be mitigated by the re-anchoring of long-dated inflation expectations at a higher level. On tariffs, Powell stated that "in general, countries that have remained open to trade, that haven't erected barriers including tariffs, have grown faster. They've had higher incomes, higher productivity." He added that more and broader tariffs are bad for the economy. Furthermore, Powell said that the FOMC has not yet seen evidence that the trade uncertainty has affected wages, but he noted that the central bank is concerned that capital spending plans may be at risk. The latest Beige Book (see next section of this report) finds that the business community is increasingly apprehensive about trade policy. BCA's Geopolitical Strategy service anticipates that trade-related uncertainty will remain in place at least until the U.S. mid-term elections in November.5 BCA views financial stability as a third mandate for the central bank,6 along with low and stable inflation, and full employment. Powell stated last week that financial stability vulnerabilities were "moderate right now," but he remarked that "we keep our eye on that very carefully after our recent experience." Chart 10 presents several indicators that the FOMC uses to assess financial vulnerabilities. Powell acknowledged the prominent status of financial stability when asked about the Fed's role. The central bank's Monetary Policy Report,7 released on July 13, has an entire section dedicated to financial stability. Powell spoke about the shape of the yield curve, saying it can relay a message about longer run neutral interest rates. BCA also recommends monitoring the price of gold for clues about the neutral rate of interest. Chart 11 shows that when the Fed funds rate is above its neutral or equilibrium rate, the 2/10 curve is flat (panel 3). Moreover, gold tends to appreciate when the stance of monetary policy is more accommodative and then the metal depreciates when the stance becomes more restrictive (panel 4). The steep decline in the gold price between 2013 and 2016 preceded downward revisions to the Fed's estimate of the neutral rate. An upside price breakout would signal that we should bump up our estimate of the neutral rate. Conversely, a large decline in gold prices would imply that monetary policy is turning restrictive. Gold prices recently headed lower. Chart 10FOMC Is Closely Monitoring##BR##Financial Stability FOMC Is Closely Monitoring Financial Stability FOMC Is Closely Monitoring Financial Stability Chart 11The 2/10 Curve,##BR##Gold And The Neutral Rate The 2/10 Curve, Gold And The Neutral Rate The 2/10 Curve, Gold And The Neutral Rate Bottom Line: The Fed will continue with gradual rate hikes until it believes policy has returned to near neutral. The yield curve and gold will help to indicate when that point is reached. Widespread Chart 12Inflation Words At A 23 Year High Inflation Words At A 23 Year High Inflation Words At A 23 Year High The Beige Book released last week ahead of the FOMC's Jul 31-August 1 meeting suggested that uncertainty surrounding U.S. trade policy remained an important headwind in June and July. The Fed's business and banking contacts mentioned either tariffs (31) or trade policy (20) a total of 51 times, an increase from 34 in May and 44 in April. In March, as President Trump announced the first round of proposed tariffs, there were only three mentions of trade or tariff-related uncertainty. Moreover, uncertainty arose nine times in July (Chart 12, panel 4); all were related to trade policy. A recent study by the Federal Reserve Bank of St. Louis8 found that GDP per capita, wages and the investment-to-GDP ratio, all decline after tariffs are implemented (Chart 13). The study covered tariffs in 14 countries from 1980 through 2016. Importantly, the researchers noted that while the data showed that past tariff increases are followed by persistent decreases in economic activity, this evidence does not necessarily mean that higher tariffs triggered these changes. It is possible that other economic events may have driven tariff increases and ensuing recessions. Despite the headwind from trade, BCA's quantitative approach to the Beige Book's qualitative data continues to point to underlying strength in the U.S. economy, a tighter labor market and higher inflation. Moreover, references to a stronger dollar have disappeared from the Beige Book, despite the recent rise in the greenback. The report also finds widespread concern about profit margins. Chart 12, panel 2 shows that at 81% in July, BCA's Beige Book Monitor ticked up from May's 67% reading. The July reading was the highest since early 2016. The recent low in November 2017 at 53% was when doubts over the tax bill weighed on business sentiment. The number of weak words in the Beige Book hit an 18 -year low in July. On the other hand, the number of strong words climbed in July to a 30-month high. The 2017 Tax Cut and Jobs Act was noted 5 times in the latest Beige Book, up from 3 in May, but still far below 15 mentions in March and 12 in April. The legislation was cast in a positive light in three of the five mentions. The implication is that most of the good news related to the tax bill has already been discounted by businesses. BCA's stance is that the dollar will move up modestly in 2018. The trade-weighted dollar has climbed by 6% since mid-April, but the elevated value of the greenback is not yet a concern for Beige Book respondents. Furthermore, based on the handful of references to a robust dollar (only eight in the past eight Beige Books), the dollar should not be a meaningful issue for corporate profits in Q2 2018. We will provide an update on Q2 S&P 500 earnings in next week's report. The dearth of recent dollar references is in sharp contrast with a flood of comments during 2015 and early 2016 (Chart 12, panel 3). The last time that eight consecutive Beige Books had so few remarks about a strong dollar was in late 2014. The disagreement on inflation between the Beige Book and the Fed's preferred price metric widened in July as the number of inflation words surged (Chart 12, panel 1). Mentions of inflation in July's Beige Book were the greatest since at least 1995. In the past, increased remarks about inflation have led measured inflation by a few months, suggesting that core PCE may still rise. Chart 13The Economic Consequences Of Trade Wars Powell Tells All Powell Tells All Moreover, July's Beige Book continued to highlight labor shortages, especially among skilled workers in key areas of the economy. Shortages of qualified workers were reported in various specialized trades and occupations, including truck drivers, sales personnel, carpenters, electricians, painters and information technology professionals. Furthermore, several districts stated that a