Market Returns

Highlights The greenback normally weakens when the U.S. business cycle matures; 2018 may prove an exception to this rule. Rising U.S. inflation could clash with deteriorating global growth, bringing the monetary divergence narrative back in vogue. This would help the dollar. EM assets are especially at risk from a rising dollar. Tightening EM financial conditions would ensue, creating additional support for the dollar. The yen is caught between bearish and bullish crosscurrents. Continue to favor short EUR/JPY and short AUD/JPY over bets on USD/JPY. Set a stop sell on EUR/GBP at 0.895, with a target at 0.8300 and a stop loss at 0.917. Feature Late in the business cycle, U.S. growth begins to slow relative to the rest of the world, and normally the U.S. dollar weakens in the process. The general trajectory of the dollar this business cycle is likely to end up following this historical pattern, and last year's decline for the greenback was fully in line with past experience. However, 2018 could be an odd year, where the dollar manages to rally thanks to a combination of softening global growth and rising inflationary pressures in the U.S., which forces the Federal Reserve to be less sensitive to the trajectory of global economic conditions than it has been since the recession ended in 2009. Normally, The USD Sags Late Cycle We have already showed that EUR/USD tends to rally once the U.S. business cycle matures enough that the Fed pushes interest rates closer to their neutral level. Essentially, because the eurozone business cycle tends to lag that of the U.S., the European Central Bank also lags the Fed, which also implies that European policy rates remain accommodative longer than those in the U.S. Paradoxically, this means that late in the cycle, European growth can outperform that of the U.S., and markets can price in more upcoming interest rate increases in Europe than in the U.S., lifting the euro in the process (Chart I-1). Chart I-1The Euro Rallies Late In The Business Cycle The Euro Rallies Late In The Business Cycle The Euro Rallies Late In The Business Cycle Not too surprisingly, these dynamics can be recreated for the entire dollar index. As Chart I-2 illustrates, when we move into the later innings of the business cycle, global growth begins to outperform U.S. growth, and in the process, the DXY weakens. There has been an exception to these dynamics - the late 1990s - when the dollar managed to rally despite the lateness of the U.S. business cycle. Back then, the dollar was in a bubble, and the strong sensitivity of the dollar to momentum (Chart I-3) helped foment self-fulfilling dollar strength.1 Moreover, EM growth was generally weak. This begs the question, could 2018 evoke the late 1990s? Chart I-2What Works For The Euro Mirrors What Works For The Dollar What Works For The Euro Mirrors What Works For The Dollar What Works For The Euro Mirrors What Works For The Dollar Chart I-3Momentum Winners: USD And JPY Crosses A Long, Strange Cycle A Long, Strange Cycle Bottom Line: Normally, the U.S. dollar tends to weaken in the later innings of the U.S. business cycle, as non-U.S. growth overtakes U.S. growth. However, in 1999 and in 2000, the dollar managed to rally despite the U.S. business cycle moving toward its last hurrah. Not A Normal Cycle This cycle has been anything but normal. Growth in the entire G-10 has been rather tepid. While it is true that potential growth, or the supply side of the economy, is lower than it once was, courtesy of anemic productivity growth and an ageing population, demand growth has also suffered thanks to a protracted period of deleveraging. But the U.S. has been quicker than most other major economies in dealing with the ills that ailed her, executing a quicker private sector deleveraging than the rest of the G-10 (Chart I-4). As a result, today the U.S. output and unemployment gaps are more closed than is the case in the rest of the G-10. As Chart I-5 illustrates, aggregate U.S. capacity utilization - which incorporates both industrial capacity utilization and labor market conditions - is at its highest level since 2006. With growth staying above trend, the inevitable is finally materializing and inflation is picking up. Chart I-4The U.S. Delevered, It Is Now Reaping The Benefits The U.S. Delevered, It Is Now Reaping The Benefits The U.S. Delevered, It Is Now Reaping The Benefits Chart I-5The Fed Is Now Less Sensitive To Foreign Shocks The Fed Is Now Less Sensitive To Foreign Shocks The Fed Is Now Less Sensitive To Foreign Shocks As Chart I-5 illustrates, aggregate U.S. capacity utilization - which incorporates both industrial capacity utilization and labor market conditions - is at its highest level since 2006. With growth staying above trend, the inevitable is finally materializing and inflation is picking up. Core PCE is now at 1.9%, and thus the 2% target is finally within reach. Just as importantly, 10-year and 5-year/5-year forward inflation breakevens have rebounded to 2.17% and 2.24% respectively, close to the 2.3% to 2.5% range - consistent with the Fed achieving its inflation target (Chart I-6). This implies that inflation expectations are getting re-anchored at comfortable levels for the Fed. As the threat of deflation and deflationary expectation passes, the Fed is escaping the fate of the Bank of Japan in the late 1990s. It also means that the Fed is now less likely to respond as vigorously to a deflationary shock emanating from outside the U.S. than was the case in 2016, when the U.S. economy still had plentiful slack, and realized and expected inflation was wobblier. The rest of the DM economies have not deleveraged, have more slack, and are more opened to global trade than the U.S. This exposure to the global economic cycle was a blessing in 2017, when global trade and global industrial activity were accelerating. But this is not the case anymore. As Chart I-7 illustrates, the Global Zew Economic Expectations survey is exhibiting negative momentum, which historically has preceded periods of deceleration in the momentum of global PMIs as well. Chart I-6Stage 1 Almost Complete The Fed Finally Enjoys ##br##Compliant Inflationary Conditions Stage 1 Almost Complete The Fed Finally Enjoys Compliant Inflationary Conditions Stage 1 Almost Complete The Fed Finally Enjoys Compliant Inflationary Conditions Chart I-7Downdraft In##br## Global Growth Downdraft In Global Growth Downdraft In Global Growth While this phenomenon is a global one, Asia stands at its epicenter. China's industrial activity is slowing sharply, as both the Li-Keqiang index2 and its leading index, developed by Jonathan LaBerge who runs BCA's China Investment Strategy service, are falling (Chart I-8, top panel). China is not alone: Korean exports and manufacturing production are now contracting on an annual basis; Singapore too is suffering from a clearly visible malaise (Chart I-8, middle and bottom panels). Advanced economies are also catching the Asian cold. Australia and Sweden, two small open economies, have seen key leading economic gauges slow (Chart I-9, top panel). Even Canadian export volumes have rolled over (Chart I-9, middle panel). Finally, the more closed European economy is showing worrying signs, with exports slowing sharply and PMIs rolling over. As we highlighted two weeks ago, even the European locomotive - Germany - is being affected, with domestic manufacturing orders now contracting on an annual basis.3 Chart I-8Asia Is The Source Of The Malaise Asia Is The Source Of The Malaise Asia Is The Source Of The Malaise Chart I-9The Cold Might Be Spreading The Cold Might Be Spreading The Cold Might Be Spreading This dichotomy between U.S. inflation and weakening global activity is resurrecting a theme that was all the rage in 2015 and 2016: monetary divergences. Fed officials sound as hawkish as ever and will likely push up the fed funds rate five times over the next 18 months even if global growth softens a bit. However, the ECB, the Riksbank, the Bank of England, the Reserve Bank of Australia, the Bank of Canada and even the BoJ are all backpedaling on their removal of monetary accommodation. They worry that growth is not yet robust enough, or that capacity utilization is not as high as may seem. The theme of monetary divergence will therefore likely be the result of non-U.S. central banks softening their rhetoric, not the Fed tightening hers. The end result is likely to cause a period of strength in the U.S. dollar, one that may have already begun. In fact, that strength is likely to have further to go for the following five reasons: First, as we showed in Chart I-3, the dollar is a momentum currency, and as Chart I-10 illustrates, the dollar's momentum is improving after having formed a positive divergence with prices. Chart I-10USD Momentum Is Picking Up USD Momentum Is Picking Up USD Momentum Is Picking Up Second, speculators and levered investors currently hold near-record amounts of long bets on various currencies, implying they are massively short the dollar (Chart I-11). This raises the probability of a short squeeze if the dollar's autocorrelation of returns stays in place. Chart I-11 A Long, Strange Cycle A Long, Strange Cycle Third, the dollar is prodigiously cheap relative to interest rate differentials (Chart I-12). While divergences from interest rate parity are common in the FX market, they never last forever. Thus, if monetary divergences become once again a dominant narrative among FX market participants, a move toward UIP equilibria will grow more likely. Fourth, rising Libor-OIS spreads have been pointing to a growing shortage of dollars in the offshore market. The decline in excess reserves in the U.S. banking system corroborates the view that liquidity is slowing drying up. Historically, these occurrences point to a strong dollar (Chart I-13). Chart I-12A Return To Interest-Rate##br## Parity? A Return To Interest-Rate Parity? A Return To Interest-Rate Parity? Chart I-13Falling Excess Bank Reserves Equals Strong Greenback Liquidity Factors Point To A Dollar Rebound Falling Excess Bank Reserves Equals Strong Greenback Liquidity Factors Point To A Dollar Rebound Falling Excess Bank Reserves Equals Strong Greenback Liquidity Factors Point To A Dollar Rebound Fifth, a strong dollar tightens EM financial conditions (Chart I-14). This could deepen the malaise already visible in Asia that seems to be slowly spreading to the global economy. This last point is essential, as it lies at the crux of the reason why the USD is the epitome of "momentum currencies." Essentially, this reflects the importance of the dollar as a source of funding for emerging market governments and businesses. The amount of EM dollar debt has been rising. In fact, excluding China, dollar-denominated debt today represents 16% of EM GDP, 65% of EM exports and 75% of EM reserves - the highest levels since the turn of the millennium (Chart I-15). Practically, this means that the price of EM currencies versus the USD is a key component to the cost of capital in EM. Chart I-14The Dollar Is The Enemy ##br##Of EM Financial Conditions The Dollar Is The Enemy Of EM Financial Conditions The Dollar Is The Enemy Of EM Financial Conditions Chart I-15EM Have A Lot ##br##Of Dollar Debt EM Have A Lot Of Dollar Debt EM Have A Lot Of Dollar Debt Additionally, EM local currency debt instruments are exhibiting their highest duration since we have data, making them more vulnerable to higher global interest rates (Chart I-16). Hence, the capital losses resulting from a given move higher in interest rates have grown, sharpening the risk that EM bond markets could experience a violent liquidation event. Moreover according to the IIF, the average sovereign rating of EM debt is at its lowest level since 2009. Normally, the allocation of global institutional investors into EM debt is positively correlated with the quality of EM issuers, but today this allocation has risen to more than 12%, the highest share in over five years. This suggests that DM investors are overly exposed to EM risk, creating another source of potential selling of EM assets. Ultimately, these risk factors can create a powerful feedback loop that support the sensitivity of the dollar to momentum. A strong U.S. dollar hurts EM assets, which prompts overexposed global investors to sell EM currencies further. This can be seen in the negative correlation of the broad trade-weighted dollar and high-yield EM bond prices (Chart I-17, top panel). Additionally, because rising EM bond yields as well as falling EM equities and currencies tighten EM financial conditions, this hurts EM growth. However, the U.S. economy is not as sensitive to EM growth as the rest of the world is.4 As a result, weakness in EM assets also translates into dollar strength against the majors (Chart I-17, middle panel). Additionally, commodity currencies tend to suffer more in this environment than European ones, as shown by the rallies in EUR/AUD concurrent with EM bond price weakness (Chart I-17, bottom panel). These risky dynamics in EM markets therefore are a key reason why we expect the U.S. dollar to be able to rally, bucking the normal weakness associated with the late stages of a U.S. business cycle expansion. Specifically, EUR/USD is set to suffer this year as the euro's technical picture has deteriorated significantly (Chart I-18), and, as we argued two weeks ago, the euro area still has plenty of slack. Chart I-16Heightened EM Duration Risk Heightened EM Duration Risk Heightened EM Duration Risk Chart I-17EM Risks Help The Greenback EM Risks Help The Greenback EM Risks Help The Greenback Chart I-18EUR/USD Technicals Are Flimsy EUR/USD Technicals Are Flimsy EUR/USD Technicals Are Flimsy Bottom Line: For the remainder of 2018, the dollar is likely to buck the weakness it normally experiences in the late innings of a .S. business cycle expansion. The U.S. is significantly ahead of the rest of the world when it comes to inflation, giving more room for the Fed to hike rates. This difference is now put in sharper focus than last year as the global economy is weakening, which could prompt a period of dovish rhetoric in the rest of the world that will not be matched by an equivalent backtracking in the U.S. Moreover, while positioning and technical considerations also favor a dollar rebound, the vulnerability of EM assets increases this risk by creating an additional drag on foreign growth. What To Do With The Yen? The yen currently sits at a tricky spot. Historically, the yen tends to depreciate against the USD when we are at the tail end of a U.S. business cycle expansion (Chart I-19). Toward the end of the business cycle, U.S. bond yields experience some upside - upside that is not mimicked by Japanese interest rates. The resultant widening in interest rate differentials favors the dollar. Chart I-19The Yen Doesn't Enjoy Late Cycle Dynamics The Yen Doesn't Enjoy Late Cycle Dynamics The Yen Doesn't Enjoy Late Cycle Dynamics On the other hand, a period of weakness in EM assets, even if prompted by a dollar rebound, could help the yen. The yen is a crucial funding currency in global carry trades, and a reversal of these carry trades will spur some large yen buying. Moreover, Japan has a net international investment position of US$3.1 trillion. This means that Japanese investors, who are heavily exposed to EM assets, are likely to repatriate some funds back home. So what to do? We have to listen to economic conditions in Japan. So far, despite an unemployment rate at 25-year lows and a job-opening-to-applicant ratio at a 44-year highs, Japan has not been able to generate much inflationary pressures. In fact, while the national CPI data has remained robust, the Tokyo CPI, which provides one additional month of data, has begun to roll over (Chart I-20). The Japanese current account is deteriorating sharply. This mostly reflects the downshift in EM economic activity as 44% of Japanese exports are destined to those markets. Interestingly, in response to the deterioration in export growth, import growth is also decelerating sharply, pointing toward a domestic impact from the foreign weakness (Chart I-21). It is looking increasingly clear that overall economic momentum in Japan is slowing. Both the shipment-to-inventory ratio as well as the Cabinet Office leading diffusion index are exhibiting sharp drops - signs that normally foretell a slowdown in industrial production and therefore a deterioration in capacity utilization, which still stands well below pre-2008 levels (Chart I-22). Chart I-20Weakening Japanese Inflation Weakening Japanese Inflation Weakening Japanese Inflation Chart I-21The Asian Malaise Is Hitting Japan The Asian Malaise Is Hitting Japan The Asian Malaise Is Hitting Japan Chart I-22Japanese Outlook Deteriorating Japanese Outlook Deteriorating Japanese Outlook Deteriorating In response to these developments, BoJ Governor Haruhiko Kuroda has been sounding more dovish. Moreover, after its latest policy meeting, the BoJ is acknowledging that it will take more time than anticipated for inflation to move toward its 2% target. In this environment, the yen has begun to weaken against the USD, especially as the greenback has been strong across the board. Moreover, USD/JPY was already trading at a discount to interest rate differentials. The downshift in Japanese economic data as well as the shift in tone by the BoJ are catalyzing the closure of this gap. Practically talking, USD/JPY is currently a very dangerous cross to play, as it is caught between various cross currents: a broad-based dollar rebound and a BoJ responding to a slowing economy can help USD/JPY; however, rising EM risks could boost it. On balance, we now expect the bullish USD forces to prevail on the yen, but we are not strongly committed to this view. Instead, have long maintained that the higher probability vehicle to play the yen is to short EUR/JPY.5 We remain committed to this strategy for the yen. Based on interest rate differentials, the price of commodities and global risk aversion, the euro can decline further against the yen, as previous overshoots are followed with significant undershoots (Chart 23, left panels). Moreover, speculators remains too long the euro versus the yen (Chart I-23, right panels). Additionally, EUR/JPY remains expensive on a long-term basis, trading 13% above its PPP-implied fair value. Finally, in contrast to Japan's large positive net international investment position, Europe's stands at -4.5% of GDP. Japanese investors have proportionally more funds held abroad than European investors do, and therefore more scope to repatriate funds in the event of rising EM asset volatility. We have also highlighted that selling AUD/JPY, while a more volatile bet than being short EUR/JPY, is another attractive way to play the risk to EM markets. Not only is AUD/JPY still very overvalued (Chart I-24), but Australia remains highly exposed to EM growth. This remains an attractive bet, despite a good selloff so far this year. Chart I-23AShort EUR/JPY Is A Cleaner Story (I) Short EUR/JPY Is A Cleaner Story (I) Short EUR/JPY Is A Cleaner Story (I) Chart I-23BShort EUR/JPY Is A Cleaner Story (II) Short EUR/JPY Is A Cleaner Story (II) Short EUR/JPY Is A Cleaner Story (II) Chart I-24AUD/JPY Is At Risk AUD/JPY Is At Risk AUD/JPY Is At Risk Bottom Line: The yen tends to depreciate against the USD in the later innings of a U.S. business cycle expansion, a response to rising U.S. bond yields. However, the yen also benefits when EM asset prices fall, a growing risk at the current economic juncture. Moreover, Japanese economic data are deteriorating and the BoJ is shifting toward a more dovish slant. The balance of these forces suggests that the yen rally against the dollar is done for now. However, the yen has further scope to rise against the EUR and the AUD. Two Charts On EUR/GBP Since we are anticipating EUR/USD to fall further toward 1.15, this also begs questions for the pound. Historically, a weak EUR/USD is accompanied by a depreciating EUR/GBP (Chart I-25). Essentially, the pound acts as a low-beta euro against the USD, and therefore when EUR/USD weakens, GBP/USD weakens less, resulting in a falling EUR/GBP. This time around, British economic developments further confirm this assessment. The spread between the British CBI retail sales survey actual and expected component has collapsed, pointing to a depreciating EUR/GBP (Chart I-26). Essentially, the brunt of the negative impact of Brexit on the British economy is currently being felt, which is affecting investor sentiment on the pound relative to the euro. Why could consumption, which represents nearly 70% of the U.K. economy, rebound from current poor readings? Once inflation weakens - a direct consequence of the previous rebound in cable - real incomes of British households will recover from their currently depressed levels, boosting consumption in the process. Chart I-25Where EUR/USD Goes,##br## EUR/GBP Follows Where EUR/USD Goes, EUR/GBP Follows Where EUR/USD Goes, EUR/GBP Follows Chart I-26Economic Conditions Also Point ##br##To A Weakening EUR/GBP Economic Conditions Also Point To A Weakening EUR/GBP Economic Conditions Also Point To A Weakening EUR/GBP Finally, today only 42% of the British electorate is pleased with having voted for Brexit, the lowest share of the population since that fateful June 2016 night. Moreover, this week, the House of Lords voted that Westminster can adjust the final deal with the EU before turning it into law. This implies that the probability of a soft Brexit, or even no Brexit at all, is increasing. However, the challenge to Theresa May's post-Brexit customs plan by MP Rees-Mogg, is creating yet another short-term hurdle that makes the path toward this outcome rather torturous. Additionally, it also raises the probability of a Corbyn-led government if the current one collapses. As a result, while the economic developments continue to favor being short EUR/GBP, the political environment is still filled with landmines, creating ample volatility in the pound crosses. We will use any rebound to EUR/GBP 0.895 to sell this pair. Bottom Line: If the euro weakens further, GBP/USD is likely to follow and depreciate as well. However, the pound will likely rally against the euro. Historically, GBP/USD behaves as a low-beta version of EUR/USD. Moreover, the maximum post-Brexit economic pain is potentially being felt right now, implying a less cloudy economic outlook for the U.K. Additionally, the probability of a soft Brexit or no Brexit at all is growing even if partial volatility remains. Set a stop sell on EUR/GBP at 0.895, with a target at 0.8300 and a stop loss at 0.917. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 2 The Li-Keqiang index is based on railway cargo volume, electricity consumption, and loan growth. 3 Please see Foreign Exchange Strategy Weekly Report, titled "The ECB's Dilemma", dated April 20, 2018, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, titled "Yen: QQE Is Dead! Long Live YYC!", dated January 12, 2018, and Foreign Exchange Strategy Weekly Report, titled "The Yen's Mighty Rise Continues... For Now", dated February 16, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was marginally positive this week. As headline PCE climbed to the targeted 2% level, the underlying core PCE also edged up to 1.9%, highlighting growing inflationary forces. However, countering these positive releases were disappointing PMIs and a slowing ISM, as well as pending home sales, which contracted on a 4.4% annual basis. Regardless, the Fed acknowledged the strength of the U.S. economy. The FOMC referred to the inflation target as "symmetric", signaling that for now, inflation above target will not be used as an excuse to lift rates faster than currently forecasted in the dots. Nevertheless, the much-awaited breakout in the dollar materialized two weeks ago. As global growth wains, key central banks such as the ECB, BoJ, and BoE are likely to retreat to a more dovish tilt, as growth forecasts are revised down. This should give the greenback a substantial boost this year. Report Links: Is King Dollar Facing Regicide? - April 27, 2018 U.S. Twin Deficits: Is The Dollar Doomed? - April 13, 2018 More Than Just Trade Wars - April 6, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data was weak: M3 and M1 money supply growth both weakened to 3.7% and 7.6%; Annual GDP growth slowed down to 2.5%, as expected; Both the headline and core measures of inflation disappointed, coming in at 1.2% and 0.7%, respectively. The euro broke down below a crucial upward-slopping trendline, which was defining the euro's rally last year. Additionally, EUR/USD has also broken the 200-day moving average technical barrier, highlighting the impact on the euro of weakening global growth and faltering European data. This decline in activity, along with the presence of hidden-labor market slack have been picked up by President Mario Draghi and other key ECB officials. Therefore, weakness in the euro is likely to continue for now. Report Links: More Than Just Trade Wars - April 6, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Nikkei manufacturing PMI surprised to the upside, coming in at 53.8. However, Tokyo inflation ex-fresh food underperformed expectations, coming in at 0.6%. Moreover, consumer confidence also surprised negatively, coming in at 43.6. Finally, housing starts yearly growth underperformed expectations, coming in at -8.3%. The Bank of Japan decided to keep its key policy rate at -0.1% last Friday. Overall, the BoJ sounded slightly more dovish, acknowledging that it might take more time for inflation to move to their 2% target. Taking this into account, it might be dangerous to short USD/JPY as the BoJ could adjust policy to depreciate the currency. However investors could short EUR/JPY to take advantage of increased risk aversion. Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been negative: Gross domestic product yearly growth underperformed expectations, coming in at 1.2%. Moreover, manufacturing PMI also surprised to the downside, coming in at 53.9. Additionally, both consumer credit and mortgage approvals underperformed expectations, coming in at 0.254 billion pounds, and 62.014 thousand approvals respectively. The pound has depreciated by nearly 5.5% in the past 2 weeks. Poor inflation and economic data as well as generalized dollar strength. Overall, we continue to be bearish on the pound, as the uncertainty surrounding Brexit will continue to scare away international capital. Moreover, the strength of the pound last year should weigh significantly on inflation, limiting the ability of the BoE to raise rates significantly. Report Links: Do Not Get Flat-Footed By Politics - March 30, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was generally good: Building permits picked up, growing at a 14.5% annual rate, and a 2.6% monthly rate, beating expectations; The trade balance outperformed expectations comfortably, coming in at AUD 1.527 million; However, the AIG Performance of Manufacturing Index went down to 58.3 from 63.1; The AUD capitulated as a result of the growing global growth weakness, trading at just above 0.75. The RBA is reluctant to hike rates as Governor Lowe sited both stress in the money market and stretched household-debt levels as key reasons for his reluctance to hike. In other news, growing tension between Australia and its largest investor, China, are emerging in response to rumors that Chinese agents have been lobbying Australian officials in order to influence Australian politics. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been mixed: The unemployment rate surprised positively, coming in at 4.4%. Moreover, employment quarter-on-quarter growth outperformed expectations, coming in at 0.6%. However, the Labour cost index yearly growth surprised to the downside, coming in at 1.9%. Finally, the participation rate also surprised negatively, coming in at 70.8%. NZD/USD has depreciated by nearly 5%. Overall we continue to be negative on the kiwi, given that an environment of risk aversion will hurt high carry currencies like the New Zealand dollar. Moreover, a slowdown in global growth should also start to hurt the kiwi economy, given that this economy is very levered to China and emerging markets. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Canadian data was mixed: Raw material price index increased by 2.1% in March, more than the expected 0.6%; GDP grew at a 0.4% monthly rate, beating expectations of 0.3%; However, the Markit manufacturing PMI disappointed slightly at 55.5. The CAD only suffered lightly despite the greenback's rally. Governor Poloz argued that the expensive Canadian housing market and the elevated household debt load have made the economy more sensitive to higher interest rates than in the past. He also pointed out that interest rates "will naturally move higher" to the neutral rate level, ultimately giving mixed signals. Despite these mixed comments by Poloz, the CAD managed to rise against most currencies expect the USD. Report Links: More Than Just Trade Wars - April 6, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: Real retail sales yearly growth underperformed expectations, coming in at -1.8%. Moreover, the KOF leading indicator also surprised negatively, coming in at 105.3 However, the SVME Purchasing Manager's Index came in at 63.9. EUR/CHF has been flat these last 2 weeks. Overall, we continue to bullish on this cross on a cyclical basis, given that the SNB will keep intervening in currency markets, as the economy is still too weak, and inflationary pressures are still to tepid for Switzerland to sustain a strong franc. However, EUR/CHF could see some downside tactically in an environment of rising risk aversion. Report Links: The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been positive: Registered unemployment surprised positively, coming in at 2.4%. Moreover, the Norges Bank credit indicator also outperformed expectations, coming in at 6.3%. USD/NOK has risen by more than 4% these past 2 weeks. This has occurred even though oil has been flat during this same time period. Overall we are positive on USD/NOK, as this cross is more influenced by relative rate differentials between the U.S. and Norway than it is by oil prices. However, the krone could outperform other commodity currencies, as oil should outperform base metals, as the latter is more sensitive to the Chinese industrial cycle than the latter. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The krona's collapse seem never ending. While the krona never responds well to an environment where global growth is weakening and where asset prices are becoming more volatile, Riksbank governor Stefan Ingves is not backing away from his dovish bias. In fact, the Swedish central bank is perfectly pleased with the krona's dismal performance. Thus, the Riksbank is creating a stealth devaluation of its currency, one that is falling under President Donald Trump's radar. Swedish core inflation currently stands at 1.5%, but it is set to increase. The Riksbank's resource utilization gauge is trending up and the Swedish housing bubble is supporting domestic consumption. As a result, the Swedish output gap is well above zero, and wage and inflationary pressures are growing. The Riksbank will ultimately be forced to hike rates much faster than it currently forecasts. Thus, we would anticipate than when the global soft patch passes, the SEK could begin to rally with great alacrity. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Feature Chart of the WeekAg Vol Will Rise Ag Vol Will Rise Ag Vol Will Rise Over the coming three months markets will be zeroing in on spring planting in the U.S., looking for deviations from the USDA's March intentions report. This will occur against the cyclical backdrop of increased volatility, as markets attempt to price the real impact of Chinese tariffs (Chart of the Week). Putting aside fundamentals, U.S. financial conditions will be a headwind to ag prices this year. Longer term, despite the more favorable USD outlook, a slowdown in China, which accounts for ~ 20% of global food demand, could be bearish for ag prices. Highlights Energy: Overweight. U.S. crude oil output rose to a record 10.3mm b/d in February according to the U.S. EIA. U.S. crude production exceeded Saudi Arabia's in 1Q18; we expect it to exceed Russia's output of 11.2mm b/d by December, 2018. Base Metals: Neutral. Permanent waivers on steel and aluminum tariffs were granted to Australian, Argentine, and Brazilian imports by U.S. firms, while exemptions on imports from the EU, Canada and Mexico were extended to June 1. Precious Metals: Neutral. USD strength is weighing on gold and silver: Our long positions on both metals are down 3.0% and 6.2%, respectively, over the past two weeks. Ags/Softs: Underweight. Ag market volatility will increase, as markets assess U.S. spring planting progress against a backdrop of a possible trade war in ags between the U.S. and China (see below). Feature All Eyes On U.S. Planting Progress It is a busy time of year for U.S. farmers as spring planting is underway. Based on the USDA's annual Prospective Planting Report, released end-March, corn and soybean plantings will fall 2% y/y and 1% y/y, respectively. If realized, corn planted area in the 2018/19 crop year will be the lowest since 2015, and, for only the second time in the history of the series, will fall behind soybean acreage (Chart 2). The USDA's survey also indicates U.S. corn and soybeans will lose ground to wheat, where farmers intend to expand acreage by 3%. Even so, wheat planting intentions are the second lowest on record since the beginning of the series in 1919, surpassed only by last year's all-time low. Mother Nature is not co-operating either: unseasonably cold and wet weather is hindering planting this spring (Table 1). Planting of corn and spring wheat are significantly behind average for this time of the year. Similarly, heading of winter wheat - which accounts for ~ 70% of total wheat intentions - is also behind schedule. Furthermore, harsh winter weather reduced the condition of almost 40% of the crop to poor or very poor, with only 33% qualifying as good or excellent, compared to last year's assessment of 13% and 54%, respectively. Chart 2U.S. Soybean Acreage To Surpass Corn In 2018/19 U.S. Soybean Acreage To Surpass Corn In 2018/19 U.S. Soybean Acreage To Surpass Corn In 2018/19 Table 1U.S. Farmers Are Behind Schedule Ag Price Volatility Will Pick Up Ag Price Volatility Will Pick Up Weather-related delays are less of a risk for soybean plantings, which begin and end later in the summer. Progress is currently in line with historical averages, and, since farmers have an additional month of planting compared to corn and wheat, it is possible they will opt to switch their unplanted corn and wheat acreage to beans. This is a downside risk to the soybean market: When all is said and done, June soybean acreage may exceed targets indicated in the USDA's March intentions report. Although farmers' current lack of headway on the fields is cause for concern, it is still possible that farmers will be able to catch up, attaining their targeted acreage. A Backdrop Of Falling Inventories The termination of China's corn stockpiling scheme, which, prior to 2016 led to the rapid buildup of domestic inventories, was accompanied by policies designed to incentivize soybean plantings over corn. In the case of corn, these policies have paid off. By the end of the current crop year we expect the drawdown in Chinese inventories - along with U.S. stockpiles - to drag world corn reserves lower for the first time since 2010/11 (Chart 3).1 China's pro-soybean production policy is expected to yield a 1.1% expansion in the oilseed's planting area, leading to a 12.8% increase in output this crop year. Regardless, domestic inventories expressed in stocks-to-use (STU) terms are projected to fall (Chart 4). Similarly, world soybean reserves will contract on the back of a decline in Argentine output, which will lead to the largest - and one of only three on record - soybean deficits in the domestic market. In the case of wheat, although U.S. output is forecast to come down this year, weighing on domestic inventories, global markets remain well supplied (Chart 5). In fact, even though USDA's monthly revisions to U.S. production have been downward, forecasts of total use also were revised down. This means the net impact on the balance will be a wider-than-expected surplus. In the case of global markets, world wheat STU ratio will increase to levels last seen in 1986. Net, despite unfavorable weather weighing on the quality and quantity of U.S. wheat crops, there is no shortage of wheat in the world, unlike corn and soybeans. Chart 3Corn Deficit Eating##BR##Away At Stockpiles Corn Deficit Eating Away At Stockpiles Corn Deficit Eating Away At Stockpiles Chart 4China STU Falls Despite##BR##Pro-Soybean Policies China STU Falls Despite Pro-Soybean Policies China STU Falls Despite Pro-Soybean Policies Chart 5Global Wheat Markets Well Supplied##BR##Amid U.S. Supply Concerns Global Wheat Markets Well Supplied Amid U.S. Supply Concerns Global Wheat Markets Well Supplied Amid U.S. Supply Concerns Bottom Line: Given the slower-than-average planting progress this year, near term prices will likely reflect developments in the U.S., as farmers rush to get the crops in the ground. While winter wheat appears to be of poor quality this year, corn and spring wheat plantings are significantly behind schedule. This raises the risk that their acreages will be abandoned in favor of soybeans, which has a later planting window. All in all, if the June acreage report aligns with farmers' planting intentions, we expect to see an increase in wheat acreage at the expense of corn and soybean, which will provide some supply relief to domestic wheat markets. U.S. Farmers Less Competitive, Especially In Soybean Markets In theory, China's announced plans to levy duties on U.S. ag imports puts U.S. farmers - part of President Trump's base - at a disadvantage. But, reality may not be as bearish. The outcome hinges on whether the U.S. will be able to ramp up its exports to other markets amid declining imports from the top bean consumer. Given the impact of weather on soybean output in Argentina - where drought cut soybean output by 30% y/y - there will be a void in global supply. Since soybeans are fungible, we expect ex-China demand to remain supported on the back of limited global supply. This will provide an opportunity for the U.S. to export its surplus, at least in this crop year. To date, there appears to be some evidence of this. Domestic supply will be insufficient to cover Argentinian consumption this year (Chart 6). In an unusual move, USDA export sales data shows Argentina booked a 240k MT purchase of U.S. soybeans for delivery in the next marketing year. Argentina traditionally is a net exporter of soybeans. While we expect tariffs to reshuffle trade flows as China attempts to ensure supplies while avoiding U.S. soybeans, the net effect in terms of global demand for U.S. soybeans may not be as bearish as is feared. China simply does not have the domestic supply to satisfy its demands for beans. While opting for Brazilian or Argentinian beans may be way around importing U.S. supplies, this will open up other export opportunities for the U.S. variety, leading to a simple restructuring of trade flows.2 Recent declines in Chinese imports of U.S. soybeans amid growing imports from Brazil have been cited as evidence of a gloomy future for U.S. soybean farmers. However, this phenomenon is part of the Chinese import cycle: Brazilian soybeans flood Chinese markets in the second and third quarters, while American supplies flow in during the last and first quarters of any given year (Chart 7). Furthermore, U.S. soybean imports have been on the downtrend since the middle of last year. Thus, this observation alone does not signal a change in trend. Chart 6Weak Argentine Output##BR##Restrict Global Supplies Weak Argentine Output Restrict Global Supplies Weak Argentine Output Restrict Global Supplies Chart 7Chinese Preference For Brazilian Beans##BR##Typical For This Time Of Year Chinese Preference For Brazilian Beans Typical For This Time Of Year Chinese Preference For Brazilian Beans Typical For This Time Of Year In fact, the premium paid for Brazilian beans over those traded in Chicago spiked earlier last month. Although it has since come down slightly, it suggests Chinese consumers will have to bear the brunt of more expensive imports. Furthermore, this makes U.S. beans relatively cheaper - and more attractive - in the global market. All the same, higher costs may entice Chinese consumers to look at adjusting the feed formula by diversifying the source of feed. Although our baseline scenario is that these tariffs will remain in place, U.S. Treasury Secretary Steven Mnuchin and U.S. Trade Representative Robert E. Lightizer's trip to Beijing may be the opening salvo to less hostile trade developments. If this is the case, we would expect these trade-related risks to ease. Bottom Line: Tariffs on U.S. soybean imports to China are, in theory, bearish for U.S. markets. However, China's reliance on these beans, along with a tight market this year, makes the outlook less gloomy. Courses of action that may be pursued by China are (1) diversifying the source of the bean, (2) reducing demand for the bean by adjusting feed formula, and (3) continuing to raise domestic soybean acreage. Given the cyclical nature of China's soybean imports, we are entering a period of naturally low demand for U.S. soybeans. Thus, we will not likely see the real impact of current trade disputes until China's demand for American beans kicks in again in 4Q18. In the meantime, a global deficit will open up alternative opportunities for U.S. exports. U.S. And Foreign Financial Conditions Drive Long Run Outlook As weather and the on-going trade tensions between the U.S. and China evolve, the U.S. financial backdrop - particularly real interest rates and the broad USD trade-weighted index (TWIB) - will remain crucial to ag markets. In line with BCA Research's House View, we expect Fed rate hikes to exceed those of other central banks, providing support to a stronger USD over the next 12 months. This will weigh on ag prices.3 Chinese economic growth also could figure prominently, based on recent research from the CME Group, which operates the world's benchmark grain futures markets.4 The relationship between China's unofficial economic gauge - the Li Keqiang Index (LKI) - and ag prices appear to operate through the currency channel. A weaker Chinese economy - reflected in the LKI - suppresses industrial commodity demand, which ends up weighing on the currencies of major commodity exporters. This means the local costs of production for these exporters fall, which, with a 1- to 2-year lag, incentivizes crop plantings in these regions. The increased supply at the margin is bearish for ag prices, all else equal. Given the current environment of a slowing Chinese economy, this relationship is relevant to the longer-term outlook. The significance of the LKI in our grains models provides some evidence of this relationship (Chart 8). When applying the analysis to Brazilian and Russian ag markets, we find the LKI to be positively correlated with the Brazilian Real and the Russian Ruble. This, in turn, explains the inverse correlation we find between the LKI and future ag production in these two markets (Chart 9). A weaker domestic currency does appear to entice farmers to increase plantings of ag commodities, allowing them to take advantage of greater local currency profits from USD-denominated ag exports. Chart 8China Slowdown May Weigh Down On Ags... China Slowdown May Weigh Down On Ags... China Slowdown May Weigh Down On Ags... Chart 9...By Incentivizing Production Ag Price Volatility Will Pick Up Ag Price Volatility Will Pick Up Bottom Line: This preliminary analysis uncovers a supply side channel through which China may impact global ag supplies. It implies that a slowing Chinese economy may in effect spur greater global ag supplies, eventually weighing down on ag prices. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Senior Analyst HugoB@bcaresearch.com 1 Despite the increase in domestic supply amid greater offerings of state reserves, much of the state corn stocks are reportedly in poor condition, only suitable as a source for ethanol production - cited as the justification for upward revisions to corn consumption this year. As such, imports will likely remain indispensable. Overall it appears that China intends to raise its industrial consumption of corn in order to digest its stockpiles, with limited impact on prices. Late last year, China announced its target of nationwide use of bioethanol gasoline by 2020. It estimates that corn stockpiles are sufficient to meet near term demand for the grain used as the ingredient in E10, and hopes to achieve a physical corn market balance within five years. 2 Please see the Ags/Softs back section titled "Can China Retaliate With Agriculture," in BCA Research Commodity & Energy Strategy Weekly Report titled "Oil Price Forecast Steady, But Risks Expand," dated March 22, 2018, available at ces.bcaresearch.com. 3 For a more detailed discussion of the impact of U.S. financial variables on ag markets, please see BCA Research Commodity & Energy Strategy Weekly Report titled "Global Financial Conditions Will Drive Grain Prices In 2018," dated November 30, 2017, available at ces.bcaresearch.com. 4 Please see "Will A Sino-U.S. Trade War Impact Grain, Meat Markets?" dated March 28, 2018, available at cmegroup.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Ag Price Volatility Will Pick Up Ag Price Volatility Will Pick Up Trades Closed in 2018 Summary of Trades Closed in 2017 Ag Price Volatility Will Pick Up Ag Price Volatility Will Pick Up

Highlights Stay overweight Chinese ex-tech stocks for now, despite the recent spell of poor relative performance. Our downgrade watch for Q2 remains in effect, however, as the risks to this position are clearly to the downside. Recent data suggests that China's industrial sector continues to slow. We also see more downside risk from monetary policy and the pace of structural reform than the market, underscoring that our stance towards China is a low-conviction overweight. Taiwan's recent outperformance has largely been passive, in that it has been driven by the movement in stock prices outside of Taiwan. The factors boosting the relative performance of technology and bank stocks are unlikely to be sustained, suggesting that investors should remain underweight Taiwan within Greater China bourses. Feature Chart 1Ex-Tech Stocks Edging Closer##BR##To A Breakdown Vs Global Ex-Tech Stocks Edging Closer To A Breakdown Vs Global Ex-Tech Stocks Edging Closer To A Breakdown Vs Global Chinese ex-technology stock prices edged closer to a technical breakdown in April (Chart 1), as ongoing concerns about the impact of a trade war with the U.S. weighed further on investor sentiment. Consumer discretionary stocks have fared particularly poorly, as President Xi's pledge to open up the auto sector (which is negative for the market share of domestic firms) underscores that car producers are facing a losing scenario even if a further escalation in trade tension with the U.S. is avoided. Panel 2 of Chart 1 shows that recent decline has brought consumer discretionary stocks back to early-2017 levels relative to the broad market. The selloff in the consumer discretionary sector has significantly benefitted one of China Investment Strategy's open trades: long investable consumer staples / short investable consumer discretionary, initiated on November 16. The trade had already been outperforming prior to Xi's pledge in response to the original basis that we articulated (negative impact on autos from environmental reforms), but the news of a likely deterioration in market share has helped the trade earn a whopping 20% in less than 6 months. We recommend that investors stick with the call for now, until greater clarity emerges about the ultimate impact of trade negotiations with the U.S. But we have also recommended that investors place Chinese ex-tech stocks on downgrade watch for Q2 (while maintaining an overweight stance versus global equities), and that technical measures should be watched closely to determine whether a downgrade is indeed warranted. Within this framework, the recent deterioration in performance is worrying, raising the question of whether it is time for investors to reduce their exposure to ex-tech shares. Stay Overweight, For Now... Three factors point to "no" as the answer: Chart 2A Pro-Cyclical Allocation Is Consistent##BR##With A China Overweight A Pro-Cyclical Allocation Is Consistent With A China Overweight A Pro-Cyclical Allocation Is Consistent With A China Overweight Despite the weakness of Chinese stock prices over the past few weeks, they have not yet broken down technically: Chart 1 highlighted that their relative performance versus global stocks remains above its 200-day moving average. For now, this is consistent with a worsening in sentiment rather than full-fledged expectations of a sharp deterioration in equity fundamentals. Investors are clearly reacting to the negative potential effect of trade protectionism on ex-tech earnings, the ultimate impact of which remains subject to negotiation. We singled out consumer discretionary stocks as being likely to fare poorly under any realistic trade outcome, but the decline in Chinese relative performance since mid-April has occurred across all sectors, suggesting that a reversal may occur outside of the discretionary sector if a trade deal is struck with the U.S. Talks in China between high level U.S. and Chinese officials tomorrow and Friday are a hopeful sign that a relatively beneficial deal for both sides may be possible, suggesting that it is too early to cut exposure. Over a 1-year time horizon, BCA continues to recommend that investors remain overweight global equities within an overall balanced portfolio. We have highlighted in previous reports that the Chinese investable stock market is now a decidedly high-beta equity market versus the global benchmark (even in ex-tech terms),1 meaning that an overweight stance is justified barring a significantly negative alpha. Since Chart 2 illustrates that Chinese ex-tech stocks have in fact generated a modestly positive alpha over the past year, a pro-cyclical asset allocation stance continues to favor an above-benchmark weight to Chinese equities ex-technology. For now, our investment recommendations remain unchanged: investors should stay overweight Chinese stocks excluding the technology sector over the coming 6-12 months. But as highlighted below, the risks to China are clearly to the downside, which supports our decision to place Chinese stocks on downgrade watch for Q2. This watch remains in effect for the coming two months, a period during which we hope fuller clarity on the U.S./China trade dispute as well as the pace of decline in China's industrial sector will emerge. Bottom Line: Stay overweight Chinese ex-tech stocks for now, despite the recent spell of poor relative performance. Our downgrade watch for Q2 remains in effect, however, as the risks to this position are clearly to the downside. ...But The Risks Are To The Downside Table 1 updates our macro data monitor that we have published in a few previous reports. The monitor tracks the data series that we found to have the most reliable leading properties when predicting the Li Keqiang index (LKI),2 which we have defined as the most relevant proxy of China's business cycle. Table 1No Convincing Signs Of An##BR##Impending Upturn In China's Economy China: A Low-Conviction Overweight China: A Low-Conviction Overweight Chart 3Lower Inventories =##BR##A Rise In Housing Construction? Lower Inventories = A Rise In Housing Construction? Lower Inventories = A Rise In Housing Construction? The table now shows a March datapoint for all of the series that we track, and continues to argue that the trend in Chinese industrial activity is down. In particular, it appears to confirm that the elevated January/February levels in Bloomberg's calculation of the LKI were likely noise, and not a signal of an impending uptrend. The table highlights that none of the components of our leading indicator for the LKI are above their 12-month moving average, and 5 out of the 6 components fell in March. While the April update of the Caixin manufacturing PMI is being released as we go to press, the official manufacturing PMI also fell in April. On the housing front, floor space sold, one of the most important leading indicators for residential construction activity in China, has also decelerated over the past two months. In last week's joint Special Report with our Emerging Markets Strategy service, my colleague Ellen JingYuan He noted that steel prices are at risk not only because of a likely increase in supply, but from weaker demand due to a potential slowdown in the property market. BCA's China Investment Strategy service has actually taken a cautiously optimistic stance towards the housing market, and noted in an early-February