lack of workers was impeding growth. In addition, "widespread", which is part of BCA's inflation word count, was used 14 times in July to describe both labor shortages and swelling input costs, up from 11 times in May. We discussed the impact of escalating labor and input costs on margins in last week's report.9 The Beige Books released this year suggest that concerns about deteriorating margins is more prevalent in 2018 versus 2017. Only 57% of comments about margins in the first five Beige Books of 2017 noted deteriorating margins. In the 2018 Beige Books, 85% of references to margins indicated concern about higher labor, interest and raw materials costs. Bottom Line: July's Beige Book supports our stance that rising inflation pressures will result in at least two more Fed rate hikes by year-end and four next year. Moreover, the Beige Book confirms that labor shortages are restraining output of goods and services in some economic sectors. Furthermore, rising input costs are pervasive and will continue to pressure corporate profit margins. BCA expects both corporate profit growth and margins to peak later this year. The nation's tax policy still gets high marks from the business community, but the impact is fading. Ongoing uncertainty over trade policy will restrain growth. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report "Constrained", published July 16, 2018. Aailable at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary "Bond Bear Still Intact", published June 5, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA Research's U.S. Equity Strategy Special Report "Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening", published April 16, 2018. Available at uses.bcaresearch.com. 4 Please see BCA Research's U.S. Equity Strategy Special Report "Portfolio Positioning For A Late Cycle Surge", published May 22, 2018. Available at uses.bcaresearch.com. 5 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," published April 4, 2018. Available at gps.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," published July 24, 2017. Available at usis.bcaresearch.com. 7 https://www.federalreserve.gov/monetarypolicy/files/20180713_mprfullreport.pdf 8 https://research.stlouisfed.org/publications/economic-synopses/2018/04/18/what-happens-when-countries-increase-tariffs 9 Please see BCA Research's U.S. Investment Strategy Weekly Report "Constrained", published July 16, 2018. Available at usis.bcaresearch.com.

Highlights Chart 1Corporate Health: Improving Everywhere, ##br##Down In The U.S. Corporate Health: Improving Everywhere, Down In The U.S. Corporate Health: Improving Everywhere, Down In The U.S. Dollar bull markets are often accompanied by positive returns for the S&P 500. While a strong dollar hurts the earnings outlook for the S&P 500, it supports an expansion of multiples by putting downward pressure on rates and elongating the U.S. business cycle. The dollar and stocks are most positively correlated when the U.S. yield curve slope is between zero and 50-basis points, and flattening. Today's environment fits this bill. BCA is neutral on U.S. in a balanced portfolio. While the USD's strength should be associated with rising U.S. equity prices, the quality of U.S. stock returns is deteriorating. This warrants a certain degree of de-risking relative to our former overweight stance. Feature For the past two weeks, we have warned investors that the dollar rally was over-extended, and that a correction was likely to ensue. However, we also argued that this correction was likely to prove a countertrend move, and that the dollar was likely to end the year at higher levels. BCA has a neutral stance on equities on both a cyclical and tactical horizon. BCA is also neutral on U.S. equities within a global equity portfolio. For investors, it becomes important to understand whether a stronger dollar constitutes an additional downside risk for stocks. This is especially relevant in the U.S., where equity valuations are comparatively elevated, and where corporate health is deteriorating relative to the rest of the world (Chart 1). In this report, we built on the research of our colleague Anastasios Avgeriou, who spearheads BCA's U.S. Equity Sector Strategy service, who has shown that the dollar and the S&P often do rise in unison.1 Ultimately, while the dollar can have an impact on the relative performance of the U.S., it is generally not a strong determinant of the trend in the S&P 500. Strong Dollar And The S&P: Good Friends Indeed A picture is worth a thousand words. As Chart 2 illustrates, a strong dollar has never really been enough to slay a bull run in the S&P 500. Between late 1978 and early 1985, the real trade-weighted dollar rallied by 45%, yet the S&P 500 was able to advance by 102%. Between 1995 and 2002, the real trade-weighted dollar increased by 33% but rallied by nearly 92%. If one were to confine their observations to 1995 to August 2000 window, the dollar would have been up 16.5% and the S&P an outstanding 223%. Finally, from its most recent cyclical bottom in 2011 to the end of 2016, the trade-weighted dollar rallied by 22%, but the S&P 500 managed to rise by another impressive 68%. It is true that the magnitude of the strength of U.S. equities in the face of a strong dollar has decreased over time. This essentially reflects the fact that in the early 1980s, 20% of S&P 500 revenues were garnered outside the U.S. versus roughly 40% today, which in turn has increased the drag on earnings created by a stronger dollar. This problem is illustrated by the negative relationship present between the dollar and U.S. earnings revisions (Chart 3). Chart 2Strong Dollar, No Problem Strong Dollar, No Problem Strong Dollar, No Problem Chart 3Dollar Is Dangerous For The Earnings Outlook Dollar Is Dangerous For The Earnings Outlook Dollar Is Dangerous For The Earnings Outlook Yet, despite this negative link between earnings revisions and the dollar, the S&P can still rise when the dollar increases. What explains this seeming paradox? The answer is almost tautological: It is multiples. A strong dollar tends to be associated with a rising P/E ratio. This is because a strong dollar has a dampening impact on inflation. As a result, when the dollar rises, the Federal Reserve can keep interest rates lower than would otherwise be the case, fomenting periods of declining bond yields (Chart 4). Thanks to lower bond yields, not only do multiples get a boost, but additionally the domestically driven U.S. economic cycle also gets elongated. This further helps stocks in the process. Another more international dimension helps explain the positive correlation between stocks and the dollar. The dollar tends to experience its strongest rallies when U.S. growth is superior to that of the rest of the G-10. As