report that there were a few signs of a pickup in activity.3 Chart 3 presents the most hopeful case, which is that the multi-year downtrend in residential construction relative to sales may be over given the significant reduction in housing inventories that has occurred over the past two years. Still, the level of inventories remains quite elevated by conventional standards, and it is difficult to see growth in residential construction sustainably rise if floor space sold remains weak, as it has been for the past two months. Given the recent evolution of the important macro data from China, our view is that the downside risk to the industrial sector should be clear to most investors. However, the potential for monetary policy easing and the extent of the tailwind for China from global growth remain two areas where we see more downside risk than some in the market. On the policy front, China's recent cut in the reserve requirement ratio (RRR) was greeted by some analysts as a sign of easing monetary policy, with others pointing to the recent decline in government bond yields as a clear sign that China's monetary policy is about to become less restrictive. However, we explained in a recent Special Report why the 3-month repo rate is currently the de-facto policy rate,4 and Chart 4 highlights that it appears to lead yields at the short-end. The recent tick down in the latter appears to be a delayed response to the sharp decline in the former, which preceded the RRR cut. Specifically, the repo rate slide was triggered by news reports in late-March that the deadline for new rules to be imposed on China's asset management industry would be extended, which is consistent with our argument that roughly 3/4ths of the tightening in monetary policy that has occurred since late-2016 has actually been regulatory/macro-prudential in nature. Given that the 3-month repo rate has since rebounded back to its post-2017 average following the announcement, we see no indication of any intension by the PBOC to ease monetary policy. Concerning trade, while the threat to China's export growth from U.S. protectionism is obvious, some investors have argued that global demand may be strong enough to overwhelm this negative effect and that it will buoy Chinese export growth (and, by extension, imports). This line of reasoning has a strong basis; Chart 5 shows that our BCA Global LEI is forecasting solid industrial production (IP) growth over the coming few months, and we have noted in past reports that there is a strong link between global IP and Chinese export growth. Chart 4No Convincing Signs Of Monetary Easing No Convincing Signs Of Monetary Easing No Convincing Signs Of Monetary Easing Chart 5Global Demand Likely To Remain Solid Global Demand Likely To Remain Solid Global Demand Likely To Remain Solid But Chart 6 presents a problem with this argument, which is that China's reform pain threshold is very likely positively correlated with global growth. In short, BCA has written extensively about how China has embarked on a multi-year reform effort that will likely weigh on growth in its early stages. We have made it clear that the pace of these reform efforts is likely to be responsive to the pace of economic growth (i.e. policymakers will set the pace to avoid a major growth slowdown), but the other side of this coin is that policymakers are likely to take advantage of a stronger export sector by increasing the pace of reforms. So while some investors view the external sector of China's economy as having some potential to counter weakness in the industrial sector if major protectionist action can be avoided, our sense is that ramped up reform efforts will offset and possibly overwhelm this positive factor, were it to occur. As a final point, in the context of Chart 6, material easing in either policy rates or the pace of reform efforts may occur over the coming 6-12 months, but it would likely be in response to a more serious slowdown in the economy than we are currently observing. As we noted in our April 18 Weekly Report,5 the possibility that Chinese authorities will need to stimulate the economy over the coming year is interesting because it raises the prospect of another economic mini-cycle in China, potentially leading to another meaningful acceleration. But the economic and financial market circumstances that would precede such an event are unlikely to be happy ones for investors, raising the risk of a serious selloff in China-related assets before policy eases sufficiently to return to an overweight stance. Chart 6If Demand For Chinese Exports Stays Strong,##BR##Reform Efforts Will Intensify China: A Low-Conviction Overweight China: A Low-Conviction Overweight Bottom Line: Recent data suggests that China's industrial sector continues to slow. We also see more downside risk than many investors from monetary policy and the pace of structural reform, underscoring that our stance towards China is a low-conviction overweight. An Update On Taiwanese Equities We last wrote about Taiwanese stocks in our December 14 Weekly Report,6 and argued that investors stick with our short MSCI Taiwan / long MSCI China trade and our underweight stance towards Taiwan vs Greater China bourses, despite extended technical conditions. Our recommendation was based on the argument that Taiwanese tech sector underperformance had been driven by material strength in the trade-weighted Taiwanese dollar (TWD), and that a lasting depreciation in the currency would be the most likely catalyst for a re-rating. Since our report in December, the relative performance of Taiwanese stocks has been volatile. After a period of underperformance versus Greater China stock prices, Taiwanese stocks then rose sharply in relative terms from late-February to early-April. The magnitude of the rise was sufficiently large to cause the relative price index to break above its 200-day moving average (Chart 7). However, Taiwanese relative performance has reversed course over the past month, retracing over half of the February to April surge. Chart 8 highlights that these confusing moves in Taiwanese stock prices versus Greater China have largely reflected passive outperformance in two sectors: tech sector outperformance versus China, and banking industry group outperformance versus global banks. On the tech front, Chinese tech stocks have been under pressure over the past month due to the tech-focused nature of U.S. import tariffs, and global investors appear to believe that Taiwanese tech stocks would not be as impacted by these tariffs as their Chinese peers. We disagree, as the export intensity of Taiwan's tech sector to China is quite high: exports to China account for 15% of Taiwan's GDP, and electronic components (i.e. semiconductors) account for nearly half of exports to China. This suggests that the tariff impact on Taiwan's tech sector will be sizeable even if it is indirect. Chart 7A Volatile Relative##BR##Performance Trend A Volatile Relative Performance Trend A Volatile Relative Performance Trend Chart 8Tech And Banks Have Driven Recent##BR##Developments In Relative Performance Tech And Banks Have Driven Recent Developments In Relative Performance Tech And Banks Have Driven Recent Developments In Relative Performance On the banking front, Chart 9 highlights that the outperformance of Taiwanese banks versus their global peers has occurred due to a failure of the former to selloff with the latter over the past few months. Global banks appear to be reacting to the recent flattening in the global yield curve caused by a rise at the short-end, whereas there is no sign of upcoming monetary policy tightening in Taiwan and Taiwanese banks have historically been low-beta versus their global peers (Chart 10). Chart 9Taiwanese Banks Have Passively##BR##Outperformed Global Banks Taiwanese Banks Have Passively Outperformed Global Banks Taiwanese Banks Have Passively Outperformed Global Banks Chart 10Continued Bank Outperformance Not##BR##Likely Barring A Decline In Global Equities Continued Bank Outperformance Not Likely Barring A Decline In Global Equities Continued Bank Outperformance Not Likely Barring A Decline In Global Equities We doubt that Taiwan's banks will continue to outperform global banks over the coming 6-12 months without a generalized selloff in global stock prices. As we noted earlier, BCA's house view is overweight global equities (and financials) over the cyclical horizon on the basis of still-strong global growth, stimulative U.S. fiscal policy, and the view that global monetary policy will not reach restrictive territory over the coming year. As such, we are inclined to lean against the recent outperformance of Taiwanese banks and, by extension, the trend in ex-tech relative performance. Bottom Line: Taiwan's recent outperformance has largely been passive, in that it has been driven by the movement in stock prices outside of Taiwan. The factors boosting the relative performance of technology and bank stocks are unlikely to be sustained, suggesting that investors should remain underweight within Greater China bourses. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Research's China Investment Strategy Special Report "China: No Longer A Low-Beta Market," published January 11, 2018. Available at cis.bcaresearch.com. 2 Please see BCA Research's China Investment Strategy Special Report "The Data Lab: Testing The Predictability Of China's Business Cycle," published November 30, 2017. Available at cis.bcaresearch.com. 3 Please see BCA Research's China Investment Strategy Weekly Report "Is China's Housing Market Stabilizing?," published February 8, 2018. Available at cis.bcaresearch.com. 4 Please see BCA Research's China Investment Strategy Special Report "Seven Questions About Chinese Monetary Policy," published February 22, 2018. Available at cis.bcaresearch.com. 5 Please see BCA Research's China Investment Strategy Weekly Report "The Question That Won't Go Away," published April 18, 2018. Available at cis.bcaresearch.com. 6 Please see BCA Research's China Investment Strategy Weekly Report "Taiwan: Awaiting A Re-Rating Catalyst," published December 14, 2017. Available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Portfolio Strategy Reviving global machinery end-demand alongside a global capex upcycle, are the key pillars of our high-conviction overweight call in the S&P construction machinery & heavy truck index. The current macro backdrop is unforgiving for defensive insurance stocks. Leading indicators of pricing power warn that softening prices coupled with expanding headcount will weigh on insurance profits in the coming quarters. Recent Changes There are no changes to our portfolio this week. Table 1 Lifting SPX Target Lifting SPX Target Feature Equities moved laterally last week and continued to consolidate the early-February tremor, unimpressed by better than expected profit growth across the board. The SPX has been oscillating in a 10% range over the past three months and has been a trader's (and bank's) paradise. There are high odds that this trading range will stay in place and the market will churn until the summer before breaking out (Chart 1). Chart 1Breakout Looming? Breakout Looming? Breakout Looming? Nevertheless, the anemic equity market response to solid earnings is slightly unnerving. Soft EPS guidance and perky input cost inflation are two thorny issues revealed this earnings season. With that in mind, we have identified three key brewing equity market headwinds: EPS growth deceleration toward 10%. Rising interest rates. U.S. dollar reflex rebound. Chart 2Monitoring The Correlation Monitoring The Correlation Monitoring The Correlation 20% profit growth is this cycle's peak rate, and we have been flagging in recent research1 that, beneath the surface, investors are slowly starting to revise expectations lower toward the 10% growth projection for calendar 2019 EPS. Simultaneously, interest rates continue their ascent and may cause some consternation in stocks. Not only does a higher discount rate weigh on valuations, but also the Fed's tightening cycle will eventually slam the brakes on the economy, with housing and the consumer feeling the higher interest rate knock-on effects most intensely. As we highlighted recently,2 we are closely monitoring the correlation between stocks and the 10-year Treasury yield and looking out for a collapse into negative territory to signal an economic (and market) choke point (Chart 2). Finally, recent ECB and BoJ chatter of easy monetary policies for as far as the eye can see, may have put a floor on the greenback, at least temporarily, with the Fed going it alone and lifting the fed funds rate into 2019 and beyond. While all three headwinds suggest that the market may have trouble breaking out of its funk in the next few months, on a cyclical 9-12 month horizon we remain upbeat on equity return prospects. Any U.S. dollar advance is likely a bear market rally and will take time to filter negatively through to earnings. Rising interest rates are also a consequence of higher economic growth which is a positive, i.e. real rates are rising alongside inflation expectations. And, if the SPX attains 10% EPS growth in 2019 as we expect, that is an above trend EPS growth rate and twice as high as nominal GDP growth, an impressive feat at this stage of the cycle. This week we are updating our SPX target to 3,200. We first came up with our SPX end-of-cycle target last July using three different methods:3 a traditional dividend discount model (DDM), EPS and multiple sensitivity analysis and forward equilibrium equity risk premium (ERP) analysis. As a reminder, this 3,200 SPX level is a peak number before the next recession hits and Table 2 summarizes our updated results (if you would like to receive the excel spreadsheet with the three models so you can tweak our inputs/assumptions please click here). In our DDM, our discount rate assumptions remain intact and very conservative. We use an up-to-date annual dividend per share number and back out dividends in U.S. dollars via the updated SPX divisor and make a conservative assumption of no buybacks in the coming years. The recession-related 10% dividend cut has moved to 2020, in line with BCA's view. Finally, we rolled over our estimates to 2023 resulting in a roughly 3,200 SPX peak value estimate. Our EPS and multiple sensitivity analysis starting point is $191 EPS in 2020 (this is in line with the sell-side bottom up estimate according to IBES data) and a 16.5 multiple. That equates to an SPX ending value of near 3200. Table 2SPX Target Using Three Different Methods Lifting SPX Target Lifting SPX Target With regard to the ERP analysis (Chart 3), our forward ERP equilibrium remains at 200bps. 2020 EPS come in at $191, and we also pencil in 100bps selloff in the bond market, resulting in an SPX 3,200 estimate. Chart 3ERP Has Room To Fall ERP Has Room To Fall ERP Has Room To Fall This week we are updating a high-conviction overweight call in a deep cyclical index, and reiterate a below benchmark allocation in a financials sub-index. The CAT Is Roaring, Is The Market Listening? Early last October we upgraded the S&P construction machinery & heavy truck (CMHT) index to overweight, and two months later we added it to the high-conviction overweight call list. On January 29th, right after the broad market hit its all-time highs, we managed to book impressive 10% relative gains as we introduced a risk management tool and instituted trailing stops to the high-conviction calls that cleared the 10% relative return mark. Subsequently, we reinstated the S&P CMHT index to the high-conviction overweight call list, at a deflated price point, as our constructive cyclical backdrop never wavered. Currently, our thesis remains intact: reviving global machinery end-demand alongside a global capex upcycle are a harbinger of sustained profit outperformance. While some leading indicators of global growth have recently crested, global output will remain brisk and above trend. When global growth is expanding, machinery demand typically demonstrates its high beta characteristics. Our global machinery exports proxy is firing on all cylinders rising to multi-year highs and sell side analysts have taken notice: S&P CMHT net earnings revisions are as good as they get (bottom panel, Chart 4). Encouragingly, the softening dollar suggests that U.S. exports have the upper hand and are grabbing market share. BCA's global machinery new orders proxy corroborates the trade data and underscores that machinery profits will overwhelm (middle panel, Chart 4). Dissecting global machinery demand is revealing. Importantly, previously moribund Chinese loan demand has reversed course and is now gaining traction. Tack on the recent steep fall in interest rates and factors are falling into place for a durable pick up in Chinese machinery consumption. Indeed, hypersensitive Chinese excavator sales continue to expand at a breakneck pace (Chart 5). Elsewhere in Asia, highly-cyclical Japanese machine tool orders likewise defy gravity vaulting to fresh all-time highs (Chart 5). The commodity complex also confirms the enticing global machinery end-demand backdrop. The broad commodity index in general and crude oil prices in particular have been reaccelerating of late. The energy space is a key end-customer for the machinery industry and $75/bbl global oil prices have reignited a fresh drilling cycle (Chart 6). Chart 4Global Machinery End-Demand Is Upbeat... Global Machinery End-Demand Is Upbeat... Global Machinery End-Demand Is Upbeat... Chart 5...And Asia Is Leading The Pack ...And Asia Is Leading The Pack ...And Asia Is Leading The Pack Chart 6Commodities Give The All Clear Sign Commodities Give The All Clear Sign Commodities Give The All Clear Sign Even the U.S. machinery demand backdrop is vibrant. The V-shaped recovery in U.S. machinery order books remains intact. Fiscal easing is reviving animal spirits and CEOs are voting with their feet: overall capital outlays are rising at a healthy clip, positively contributing to GDP growth, with machinery fixed capital formation growth recently clearing the 20%/annum hurdle (Chart 7). Capex intentions according to the regional Fed surveys are also holding near recent cyclical highs, and were Congress to pass an infrastructure bill that would be an additional boon to machinery top and bottom line growth (Chart 7). On the domestic operating front, machinery factories are humming and given that capacity is contracting, the industry is regaining its pricing power footing (Chart 8). The upshot is that this high-operating leverage industry should continue to enjoy outsized profit gains. Chart 7Even U.S. Machinery Demand Is Firming Even U.S. Machinery Demand Is Firming Even U.S. Machinery Demand Is Firming Chart 8Operating Metrics Flashing Green Operating Metrics Flashing Green Operating Metrics Flashing Green Nevertheless, there are two key risks to our otherwise bullish machinery thesis that we are closely monitoring. First, input costs are on the rise both in terms of labor and raw commodities (bottom panel, Chart 9). If the industry fails to pass this input cost inflation down the supply chain, then a margin squeeze is likely. Second, and most importantly, a hard landing in China would put our constructive machinery view offside, but we assign low odds to a gap down in Chinese economic activity (middle panel, Chart 9). Finally, given the recent consolidation phase, the S&P CMHT index has a valuation cushion as per the neutral reading in our relative valuation indicator. Similarly overbought conditions have been worked out and our technical indicator is also hovering near the neutral zone offering a compelling entry point to commit fresh capital (Chart 10). Chart 9Two Risks To Bullish View Two Risks To Bullish View Two Risks To Bullish View Chart 10Compelling Entry Point Compelling Entry Point Compelling Entry Point Bottom Line: We reiterate our high-conviction overweight call in the S&P construction machinery & heavy truck index. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR. Insurance Expiry Notice While we continue to recommend a core portfolio overweight in the S&P financials index via the banks (high-conviction), asset managers and investment banks sub-indexes, the S&P insurance index remains our sole underweight. Unlike its financials brethren, the insurance industry is defensive rather than cyclical and thrives when the economy is slowing. Fairly stable, recurring and, most of the time, predictable revenue streams are sought after attributes when economic growth is scarce. Currently, the U.S. and global economies are expanding above trend, the global capex upcycle is running at full steam and CEOs and consumers alike exude confidence. Under such a backdrop, investors have historically avoided insurance equities. Chart 11 drives this point home. Over the past four decades the greenback and relative share prices have been positively correlated. The U.S. dollar peaked in December 2016 and since then it has been goosing global output, and simultaneously weighing on insurance stocks. Similarly, a rising 10-year Treasury yield reflecting improving economic growth also anchors insurance stocks (10-year Treasury yield shown inverted, Chart 12). While higher interest rates are positive for investment portfolio income, they also imply mark-to-market losses on bond portfolios. Higher interest rates also incent insurers to underwrite at a faster pace with more lenient standards, which is often a precursor to increased competition and diminishing pricing power, eventually sapping profits. Chart 11Insurance Is Defensive Insurance Is Defensive Insurance Is Defensive Chart 12Higher Yields Hurt More Than Help Higher Yields Hurt More Than Help Higher Yields Hurt More Than Help On the pricing front, there seems to be a bifurcated market. Auto insurance pricing is hardening, but home insurance is moving in the opposite direction (Chart 13). The slingshot recovery in auto loans versus residential real estate loans partially explains the big delta in pricing as subprime auto loans excesses have, at the margin, boosted new and used vehicle sales. This is not sustainable and there are high odds that this extra demand will level off in the coming months as the subprime auto credit screws inevitably tighten, eventually dampening car insurance prices. Worrisomely, the latest Fed Senior Loan Officer Survey revealed that not only is demand for auto loans waning, but also bankers are no longer willing extenders of auto related credit. Taken together, momentum in housing and auto sales is nil, warning that insurance top line growth will trail the broad market (Chart 14). Unsurprisingly, relative consumer outlays on insurance remain moribund, and a far cry from the previous cyclical peak, warning that it is premature to expect a valuation re-rating (second panel, Chart 15). Chart 13Margin Trouble? Margin Trouble? Margin Trouble? Chart 14Softening Demand Softening Demand Softening Demand Chart 15Insurance Indicator Message: Shy Away Insurance Indicator Message: Shy Away Insurance Indicator Message: Shy Away With regard to input costs, insurance labor additions continue unabated, trumping overall non-farm payrolls and the broad financial services industry since the GFC trough. Our insurance wage bill proxy is closing in on 4%/annum (bottom panel, Chart 13), warning that a margin squeeze looms. Our Insurance Indicator does an excellent job encapsulating all of these different signals and has recently taken a turn for the worse (third panel, Chart 15), underscoring that the path of least resistance is lower for relative share prices in the coming months. Bottom Line: We reiterate our underweight stance in the S&P insurance index. The ticker symbols for the stocks in this index are: BLBG: S5INSU - AIG, CB, MET, MMC, PRU, TRV, AFL, AON, ALL, PGR, WLTW, HIG, PFG, L, CINF, LNC, XL, AJG, UNM, TMK, AIZ, RE, BHF. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?" dated July 10, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Stay neutral small over large caps (downgrade alert)

Highlights Global equities are poised for a "blow-off" rally over the next 12-to-18 months. Long-term return prospects, however, are poor. The final innings of the 1991-2001 economic expansion saw a violent rotation in favor of value stocks and euro area equities. We expect history to repeat itself. After sagging by as much as 7% in the second half of 1998 and going nowhere in 1999, the dollar rose by 13% between January 2000 and February 2002. The greenback today is similarly ripe for a second wind. The correlation between the dollar and oil prices was fairly weak in the late 1990s. The correlation is likely to weaken again now that U.S. crude imports have fallen by about 70% from their 2006 highs thanks to the shale boom. The U.S. 10-year Treasury yield peaked at 6.79% in January 2000. Thus far, there is scant evidence that the recent increase in bond yields is having a major effect on either U.S. capital spending or housing demand. This suggests yields can go higher before they enter restrictive territory. Feature Learning From The Past The theme of this year's BCA annual Investment Conference - which will be held in Toronto in September and will feature a keynote address by Janet L. Yellen - is, appropriately enough, entitled "Investing In A Late-Cycle Economy."1 In the spirit of our conference, this week's report looks back at the market environment at the tail end of the 1991-2001 expansion in order to distill some lessons for today. The mid-to-late 1990s was a tale of contrasts. The U.S. was thriving, spurred on by accelerating productivity growth, falling inflation, and a massive corporate capex boom. Southern Europe was also doing well, aided by falling interest rates and optimism about the coming introduction of the euro. On the flipside, Germany - dubbed by many pundits at the time as the sick man of Europe - was still coping with the hangover from reunification. Japan was mired in deflation. Emerging markets were melting down, starting with the Mexican peso crisis in late 1994, followed by the Asian crisis, and finally the Russian default. In the financial world, the following points are worth highlighting (Chart 1): Chart 1AFinancial Markets In The Late 1990s (I) Financial Markets In The Late 1990s (I) Financial Markets In The Late 1990s (I) Chart 1BFinancial Markets In The Late 1990s (II) Financial Markets In The Late 1990s (II) Financial Markets In The Late 1990s (II) Russia's default and the implosion of Long-term Capital Management (LTCM) led to a gut-wrenching 22% decline in the S&P 500 in the late summer and early fall of 1998. This was followed by a colossal 68% blow-off rally over the subsequent 18 months. The collapse of LTCM marked the low point for EM assets for the cycle. The combination of cheap currencies, rising commodity prices, and a newfound resolve to enact structural reforms paved the way for a major EM boom over the following decade. The VIX and credit spreads trended upwards during the late 1990s, even as U.S. stocks climbed higher. Rising equity volatility and wider spreads were partly a reaction to problems abroad. However, they also reflected the deterioration in U.S. corporate health and heightened fears that stock market valuations had reached unsustainable levels. The U.S. stock market peaked in March 2000. However, that was only because the tech bubble burst. Outside of the technology sector, the S&P 500 actually increased by 9.2% between March 2000 and May 2001. Value stocks finally began to outperform growth stocks in 2000, joining small caps, which had begun to outperform a year earlier. European equities also surged towards the end of the bull market, outpacing the U.S. by 34% in local-currency terms and 21% in dollar terms between July 1999 and March 2000. The strong U.S. economy during the late 1990s ushered in a prolonged period of dollar appreciation that lasted until February 2002. That said, the greenback did not rise in a straight line. The dollar fell by as much as 7% in the second half of 1998 as the Fed cut rates in response to the LTCM crisis. It went sideways in 1999 before resuming its upward trend in early 2000. The correlation between the dollar and oil prices was much weaker in the 1990s compared to the first 15 years of the new millennium. After falling from a high of 6.98% in April 1997 to 4.16% in October 1998, the 10-year U.S. Treasury yield rose to 6.79% in January 2000. The Fed would keep raising rates until May of that year. The recession began in March 2001. Now And Then Just as in the tail end of the 1990s expansion, the global economy is doing reasonably well these days. Growth has cooled over the past few months, but should remain comfortably above trend for the remainder of the year. After struggling in 2014-16, Emerging Markets are on the mend, thanks in part to the rebound in commodity prices. During the 1990s cycle, the U.S. was the first major economy to reach full employment. The same is true today. The headline unemployment rate has fallen to 4.1%, just shy of the 2000 low of 3.8%. The share of the working-age population out of the labor market but wanting a job is back to pre-recession levels. The same goes for the share of unemployed workers who have quit - rather than lost - their jobs (Chart 2). One key difference concerns fiscal policy. The U.S. federal budget was in great shape in 2000. The same cannot be said today. Chart 3 shows that the fiscal deficit currently stands at 3.5% of GDP. The deficit is on track to deteriorate to 4.9% of GDP in 2021 even if growth remains strong. Federal government debt held by the public is also set to rise to 83.1% of GDP in 2021, up from 33.6% of GDP in 2000. Unlike in the past, the U.S. government will have less scope to ease fiscal policy when the next recession rolls around. Chart 2An Economy At Full Employment An Economy At Full Employment An Economy At Full Employment Chart 3The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Further Upside For Global Bond Yields Deleveraging headwinds, excess spare capacity, slow potential GDP growth, and chronically low inflation have all conspired to keep a lid on global bond yields. That is starting to change. Credit growth has accelerated, while output gaps have shrunk. The structural outlook for productivity growth is weaker than it was in the 1990s, but a cyclical pickup is likely given the recent recovery in capital spending. Chart 4 shows that there is a reasonably strong correlation between business capex and productivity growth. On the inflation side, the 3-month annualized change in U.S. core CPI and core PCE has reached 2.9% and 2.8%, respectively. The prices paid component of the ISM manufacturing index hit a seven-year high in March. The New York Fed's Underlying Inflation Gauge has zoomed to 3.1% (Chart 5). The market has been slow to price in the prospect of higher U.S. inflation (Chart 6). The TIPS 10-year breakeven rate is still roughly 20 bps below where it traded in the pre-recession period, even though the unemployment rate is lower now than at any point during that cycle. As long-term inflation expectations reset higher, bond yields will rise. Higher inflation expectations will also push up the term premium, which remains in negative territory. Chart 4Pickup In Capex Brightens ##br##The Cyclical Productivity Outlook Pickup In Capex Brightens The Cyclical Productivity Outlook Pickup In Capex Brightens The Cyclical Productivity Outlook Chart 5Inflation##br## Is Coming... Inflation Is Coming... Inflation Is Coming... Inflation Is Coming... Inflation Is Coming... Chart 6...Which Could Take ##br##Bond Yields Higher ...Which Could Take Bond Yields Higher ...Which Could Take Bond Yields Higher The upward pressure on yields could be amplified if the market revises up its assessment of the terminal real rate. Perhaps in a nod to what is to come, the Fed revised its terminal fed funds projection from 2.8% to 2.9% in the March 2018 Summary of Economic Projections. However, this is still well below the median estimate of 4.3% shown in the inaugural dot plot in January 2012. The U.S. Economy Is Not Yet Succumbing To Higher Rates For now, there is little evidence that higher rates are having a major negative effect on the economy. Business capital spending has decelerated recently, but that appears to be a global phenomenon. Capex has weakened even more in Japan, where yields have barely moved. In any case, the slowdown in U.S. investment spending has been fairly modest. Core capital goods orders disappointed in March, but are still up 7% year-over-year. Likewise, while our capex intention survey indicator has ticked lower, it remains well above its historic average. And despite elevated corporate debt levels, high-yield credit spreads are subdued and banks continue to ease lending standards for commercial and industrial loans (Chart 7). In the household realm, delinquency rates are rising and lending standards are tightening for auto and credit card loans. However, this has more to do with excessively strong lending growth over the preceding few years than with higher interest rates. Particularly in the case of credit card lending, even large movements in the fed funds rate tend to translate into only modest percent changes in debt service payments because of the large spreads that lenders charge on unsecured loans. The financial obligation ratio - a measure of the debt service burden for the average household - is rising but is still close to the lowest levels in three decades. Mortgage debt, which accounts for about two-thirds of all household credit, is near a 16-year low as a share of disposable income (Chart 8). As Ed Leamer perceptively argued in his 2007 Jackson Hole address entitled "Housing Is The Business Cycle," housing is the main avenue by which monetary policy affects the real economy.2 Similar to business capital spending, while the housing data has leveled off to some extent, it still looks pretty good: Building permits and housing starts continue to rise. New and existing home sales rebounded in March. Home prices have accelerated. The S&P/Case Shiller Home Price Index saw its strongest month-over-month gain in February since 2005. The MBA Mortgage Applications Purchase Index is up 11% year-over-year. The percentage of households looking to buy a home in the next six months is at a cycle high. Homebuilder sentiment has dipped slightly, but it remains at rock-solid levels (Chart 9). Chart 7Capital Spending ##br##Still Quite Robust Capital Spending Still Quite Robust Capital Spending Still Quite Robust Chart 8Household Debt Load And Financial Obligations##br## Are At Pre-Housing Bubble Levels Household Debt Load And Financial Obligations Are At Pre-Housing Bubble Levels Household Debt Load And Financial Obligations Are At Pre-Housing Bubble Levels Chart 9The Housing Sector##br## Is Doing Fine The Housing Sector Is Doing Fine The Housing Sector Is Doing Fine Fixed-Income: Hedged Or Unhedged? Bond positioning is quite short, so a temporary dip in yields is probable. However, investors should expect bond yields to rise more than is currently discounted over the next 12 months. BCA's fixed income strategists favor cyclically underweighting the U.S., Canada, and core Europe, while overweighting Australia, the U.K., and Japan in currency-hedged terms. Table 1 shows that the hedged yield on U.S. 10-year Treasurys is only 20 bps in EUR terms, and 38 bps in yen terms. Table 1Global Bond Yields: Hedged And Unhedged Investing In A Late-Cycle Economy: Lessons From The 1990s Investing In A Late-Cycle Economy: Lessons From The 1990s The low level of hedged U.S. yields today means that Treasurys are unlikely to enjoy the same inflows as in the past from overseas investors. This could push yields higher than they otherwise would go. To gain the significant yield advantage that U.S. government debt now commands, investors would need to go long Treasurys on a currency-unhedged basis. For long-term investors, this is a tantalizing investment. The current spread between 30-year Treasurys and German bunds stands at 192 bps. The euro would have to appreciate to 2.15 against the dollar for buy-and-hold investors to lose money by going long Treasurys relative to bunds.3 Such an overshoot of the euro is unlikely to occur, especially since the structural problems haunting Europe are no less daunting than those facing the United States. A Pop In The Dollar? Admittedly, the near-term success of a strategy that buys Treasurys, currency-unhedged, will hinge on what happens to the dollar. As occurred at the turn of the millennium, the dollar could find a bid as the Fed is forced to raise rates more aggressively than the market is pricing in. In this regard, large-scale U.S. fiscal stimulus, while arguably bearish for the dollar over the long haul, could be bullish for the dollar in the near term. My colleague Jennifer Lacombe has observed that flows into U.S.-listed European equity ETFs, such as those offered by iShares (EZU) and Vanguard (VGK), have reliably led the euro-dollar exchange rate by about six months (Chart 10).4 Recent outflows from these funds augur poorly for the euro. Rising hedging costs could also prompt more investors to buy U.S. fixed-income assets currency-unhedged, which would raise the demand for dollars (Chart 11).5 Chart 10ETF Flows Point To Lower EUR/USD ETF Flows Point To Lower EUR/USD ETF Flows Point To Lower EUR/USD Chart 11The Dollar Could Bounce The Dollar Could Bounce The Dollar Could Bounce The Oil-Dollar Correlation May Be Weakening Investors are accustomed to thinking that the dollar tends to be inversely correlated with oil prices. That relationship has not always been in place. Brent bottomed at just over $9/bbl in December 1998. Crude prices tripled over the subsequent 20 months. The broad trade-weighted dollar actually rose by 5% over that period. The dollar has strengthened by 2.8% since hitting a low on September 8, 2017, while Brent has gained 37% over this period. This breakdown in the dollar-oil correlation harkens back to late 2016: Brent rose by 26% between the U.S. presidential election and the end of that year. The dollar appreciated by 4% during those months. We are not ready to abandon the view that a stronger dollar is generally bad news for oil prices. However, the relationship between the two variables seems to be fading. Chart 12 shows that the two-year rolling correlation coefficient of monthly returns for Brent crude and the broad trade-weighted dollar has weakened in recent years. Chart 12The Negative Dollar-Oil Correlation Has Weakened The Negative Dollar-Oil Correlation Has Weakened The Negative Dollar-Oil Correlation Has Weakened This is not too surprising. Thanks to the shale boom, U.S. oil imports have fallen by about 70% since 2006 (Chart 13). This has made the U.S. trade balance less sensitive to changes in oil prices. The recent surge in oil prices has also been strengthened by OPEC 2.0's decision to reduce the supply of crude hitting the market, ongoing turmoil in Venezuela, and the possibility that Iranian sanctions could take 0.3-0.8 million barrels a day off the market. A reduction in oil supply is bad for global growth at the margin. However, weaker global growth is good for the dollar (Chart 14). OPEC's production cuts also increase the scope for U.S. shale producers to gain global market share over the long haul, which should help the greenback. As such, while a modestly strong dollar over the remainder of the year will be a headwind for oil, it may not be a strong enough impediment to prevent Brent from rising another $6/bbl to reach $80/bbl, as per our commodity team's projections. Chart 13U.S. Oil Imports ##br##Have Collapsed U.S. Oil Imports Have Collapsed U.S. Oil Imports Have Collapsed Chart 14Slowing Global Growth Tends##br## To Be Bullish For The Dollar Slowing Global Growth Tends To Be Bullish For The Dollar Slowing Global Growth Tends To Be Bullish For The Dollar The Outlook For Equities Following the script of the late 1990s, stock market volatility has risen this year, as investors have begun to fret about the durability of the nine year-old equity bull market. Valuations are not as extreme as they were in 2000, but they are far from cheap. The Shiller P/E for U.S. stocks stands at 31, consistent with total nominal returns of only 4% over the next decade (Chart 15). On a price-to-sales basis, U.S. stocks have surpassed their 2000 peak (Chart 16). Such a rich multiple to sales can be justified if profit margins stay elevated, but that is far from a sure thing. Yes, the composition of the stock market has shifted towards sectors such as technology, which have traditionally enjoyed high margins. The explosion of winner-take-all markets has also allowed the most successful companies to dominate the stock market indices, while second-tier companies get pushed to the sidelines (Chart 17). Chart 15Long-Term Investors, Take Note Long-Term Investors, Take Note Long-Term Investors, Take Note Chart 16U.S. Stocks Are Pricey U.S. Stocks Are Pricey U.S. Stocks Are Pricey Chart 17Only The Best Investing In A Late-Cycle Economy: Lessons From The 1990s Investing In A Late-Cycle Economy: Lessons From The 1990s Nevertheless, there continues to be a strong relationship between economy-wide profits and the ratio of selling prices-to-unit labor costs (Chart 18). The latest data suggest that U.S. wage growth has picked up in the first quarter (Table 2). Low-skilled workers, whose wages tend to be better correlated with economic slack than those of high-skilled workers, are finally seeing sizable gains. Chart 18U.S. Profit Margins Could Resume Mean-Reverting... U.S. Profit Margins Could Resume Mean-Reverting... U.S. Profit Margins Could Resume Mean-Reverting... Table 2...If Wage Growth Continues Accelerating Investing In A Late-Cycle Economy: Lessons From The 1990s Investing In A Late-Cycle Economy: Lessons From The 1990s Even if productivity growth accelerates, unit labor costs are likely to rise faster than prices, pushing profit margins for many companies lower. Bottom-up analysts expect annual EPS growth to average more than 15% over the next five years, a level of optimism not seen since 1998 (Chart 19). The bar for positive surprises on the earnings front is getting increasingly high. Go For Value Historically, stocks tend not to peak until about six months before the start of a recession. Given our expectation that the next recession will occur in 2020, global equities could still enjoy a blow-off rally after the current shakeout exhausts itself. But when the music stops, the stock market is heading for a mighty fall. Given today's lofty valuations and the uncertainty about the precise timing of the next recession, we would certainly not fault long-term investors for taking some money off the table. For those who feel compelled to stay fully invested, our advice is to shift allocations towards cheaper alternatives. Value stocks have massively underperformed growth stocks for the past 11 years (Chart 20). Today, value trades at a greater-than-normal discount to growth. Earnings revisions are moving in favor of value names. Just like at the turn of the millennium, it may be value's turn to shine. Chart 19The Bar For Positive Earnings Surprises Has Risen The Bar For Positive Earnings Surprises Has Risen The Bar For Positive Earnings Surprises Has Risen Chart 20Value Stocks: An Attractive Proposition Value Stocks: An Attractive Proposition Value Stocks: An Attractive Proposition Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For more information about our Investment Conference, please click here or contact your account manager. 2 Edward E. Leamer, "Housing Is The Business Cycle," Proceedings, Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, (2007). 3 To arrive at this number, we multiply the current exchange rate by the degree to which EUR/USD would have to strengthen, on average, every year for the next 30 years in order to nullify the carry advantage of holding Treasurys over bunds. Thus, 1.217*(1.0192)^30=2.15. Granted, investors expect inflation to be about 45 bps lower in the euro area than in the U.S. over the next three decades. However, this would only lift the Purchasing Power Parity (PPP) value of EUR/USD from its current level of 1.32 to 1.51. This would still leave the euro 42% overvalued. 4 Please see Global ETF Strategy Special Report, "Do ETF Flows Lead Currencies?" dated April 18, 2018. 5 When a foreign investor buys U.S. bonds currency-hedged, this entails two transactions. First, the investor must purchase the bond, and second, the investor must sell the dollar forward (which is similar to shorting it). The former transaction increases the demand for dollars, while the latter increases the supply of dollars. Thus, as far as the value of the dollar is concerned, it is a wash. In contrast, if foreign investors buy bonds currency-unhedged, there is no offsetting increase in the supply of dollars, and hence the dollar will tend to strengthen. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Chart of the WeekCrude Oil Prices Align With##BR##Supply-Demand Fundamentals Crude Oil Prices Align With Supply-Demand Fundamentals Crude Oil Prices Align With Supply-Demand Fundamentals Hedge funds are backing up the truck to get long oil in their portfolios, putting on record or near-record positions in everything from crude oil to gasoline, as global markets tighten and OPEC 2.0 leaders hint they are comfortable with prices that are higher for longer.1 When speculators significantly increase their positions in the market - on the long or the short side - market participants, policymakers and the general public typically begin to wonder whether prices are being artificially distorted by this activity. Our research into the effects of speculation in oil markets is not raising alarm bells at present. If anything, our fundamental models indicate prices are clearing the market in line with supply, demand and inventories (Chart of the Week). We remain overweight oil, and would use sell-offs to add to existing length, including energy-heavy commodity index exposure. Energy: Overweight. Oil markets remain on edge ahead of the May 12 deadline for U.S. President Trump to extend waivers on Iranian export sanctions. If waivers are extended, markets could sell off. Base Metals: Neutral. Aluminum prices fell ~ 10% earlier in the week on news the U.S. would extend the period during which American customers of Rusal had to comply with sanctions against Oleg Deripaska, the company's principal shareholder. U.S. officials also suggested they would lift the sanctions if Deripaska relinquished control over Rusal. Precious Metals: Neutral. Our tactical long position in spot silver established a week ago is down 3.1%, along with gold. A stronger USD weighed on both markets. Ags/Softs: Underweight. Chinese importers of U.S. sorghum petitioned their government to waive the 179% deposit required by Chinese customs for cargoes on the water, according to Reuters.2 The news service also reported soybean trade between the U.S. and China has ground to a halt. Feature Hedge funds are taking their oil exposure to record or near-record highs in crude oil and refined products markets. A tally of positioning by Reuters to the week ended April 20, 2018, shows specs took net oil and products positions to 1.41 billion barrels across CME Group's crude and products futures markets and those of the Intercontinental Exchange (ICE) (Chart 2).3 The reasons cited for the marked increase in speculative positioning in the oil markets have featured in our research since OPEC 2.0's formation in November 2016. These include: Restraint and erosion on the supply side. Production discipline by OPEC and non-OPEC producers has limited supply growth (Chart 3): We estimate crude oil production this year at 99.70mm b/d vs. our March estimate of 100.20mm b/d. Accelerated deterioration of Venezuelan supply has helped constrain global production growth; Chart 2Spec Open Interest Surges Spec Open Interest Surges Spec Open Interest Surges Chart 3OPEC 2.0 Discipline Restrains Supply OPEC 2.0 Discipline Restrains Supply OPEC 2.0 Discipline Restrains Supply Continued expansion of global demand (Chart 4). In our modeling, consumption growth for this year will be 1.70mm b/d, bringing demand to 100.30mm b/d in 2018. We expect growth for next year of 1.70mm b/d, which will take consumption to 102.00mm b/d; Together, these major fundamental drivers have combined to drain OECD commercial inventories by 395mm barrels from their peak of 3.1 billion barrels in July, 2016 (Chart 5). Chart 4Global Growth Supports Demand Global Growth Supports Demand Global Growth Supports Demand Chart 5OECD Inventories Will Continue Drawing OECD Inventories Will Continue Drawing OECD Inventories Will Continue Drawing As we noted last week, our price forecasts for Brent and WTI crude oil are unchanged at $74 and $70/bbl this year, and $67 and $64/bbl, respectively, next year. We expect OPEC 2.0 to provide forward guidance on its production for 2019, after member states agree on an organizational structure that institutionalizes it as a permanent production-management coalition. As we cautioned last week, this likely will cause us to revise our price forecast for 2019 upward.4 Measuring Speculative Influence In Oil Markets Oil speculators occupy a unique place in the academic literature, and the public's imagination. In the literature, academics largely see them either as bit players in the evolution of oil prices, or as traders who, by their activity, push price to levels far beyond anything justified by the fundamentals, particularly when commodity prices are rising.5 When that commodity is crude oil, and its chief refined product, gasoline - commodities with highly visible prices consumers can track continuously - everyone has an opinion. Not unsurprisingly, the media and politicians join this chorus of recrimination in rising markets, and vilify speculators as well.6 This is hardly surprising. Speculative influence over commodity prices - and the motives of speculators - has been debated for centuries.7 Chart 6Speculative Intensity (Working's T) Vs. Price Speculative Intensity (Working's T) Vs. Price Speculative Intensity (Working's T) Vs. Price In the modern era, Holbrook Working, the great Stanford ag economist, developed a speculative intensity index in 1960 to measure the effect of commodity market speculation.8 Working's T Index shows how much speculative positioning exceeds the net demand for hedging from commercial participants in the market.9 Excessive speculation - spec positioning in excess of hedging demand by commercial interests - could be read into index values above 1.0. However, the U.S. CFTC notes values of Working's T at or below 1.15 do not provide sufficient liquidity to support hedging, even though "there is an excess of speculation, technically speaking."10 We plotted Working's T for Brent and WTI futures, and find speculative positioning has ranged between 1.10 and 1.60 (Chart 6). Speculative intensity was trending upward from 2000 - 2014, and then trended lower. Since January 2018, it has averaged 1.4. We would note this latter period encompasses the OPEC market-share war launched in November 2014, and the formation of OPEC 2.0 in November 2016. This was an especially difficult market for hedge funds and speculators generally, particularly last year, when many funds were forced to shutter their operations. Over the past three years, markets have had to adjust to a production free-for-all arising from OPEC's market-share war, which was followed by a supply shock induced by OPEC 2.0, when it agreed to remove 1.80mm b/d of oil production from the market.11 Given this backdrop, it is not surprising to see speculative intensity in oil markets falling, as our chart indicates. Specs And Prices Our research shows the evolution of oil prices is dominated by fundamentals - supply, demand, inventory and broad trade-weighted USD being the dominant fundamentals - and not by spec positioning.12 In forthcoming research, we will dig deeper into this, and also look at the evolution of price volatility in the oil markets. Our analysis using Working's T indicates speculators provide sufficient liquidity to hedgers in the Brent and WTI futures markets, suggesting they are fulfilling the role posited by the IEA in its 2012 medium-term analysis: "Speculators should not be viewed as adversarial agents. Rather, they are essential participants for the proper functioning of commodity derivatives markets by providing the necessary liquidity, thereby reducing market volatility."13 Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 OPEC 2.0 is the name we coined for the OPEC/non-OPEC producer coalition lead by the Kingdom of Saudi Arabia (KSA) and Russia, which pledged to remove 1.80mm b/d of production from the market. 2 Please see "China's sorghum importers ask government to drop tariff for cargoes en route," published by uk.reuters.com April 24, 2018, and "After sorghum spat, U.S. - China trade fears halt soybean imports," published April 25, 2018. 3 Please see "Commentary: Hedge fund oil bulls on the rampage as bears vanish," published by uk.reuters.com on April 23, 2018. 4 For our most recent assessment of supply-demand fundamentals, please see "Tighter Balances Make Oil Price Excursions To $80/bbl Likely," published by BCA Research's Commodity & Energy Strategy April 19, 2018. It is available at ces.bcaresearch.com. 5 Bookending this research are Hamilton, James D. (2009), "Causes and Consequences of the Oil Shock of 2007 - 08," published by the Brookings Institution re fundamentals dominating the evolution of oil prices, and, at the other end, Singleton, Kenneth (2011), "Investor Flows and the 2008 Boom/Bust in Oil Prices," available at SSRN. 6 Please see the International Energy Agency's "Oil: Medium-Term Market Report 2012," for a discussion on speculation beginning on p. 21. 7 See, for example, the discussion of how Thales of Miletus in modern-day Turkey monopolized the olive-press market, and how another unnamed individual in Sicily cornered the iron market, in the Politics of Aristotle, a Greek philosopher of the 4th century BCE (at 1259a in Politics). 8 Working was a pioneer in the analysis of prices and agricultural trading markets. Please see Working, Holbrook (1960), "Speculation on Hedging Markets," Stanford University Food Research Institute Studies 1: 185-220. 9 We use the specification of Working's T found in Adjemian, M. K., V. G. Bruno, M. A. Robe, and J. Wallen. "What Drives Volatility Expectations in Grain Markets?" Proceedings of the NCCC-134 Conference on Applied Commodity Price Analysis, Forecasting, and Market Risk Management (pp. 18, 19). Working's T is calculated as Specs Back Up The Truck For Oil Specs Back Up The Truck For Oil with SS = Speculative Short Open Interest, SL = Speculative Long Open Interest, HL = Hedge Long Open Interest, and HS = Hedge Short Open Interest. The U.S. Commodity Futures Trading Commission (CFTC) notes, "Working's T-index is silent on the direction of speculation (long versus short). Instead, the amount of speculation is gauged relative to what is needed to balance hedging positions. Because it is directionless Working's T-index is only tested as a causal variable for market volatility." Please see Irwin, S. H. and D. R. Sanders (2010), "The Impact of Index and Swap Funds on Commodity Futures Markets: Preliminary Results", OECD Food, Agriculture and Fisheries Working Papers, No. 27. 10 Please see Irwin and Sanders (2010), p. 5. 11 We discuss the extremely difficult trading environment confronted by hedge funds and others over the past two years in our Special Report titled "Key Themes For Energy Markets in 2018," which was published by BCA Research's Commodity & Energy Strategy December 7, 2017. It is available at ces.bcaresearch.com. 12 Granger-causality tests on Brent and WTI prices between 2010 and now - the post-GFC era - show the level of prices leads spec position levels in these markets. 13 Please see (p. 22) of the IEA's 2012 Medium-term Market Report cited above. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Specs Back Up The Truck For Oil Specs Back Up The Truck For Oil Trades Closed in 2018 Summary of Trades Closed in 2017 Specs Back Up The Truck For Oil Specs Back Up The Truck For Oil