Chart 5 illustrates, the bulk of the early 1980s dollar rally, of the late 1990s rally, and of the 2011 to early 2017 rally materialized when U.S. economic activity was outperforming. In all these instances, the relative strength of the U.S. economy attracted funds from abroad. This also meant that foreign funds flowing into the U.S. economy bolstered liquidity in the U.S. economy. Not only did this liquidity support economic activity, thereby counterbalancing the drag created by a stronger dollar, these funds also found their way into asset markets, generating higher multiples in the U.S. in the process. Chart 4Strong Dollar Hurts Yields Strong Dollar Hurts Yields Strong Dollar Hurts Yields Chart 5Growth Differentials Matter For The Dollar Growth Differentials Matter For The Dollar Growth Differentials Matter For The Dollar Bottom Line: A strong dollar in and of itself has never been enough to derail a bull market in the S&P 500. While a strong dollar creates a hurdle for foreign earnings accruing to U.S. firms, higher multiples often compensate for this negative. Essentially, a higher dollar causes downside to bond yields, warranting lower hurdle rates and higher valuations. Moreover, a stronger dollar diminishes inflationary pressures in the U.S., warranting easier Fed policy than would otherwise be the case. Since the U.S. economy is domestically driven, this elongates the business cycle, helping stocks in the process. Correlation And The Yield Curve Slope While a strong dollar does not seem to be a death threat for the equity market, are there environments when the dollar and the S&P 500 are more correlated than others? Table 1Dollar Versus S&P 500 Correlation: ##br##A Function Of The Yield Curve The S&P Doesn't Abhor A Strong Dollar The S&P Doesn't Abhor A Strong Dollar The answer to this question is yes. As Table 1 illustrates, the correlation between the dollar and the S&P 500 fluctuates significantly based on both the slope of the yield curve and whether the yield curve is flattening or not. Interestingly, when the yield curve is steep (defined as greater than a 50-basis-point spread between 10-year and 2-year Treasury yields), the dollar and U.S. stock prices tend to move in opposite directions. However, when the yield curve is flatter but before it has yet to invert (a yield curve slope of between zero and 50 basis points), the correlation between the dollar and the S&P 500 changes: it becomes positive. In fact, the time at which the correlation between stocks and the dollar is the highest is when the yield curve slope is in that zone and is also flattening. This is surprising, but at the same time it makes sense. We know that when the yield curve is flat but not inverted, the stock market tends to still rally (Chart 6). However, this flattening yield curve indicates that monetary conditions are not as accommodative as they once were. Interestingly, while the dollar performs poorly in the early innings of a monetary tightening campaign, it performs much better when monetary conditions are not so easy anymore that they juice up global growth, but they are not yet tight enough to cause an imminent recession in the U.S.2 This corresponds to a an environment with a flatter yield curve that has yet to invert, such as the one in place today. In light of these observations, the close correlation between the S&P 500 and the dollar in this environment should not be very surprising. Chart 6Flat And Flattening: No Problem For Stocks Flat And Flattening: No Problem For Stocks Flat And Flattening: No Problem For Stocks Bottom Line: The dollar and the stock market are not always positively correlated. However, when the U.S. yield curve slope stands between zero and 50 basis points and is flattening, the positive correlation between the S&P 500 and the dollar is at its strongest. This defines today's environment. Investment Implications BCA thinks the U.S. dollar has ample downside on a long-term basis. After all, the U.S. dollar trades at a significant premium to its PPP fair value, and this kind of overvaluation historically indicates significant downside for the greenback on a multi-year time horizon (Chart 7). Moreover, the Trump administration's fiscal policy is likely to result in a widening of both the fiscal and current account deficits. While a twin deficit rarely impacts the dollar negatively, so long as U.S. real rates rise relative to the rest of the world, it nonetheless often ends up being a harbinger of long-term weakness in the greenback.3 It is hard to make any inference for the S&P 500 based on a bearish long-term dollar view as historically, during a structural dollar bear market, the relationship between the greenback and the S&P has been rather ambiguous. However, BCA also thinks the 2018 dollar rally is not over. As Chart 8 shows, when U.S. rates are in the top of the distribution of interest rates among G-10 economies, the dollar tends to perform well. The U.S.'s status as the global high-yielder is currently unchallenged. This suggests the dollar has a natural advantage over other currencies through the remainder of the year. Chart 7Long-Term Downside For The Dollar... Long-Term Downside For The Dollar... Long-Term Downside For The Dollar... Chart 8...But 2018 Rally Is Not Over ...But 2018 Rally Is Not Over ...But 2018 Rally Is Not Over Moreover, as the U.S. economy is less exposed to the global industrial cycle than the rest of the world is, the U.S. dollar will benefit from the softening global economic environment. This is even truer, given that the U.S. economy was already set to outperform other G-10 economies even before the soft patch in global trade began. As a result, long-term flows into the U.S. are strong, which is generating a basic balance-of-payments surplus (Chart 9). American investors are not blind to this reality; the higher expected rate of returns on U.S. projects along with U.S. corporations bringing earnings back home to take advantage of the Trump tax cuts is generating outsized repatriation flows into the country, historically a good correlate of a strong dollar (Chart 10). This phenomenon is likely to remain alive through the remainder of the year. Chart 9Money Is Making Its Way Into The U.S. Money Is Making Its Way Into The U.S. Money Is Making Its Way Into The U.S. Chart 10Americans Like Their Dollar Americans Like Their Dollar Americans Like Their Dollar Since the U.S. yield curve slope currently stands between zero and 50 basis points while it is flattening in response to the Fed's interest rate hikes, we are in the part of the cycle where the dollar and stocks are positively correlated, and where they in fact often rise together. This suggests the S&P 500 has more upside ahead for the rest of the year as well. It is important to note that the tech