Highlights The scale of "de-capacity" reforms is diminishing considerably - old, inefficient capacity shutdowns are declining. Sizable new technologically advanced and ecologically friendly capacity is coming on stream for both steel and coal in 2018 and 2019. We project this will boost steel and coal output by 5.2% and 4.7% respectively, this year at a time when demand is set to slow. Steel, coal, iron ore and coke prices are all vulnerable to the downside. Share prices of the companies and currencies of countries that supply these commodities to China are most at risk. Feature Last November, our report titled, "China's "De-Capacity" Reforms: Where Steel & Coal Prices Are Headed," painted a negative picture for steel and coal prices over 2018 and 2019.1 Since then, after having peaked in December and February respectively, both steel and thermal coal prices have so far declined by about 20% from their respective tops (Chart 1). In the meantime, iron ore and coking coal have also exhibited meaningful weakness (Chart 2). Chart 1More Downside In Steel And Coal Prices More Downside In Steel And Coal Prices More Downside In Steel And Coal Prices Chart 2Iron Ore And Coking Coal Prices Are Also At Risk Iron Ore And Coking Coal Prices Are Also At Risk Iron Ore And Coking Coal Prices Are Also At Risk In this report, we revisit the topic of de-capacity reforms and examine how Chinese supply side reforms in 2018 will affect steel and coal prices. The key message is as follows: Having implemented aggressive capacity reduction over the past two years, the authorities are shifting the focus of supply side reforms from "de-capacity" to "replacement" of already removed capacity with technologically advanced capacity. This means the scale of "de-capacity" reforms is diminishing considerably - old, inefficient capacity shutdowns are declining. In addition, sizable new technologically advanced and ecologically friendly capacity is coming on stream for both steel and coal in 2018 and 2019. From an investing standpoint, this means both steel and coal prices are still vulnerable to the downside. Both could drop by more than 15% from current levels over the course of 2018. Diminishing Scale Of "De-Capacity" Reforms Reducing capacity (also called "de-capacity") in the oversupplied steel and coal markets has been a key priority within China's structural supply side reforms over the past two years. Steel Table 1 shows that the capacity reduction target for steel in 2018 is 30 million tons, which is much lower than the 45 million tons in 2016 and 50 million tons in 2017. Table 1Capacity Reduction: Target And Actual Achievement Revisiting China's De-Capacity Reforms Revisiting China's De-Capacity Reforms In addition, between May and September 2017, the "Ditiaogang"2 removal policy eliminated about 120 million tons of steel capacity, and sharply reduced steel products production. Most of Ditiaogang capacity was completely dismantled last year. Therefore, there is not much downside to steel production from Ditiaogang output cutbacks going forward. Furthermore, between October and December 2017, environmental policies aimed at fighting against winter smog also cut steel products output substantially, which pushed steel prices to six-year highs in December (Chart 3). Chart 3Policy Actions And Market Dynamics: Steel Sector Policy Actions And Market Dynamics: Steel Sector Policy Actions And Market Dynamics: Steel Sector In particular, in the last quarter of 2017, to ensure fewer smog days around the Beijing area, Tianjin's steel products output was reduced by 50% from a year earlier. The second biggest contribution to total steel output decline occurred in Hebei - the largest steel-producing province in China - where steel output plummeted by 7%. Excluding Tianjin and Hebei, national steel products output fell only by 3.9% from a year ago. As a long-term solution to ameliorate ecology and air quality around Beijing, the government is aiming to reduce the heavy concentration of steel production in Tianjin and Hebei by shifting a considerable portion of steel capacity to other regions in 2018 and following years. These two provinces together accounted for about 30.6% of the nation's steel products output in 2016; their share dipped to 27.6% in 2017. As a result, next winter the required production reduction from these regions to achieve the air quality targets in Beijing will be smaller. In short, the scale of specific policy driven steel output reduction in 2018 will be meaningfully lower than last year. Coal For coal, despite the same target as last year (150 million tons), the actual capacity cut this year will be much less than last year's actual reduction of 250 million tons, which exceeded the 150 million-ton target. Amid still-high coal prices, the authorities will be more tolerant of producers not cutting too much capacity. Plus, with nearly two-thirds of the 2016-2020 target for capacity cuts having already been achieved in the past two years, there is much less outdated capacity in the industry (Table 1 above). In addition, the government's environment-related policies also led to a decline in total national coal output between October-December 2017 (Chart 4), with Hebei posting the biggest cut in coal output among all provinces. Chart 4Policy Actions And Market Dynamics: Coal Sector Policy Actions And Market Dynamics: Coal Sector Policy Actions And Market Dynamics: Coal Sector However, the authorities shortly thereafter relaxed restrictions on coal output, as the country was severely lacking gas supply for heating. In January and February of this year, the authorities reversed course, demanding that producers accelerate new advanced capacity replacement and increase coal production. Bottom Line: The scale of China's "de-capacity" reforms are diminishing, resulting in a lessening production cuts. Installing Technologically Advanced Capacity China's supply side reforms have included two major components - reducing inefficient capacity and low-quality supply that damaged the environment while boosting medium-to-high-quality production that is economically efficient and ecologically friendly. In brief, having removed significant obsolete capacity in the past two years, the policy focus is now shifting to capacity replacement. The latter enables China to upgrade its steel and coal industries to become more efficient and competitive worldwide, as well as ecologically safer. To guard against excessive production capacity of steel and coal, the authorities are reinforcing the following replacement principle: the ratio of newly installed-to-removed capacity should be less or equal to one. Two important points need to be noted: First and most important, the zero or negative growth of total capacity of steel and coal does not necessarily mean zero or negative growth in steel and coal output. For example, while total capacity for crude steel and steel products declined 4.8% and 1.8% year-on-year in 2016 respectively, output actually increased 0.5% and 1%. Despite falling total capacity, rising operational capacity could still contribute to an increase in final output. Total capacity (measured in tons) for steel and coal production includes both operational capacity and non-operational capacity, the latter representing obsolete/non-profitable capacity. As more technologically advanced capacity is installed to replace the already-removed one, both the size of operational capacity and the capacity utilization rate (CUR) will rise. Typically, advanced technologies have a higher CUR - consequently, production will grow. Second, an increase in the CUR of existing operational capacity will also result in rising output. In 2018, odds are that both the steel and coal industries in China will have non-trivial output increases as a result of new advanced capacity coming on stream. Steel Since late 2015, in environmentally sensitive areas of the Beijing-Tianjin-Hebei region and the Yangtze River Delta and the Pearl River Delta, steel plants have been required to add no more than 0.8 tons of new capacity for every 1 ton of outdated capacity removed. For other areas, the same ratio is 1 or less. Electric furnace (EF) steel-producing technology - which is cleaner, more advanced and used to produce high-quality specialized steel products - has become the major type of new capacity addition. This technology is favored by both the government and steel producers. Chinese EF-based steel production accounted for only 6.4% of the nation's total steel output in 2016, far lower than the world average of 25.7% (Chart 5). The EF technology uses scrap steel as raw materials, graphite electrodes and electricity to produce crude steel. Graphite electrodes, which have high levels of electrical conductivity and the capability of sustaining extremely high levels of heat, are consumed primarily in electric furnace steel production. Chart 6 demonstrates that prices of both graphite electrode and scrap steel have surged since mid-2017. This signifies that considerable new EF production capacity has been coming on stream. Chart 5Chinese Electric Furnace Crude Steel ##br##Production Will Go Up Revisiting China's De-Capacity Reforms Revisiting China's De-Capacity Reforms Chart 6Considerable New Addition Of##br## Chinese Electric Furnace Capacity Considerable New Addition Of Chinese Electric Furnace Capacity Considerable New Addition Of Chinese Electric Furnace Capacity Indeed, in 2017 alone, 44 units of EF were installed. In comparison, between 2014 and 2016, only 47 units of EF were installed. As the completion of a new EF installation in general takes eight to 10 months, all of EF capacity installed in 2017 - about 31 million tons of crude steel production capacity - will be operational in 2018. In addition, a report from China's Natural Resource Department indicates that as of mid-December there have been 54 replacement projects with total new steel production capacity of 91 million tons (including new EF capacity, new traditional capacity and recovered capacity). This compares to 120 million tons of capacity removed in 2016-'17. Assuming 60% of this 91 million tons capacity will be operating throughout 2018 at a utilization rate of 80% (the NBS 2017 CUR for the ferrous smelting and pressing industry was 75.8%), this alone will result in 43.6 million tons more output in 2018 from a year ago (5.2% growth from 2017 output) (Table 2). Table 2Strong Profit Margins Will Encourage Steel Production Revisiting China's De-Capacity Reforms Revisiting China's De-Capacity Reforms At the same time, strong profit margins will encourage steel makers to produce as much as possible to maximize profits (Chart 7). This will be especially true if the incumbent companies have to absorb liabilities of firms that were shutdown (please refer to page 14 for the discussion on this point). Facing more debt from shutdowns of other companies, steel incumbent producers would have an incentive to ramp up their production to generate more cash. Yet, we do not assume a rise in CUR for existing steel capacity. Hence, crude steel output growth in 2018 will likely be around 5.2%, higher than the 3% growth in 2017. This is in line with the top 10 Chinese steel producers' projected crude steel output growth in 2018 of 5.5%, based on their published production guidance data. The Ditiaogang and environmental policy caused a significant contraction in steel products growth in 2017, but will have limited impact in 2018 as discussed above. Eventually, increasing crude steel output will translate into strong growth in steel products output3 (Chart 8). Chart 7Strong Profit Margins ##br##Will Encourage Steel Production Strong Profit Margins Will Encourage Steel Production Strong Profit Margins Will Encourage Steel Production Chart 8Steel Products Production ##br##Will Rebound In 2018 Steel Products Production Will Rebound In 2018 Steel Products Production Will Rebound In 2018 Coal China's current coal capacity is about 5310 million tons, with 4780 million tons as operational capacity and the remaining 530 million tons as non-operational capacity, which has not produced coal for some time. As in general it takes roughly three to five years to build a coal mine, it will take a long time to replace the obsolete capacity. Yet there is hidden coal capacity in China. The China Coal Industry Association estimated last year that there was about 700 million tons of new technologically advanced capacity that has already been built and is ready to use, but has not yet received government approval. This is greater than the 530 million tons of coal production removed in the past two years by de-capacity reforms - equivalent to about 20% of China's total 2017 coal output. This hidden capacity originated from the fact that coal producers in China historically began building mines before applying for approval. However, since 2015, all applications for new coal mines have been halted. Consequently, in the past three years a lot of capacity has already been built but has not been put into operation. Some 70% of this hidden capacity includes large-scale coal mines, each with annual capacity of above 5 million tons. In comparison, China has about 126 million tons of small mines with annual capacity of 90,000 tons that will be forced to exit the market this year as they are non-competitive due to their small scale and inferior technology. Why do we expect this hidden capacity to become operational going forward? The authorities now allows trading in the replacement quota for coal across regions. Producers having these ready-to-use high-quality mines can buy the replacement quota from the producers who have eliminated the outdated capacity. The government wants to accelerate the process of allowing the advanced capacity to be in operation as fast as possible. The following policy initiative supports this: A new policy directive released this past February does not even require coal producers with advanced capacity to pay the quota first in order to apply for approval - they can apply for approval to start the replacement process first, and then have one year to pay for it. Economically, quotas trading makes sense. The mines with advanced technology that have lower costs and higher profit margins should be able to pay a reasonably high (attractive) price for quotas to companies with inferior technologies, so that the latter will be better off selling their quotas than continuing operations. The proceeds from the selling quotas will be used to settle termination benefits for employees of low-quality coal mines. Regarding our projections for coal output in 2018, assuming 30% of the 700 million tons of capacity among high-quality mines will be operational this year at a CUR of 78% (the NBS 2017 coal industry CUR was 68.2%), this alone will bring a 164 million-ton increase in coal output (4.7% of the 2017 coal output) (Table 3). Table 3Chinese Coal Output Will Rise By 4.7% In 2018 Revisiting China's De-Capacity Reforms Revisiting China's De-Capacity Reforms In addition, still-high profit margins could encourage existing coal producers to increase their CUR this year (Chart 9). Yet, we do not assume a rise in CUR for existing coal mining capacity. In total, Chinese coal output may increase 4.7% this year, higher than last year's 3.2% growth (Chart 10). Chart 9Strong Profit Margins Will Boost Coal Production Strong Profit Margins Will Boost Coal Production Strong Profit Margins Will Boost Coal Production Chart 10Coal Output Is Already Rising Coal Output Is Already Rising Coal Output Is Already Rising Bottom Line: Sizable technologically advanced new capacity is coming on stream for both steel and coal. This will boost both steel and coal output by about 5.2% and 4.7%, respectively, this year. Impact On Global Steel And Coal Prices In addition to diminishing capacity cuts and new technologically advanced capacity additions, the following factors will also weigh on steel prices: Relatively high steel product inventories (Chart 11, top panel) Weakening steel demand, mainly due to a potential slowdown in the property market4 Declining infrastructure investment growth (Chart 11, bottom panel). Chinese net steel product exports contracted 30% last year as steel producers opted to sell steel products domestically on higher domestic steel prices (Chart 12). Chart 11Elevated Steel Product Inventory##br## And Weakening Demand bca.ems_sr_2018_04_26_c11 bca.ems_sr_2018_04_26_c11 Chart 12China's Steel Product Exports ##br##Will Rebound China's Steel Product Exports Will Rebound China's Steel Product Exports Will Rebound Falling domestic steel prices may lead steel producers to ship their products overseas. In addition, the government has reduced steel products export tariffs starting January 1, 2018, which may also help increase Chinese steel product exports this year. This will pass falling Chinese domestic steel prices on to lower global steel prices. Between 2015 and 2017, about 1.6% of all Chinese steel exports were shipped to the U.S. Even if U.S. tariffs dampen its purchases of steel from China, mainland producers will try to sell their products to other countries. In a nutshell, U.S. tariffs will not prevent the transmission of lower steel prices in China to the global steel market. With respect to coal, in early April the Chinese government placed restrictions on Chinese coal imports at major ports in major imported-coal consuming provinces including Zhejiang, Fujian and Guangdong (Chart 13). The government demanded thermal power plants in those areas to limit their consumption of imported coal and use domestically produced coal. Clearly the government is trying to avoid cheaper imports flooding into the domestic coal market amid still elevated prices. This will help prevent a big drop in domestic coal prices but will be bearish for global coal prices. For example, 40% and 30% of Chinese coal imports are from Indonesia and Australia, respectively (Chart 14). These economies and their currencies are at risk from diminishing Chinese coal imports. Chart 13Chinese Coal Imports Will Decline Chinese Coal Imports Will Decline Chinese Coal Imports Will Decline Chart 14Indonesia and Australia May Face Falling ##br##Coal Demand From China Indonesia and Australia May Face Falling Coal Demand From China Indonesia and Australia May Face Falling Coal Demand From China For the demand side, continuing strong growth in non-thermal power supplies such as nuclear, wind and solar will curb thermal power growth in the long run and thus limit thermal coal consumption growth in China. This may also weigh on domestic coal prices and discourage coal imports. Bottom Line: The downtrend in domestic steel and coal prices will weigh on the global steel and coal markets. What About Iron Ore And Coking Coal? Iron ore and coking coal prices are also at risk: Chart 15Record High Chinese Iron Ore Inventory Record High Chinese Iron Ore Inventory Record High Chinese Iron Ore Inventory Given about 40% of newly installed steel capacity is advanced electric furnace (EF) based - which requires significant amounts of scrap steel rather than iron ore and coke - rising steel output will increase demand for iron ore and coke disproportionally less. As more Chinese steel producers shift to EF technology, mainland demand for iron ore and coke will diminish structurally in the years to come. Despite weakness in both domestic iron ore production and iron ore imports, Chinese iron ore inventories at major ports, expressed in number of months of consumption, have still reached record highs (Chart 15). This suggests rising EF capacity has indeed been constraining demand for iron ore. Increasing coal output will bring more coking coal and a corresponding rise in coke supply, thereby further depressing coke prices. Bottom Line: Global iron ore and coking coal prices are also vulnerable to the downside. Investment Implications From a macro perspective, investors can capitalize on these themes via a number of strategies: Shorting iron ore and coal prices, or these commodities producers' stocks. Chart 16Chinese Steel And Coal Shares:##br## Puzzling Drop Amid High Profit Chinese Steel And Coal Shares: Puzzling Drop Amid High Profits Chinese Steel And Coal Shares: Puzzling Drop Amid High Profits Going short the Indonesian rupiah (and possibly the Australian dollar) versus the U.S. dollar. Australia and Indonesia are large exporters of coal and industrial metals to China - they account for 30% and 40% of Chinese coal imports, respectively, so their currencies are vulnerable. Notably, although steel and coal prices are still well above their 2015 levels and producers' profit margins are very elevated, share prices of Chinese steel makers and coal producers have dropped almost to their 2015 levels (Chart 16). From a top-down standpoint, it is hard to explain such poor share price performance among Chinese steel and coal companies when their profits have been booming. Our hunch is that these companies have been forced by the government to shoulder the debt of the peer companies that were shut down. This is an example of how the government can force shareholders of profitable companies to bear losses from restructuring by merging zombie companies into profitable ones. On a more granular level, rapidly expanding EF steel-making capacity in China will lead to outperformance of stocks related to EF makers, graphite electrode producers and domestic scrap steel collecting companies. First, demand for graphite electrodes continues to rise, as EF steel production expands. Prices of graphite electrodes may stay high for quite some time (Chart 6 above, top panel). Second, scrap steel prices may go higher or stay high to encourage more domestic scrap steel collection. Companies who collect domestic scrap steel may soon have beneficial policy support, which will create huge potential for expansion (Chart 6 above, bottom panel). Third, EF makers will also benefit due to strong sales of electric furnaces. As a final note, equity investors should consider going long thermal power producers versus coal producers as thermal power producers will benefit from falling coal prices. Ellen JingYuan He, Associate Vice President Frontier Markets Strategy EllenJ@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report, "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed", dated November 22, 2017, available at ems.bcaresearch.com. 2 "Ditiaogang" is low-quality steel made by melting scrap metal in cheap and easy-to-install induction furnaces. These steel products are of poor quality, and also lead to environmental degradation. 3 The big divergence between crude steel production expansion and steel products output contraction last year was due to both the removal of "Ditiaogang" and statistical issues. "Ditiaogang" is often converted into steel products like rebar and wire rods. As steel produced this way is illegal, it is not recorded in official crude steel production data. However, after it is converted into steel products, official steel products production data do include it. 4 Please see Emerging Markets Strategy Special Report, "China Real Estate: A New-Bursting Bubble?", dated April 6, 2018, available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Our base case outlook is unchanged. We do not see a recession in the U.S. before 2020, and the U.S. equity market could reward investors with high single-digit total returns this year and next. Nonetheless, the cycle is well advanced and, given current valuations, the long-term outlook for returns in the major asset classes is far less appealing. The risk/reward balance is unfavorable. Investors should therefore separate strategy from forecast. U.S. unemployment is very low and we are beginning to see hints of late-cycle inflation dynamics. Core inflation could soon be at the Fed's 2% target, which means that the FOMC will have to consider becoming outright restrictive in order to slow growth and raise the unemployment rate. The risks facing equities, EM assets and spread product will escalate at that point. The advanced stage in the cycle and our bias for capital preservation requires us to heed the recent warnings from our growth indicators and 'exit' timing checklist. The geopolitical calendar is also stacked with risk for markets over the next month at least. The implication is that we are tactically trimming risk asset exposure to benchmark. We expect to shift back to overweight once our indicators improve and/or the geopolitical tensions fade. This month we provide total return estimates for the major U.S. asset classes under our base case outlook and two alternative scenarios. We place the odds at 50% for the base case, 20% for the optimistic scenario and 30% for a recession in 2019. We also review the U.S. fiscal outlook, which is clearly unsustainable over the long-term. While we do not see a dollar crisis anytime soon, the prospect of large and sustained federal budget deficits supports the view that the dollar will continue on a long-term downtrend (although it is likely to buck the trend in the coming months). It also supports our view that the multi-decade Treasury bull market is over. U.S. consumers will not be particularly sensitive to rising borrowing rates, although there are pockets of excessive borrowing that will no doubt result in a spike in defaults in selected sectors when the next economic downturn arrives. Feature It was the summer of 2009. Risk assets were bombed out, investor sentiment was deeply depressed, business leaders were shell-shocked, the Fed was easing and some 'green shoots' of recovery were emerging. Plentiful economic slack also meant that there was a long potential runway for the economy and earnings to grow. Given that backdrop, it was appropriate to begin rebuilding risk portfolios and ride out any additional turbulence in the markets. Today's situation is almost the mirror image. The economic expansion is well advanced, there is little slack, the Fed is tightening, risk assets are expensive, and investor equity sentiment is frothy. The long-term outlook for returns in the major asset classes is underwhelming to say the least. Table I-1 updates the long-run return expectations we published in the 2018 BCA Outlook. Some technical adjustments make the numbers look a little better but, still, a balanced portfolio will deliver average returns over the long-term of only 3.8% and 1.8% in nominal and real terms, respectively. Table I-110-Year Asset Return Projections May 2018 May 2018 For stocks, the expected returns are poor by historical standards because we assume a mean-reversion in multiples and a decline in the profit share of total income. These assumptions may turn out to be too pessimistic if there is no redistribution of income shares from the corporate sector back to labor and/or P-E ratios remain at historically high levels. Equities obviously would do better than our estimates in this case, but the point is that it is very hard to see returns in risk assets anywhere close to their 1982-2017 average over the long haul. On a two-year horizon, our base case outlook still sees decent equity returns. Nonetheless, the risk/reward balance has become quite unfavorable because the cycle is so advanced. It is therefore prudent to focus on capital preservation and be quicker to trim risk exposure when the outlook becomes cloudier. Losing Sleep Investors have cheered some easing in the perceived risk of a trade war in recent weeks. Nonetheless, a number of items have made us more nervous about the near term. First, our Equity Scorecard has dropped to one, well below the critical value of three that is consistent with positive equity returns historically (Chart I-1). Table I-2 updates our Exit Checklist of items that we believe are important for the equity allocation call. Five of the nine are now giving a 'sell' signal, pointing to at least a technical correction. Chart I-1Our Equity Scorecard Turned Negative Our Equity Scorecard Turned Negative Our Equity Scorecard Turned Negative Table I-2Exit Checklist For Risk Assets May 2018 May 2018 Moreover, we highlighted last month that global growth appears to be peaking (Chart I-2). Our Global Leading Economic Indicator is still bullish, but its diffusion index has plunged below zero. The Global ZEW index and our Boom/Bust indicator have fallen sharply and the global PMI index ticked down (albeit, from a high level). Industrial production in the major economies has eased. Korean and Taiwanese exports, which are a barometer of global industrial activity, have decelerated as well. Chart I-2Economic Indicators Have Softened Economic Indicators Have Softened Economic Indicators Have Softened While we expect global growth to remain at an above-trend pace for at least the next year, the peaking in some coincident and leading indicators is worrying nonetheless. Other items to keep investors up at night include the following: Loss Of Fed Put: With inflation likely to reach the Fed's target in the next couple of months, and policymakers worried about froth in markets, the FOMC will be less predisposed to ease at the first hint of economic softness (see below). Inflation Surge: There is a lot of uncertainty around estimates of the level of the unemployment rate that is consistent with rising wage and price pressures. Inflation could suddenly jump if unemployment is far below this critical level, leading to a blood bath in the bond market that would reverberate through all other assets. The fact that long-term inflation breakevens have surged along with the 10-year Treasury yield in the past couple of weeks is an ominous sign for risk assets. Neutral Rate: We agree with the Fed that the neutral fed funds rate is rising, but nobody knows exactly where it is at the moment. If the neutral rate is lower than the Fed believes, then the economy could suddenly stall as actual rates rise above the neutral level. Trade War: President Trump's popularity among Republican voters is rising, which gives him the ability to weather turbulence in the stock market while he 'gets tough' on trade. The fact that U.S. Treasury Secretary Mnuchin will visit China is a hopeful sign. Nonetheless, we do not believe that we have seen peak pessimism on trade because the President needs to placate his supporters in the mid-west that are in favor of protectionism. The summer months could be volatile as market confusion grows amidst a plethora of upcoming event risks.1 Iran: This year's premier geopolitical risk is the potential for renewed U.S.-Iran tensions. Ahead of the all-important May 12 deadline - when the White House will decide whether to end the current waiver of economic sanctions against Iran - President Trump has staffed his cabinet with two hawks (Bolton and Pompeo). Meanwhile, tensions in Syria are building with the potential for U.S. and Iranian forces to be directly implicated in a skirmish. Russia: Tensions between the West and Russia are also building again. Stroke Of Pen Risk: There is a rising probability that the current administration decides to up the regulatory pressure on Amazon. Other technology companies like Facebook and Google also face "stroke of pen" risks. On a positive note, first quarter earnings season is off to a good start in the U.S. Earnings have surprised to the upside by a wide margin, which is impressive given that analysts bumped up their Q1 assessments in 10 of 11 sectors between the start of 2018 and the beginning of the Q1 reporting season. Analysts' estimates typically move lower as a quarter unfolds, which has the effect of lowering the bar for results to beat expectations. That said, a lot of good news is already discounted in the U.S. market. Chart I-3 highlights that bottom-up analysts' expected annual average EPS growth for the S&P 500 over the next five years has shot up to more than 15%, a level not seen since 1998! This is excessive even considering that the estimates include the impact of the tax cuts. History teaches that investors should be wary during periods of earnings euphoria. Chart I-3Five-Year Bottom-Up EPS Growth Estimates Are Impossibly High Five-Year Bottom-Up EPS Growth Estimates Are Impossibly High Five-Year Bottom-Up EPS Growth Estimates Are Impossibly High Given these risks, market pricing and our checklist, we adjusted the tactical (3-month) House View recommendation on risk assets to benchmark in April. We see this shift as tactical, and expect to move back to overweight once our growth indicators bottom and the geopolitical situation calms down a little. Our base case outlook remains constructive for risk assets on a cyclical (6-12 month) view. Three Scenarios This month we consider two alternative scenarios to our base case outlook and provide estimates of how several key asset classes would perform between now and the end of 2019: Base Case: U.S. real GDP growth accelerates to 3.3% year-over-year by the end of 2018 on the back of fiscal stimulus and improving animal spirits in the corporate sector. Growth is expected to decelerate in 2019, but remain above trend. Profit margins are squeezed marginally by rising wage pressure. The recession we expect to occur in 2020 is beyond the horizon of this exercise. Optimistic Case: The multiplier effects of the fiscal stimulus could be larger than we are assuming if consumers decide to spend most of the tax windfall, and the corporate sector cranks up capital spending due to accelerated depreciation, the tax savings and repatriated overseas funds. We assume that real GDP growth is about a half percentage point higher than the base case in both 2018 and 2019. This is only modestly stronger than the base case because, given that the economy is already at full employment, the supply side of the economy will constrain growth. Even more margin pressure partially offsets stronger top line growth for corporations. Pessimistic Case: The fiscal multiplier effects turn out to be smaller than expected, compounded by the growth-sapping impact of a tariff war and a spike in oil prices due to tensions in the Middle East. The corporate and consumer sectors are more sensitive to rising interest rates than we thought (see below for more discussion of U.S. consumer vulnerabilities). Growth begins to slow toward the end of 2018, culminating in a recession in the second half of 2019. Margins are squeezed initially, but then rise as labor market slack opens up next year. This is more than offset, however, by declining corporate revenues. Chart I-4 presents the implications for S&P 500 EPS growth in the three scenarios, according to our top-down model. Four-quarter trailing profit growth comes in at a respectable 15% and 8½%, respectively, in 2018 and 2019 in our base case. The optimistic scenario would see impressive profit growth of 20% and 13%. Trailing EPS expands by 9% this year in the pessimistic case, but contracts by about the same amount next year. Chart I-4Three Scenarios For S&P 500 EPS Growth Three Scenarios For S&P 500 EPS Growth Three Scenarios For S&P 500 EPS Growth In order to use these EPS forecasts to estimate expected S&P 500 returns, we made assumptions regarding an appropriate 12-month forward P/E ratio (Table I-3). We also translated our trailing EPS forecasts into 12-month forward estimates based on historical cyclical patterns. The 12-month forward P/E ratio is 17 as we go to press (based on Standard and Poors figures). We assume the ratio is flat this year in the base case, before edging lower in 2019 due to rising interest rates. The forward P/E is assumed to edge up in the optimistic case in 2019, but then falls back in 2019 as rates rise. In the recession scenario, we conservatively assume that this ratio falls to 15 by the end of this year, and to 13 by the end of 2019. We incorporate a 2% dividend yield in all scenarios. Over the next two years, the S&P 500 delivers an 8% annual average return in our baseline, and 13% in the optimistic case. As would be expected, investors suffer painful losses of 13% this year and roughly 20% next year in the case of recession, as the drop in multiples magnifies the earnings contraction. Table I-4 presents total return estimates for the 10-year Treasury under the three scenarios. The bond will provide an average return of close to zero in our base case. It suffers heavy losses in 2018 if growth turns out to be stronger than we expect, because a faster acceleration in inflation would spark a sharp upward revision to the path of short-term rates. Long-term inflation expectations would rise as well. The 10-year yield finishes 2019 at 3.5% in the base case, and at 3.75% in the optimistic growth scenario. In contrast, total returns are hefty in the recession case as the 10-year yield drops back below 2%. Table I-3S&P 500 Return Scenarios May 2018 May 2018 Table I-410-year Treasury Return Scenarios May 2018 May 2018 We believe the risk/reward profile is less attractive for corporate bonds than it is for equities (Table I-5). Strong profit growth in the base and optimistic cases is positive for corporates, but this is offset by deteriorating financial ratios as interest rates rise in the context of high leverage ratios. We expect investment-grade (IG) spreads to widen modestly even in the base case, providing a small negative excess return. We see spreads moving sideways at best in our optimistic scenario, giving investors a small positive excess return of about 100 basis points. In the case of a recession, we could see the option-adjusted spread of the Barclay's IG index surging from 105 basis points today to 250 basis points. Excess returns would obviously be quite negative. Table I-5U.S. Investment Grade Corporate Bonds May 2018 May 2018 All of these projected returns are only meant to be suggestive because they depend importantly on several key assumptions. Still, we wanted to provide readers with a sense of the risks for returns around our base case outlook. We place the odds at 50% for the base case, 20% for the optimistic scenario and 30% for a recession. U.S. Fiscal Policy: Good And Bad News The probabilities attached to the baseline and optimistic scenarios are supported by the U.S. fiscal stimulus that is in the pipeline. The IMF estimates that the tax cuts and spending increases will provide a fiscal thrust of 0.8% in 2018 and 0.9% in 2019, not far from the estimates we presented last month (Chart I-5).2 This represents a powerful tailwind for growth for the next two years. We must turn to the Congressional Budget Office (CBO) projections to gauge the longer-term implications. On a positive note, the CBO revised up its estimate of the economy's long-run potential growth rate on account of the supply-side benefits of lower taxes and the immediate expensing of capital outlays. Faster growth over the long run, on its own, reduces the projected cumulative budget deficit over the 2018-2027 period by $1 trillion. However, this positive impact is swamped by the direct effect on the budget of the tax breaks and increased spending. The CBO estimates that the net effect of the fiscal adjustments will be a $1.7 trillion increase in the cumulative budget deficit over the next decade, relative to the previous baseline (Chart I-6). The annual deficit is projected to surpass $1 trillion in 2020, and peak as a share of GDP at 5.4% in 2022. Federal government debt held by the private sector will rise from 76% this year to 96% in 2028 in this scenario. Chart I-5U.S. Fiscal Stimulus Will Support Growth May 2018 May 2018 Chart I-6U.S. Federal Budget: A Lot More Red Ink U.S. Federal Budget: A Lot More Red Ink U.S. Federal Budget: A Lot More Red Ink The deficit situation begins to look better after 2020 because a raft of "temporary provisions" are assumed to sunset as per current law, including some of the personal tax cuts and deductions included in the 2017 tax package. As is usually the case, the vast majority of these provisions are likely to be extended. The CBO performed an alternative scenario in which they extend the temporary provisions and grow the spending caps at the rate of inflation after 2020. In this more realistic scenario, the deficit reaches 6% of GDP by 2022 and the federal debt-to-GDP ratio hits almost 110% of GDP in 2028. This is not a pretty picture and investors are wondering what it means for government bond yields and the dollar. We noted in the March 2018 Bank Credit Analyst that academic studies published before 2007 suggested that every percentage point rise in the government's debt-to-GDP ratio added roughly three basis points to the equilibrium level of bond yields. If this is correct, then a rise in the U.S. ratio of 25 percentage points over the next decade would lift the equilibrium long-term bond yields by 75 basis points. This estimated impact on yields should not be thought of as a default risk premium because there is no reason to default when the Fed can simply print money in the event of a funding crisis. Rather, a worsening fiscal situation could show up in higher long-term inflation expectations if investors were to lose confidence in the Fed's inflation target. Higher real yields could also come about through the 'crowding out' effect; since growth is limited in the long run by the supply side of the economy, a larger government sector means that some private sector demand needs to be crowded out via higher real interest rates. Deficits And The Dollar We discussed the potential debt fallout for the U.S. dollar from an economic perspective in the April 2018 Special Report. While the fiscal stimulus means that the U.S. twin deficits are set to worsen, the situation is not so dire that the U.S. dollar is about to fall off a cliff because of sudden concerns regarding U.S. debt sustainability among international investors. The U.S. is not close to the point where investors will begin to seriously question America's ability to service its debt. Nonetheless, with President Donald Trump's overt calls for American geopolitical retrenchment from global commitments, investors have asked whether the end of the dollar as the global reserve currency is nigh. This month's Special Report beginning on page 22 examines this issue. There is no evidence at the moment that the U.S. dollar is losing any market share and we do not foresee any sudden shifts away from the U.S. dollar as a reserve currency. However, cracks are beginning to form, especially with regard to the RMB. We also believe that the euro is likely to benefit from a structural tailwind as global reserve managers increase the share of the euro in their reserves. A trade war would accelerate the diversification away from the dollar. Chart I-7Economic Slack: U.S./Eurozone Comparison Economic Slack: U.S./Eurozone Comparison Economic Slack: U.S./Eurozone Comparison The conclusions of this month's Special Report support those of last month's analysis; the dollar will continue on its long-term downtrend, although there is still room for a counter-trend rally this year. We do not see much upside against the yen in the near term, but we expect some of the euro's recent strength to be unwound. A debate is raging within the halls of the European Central Bank regarding the amount of Europe's economic slack. On this we side with President Draghi, who believes that there is still plenty of excess capacity in the labor market. The Eurozone's unemployment rate has reached the level of full employment as estimated by the OECD. However, Chart I-7 shows various measures of hidden unemployment, including discouraged workers and those that have been out of work for more than a year. In all cases, the Eurozone appears to be behind the U.S. in terms of getting back to full employment. This, along with the recent softening in some of the Eurozone's economic data, will keep the ECB wedded to low interest rates even as it terminates the asset purchase program this autumn. Long-dated forward rate differentials are beginning to move back in favor of the dollar relative to the Euro. Dollar strength will also be at the expense of most of the EM currencies. The Long-Term Consequences Of Government Debt While it is somewhat comforting that the U.S. twin-deficits are unlikely to spark financial panic in the short- to medium term, the U.S. and global debt situations are not without consequences. The latest IMF Fiscal Monitor again sounded the alarm over global debt levels, especially government paper. The Fund argues that debt sustainability becomes increasingly questionable once the general government debt/GDP ratio breaches 85%. The IMF points out that more than one-third of advanced economies had debt above 85% in 2017, three times more countries than in 2000. And this does not include the implicit liabilities linked to pension and health care spending. The good news is that the IMF expects that most of the major economies will see a reduction in their general government debt/GDP ratios between 2017 and 2023. The big exception is the U.S., where the average deficit is expected to far exceed the other major countries (Charts I-8A and I-8B). The U.S. cyclically-adjusted budget deficit is projected to be almost 7% of GDP in 2019! Including all levels of government, the IMF estimates that the U.S. debt/GDP ratio will rise by about nine percentage points, to almost 117%, between 2017 and 2023. Chart I-8AIMF Projections (I) May 2018 May 2018 Chart I-8BIMF Projections (II) May 2018 May 2018 U.S. fiscal trends are clearly unsustainable in the long-term. Taxes will have to rise or entitlement programs will have to be slashed at some point. The question is whether Congress administers the required medicine willingly, or is forced to do so by rioting markets. We do not believe that the dollar's 'day of reckoning' will happen anytime soon, but growing angst over the U.S. fiscal outlook supports our view that the multi-decade Treasury bull market is over. In the near term, the main threat to the global bond market is a mini 'inflation scare' in the U.S. Fed Will Soon Reach 2% Goal Chart I-9Inflation May Soon Reach The Fed's Target Inflation May Soon Reach The Fed's Target Inflation May Soon Reach The Fed's Target The 10-year Treasury yield is testing the 3% support level as we go to press. In part, upward pressure on yields likely reflects some calming of tensions regarding global trade and the news that the U.S. will hold face-to-face discussions with North Korea. Moreover, long-term inflation expectations have been rising in most of the major countries. Investors appear to be waking up to how strong U.S. inflation has been in recent months, driven in part by an unwinding of base effects that temporarily depressed the annual inflation rate. U.S. core CPI inflation has already quickened from 1.8% in February to 2.1% in March (Chart I-9). This acceleration will also play out in the core PCE deflator, the Fed's preferred inflation metric. Even if the core PCE deflator rises only 0.1% month-over-month in March, year-over-year core PCE inflation will increase to 1.85%. This would be above Bloomberg and Fed estimates for the end of the year. If the core PCE deflator rises 0.2% m/m in March - a reading more consistent with recent trends - then year-over-year core PCE inflation will almost reach the Fed's 2% target. The FOMC will not be alarmed even if inflation appears set to overshoot the 2% target. Nonetheless, Fed officials will be forced to adjust the communication language because they can no longer argue that "accommodative" monetary policy is still appropriate. In other words, policymakers will have to openly admit that policy will have to become outright restrictive. The Fed's "dot plot" could then be revised higher. The policy risks facing equities, EM assets and spread product will escalate once it becomes clear that the FOMC is actively targeting slower economic growth and a higher unemployment rate. As for Treasurys, the surge in the 10-year yield to 3% has been quick and we would not be surprised to see another consolidation period. Eventually, however, we expect the yield to reach 3.5% before the bear phase is over. How Vulnerable Are U.S. Households? The ultimate peak in U.S. yields will depend importantly on the economy's sensitivity to rising borrowing costs. Our research on excessive borrowing in recent months has focussed on the U.S. corporate sector. Next month we will review corporate vulnerabilities in the Eurozone. But what about U.S. consumers? Overall debt as a ratio to GDP or personal income has fallen back to pre-housing bubble levels, underscoring that the household sector has deleveraged impressively (Chart I-10). Household net worth has surpassed the pre-Lehman peak and our "wealth effect" proxy suggests that the rise in asset prices and recovery in home values provide a strong tailwind for spending (Chart I-11). The proxy likely overstates the size of the tailwind due to the lack of cash-out refinancing. Chart I-10U.S. Consumers Have Deleveraged U.S. Consumers Have Deleveraged U.S. Consumers Have Deleveraged Chart I-11'Wealth Effect' Is A Tailwind ''Wealth Effect''' Is A Tailwind ''Wealth Effect''' Is A Tailwind The financial obligation ratio (FOR) - a measure of the debt service burden for the average household - is rising but is still close to the lowest levels in three decades (Chart I-12). Chart I-13 shows a broader measure of the burden that households face when paying for essentials; interest payments, food, medical care and energy. These are all expenses that are difficult to trim. Spending on essentials has increased over the past couple of years to a little under 42% of disposable income due to rising interest rates and a continuing uptrend in out-of-pocket medical care costs. However, the ratio is below the post-1980 average level and has only risen back to levels that existed in 2011/12. From this perspective, it is difficult to believe that rising gasoline prices will dominate the benefits of the tax cuts on household spending. Chart I-12Past The Peak Of U.S. Consumer Credit Quality Past The Peak Of U.S. Consumer Credit Quality Past The Peak Of U.S. Consumer Credit Quality Chart I-13Spending On Essentials Is Not Onerous Spending On Essentials Is Not Onerous Spending On Essentials Is Not Onerous The labor market is clearly supportive for consumer spending. Wage growth has been disappointing so far in this recover, and real personal disposable income has slowed over