sector is now the most at risk from the dollar strength as it has the largest percentage of foreign sales (Chart 11). However, BCA is neutral on stocks on a cyclical horizon. This is not because stocks will not be able to eke out some positive returns; it is because we are acutely aware that we stand close to the end of the bull market. Moreover, the end of an equity bull market is often marked by a pick-up in volatility. Accordingly, risk-adjusted returns for U.S. equities are declining. Hence, while an underweight stance on stocks is not yet warranted, a neutral stance is appropriate as we believe that it is better to be early and leave some money on the table than to be late.4 There remains a big risk that could cause the dollar to rally and stocks to fall, despite where we stand in the cycle: trade disputes. As Chart 12 illustrates, since May, tariff announcements and protectionist pronouncements have buoyed the dollar. However, the same announcements ultimately represent a real risk to profits as they create a real danger for global supply chains and imply higher cost of goods sold by U.S. corporations. Investors should monitor these risks closely. Chart 11S&P 500: Aggregate Sector International Revenue Exposure (%) The S&P Doesn't Abhor A Strong Dollar The S&P Doesn't Abhor A Strong Dollar Chart 12While Tariffs Can Help The Dollar, ##br##They Will Not Help Stocks While Tariffs Can Help The Dollar, They Will Not Help Stocks While Tariffs Can Help The Dollar, They Will Not Help Stocks Bottom Line: BCA anticipates the dollar to be able to rise over the course of the next six to nine months, as U.S. rates are in favor of the greenback and domestic growth outperformance will continue to favor inflows into the U.S. This bullish view on the U.S. dollar currently does not constitute a reason to downgrade stocks to underweight. In fact, at this stage of the cycle, U.S. stocks and the dollar tend to rise in unison. However, since the quality of the equity gains is likely to deteriorate as equity volatility is on an uptrend, BCA prefers to maintain a neutral cyclical stance on equities within a balanced portfolio rather than an overweight stance. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see U.S. Equity Sector Strategy Insight Report, titled "Can the S&P 500 Continue Rising Alongside the U.S. Dollar?", dated October 13, 2016, available at uses.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "This Time Is NOT Different," dated May 25 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Twin Deficits: Bearish Or Not, The Fed Holds The Trump Card," dated February 23 2018, available at fes.bcaresearch.com 4 Please see The Bank Credit Analyst Special Report, titled "U.S. Fiscal Policy: An Unprecedented Macro Experiment," dated June 28, 2018 available at bcaresearch.com. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Portfolio Strategy Firming crude oil prices and recovering capex budgets suggest that energy E&P stocks are in a sweet spot and primed for outperformance. Decreasing refining margins, a deteriorating supply/demand backdrop and extended relative valuations suggest that refiners are a sell. Recent Changes Lift the S&P oil & gas exploration & production index to overweight today. Downgrade the S&P oil & gas refining & marketing index to underweight today. Table 1 Soldiering On Soldiering On Feature Equities broke out of their recent trading range last week on the eve of earnings season despite protectionist rhetoric. While Q2/2018 EPS euphoria may serve as a catalyst to catapult the SPX to fresh all-time highs in the coming months, especially given the collapse in stock correlations (CBOE implied correlation index shown inverted, Chart 1), sell-side analysts have now revised down Q1/2019 EPS growth estimates by 300bps to 7%. We view Q1/2019 earnings as critically important, as they will give us the first clean read on trend EPS growth. By that time the one-off impact of tax reform will be filtered out of the data. At present, Q1/2019 EPS estimates are likely suffering for two reasons: delayed P&L FX translation effects from a year-to-date rise in the U.S. dollar and difficult year-over-year comparisons with a blowout Q1/2018 quarter. In recent research, we have been flagging the currency as the single biggest risk to our sanguine equity market view. In other words, a sustainable breakout in equities requires a sideways-to-lower move in the greenback (trade-weighted U.S. dollar shown inverted, Chart 2). Chart 1All-Time Highs Ahead... All-Time Highs Ahead... All-Time Highs Ahead... Chart 2...But Watch The Greenback ...But Watch The Greenback ...But Watch The Greenback Drilling beneath the surface, Charts 3 & 4 show net earnings revisions (NER) per sector as a four week average and Chart 5 summarizes the latest data points for an easier comparison. Industrials NER have taken a hit on the back of Trump's tariff rhetoric and recent implementation. Nevertheless, the tech sector shows no signs of infiltration either from a rising currency or Trump's protectionist actions. As a reminder, the IT sector garners 60% of its sales from abroad and remains the most important sector to monitor for any broad market EPS inflection points.1 Chart 3Sector... Sector... Sector... Chart 4...Net EPS Revisions ...Net EPS Revisions ...Net EPS Revisions On the economic front, a softening U.S. dollar would be synonymous with a reacceleration in global growth. We are currently in the seventh month of the economic soft patch and there are high odds that by early fall the tide will turn. The global non-manufacturing PMI is already signaling that a pick up in growth is forthcoming. Historically, the global services PMI has been an excellent leading indicator of its sibling, the global manufacturing PMI, and the current message is to expect an end to the global growth deceleration sometime in the autumn (Chart 6). Chart 5Watch Tech Stocks Soldiering On Soldiering On Chart 6Longest Uninterrupted Payrolls Expansion On Record!!! Largest Uninterrupted Payrolls Expansion On Record!!! Largest Uninterrupted Payrolls Expansion On Record!!! In the U.S., the ISM manufacturing survey reaccelerated last month despite Trump's protectionist rhetoric with both trade subcomponents of the survey - new export orders and imports - rising smartly. Even the latest employment report came in above expectations, and confirmed that the U.S. economy is firing on all cylinders and remains a key global growth engine. Importantly, non-farm payrolls have been expanding on a month-over-month basis for the longest period on record hitting 93 consecutive months as of June (Chart 7). Similarly, the yield curve has remained positively sloped for a record 134 straight months (please see Chart 2 from our April 16th Special Report titled 'Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening'). Tack on China's recent easing in monetary conditions, as evidenced by both a depreciating currency (steepest month-over-month depreciation since 1994) and falling interest rates (Chart 8), and the likelihood of additional easing measures in the pipeline, and the world's two largest economies will likely lead global growth out of its recent mini-slump. Chart 7Can Services Pull Up Manufacturing? Can Services Pull Up Manufacturing? Can Services Pull Up Manufacturing? Chart 8China Is Easing Monetary Conditions China Is Easing Monetary Conditions China Is Easing Monetary Conditions This week we are refining our energy sector sub-surface positioning that sustains the broad energy complex in the overweight column, and we reiterate its high-conviction status. E&P Is Flaring Up... Exploration & production (E&P) stocks have significantly trailed crude oil prices since the latter broke out roughly a year ago (Chart 9). There are high odds that a catch up phase looms and we recommend to boost exposure to this late-cyclical energy sub-index to overweight. Disbelief in the longevity of the increase in oil prices is the likely culprit weighing on E&P stocks along with a bottleneck-induced steep shale oil price discount to WTI. Keep in mind that as oil prices were collapsing during the global manufacturing recession of late-2015/early-2016, the U.S. E&P industry went through a clean-up phase where a plunge in free cash flow (FCF) caused a spike in bankruptcies on the back of extreme balance sheet degradation (Chart 10). Chart 9Most Vulnerable Gap Has To Be Filled Most Vulnerable Gap Has To Be Filled Most Vulnerable Gap Has To Be Filled Chart 10Balance Sheets Getting Repaired Balance Sheets Getting Repaired Balance Sheets Getting Repaired Chart 11No Longer Stressed No Longer Stressed No Longer Stressed In more detail, E&P FCF got squashed, dropping by 66% from peak to trough as net debt ballooned by 30% during the same time frame. And, in response, independent energy producers' junk bond spreads skyrocketed to over 20%, surpassing even the Great Recession peak (Chart 11). Nevertheless, the steep recovery in underlying commodity prices along with the forgiving debt and equity markets that lent a helping hand to this extremely fragmented industry, has restored some semblance of normality in the E&P space. The second panel of Chart 9 shows that shale oil production is rising at a healthy clip following a long bottoming phase on the heels of reaccelerating WTI crude oil prices. Not only is OPEC 2.0 supporting oil price gains, but sustained domestic inventory draws are also underpinning crude prices. BCA's Commodity & Energy Strategy service remains positive on the oil price backdrop with oil price risks skewed to the upside. The upshot is that the recovery in E&P cash flow growth will continue in the coming months (second & third panels, Chart 10). Similar to the broad energy complex that integrateds dominate, oil & gas E&P producers are a capital expenditure upcycle play, which remains a key BCA theme for the year (middle panel, Chart 12). Rising oil prices are conducive to additional energy-related investments (bottom panel, Chart 9). Importantly, there is a sizable divergence between the oil & gas rig count and relative share prices that will likely narrow via a catch up phase in the latter (top panel, Chart 12). National data confirm the Baker Hughes weekly rig count that has been in a V-shaped recovery. Energy related investment has doubled from the depths of the manufacturing recession (bottom panel, Chart 12), and if oil prices even stand pat at current levels, additional drilling will most likely take place in the biggest shale plays (Permian, Eagle Ford, Marcellus and Bakken) where breakeven costs are roughly 30% lower. All of this suggests that U.S. producers will continue to pump oil at a brisk pace, and earnings will likely overwhelm. Sell side analysts have taken notice and relative EPS estimates are following crude oil prices higher. Similarly, S&P oil & gas E&P net EPS revisions are also in positive territory (Chart 13). Chart 12Capex Upcycle Beneficiary Capex Upcycle Beneficiary Capex Upcycle Beneficiary Chart 13Following Oil Higher Following Oil Higher Following Oil Higher Adding it up, there are high odds that E&P stocks will continue to outpace the broad energy complex and the SPX on the back of firming capex budgets and sustained oil inflation. Bottom Line: We are boosting the S&P oil & gas E&P index to an overweight stance. The ticker symbols for the stocks in this index are: BLBG: S5OILP - COP, EOG, APC, PXD, DVN, CXO, MRO, APA, HES, NBL, EQT, COG, XEC and NFX. ...But Refiners Are Flaming Out While we are warming up to the S&P oil & gas E&P index, the opposite is true for the pure play S&P oil & gas refining & marketing index, and recommend to trim exposure below benchmark. Refiners have taken it to the chin over the past six weeks underperforming both the SPX and the broad energy complex, and deteriorating industry fundamentals signal that more pain lies ahead. The middle panel of Chart 14 shows that crack spreads have given way recently, and as the Brent/WTI crude oil spread closes in on the zero line, refining margins will remain under intense downward pressure. Already, margins are contracting on a six-month rate of change basis and that will continue to weigh on relative share prices (bottom panel, Chart 14). This is an ominous sign for relative profits that will likely follow crack spreads lower. The refining supply/demand backdrop is also waning. Refined products consumption has sunk recently, and the year-to-date steep momentum reversal of 13 percentage points suggests that relative profits will underwhelm (top & middle panels, Chart 15). Not only is demand faltering, but the news is equally grim on refining inventories. In fact, there is no apparent supply side offset: gasoline stocks are rising (gasoline inventories shown inverted, bottom panel, Chart 15). This supply/demand backdrop will weigh on industry profitability. Worrisomely, the sell side's analyst community is extremely optimistic with regard to 12-month forward relative EPS growth estimates (north of 20%, not shown). On a 5-year forward relative EPS basis Wall Street's exuberance is unprecedented: analysts expect refiners to double the SPX's 16% long-term EPS growth rate (Chart 16). We would lean against these great expectations. Chart 14Refiners Rally Has Cracked Refiners Rally Has Cracked Refiners Rally Has Cracked Chart 15Mind The Supply/Demand Backdrop Mind The Supply/Demand Backdrop Mind The Supply/Demand Backdrop Chart 16Too Much Optimism Too Much Optimism Too Much Optimism Adding insult to injury, relative valuations do not offer any cushion in case of any profit mishaps as they are hovering near previous cyclical peaks and significantly higher than the historical mean (bottom panel, Chart 16). Netting it out, decreasing refining margins, a deteriorating supply/demand backdrop and extended relative valuations suggest that refiners are a sell. Bottom Line: Trim the S&P oil & gas refining & marketing index to underweight. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC, ANDV and HFC. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Unwavering," dated June 4, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Arthur Budaghyan, Senior Vice President Chief Emerging Markets Strategist Highlights The authorities in China have begun easing liquidity conditions but that is not sufficient to turn positive on mainland growth. For the next six months at least, the mainland's growth conditions will continue deteriorating and that warrants a negative stance on China-related risk assets, including commodities and EM. The path of least resistance for the dollar is up. This will continue to weigh on EM risk assets. A narrowing interest rate differential between China and the U.S. will continue exerting downward pressure on the RMB's value versus the dollar. Our credit stress test on Turkish banks suggests their stocks are not yet cheap assuming the non-performing loan ratio rises to 15%. Stay short banks and the lira. Feature China's economic slowdown, ongoing trade wars and accumulating U.S. inflation pressures will continue propping up the U.S. dollar, thereby sustaining a perfect storm for EM financial markets. This is taking place amid the poor structural fundamentals in the developing economies and the existing overhang of investor positions in EM. Altogether this argues for more downside in EM financial markets. A strong dollar is also a bad omen for developed markets' stock indexes. The reason being that the dollar is a countercyclical variable, and the greenback's rallies usually coincide with global trade downturns that are bearish for global cyclical equity sectors (Chart I-1). Needless to say, tariffs on imports are ultimately negative for global trade, and will exacerbate the global growth slowdown that has been occurring since early this year. In fact, there is anecdotal evidence that global trade has so far temporarily benefited from mounting expectations of tariffs.1 Companies have ordered more inputs and shipped more goods in advance of higher tariffs coming into effect. This is why global shipments and manufacturing production have so far held up reasonably well, while business expectations have plummeted (Chart I-2). Consequently, global trade and manufacturing production will likely record considerable weakness later this year. Since markets are typically forward looking, asset prices will adjust beforehand. Chart I-1Global Industrial Stocks And U.S. Dollar Global Industrial Stocks And U.S. Dollar Global Industrial Stocks And U.S. Dollar Chart I-2Global Trade Is Heading South Global Trade Is Heading South Global Trade Is Heading South We are maintaining our negative stance on EM stocks, currencies, credit markets and high-yielding local bonds. China Is Easing Liquidity, But Don't Hold Your Breath Chart I-3Chinese Interest Rates And EM Stocks: ##br##Positively Correlated Chinese Interest Rates And EM Stocks: Positively Correlated Chinese Interest Rates And EM Stocks: Positively Correlated China's softening industrial data, growing anecdotal evidence of a worsening credit crunch in the economy, U.S. tariffs, and plunging domestic share prices have been sufficient for the authorities to ease liquidity conditions in the Chinese banking system. Not surprisingly, many investors are wondering whether the worst is over for Chinese stocks and China-related financial markets worldwide, including those in EM. At the current juncture, liquidity easing by the PBOC is a necessary but not sufficient condition to turn positive on this nation's industrial cycle as well as EM risk assets. We have the following considerations on this topic: First, China's risk-free interest rates - government bond yields - led the selloff in both EM and Chinese stocks (Chart 3). These bond yields have plunged since November, foreshadowing the slowdown in China's growth and the carnage in EM/Chinese financial markets. By and large, there has been a positive correlation between EM share prices and China's local bond yields and interbank rates as illustrated on Chart I-3. For example, EM stocks, currencies and credit markets rallied substantially in 2017 in the face of rising interest rates in China. Likewise, they dropped in the second half of 2015 as bond yields and money market rates in China plunged. The rationale behind the positive correlation between EM risk assets and Chinese interest rates is that the latter rise and EM risk assets rally when the mainland economy is improving. The opposite is also true. At the moment, Chinese risk-free bond yields will likely continue to drop as additional slowdown in growth is in the cards. This heralds a further drop in EM financial markets. Second, any major stimulus will constitute a retraction of the Chinese government's policy of deleveraging and containing financial risks. The latter is the code phrase Chinese authorities use to stop fueling bubbles and speculative excesses. Hence, any policy stimulus will for now be measured and insufficient to boost growth this year. China is saddled with massive debt and money overhangs and a bubbly property market. Ongoing enormous expansion in money supply (i.e., RMB deposits)2 (Chart I-4) and a narrowing interest rate differential over the U.S. will continue exerting downward pressure on the RMB's value (Chart I-5). Chart I-4'Helicopter Money' In China Helicopter Money' In China Helicopter Money' In China Chart I-5The RMB Will Depreciate Further The RMB Will Depreciate Further The RMB Will Depreciate Further Even though capital controls have tightened since 2015, the capital account is not perfectly closed. As such, shrinking interest rate deferential versus the U.S. warrants further yuan depreciation. In short, the authorities cannot reduce interest rates further and expand money/credit growth at a double-digit rate without tolerating sizable currency deprecation. If the Chinese authorities opt for a large fiscal and credit stimulus again, the nation's structural imbalances will grow further. In this scenario, the Middle Kingdom's secular growth outlook will deteriorate, and policymakers' manoeuvring room to stimulate in the future will narrow. Chart I-6China: The Industrial Cycle Is Slumping China: The Industrial Cycle Is Slumping China: The Industrial Cycle Is Slumping Crucially, China's enormous money and credit creation are entirely unrelated to its high savings rate. Money and credit in China have