the past year. Nonetheless, the economy continues to produce new jobs at an impressive pace, unemployment claims are close to all-time lows, and households are feeling confident about their future income and job prospects. Some market pundits have pointed to the falling household savings rate as a warning sign that consumers are 'tapped out' (Chart I-14). We are less concerned. The savings rate tends to decline during economic expansions and rises almost exclusively during recessions. All else equal, one could make the case that U.S. households should save more over their lifetimes. Nonetheless, a falling savings rate is consistent with strong, not weak, economic activity. That said, some signs have emerged that not all consumer lending in recent years has been prudent. Bank and finance company loan delinquency rates are rising, especially for credit cards and autos (Chart I-15). While the FOR is still low, it is rising and it tends to lead bank loan delinquency rates (Chart I-12). These trends usually occur just prior to a recession. Chart I-14Savings Rate Falls During Expansions Saving Rate Falls During Expansions Saving Rate Falls During Expansions Chart I-15Some Signs Of Excessive Lending Some Signs Of Excessive Lending Some Signs Of Excessive Lending There has also been an alarming surge in credit card charge-off rates, which have reached recession levels among banks that are outside of the top 100 (Chart I-15, top panel). Anecdotal evidence suggests that large banks offered lush cash rewards and points to attract higher-quality customers. Smaller banks could not compete on cash rewards, and instead had to loosen credit requirements for card issuance. The deterioration in the credit-quality composition of these banks' loan portfolios helps to explain why delinquencies have increased despite a robust labor market. The Fed's senior loan officer survey shows that expected delinquencies and charge-offs are rising even among large banks. One risk is that, while overall credit growth has been weak in this expansion, it has been concentrated in lower-income households. However, the Fed's Survey of Consumer Finances does not flag a huge problem. Various measures of credit quality have not deteriorated for lower income households since 2007 (latest year available; Chart I-16). Chart I-16Credit Quality For Lower ##br##Income U.S. Households Credit Quality For Lower Income U.S. Households Credit Quality For Lower Income U.S. Households The bottom line is that there are pockets of excessive borrowing that will no doubt result in a spike in defaults in selected sectors when the next economic downturn arrives. Nonetheless, the backdrop for consumer health has not deteriorated to the point where the U.S. household sector will be ultra-sensitive to higher interest rates on a broad scale. Investment Conclusions Our base case outlook is unchanged this month. We do not see a recession in the U.S. before 2020, and the U.S. equity market could reward investors with high single-digit total returns this year and next. Nonetheless, one must separate strategy from forecast at this point in the cycle. U.S. unemployment is very low and we are beginning to see hints of late-cycle inflation dynamics. Core inflation could soon be at the Fed's 2% target, while rising energy and base metal prices add to the broader inflationary backdrop. Strong global oil demand growth and the OPEC/Russia production cuts are draining global oil inventories and supporting prices. Sanctions against Iran and/or Venezuela that further restrict supply could easily send oil prices to more than US$80/bbl this year. Investors should remain overweight energy plays. The implication is that the Fed may have to tighten into outright restrictive territory. The advanced stage in the cycle and our bias for capital preservation requires us to heed the warnings from our indicators and timing checklist. The geopolitical calendar is also stacked with risk for markets over the next month at least. Thus, we are tactically trimming risk asset exposure to benchmark until our indicators improve and/or geopolitical tensions fade. Investors should also be more cautious in their equity sector allocation for the very near term. We continue to favor Eurozone stocks over the U.S. (currency hedged), since the threat from monetary tightening is greater in the latter market and we expect the dollar to appreciate. We are neutral on the Nikkei because the risk of a rising yen offsets currently-strong EPS growth momentum. Stay short duration within global bond portfolios, and remain underweight the U.S., Canada and core Europe (currency hedged). Overweight Australia and the U.K. The Aussie economy will continue to underperform, and the U.K. economy will not allow the Bank of England to hike rates as much as is currently discounted. Mark McClellan Senior Vice President The Bank Credit Analyst April 26, 2018 Next Report: May 31, 2018 1 For a list of these events, see Table 2 in the BCA Geopolitical Strategy Weekly Report "Expect Volatility... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. 2 The fiscal thrust is the change in the cyclically-adjusted budget balance as a share of GDP. It is a measure of the initial impetus to real GDP growth, but the actual impact on growth depends on fiscal "multipliers". II. Is King Dollar Facing Regicide? This month's Special Report is a joint effort by BCA's Geopolitical and Foreign Exchange strategists, along with contributing editors Mehul Daya and Neels Heyneke (Strategists at Nedbank CIB Research). It is a companion piece to last month's Special Report, in which I discussed the short- and long-term outlook for the U.S. dollar from a purely economic perspective. This month's analysis takes a geopolitical perspective, focusing on the possibility that the U.S. dollar will lose its reserve currency status and weaken over the long term. I trust that you will find the Report as insightful as I did. Mark McClellan Reserve currencies are built on a geopolitical and macroeconomic foundation. For the U.S. Dollar, these foundations remain in place, but cracks are emerging. Relative decline in American power, combined with a loss of confidence in the "Washington Consensus" at home, are eroding the geopolitical foundations. Meanwhile, threats to globalization, a slower pace of petrodollar recycling, and stresses in the Eurodollar system are eroding the macroeconomic foundations. The Renminbi is not an alternative to King Dollar, but the euro remains a potential challenger in the coming interregnum years that will see the world transition from American hegemony... to something else. In the long run, we envision a multipolar currency regime to emerge alongside a multipolar geopolitical world order. In this report, BCA's Geopolitical and Foreign Exchange strategies join efforts with contributing editors Mehul Daya and Neels Heyneke (Strategists at Nedbank CIB Research) to examine the conditions necessary for the decline of a reserve currency. Specifically, we seek to answer the question of whether the U.S. dollar is at the precipice of such a decline. With President Donald Trump's overt calls for American geopolitical retrenchment from global commitments, investors have asked whether the end of the dollar as the global reserve currency is nigh. After all, King Dollar has fallen by 9.7% since President Trump's inauguration on January 20, while alternatives of dubious value, such as a slew of cryptocurrencies, have seen a rally of epic proportions (Chart II-1). Professor Barry Eichengreen, a world-renowned international economics historian,1 has recently penned an insightful paper proposing a link between the robustness of military alliances and currency reserve status.2 According to the analysis, reserve currency status reflects both economic fundamentals - safety, liquidity, network effects, and economic conditions - and geopolitical fundamentals. In the case of close U.S. military allies, such as South Korea and Japan, the choice of the dollar as store of value is explained far more by the geopolitical links to the U.S., rather than the importance of the dollar for their economies. The authors warn that if the U.S. "withdraws from the world," the impact could be as large as an 80 basis points rise in the U.S. long-term interest rate. Intriguingly, some of what Professor Eichengreen posits could happen has already happened. For example, the share of foreign holdings of U.S. Treasuries by military allies has already declined by a whopping 25% (Chart II-2). And yet the demand for King Dollar assets was immediately picked up by non-military allies, proving the resiliency of greenback's status as the reserve currency. Chart II-1Is Trump Guilty Of Regicide? Is Trump Guilty Of Regicide? Is Trump Guilty Of Regicide? Chart II-2Geopolitics Is Not Driving ##br##Demand For Treasuries Geopolitics Is Not Driving Demand For Treasuries Geopolitics Is Not Driving Demand For Treasuries When it comes to global currency reserves, the U.S. dollar continues to command 63%, roughly the same level it has commanded since 2000 (Chart II-3). Interestingly, alternatives remain roughly the same as in the past, with little real movement (Chart II-4). The Chinese renminbi remains largely ignored as a global reserve currency and its use across markets and geographies appears to have declined since the imposition of full capital controls in October 2015 (Chart II-5). Chart II-3Dollar Remains King Dollar Remains King Dollar Remains King Chart II-4The Euro Is The Only Serious Competitor To King Dollar... May 2018 May 2018 Chart II-5...The Renminbi Is Not May 2018 May 2018 However, some cracks in the foundation are emerging. A recent IMF paper, penned by Camilo E. Tovar and Tania Mohd Nor,3 uses currency co-movements to determine which national currencies belong to a particular reserve currency bloc.4 Their work shows that the international monetary system has already transitioned from a bi-polar system - consisting of the greenback and the euro - to a multipolar one that includes the CNY (Chart II-6). However, the CNY's influence does not extend beyond the BRICS and is scant in East Asia, the geographical region that China already dominates in trade (Chart II-7), albeit not yet geopolitically (Map II-1). Chart II-6Renminbi Does Command A Large Currency 'Bloc'... Renminbi Does Command A Large Currency '''Bloc'''... Renminbi Does Command A Large Currency '''Bloc'''... Chart II-7...But Despite China's Dominance Of East Asia... ...But Despite China's Dominance Of East Asia... ...But Despite China's Dominance Of East Asia... Map II-1...Renminbi's 'Bloc' Is Not In Asia! May 2018 May 2018 Our conclusion is that the geopolitical and economic tailwinds behind the greenback's status as a global reserve currency are shifting into headwinds. This process, as we describe below, could increase the risk of a global dollar liquidity shortage, buoying the greenback in the short term. In the long term, however, a transition into a multipolar currency arrangement could rebalance some of the imbalances created by the collapse of the Bretton Woods System and is not necessarily to be feared. The Geopolitical Fundamentals Of A Reserve Currency Nothing lasts forever and the U.S. dollar will one day join a long list of former reserve currencies that includes the Ancient Greek drachma, the Roman aureus, the Byzantium solidus, the Florentine florin, the Dutch gulden, the Spanish dollar, and the pound sterling. All of the political entities that produced these reserve currencies have several factors in common. They were the geopolitical hegemons of their era, capable of controlling the most important trade routes, projecting both hard and soft power outside of their borders, and maintaining a stable economy that underpinned the purchasing power of their currency. Table II-1 illustrates several factors that we believe encapsulate the necessary conditions for a dominant international currency. Table II-1Insights From History: What Makes A Reserve Currency? May 2018 May 2018 Geopolitical Power As Eichengreen posits, geopolitical fundamentals are essential for reserve currency status. Military power is necessary in order to defend one's national and commercial interests abroad, compel foreign powers to yield to those interests, and protect allies in exchange for their acquiescence to the hegemonic status quo. An important modern world example of such "gunboat diplomacy" was the 1974 agreement between the U.S. and Saudi Arabia.5 In exchange for dumping their petro-dollars into U.S. debt, Riyadh received an American commitment to keep the Saudi Kingdom safe from all threats, both regional (Iran) and global (the Soviet Union). It also received special permission to keep its purchases of U.S. Treasuries secret. Chart II-8The Exorbitant Privilege In One Chart May 2018 May 2018 As with all the empires surveyed in Table II-1, allies and vassal states were forced to use the hegemon's currency in their trade and investment transactions as a way of paying for the security blanket. To this day, there is no better way to explain the "exorbitant privilege" that the dollar commands. Chart II-8 illustrates that the U.S. enjoys positive net income despite a massively negative net international investment position. It is true that the U.S.'s foreign assets are skewed toward foreign direct investment and equities, investments that have higher rates of returns than the fixed-income liabilities the U.S. owes to the rest of the world. But the U.S.'s positive net income balance has been exacerbated by the willingness of foreigners to invest their assets into the U.S. for little compensation, something illustrated by the fact that between 1971 and 2007, the ex-post U.S. term premium has been toward the lower end of the G10. Additionally, as foreigners are also willing holders of U.S. physical cash, the U.S. government has been able to finance part of its budget deficit with instruments carrying no interest payments. This is what economists refer to as seigniorage, a subsidy to the U.S. government equivalent to around 0.2% of GDP per annum (or roughly $39.5 bn in 2017). In essence, American allies are paying for American hegemony through their investments in U.S. dollar assets, and this lets the U.S. live above its means. But ultimately, the quid pro quo is perhaps as much geopolitical as economic. There is one, non-negligible, cost for U.S. policymakers. The greenback tends to appreciate during periods of global economic stress due to its reserve currency status.6 This means that each time the U.S. needs a weak dollar to reflate its economy, the dollar moves in the opposite direction, adding deflationary pressures to an already weak domestic economy. Compared to the benefits, which offer the U.S. a steady-stream of seigniorage income and low-cost financing, the cost of reserve currency status is acceptable. Chart II-9U.S. Naval Strength Still Supreme... U.S. Naval Strength Still Supreme... U.S. Naval Strength Still Supreme... Economic Power Aside from brute force, an empire is built on commercial and trade links. There are two reasons for this. First, trade allows the empire to acquire raw materials to fuel its economy and technological advancement. Second, it also gives the "periphery" a role to play in the empire, a stake in the world system underpinned by the hegemonic core. This creates an entire layer of society in the periphery - the elites enriched by and entrenched in the Empire - with existential interest in the status quo. For the past five centuries, commercial dominance has been underpinned by naval dominance. As the Ottoman Empire and the Ming Dynasty closed off the overland routes in the fourteenth and fifteenth centuries, Europeans used technological innovation to avoid the off-limits Eurasian landmass and establish alternative - and exclusively naval - routes to commodities and new markets. This has propelled a succession of largely naval empires: Portuguese, Spanish, Dutch, French, British, and finally American. Several land-based powers tried to break through the nautical noose - Ottoman Turks, Sweden, Hapsburg Austria, Germany, and the Soviet Union - but were defeated by the superiority of naval-based power. Dominance of the seas allows the hegemonic core to unite disparate and far-flung regions through commerce and to call upon vast resources in case of a global conflict. Meanwhile, the hegemon can deny that commerce and those resources to land-locked challengers. This is how the British defeated Napoleon and how the U.S. and its allies won World War I and II. The U.S. remains the supreme naval power (Chart II-9). While China is building up its ability to push back against the U.S. navy in its regional seas (East and South China Seas), it will be decades before it is close to being able to project power across the world's oceans. While the former is necessary for becoming a regional hegemon, the latter is necessary for China to offer non-contiguous allies an alternative to American hegemony. Bottom Line: The foundation of a global reserve currency status is geopolitical fundamentals. The U.S. remains well-endowed in both. American Hegemony - From Tailwinds To Headwinds Chart II-10...But Overall Hegemony Is In Decline ...But Overall Hegemony Is In Decline ...But Overall Hegemony Is In Decline The U.S. is already facing a relative geopolitical decline due to the rise of major emerging markets like China (Chart II-10). This theme underpins BCA Geopolitical Strategy's view that the world has already transitioned from American hegemony to a multipolar arrangement.7 In absolute terms, the U.S. still retains the hard and soft power variables that have supported the USD's global reserve status and will continue to do so for the next decade (which is the maximum investment horizon of the vast majority of our clients). However, there are three imminent threats to the status quo that may accentuate global multipolarity: Populism: The global hegemon could decide to withdraw from distant entanglements and institutional arrangements. In the U.S., an isolationist narrative has emerged suggesting that America's status as the consumer and mercenary of last resort is unsustainable (Chart II-11). President Obama was elected on the promise of withdrawing from Iraq and Afghanistan; his administration also struck a major deal with Iran to reduce American exposure to the Middle East. Donald Trump won the presidency on an even more isolationist platform and he and several of his advisors have voiced such a view over the past 15 months. The appeal of isolationism could resurface as it is a potent political elixir based on a much deeper rejection of globalization among the American public than the policy establishment realized (Chart II-12). Chart II-11Trump Is Rebelling Against The Post-Cold War System May 2018 May 2018 Chart II-12Americans Are Rebelling Against The 'Washington Consensus' May 2018 May 2018 Return of the land-based empire: While the U.S. remains the preeminent naval power, its leadership in military prowess could be wasted through a suboptimal grand strategy. The U.S. has two geopolitical imperatives: dominate the world's oceans and ensure the disunity of the Eurasian landmass.8 Eurasia has sufficient natural resources (Russia), population (China), wealth (Europe), and geographical buffer from naval powers (the seas surrounding it) to become self-sufficient. Hence any great power that managed to dominate Eurasia would have no need for a navy as it would become a superpower by default. Why would America's European allies abandon their U.S. security blanket for an alliance with Russia and China? First, stranger shifts in alliance structure have occurred in the past.9 Second, because a mix of U.S. mercantilism and isolationism could push Europe into making independent geopolitical arrangements with its Eurasian peers, even if these arrangements were informal. The advent of the cyber realm: Finally, the advent of the Internet as a new realm of great power competition reduces the relative utility of hard power, such as a navy. Great empires of the past struggled when confronted with new arenas of conflict such as air and submarine. New technologies and new arenas can yield advantages in traditional battlefields. Today, the U.S. must compete for hegemony in space and cyber-space with China, Russia, and other rivals. In these mediums, the U.S. does not have as great of a head start as it has in naval competition. Bottom Line: The U.S. remains the preeminent global power. However, its status as a hegemon is in relative decline. Domestic populism, suboptimal grand strategy, and the advent of cyber and outer-space warfare could all accelerate this decline on the margin. The Economic Fundamentals Of U.S. Dollar Reserve Status One unique aspect of the U.S. dollar as a reserve currency is that it is a fiat currency, i.e. paper money limited in supply only by policy. Throughout human history, most dominant currency reserves were based on commodities that were rare or difficult to acquire, like silver or gold.10 When the U.S. dollar was decoupled from gold prices in 1971, it became the only recent example of a global reserve currency backed by nothing but faith (the pound was for most of its period of dominance backed by gold). Money serves three functions in the economy. It is a means of payment, a unit of account, and a store of value. The last comes into jeopardy when the reserve currency has to supply the world with more and more liquidity, also known as the "Triffin dilemma". By definition, as the global reserve currency, the USD has to be plentiful enough for the global economy and financial system to function adequately. The U.S. government must constantly supply dollars to this end. Chart II-13 illustrates the timeline of global dollar liquidity, which we define as the total U.S. monetary base in circulation (U.S. monetary base plus holdings of U.S. Treasury securities held in custody for foreign officials and international accounts). The world has seen an ever-expanding U.S. dollar monetary base since 1988. Only during periods where the price of money (i.e. the Federal funds rate) has increased, has the money creation process slowed. Now that the expansion of the global USD monetary base is slowing, overall dollar liquidity is as important as the price, if not more (Chart II-14). Chart II-13Global Dollar Liquidity... May 2018 May 2018 Chart II-14...Drives Global Asset Prices ...Drives Global Asset Prices ...Drives Global Asset Prices The constant increase of dollar liquidity has made the greenback the "lubricant" of today's global financial system. There are three major forces at work beneath this condition: Recycling of petrodollars into the global financial system; Globalization and the build-up of - mainly USD-denominated - FX reserves; Deregulation of the Eurodollar system.11 Petrodollars Commodity exporters, mainly oil producers, sell their products in exchange for U.S. dollars. In addition, most Middle Eastern producers recycle their profits into U.S. dollars due to the liquidity and depth of U.S. capital markets. By 1980, the majority of oil producers were trading in U.S. dollars and were similarly investing their surpluses into the U.S. financial system in the form of U.S. government debt securities. The growth in petrodollars has allowed the world's dollar monetary base to grow substantially. This was both enabled by direct issuance of U.S. debt securities funded by petrodollar purchases and also through the Eurodollar system whereby banks outside the U.S. held large deposits of surplus dollar earnings from Middle East oil producers. Globalization The contemporary wave of globalization began in the mid-1980s, when it became evident that the Soviet Union was in midst of a deep economic malaise. This prompted the new Soviet Premier Mikhail Gorbachev to launch perestroika ("restructuring") in 1985, throwing in the proverbial towel in the contest between a statist planned economy and a free market one. Alongside the rise in global trade, financial globalization rose at a very rapid pace as cross-border capital flows more than doubled as a percentage of global GDP from 1990 onward. In the U.S., the economic boom of the 1990s was the longest expansion in history, with growth averaging 4% during the period. The U.S. trade deficit ballooned, providing the world with large amounts of dollar liquidity in the process. The flipside of the massive current account deficit was the accumulation of FX reserves in Europe and Asia, largely denominated in U.S. dollars. These insensitive buyers of U.S. debt indirectly financed the U.S. trade deficit, and also indirectly fuelled the debt super cycle and asset inflation as the "savings glut" compressed the world's risk-free rate and term premium. In other words, financial globalization combined with excess international savings morphed into a global quid pro quo. The world economy needed liquidity to finance growth and capital investment. In a system where the greenback stood at the base of any liquidity build up, this meant that the world needed dollars to finance its development. The world was thus willing to finance the U.S. current account deficit at little cost. The Eurodollar System The Eurodollar system was originally a payment system introduced after World War II as a result of the Marshal Plan. Because global trade was dominated by the U.S. - the only country that retained the capacity to produce industrial goods - foreigners had to be able to access U.S. dollars where they were domiciled in order to buy capital goods. The U.S. current account deficit played a role in growing that Eurodollar market. While a lot of the dollars supplied to the rest of the world through the U.S. current account deficit ended up going back to the U.S. via its large capital account surplus, a significant portion remained in offshore jurisdictions, providing an important fuel for the Eurodollar markets. In fact, more than two-thirds of U.S.