been driven by speculative behavior of Chinese banks and borrowers not households' high savings rate. We have discussed these issues in detail in our past special reports3 and will not expand on them here. Third, there has been money/credit tightening on three fronts in China - liquidity, regulatory and anti-corruption. Even though liquidity conditions in the banking system are now ameliorating, as evidenced by the plunge in interbank rates, the regulatory clampdown on the shadow banking system as well as the anti-corruption campaign targeting the financial industry are still underway. The latter policy initiatives will continue to curb credit creation by suppressing banks' and shadow banking institutions' ability and willingness to finance the real economy. In fact, it is not inconceivable that the regulatory clampdown and anti-corruption campaign will have a larger impact on credit supply than the decline in borrowing costs. Finally, policy easing and tightening works with a time lag. China's business cycles and related financial markets do not always respond swiftly to changes in policy stance. Specifically, monetary and fiscal policies were easing substantially from the middle of 2015, yet EM/China-related risk assets continued to plummet for six months until February 2016. Conversely, policy was tightening in China throughout 2017, yet EM/China-related asset markets did well in 2017. In brief, there could be a long lag between a change in policy stance and a reversal in financial markets. For now, we reckon that the cumulative effect of policy tightening of the past 18 months will continue to seep through the Chinese economy till the end of this year. Chart I-6 demonstrates that various industrial cycle indicators continue to deteriorate. Bottom Line: The authorities in China have begun easing liquidity conditions but that is not sufficient to turn positive on Chinese growth and China-related risk assets, including commodities and EM. For the next six months at least, the mainland's growth conditions will continue deteriorating and that warrants a negative stance on China-related risk assets. More Downside The indicators that have been useful in foretelling the turmoil in EM financial markets this year are signaling that a negative stance is still warranted: One indicator that gave an early warning signal for the current EM selloff was EM sovereign and corporate bond yields. At the moment, the average of EM dollar-denominated corporate and sovereign bond yields continues to presage lower EM stock prices, as demonstrated in Chart I-7 - bond yields are shown inverted in this chart. Chart I-7Rising EM Borrowing Costs Are Bearish For Their Stocks Rising EM Borrowing Costs Are Bearish For Their Stocks Rising EM Borrowing Costs Are Bearish For Their Stocks Notably, EM share prices display lower correlation with U.S. bond yields and U.S. TIPS yields than with EM corporate and sovereign bond yields (Chart I-8). Why are EM share prices exhibiting a stronger correlation with EM bond yields rather than with U.S. Treasury yields? The basis is that EM equities are sensitive to EM - not U.S. - borrowing costs. So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate and sovereign U.S. dollar bond yields - i.e. EM borrowing costs in dollars - will decline, and EM share prices will rally (Chart I-7). But when EM corporate (or sovereign) yields rise - irrespective of whether because of rising U.S. Treasury yields or widening EM credit spreads - EM borrowing costs in dollars rise, and consequently equity prices come under considerable selling pressure. In other words, a drop in U.S. bond yields on its own is not enough for EM share prices to advance, and conversely, a rise in U.S. bond yields is not sufficient for EM stocks to drop. It is movements in EM U.S. dollar bond yields, which are comprised of U.S. Treasury yields and EM credit spreads, that matter for the direction of EM equity prices. Regarding local bond yields, EM share prices typically exhibit a strong negative correlation with EM domestic government bonds yields - the latter are shown inverted on this chart (Chart I-9). Since we expect EM currencies to depreciate further and, given the negative correlation between EM currency values and their local bond yields, the latter will continue rising. Chart I-8EM Stocks And U.S. Rates: ##br##Mixed Relationship EM Stocks And U.S. Rates: Mixed Relationship EM Stocks And U.S. Rates: Mixed Relationship Chart I-9EM Equities And Local Bond Yields: ##br##Strong Correlation EM Equities and Local Bond Yields: Strong Correlation EM Equities and Local Bond Yields: Strong Correlation The risky-to-safe-haven currency ratio4 continues to fall after experiencing a major breakdown early this year (Chart I-10, top panel). Historically, this ratio has been correlated with EM share prices and currently heralds further downside (Chart I-10, bottom panel). This ratio also is agnostic to the dollar's direction - it swings between risk-on versus risk-off regimes in financial markets, regardless of the general trend in the greenback. Hence, this indicator answers the question of the direction of EM share prices, regardless of the dollar's trend. Finally, key to EM performance has been corporate profits. Presently, the outlook for EM corporate profits is still negative, as suggested by the negative readings on China's money and credit (Chart I-11). Chart I-10Are Risk Assets In A Bear Market? bca.ems_wr_2018_07_12_s1_c10 bca.ems_wr_2018_07_12_s1_c10 Chart I-11EM Corporate Profits Will Likely Shrink EM Corporate Profits Will Likely Shrink EM Corporate Profits Will Likely Shrink Bottom Line: EM risk asset will continue selling off and underperforming their DM counterparts. Stay short/underweight EM risk assets. The Dollar's Trend Is Still Up The U.S. dollar is instrumental to EM financial market trends. We expect the dollar rally to persist for now - at least through the end of this year. The underlying inflation gauge measure calculated by New York Fed points to further acceleration in U.S. consumer price inflation (Chart I-12). Furthermore, America's job market is continuing to tighten. In brief, U.S. domestic demand will stay robust even as global trade slumps. These will limit the Federal Reserve's ability to back off from tightening, even if EM financial markets continue to sell off. Chart I-12U.S. Inflation Risks Are To The Upside U.S. Inflation Risks Are To The Upside U.S. Inflation Risks Are To The Upside Remarkably, a strong U.S. exchange rate is needed to cap America's growth and inflation and to boost growth in the rest of the world, especially in Asia. Given the widening growth momentum between the U.S. and Asia, the dollar will likely need to rally significantly to reverse the growth differential currently moving in favor of America. This will be especially true if more trade tariffs are imposed. Odds are that the RMB will depreciate further given the backdrop of lower interest rates in China - discussed above. That will cause a downturn in emerging Asian currencies. A strong dollar, a slowdown in Chinese/EM demand for commodities and large net long positions by investors in oil and copper all argue for a considerable drop in commodities prices in the months ahead. This is bearish for Latin American and many other EM exchange rates. Bottom Line: The path of least resistance for the dollar is up. This will continue to weigh on EM risk assets. With respect to currency positions, we recommend investors to continue to short a basket of EM currencies such as BRL, ZAR, TRY, MYR and IDR versus the dollar. CLP and KRW are also among our shorts given our bearish outlook for copper prices, global trade and Asian currencies. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Turkish Banks: A Bargain Or Value Trap? 12 July 2018 Turkish bank stocks have now fallen by 40% in local currency terms and by 55% in U.S. dollar terms since their peak early this year (Chart II-1), prompting the question whether they have become a bargain or are still a value trap. Banks represent 30% of the Turkey MSCI index and are integral to the performance of this bourse. Although Turkish banks appear to be cheap with their price-to-trailing earnings ratio at 4.5 and their price-to-book value ratio at 0.62, they are still vulnerable to a substantial rise in non-performing loans (NPL) and ensuing provisioning, write-off and equity dilution. Turkey has been experiencing an enormous credit binge for years and its interest rates have risen by 600 basis points since the start of the year. Yet, current NPLs and provisions stand at a mere 3% and 2.3% of total outstanding loan, respectively (Chart II-2). Chart II-1Turkish Stocks: A Long-Term Perspective Turkish Stocks: A Long-Term Perspective Turkish Stocks: A Long-Term Perspective Chart II-2Turkish Banks Are Underprovisioned Turkish Banks Are Underprovisioned Turkish Banks Are Underprovisioned The creditworthiness of debtors is worse when one takes into account that Turkish companies have large foreign currency debt and a record amount of foreign debt obligations due in 2018 (Chart II-3). In our credit stress test, we assume that in the baseline scenario the non-performing credit assets (NPCA) ratio will rise to 15% (Table II-1). Taking into account that the NPL-to-total loan ratio reached 18% in 2002 after the 2001 currency crisis, we believe 15% is a reasonable estimate. Chart II-3Turkey: Record High Foreign Debt Obligations Turkey: Record High Foreign Debt Obligations Turkey: Record High Foreign Debt Obligations Table II-1Credit Stress Test For Turkish Banks EM: A Perfect Storm EM: A Perfect Storm To put this number further into perspective, India - one of the very few countries within the EM universe to have somewhat fully recognized its NPLs - currently has an NPL ratio of 15% on its public banks. Chart II-4Turkish Equities: ##br##A Cyclically-Adjusted P/E Ratio Turkish Equities: A Cyclically-Adjusted P/E Ratio Turkish Equities: A Cyclically-Adjusted P/E Ratio If we assume that Turkish bank stocks at the end of this cycle will trade at a price-to-book ratio of 1 after adjusting for all credit losses, then banks' stock prices are currently about 17% overvalued in the baseline scenario of 15% NPCA (Table II-1, the middle row). In all three scenarios, we assume a recovery rate of 40%. With regards to the overall equity market, Chart II-4 demonstrates that the cyclically-adjusted P/E (CAPE) ratio for Turkish stocks is currently around 5, compared to the historical average of 8. For the bourse's CAPE ratio to drop to two standard deviations below its mean, share prices have to fall by another 20-25%. This is plausible given the outlook for more populist economic policies following the recent elections. Besides, corporate profits will contract considerably because of the monetary tightening that has occurred since early this year. The exchange rate is critical for Turkish financial markets. As such, revisiting currency valuation is also important. Our favorite measure of currency valuation is the real effective exchange rate based on unit labor costs. This takes into account both wages and productivity. Hence, it gauges competitiveness much better than the measures of real effective exchange rate based on consumer and producer prices. Using this measure, as of July 11 the lira was slightly more than one standard deviation below its historical mean (Chart II-5). For it to reach two standard deviations below its mean, it would roughly take another 15-17% depreciation, versus an equal-weighted basket of the dollar and euro. Given the current macroeconomic backdrop and the outlook for more unorthodox policies, including possible capital controls following President Erdogan's appointment of his son-in law as the key economic policymaker, the lira will likely undershoot. Meantime, foreign holdings of Turkish local bonds and stocks were not yet depressed as of June 29 (Chart II-6). Chart II-5Turkish Lira: An Undershoot Is Likely Turkish Lira: An Undershoot Is Likely Turkish Lira: An Undershoot Is Likely Chart II-6Foreign Ownership Is Still High Foreign Ownership Is Still High Foreign Ownership Is Still High Bottom Line: Provided Turkey's political outlook has deteriorated further after the recent elections, we assess that only after a 15% depreciation in the lira versus an equal-weighted basket of the dollar and euro, in combination with a 15-20% drop in stocks in local currency terms, will Turkish equities be a true bargain and warrant a positive stance. For now, dedicated EM equity and fixed income portfolios (both credit and local currency bonds) should continue to underweight Turkey. Our open directional trades at the moment remain: Short Turkish bank stocks Short TRY / long USD. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the following article Global automakers hail more ships as trade battles heat up. 2 Please see Emerging Markets Strategy Weekly Report "Follow The Money, Not The Crowd," dated July 26, 2017, available on ems.bcaresearch.com 3 Please see Emerging Markets Strategy Special Report "The True Meaning Of China's Great 'Savings' Wall," dated December 20, 2017, available on ems.bcaresearch.com; and Emerging Markets Strategy Special Report "Is Investment Constrained By Savings? Tales Of China And Brazil," dated March 22, 2018, link is available on page 17. 4 Average of cad, aud, nzd, brl, clp & zar total return indices relative to average of jpy & chf total returns (including carry); rebased to 100 at January 2000. Equity Recommendations Fixed-Income, Credit And Currency Recommendations