-dollar claims in the Eurodollar market can be traced back to U.S. entities. After this original impetus, the Eurodollar market grew by leaps and bounds amid a number of regulatory advantages introduced in the 1980s. These changes in regulations not only deepened the participation of European and Japanese banks in the offshore markets, it also allowed U.S. banks to shift capital to Europe, harvesting a lower cost of capital in the process.12 The next growth phase in the Eurodollar system came with the evolution of shadow banking, in which credit was created off balance sheet by lending out collateral more than once, thus enabling banks to obtain higher gearing. This process is known as "re-hypothecation." In the U.S. there was a limit to which banks were allowed to gear collateral, which was not the case in Europe. Hence, to take advantage of this regulatory leniency, global banks grew further through the offshore market, causing an additional expansion in the Eurodollar market.13 Ultimately, this implies that over the past 30 years, the growth of the Eurodollar system has mainly been a consequence of the architecture of the international financial system. Headwinds To Dollar Liquidity The forces contributing to the extraordinary growth in dollar liquidity have begun to fade. In brief: Protectionism and populism: A slowdown in global trade has occurred for a number of structural, non-geopolitical reasons, especially if one controls for the recovery of energy prices (Chart II-15).14 This slowdown implies a slower accumulation of international FX reserves and a reduction of the "savings glut." If protectionism were to compound the effects - by shrinking the U.S. trade deficit - the result for global dollar liquidity would be negative. The consequence would be a certain degree of "quantitative tightening" of global dollar liquidity. Energy prices: Despite the recovery in energy prices, oil producers continue to struggle to rein in their budget deficits. Deficits blew out during the high-spending era buoyed by high oil prices (Chart II-16). Today, oil producing countries have less oil revenues to spend on the Treasury market, as their cash is needed at home. Meanwhile, the U.S. is slowly moving towards partial energy independence, further shrinking its trade deficit. Chart II-15Global Trade Growth Has Moderated Global Trade Growth Has Moderated Global Trade Growth Has Moderated Chart II-16Petrodollars Are Scarce Petrodollars Are Scarce Petrodollars Are Scarce Eurodollar system: The monetary "plumbing" has become clogged since 2014 after the Fed stopped growing its balance sheet and sweeping Basel III bank regulations took effect. The cost of acquiring U.S. dollars in Eurodollar markets currently stands at a premium. This extra cost cannot be arbitraged away due to the restrictive capital rules imposed under Basel III, which have raised the cost of capital for banks. This can be seen in the persistent widening of USD cross-currency basis-swap spreads and more recently, in the rise of the Libor-OIS spread (Chart II-17). The introduction of interest on excess reserves by the Federal Reserve is further draining dollars from the Eurodollar system. The velocity of dollar usage in international markets is unlikely to return to the pace experienced from 1995 to 2008, when the shadow banking system grew rapidly. To complicate matters, dollar-denominated debt issued outside of the U.S. by non-U.S. entities such as banks, governments, and non-financial corporations has grown substantially. This could exacerbate the scramble for dollars in case of a global shortage. For example, the stock of outstanding dollar debt issued by foreign nonfinancial corporations currently stands at US$10 trillion (Chart II-18). Chart II-17Mounting Stress In The Eurodollar System Mounting Stress In The Eurodollar System Mounting Stress In The Eurodollar System Chart II-18Foreign Dollar Debt Is At $10 Trillion May 2018 May 2018 Why is the Eurodollar system so important? Today is the first time in the world's history that this much debt has been accumulated in the global reserve currency outside of the country that issues that currency. The Eurodollar system is thus a key source of liquidity for global borrowers. It is also necessary to ensure that these borrowers can access U.S. dollars when the time comes to repay their USD-denominated obligations. The U.S. trade deficit is effectively the source of the growth of the monetary base in the Eurodollar system, and the stock of dollar-denominated debt issued by non-U.S. entities is the world's broad money supply. With the money multiplier in the offshore USD markets having fallen in response to the regulatory tightening that followed the Great Financial Crisis, broad USD money supply in the Eurodollar system will be hyper sensitive to any decline in the U.S. current account deficit. Less global imbalances would therefore result in a further increase in USD funding costs in the international system, and potentially into a stronger U.S. dollar as well, making this dollar debt very expensive to repay. This raises the likelihood of a massive short-squeeze in favour of the U.S. dollar, challenging the current downward trajectory in the U.S. dollar, at least in the short term. Another consequence of a higher cost of sourcing U.S. dollars in the Eurodollar market tends to be rising FX volatility (Chart II-19). An increase in FX volatility should represent a potent headwinds for carry trades. This, in turn, will hurt liquidity conditions in EM economies. Hence, EM growth may be another casualty of problems in the Eurodollar system. Chart II-19Eurodollar Stress Produces FX Volatility Eurodollar Stress Produces FX Volatility Eurodollar Stress Produces FX Volatility Thus, the risks associated with U.S. protectionism go well beyond the risks to global trade. If severe enough, protectionism can threaten the plumbing system of the global economy. Bottom Line: The global economy has been supplied with dollar-based liquidity through the Eurodollar market. At the base of this edifice stands the U.S. trade-deficit, which was then magnified by the issuance of U.S. dollar-denominated debt by non-U.S. entities. This system is becoming increasingly tenuous as Basel III regulations have increased the cost of capital for global money-center banks, resulting in a downward force on the money multiplier in the offshore dollar funding system. In this environment, the risk to the system created by protectionism rises. If Trump and his administration can indeed scale back the size of the U.S. trade deficit, not only will the growth of the U.S. dollar monetary base be broken, but since the monetary multiplier of the Eurodollar system is also impaired, the capacity of the system to provide the dollars needed to fund all the liabilities it has created will decline. This could result in a serious rise in dollar funding costs as well as a tightening of global liquidity that will hurt global growth and result in a dollar short squeeze. This implied precarious situation raises one obvious question: Could we see the emergence of another reserve asset to complement the dollar, alleviating global liquidity risk? If Something Cannot Go On Forever, It Will Stop A global shortage of dollars is not imminent but could result from the forces described above. Even so, it is unlikely that the U.S. dollar faces any sudden end to its role as the leading global reserve currency. However, the world is unlikely to abide by a system that limits its growth potential either. The demise of the Bretton Woods system is important to keep in mind. The Bretton Woods system tied the supply of global liquidity to the supply of U.S. dollars. Initially this was not a problem as the U.S. ran a trade surplus. But it became a significant issue when the rest of the world began to question the U.S. commitment to honouring the $35/oz price commitment amidst domestic profligacy and money printing. Ultimately, the system broke down for this very reason. The strength of the global economy, along with the size of the U.S. current account deficit, was creating too many offshore dollars. Either the global money supply had to shrink, or gold had to be revalued against the dollar. The unpegging of the dollar from gold effectively resulted in the latter. However, the 1971 Smithsonian Agreement that replaced the gold standard with a dollar standard retained the dollar's hegemony. There was simply no alternative at the time. Today, it is unlikely that the global economy will stand idle in the face of a potentially sharp tightening of global liquidity conditions. We posit that this rising dollar funding costs will be the most important factor to decrease the importance of the dollar in the global financial system. Since the demand for the USD as a reserve currency is linked to its use as a liability by banks and financial systems outside of the U.S., if the USD gets downgraded as a source of financing by global banks, the demand for the greenback in global reserves will decline.15 As the share of dollars in foreign reserve coffers decreases, the dollar will likely depreciate over time as it will stop benefiting from the return-inelastic demand from reserve managers. Profit-motivated private investors will demand higher expected returns on dollar assets in order to finance the U.S. current account deficit. Despite this important negative, the dollar will still be the most important reserve asset in the world for many decades. After all, the decline of the pound as the global reserve asset in the interwar period was a gradual affair. Nonetheless, the share of reserves concentrated in USD assets as well as the share of international liabilities issued in USD will decrease, potentially a lot quicker than is thought possible. Chart II-20Reserve Currency Status ##br##Can Diminish Quickly May 2018 May 2018 For example, Eichengreen has shown that the pound sterling's share of non-gold global currency reserves fell from 63% in 1899 to 48% in 1913, just 14 years later (Chart II-20). It is instructive that this pre-World War I era coincides with today's multipolar geopolitical context. It similarly featured the decline of a status quo power (the U.K.) and the emergence of a rising challenger (the German Empire). What are the alternatives to the dollar? Obviously, the euro will have a role in this play. The euro today only represents 20% of global reserve assets, and considering the size of the Euro Area economy as well as the depth of its capital markets, the euro's place in global reserves has room to increase. In fact, the share of euros in global reserves is 15% smaller than that of the combined continental European national currencies in 1990 (see Chart II-4 on page 25). The CNY can also expect to see its share of international reserves increase. While China does not have the same capital-market depth as the Euro Area, it is gaining wider currency. The One Belt One Road project is causing many international projects to be financed in CNY and China's economic and military heft is still growing fairly rapidly. Nevertheless, China's closed capital account continues to weigh against the CNY's position. As Chart II-21 illustrates, there is a relationship between a country's share of international global payments and inward foreign investment. Essentially, investors want to know that they can do something (buy and sell goods and services) with the currency that they use to settle their payments. In particular, they want to know that they can use the currency in the economy that issues it. As long as it keeps its capital account closed, China will fail to transform the CNY into a reserve currency. Chart II-21A Reserve Currency With A Closed Capital Account? Forget About It! May 2018 May 2018 This means that for at least the next five years, the renminbi's internationalization will be limited. If U.S. protectionism is severe enough, China's economic transition is less likely to be orderly and capital account liberalization could be delayed further. In terms of investment implications, this suggests that for the coming decade, the euro is likely to benefit from a structural tailwind as global reserve managers increase their share of euro reserves. The key metric that investors should follow to gauge whether or not the euro is becoming a more important source of global liquidity is not just the share of euros in global reserves, but also the amount of foreign-currency debt issued in euros by non-euro area entities in the international markets. In all likelihood, before the world transitions toward a unit of account other than the USD, tensions will grow severe, as they did in the late 1960s. It is hard to know when these tensions will become evident. This past winter, the USD basis-swap spread began to widen along with the Libor-OIS spread, but while the Libor-OIS spread remains wide, basis-swap spreads have normalized. Nonetheless, by the end of this cycle, we would expect a liquidity event to cause stress in global carry trades and EM assets. It is important that investors keep a close eye on basis-swap and Libor-OIS spreads to gauge this risk (Chart II-22). Chart II-22Are We Nearing A Global Liquidity Event? Are We Nearing A Global Liquidity Event? Are We Nearing A Global Liquidity Event? Additionally, the more protectionist the U.S. becomes, the larger the diversification away from the dollar by both global reserve managers and international bond issuers could become. This is because of two reasons: First, if the U.S. actually manages to pare down its trade deficit, this will accentuate the decline in the supply of base money in the international system. Second, rising trade protectionism out of the White House gives the world the impression that economic mismanagement is taking hold of the U.S., raising the spectre of stagflation. Finally, the next global reserve asset does not have to be a currency. After all, for millennia, that role was fulfilled by commodities such as gold, silver, or copper. Thus, another asset may emerge to fill this gap. At this point in time it is not clear which asset this may be. Bottom Line: A severe liquidity-tightening caused by a scarcity of U.S. dollars would create market tumult around the world. We worry that such a risk is growing. However, it is hard to envision the global economy falling to its knees. Instead, the global system will likely do what it has done many times before: evolve. This evolution will most likely result in new tools being used to increase the global monetary base. At the current juncture, our best bet is that it will be the euro, which will hurt the USD's exchange rate at the margin on a secular basis. This brings up the very important question of whether the euro is politically viable. We have turned to this question many times over the past seven years. Our high conviction view is still that the euro will survive over the foreseeable time horizon.16 Marko Papic, Senior Vice President Chief Geopolitical Strategist Mathieu Savary, Vice President Foreign Exchange Strategy Mehul Daya Consulting Editor Neels Heyneke Consulting Editor 1 And an erstwhile member of BCA's Research Advisory Board. 2 Please see Eichengreen, Barry et al, "Mars or Mercury? The Geopolitics of International Currency Choice," dated December 2017, available at nber.org. 3 Please see Tovar, Camillo and Tania Mohd Nor, 2018 "Reserve Currency Blocks: A Changing International Monetary System?," IMF Working Paper WP/18/20, Washington D.C. 4 The authors are essentially examining the extent to which national currencies are anchored to a particular reserve currency. 5 Please see David Shapiro, The Hidden Hand Of American Hegemony: Petrodollar Recycling And International Markets, New York: Columbia University Press. Also, Andrea Wong, "The Untold Story Behind Saudi Arabia's 41-Year Secret Debt," The Independent, dated June 1, 2016, available at independent.co.uk. 6 Please see The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, and Geopolitical Strategy Strategic Outlook, "We Are All Geopolitical Strategists Now," dated December 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "The Trump Doctrine," February 1, 2017, available at gps.bcaresearch.com. 9 Entente cordiale being particularly shocking at the time it was formalized in 1904. Other examples of ideologically heterodox alliances include the USSR's alliance first with Nazi Germany and then with Democratic America during World War II; the notorious alliance of Catholic France with Muslim Turks against its Christian neighbors throughout the seventeenth and eighteenth centuries; or Greek alliances with the Carthaginians against Rome in the third century BC. 10 Another exception to this rule was the Yuan Dynasty, established by Mongol ruler Kublai Khan, which issued fiat money made from mulberry bark. In fact, the mulberry trees in the courtyard at the Bank of England serve as a reminder of the origins of fiat money. 11 Eurodollar system simply refers to U.S. dollars that are outside the U.S. 12 Firstly, the absence of Regulation Q in offshore markets meant that regulatory arbitrage was possible, i.e. there was no ceiling imposed on interest rates on deposits at non-U.S. banks. Then, in the late 1990s, the Eurodollar system had another jump start with the amendment to Regulation D, which meant that non-U.S. banks were exempted from reserve requirements. 13 European banks specifically, but also U.S. banks with European branches, were aggressive buyers/funders of exotic derivatives products, such as CDO, MBS, SIVS. Most of these activities were off-balance sheet and took place in the Eurodollar system because a number of regulatory arbitrages existed. This is one of the main reasons that the Federal Reserve's bailout programs were largely focused towards foreign banks. The Fed's swap lines were heavily used by foreign central banks in order to clean up the operations of their own financial institutions. 14 Please see BCA Global Investment Strategy Special Report, "Why Has Global Trade Slowed?," dated January 29, 2016, available at gis.bcaresearch.com 15 Shah, Nihar, "Foreign Dollar Reserves and Financial Stability," December 2015, Harvard University. 16 Please see BCA Geopolitical Strategy Special Report, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011; "No Apocalypse Now?," dated October 31, 2011; "The Draghi 'Bait And Switch," dated January 9, 2013; "Europe: The Euro And (Geo)politics," dated February 11, 2015; "Greece After The Euro: A Land Of Milk And Honey?," dated January 20, 2016; "After BREXIT, N-EXIT?," dated July 13, 2016; "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017. III. Indicators And Reference Charts A key divergence has emerged between the U.S. corporate earnings data and our equity-related indicators. The divergence supports our tactical cautiousness on risk assets. Forward earnings have soared on the back of the U.S. tax cuts and upgrades to the growth outlook. Earnings are beating expectations by a wide margin so far in the Q1 earnings season, which is reflected in very elevated levels for the net revisions ratio and net earnings surprises. However, the S&P 500 has failed to gain any altitude on the back of the positive earnings news, in part because bond yields have jumped. Our Monetary Indicator moved further into bearish territory, and our Equity Technical indicator is below its 9-month moving average and is threatening to break below the zero line (which would be another negative signal). Valuation has improved marginally, but is still stretched, according to our Composite Valuation Indicator. Our Speculation Indicator does not suggest that market frothiness has waned at all, although sentiment has fallen back to neutral level. It is also worrying that our U.S. Willingness-to-Pay indicator took a sharp turn for the worse in April. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. U.S. flows have clearly turned negative for equities, although flows into European and Japanese markets are holding up for now. Finally, our Revealed Preference Indicator (RPI) for stocks flashed a 'sell' signal in April. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. As for bonds, oversold conditions have emerged but valuation has not yet reached one standard deviation, the threshold for undervaluation. This suggests that there is more upside potential for Treasury yields. The U.S. dollar broke out of its recent tight trading range to the upside in April, although this has only resulted in an unwinding of oversold conditions according to our Composite Technical Indicator. The dollar is expensive on a PPP basis, but we still expect the dollar to rally near term. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights Corporate Bonds & The Yield Curve: Corporate bond excess returns fall sharply once the yield curve flattens to below 50 basis points, though they typically remain positive until the yield curve inverts. Interestingly, excess returns for equities relative to Treasuries exhibit the opposite pattern. Corporate Bonds & Leverage: The outlook for top-line corporate revenue growth is strong, but employee compensation costs will also rise this year. We are doubtful that corporate profit growth will keep pace with debt growth for the remainder of year, meaning that leverage is likely to rise. Rising leverage will be a signal to reduce exposure to corporate bonds. Bond Map: We perform a back-test to assess the effectiveness of the Bond Map framework for sector allocation that was introduced in last week's report. Feature It's been a while, but last week's bond market performance was reminiscent of an old fashioned risk-on phase. The 10-year Treasury yield reached its highest level since early 2014, causing a temporary halt in the yield curve's flattening trend. Spread product also responded to investor optimism, and returns from the investment grade corporate bond index now lag the duration-equivalent Treasury index by only 52 basis points year-to-date, up from a mid-March trough of -94 bps (Chart 1). High-Yield index returns also rebounded, and that index is now outpacing Treasuries by +150 bps so far this year. Chart 1Corporate Credit: Annual Excess Returns Corporate Credit: Annual Excess Returns Corporate Credit: Annual Excess Returns But for corporate bond investors, now is not the time for complacency. Out of the criteria we use to signal turns in the credit cycle, we are progressively checking more and more off our list.1 Spreads are already tight relative to history and corporate debt levels are already high. That much has been true for some time. Next up, we await a more restrictive monetary policy and a more severe slow-down in corporate profit growth to below the pace of corporate debt growth. Both of those conditions also need to be met before corporate defaults start to occur and spreads start to widen materially. In this week's report we consider each of those two conditions in turn, noting the triggers that will need to be hit for us to downgrade our current overweight allocation to corporate bonds. Condition 1: Restrictive Monetary Policy Chart 2Monetary Policy Not Yet Restrictive Monetary Policy Not Yet Restrictive Monetary Policy Not Yet Restrictive On the monetary policy front, we expect that monetary conditions will turn restrictive in the not-to-distant future (Chart 2). For the time being, long-maturity TIPS breakeven inflation rates are still below levels that are consistent with the Fed achieving its 2% inflation target. The 10-year TIPS breakeven inflation rate is currently 2.17% and the 5-year/5-year forward TIPS breakeven inflation rate is 2.24%. But once both of those rates reach a range between 2.3% and 2.5%, they will be consistent with well-anchored inflation expectations and the Fed will have one less reason to stay cautious. We will start paring exposure to corporate bonds once both the 10-year TIPS breakeven inflation rate and the 5-year/5-year forward TIPS breakeven inflation rate cross above the 2.3% threshold. The re-anchoring of inflation expectations will also impart further upside to nominal Treasury yields, and we therefore maintain our below-benchmark duration stance and continue to follow the road-map laid out in our February report detailing the two-stage Treasury bear market.2 Another traditional signal of restrictive monetary policy is a flat or inverted yield curve (Chart 2, panel 2). Intuitively, a very flat yield curve tells us that the market expects very few (if any) Fed rate hikes in the future. An inverted yield curve tells us that the market actually anticipates rate cuts. While the yield curve is not yet close to inverting, it is approaching levels that are consistent with much lower (and often negative) excess returns for both investment grade and high-yield corporate bonds, as is discussed below. A third indicator of the stance of monetary policy is simply the spread between the real federal funds rate and an estimate of its equilibrium level - the level consistent with neither an accommodative nor a restrictive policy stance (Chart 2, bottom panel). While the fact that the real fed funds rate is currently quite close to the popular Laubach-Williams estimate of its equilibrium level certainly reinforces our view that policy is almost restrictive, the large degree of uncertainty inherent in this sort of estimate leads us to prefer the market signals from the slope of the yield curve and TIPS breakeven inflation rates when forming an investment strategy. The Yield Curve And Corporate Bond Returns To assess the importance of the yield curve as a predictor of turns in the credit cycle, we split each cycle going back to the mid-1970s into regimes based on the yield curve slope. We then calculate excess returns during each phase for both investment grade and high-yield corporate bonds, as well as the stock-to-bond total return ratio. We use the 3/10 yield curve slope instead of the more often quoted 2/10 slope because it allows for the inclusion of more historical data. This decision did not materially impact the results of our analysis. Chart 3 shows how we divided each cycle into three phases: Chart 3Corporate Bond Performance And The Yield Curve Corporate Bond Performance And The Yield Curve Corporate Bond Performance And The Yield Curve Phase 1 runs from the end of the previous NBER-defined recession until the slope crosses below 50 bps. Phase 2 runs from the time that the slope crosses below 50 bps until it crosses below zero. Phase 3 runs from the time that the yield curve first inverts to the start of the next recession. Notice that we do not include recessionary periods in our analysis, usually the periods with the worst excess corporate bond returns. The results of our analysis are shown in Table 1, and the first obvious result is that corporate bond excess returns are much higher in Phase 1 than in Phase 2, although Phase 2 returns are usually still positive.3 Negative excess returns occur more often than not in Phase 3, after the yield curve has inverted. Table 1Risk Asset Performance In Different Yield Curve Regimes As Good As It Gets For Corporate Debt As Good As It Gets For Corporate Debt The biggest exception to the above observations is that Phase 2 High-Yield returns actually exceeded Phase 1 High-Yield returns in the 2001-07 cycle. In our view, this exception results from the fact that corporate profit growth was well above corporate debt growth in 2005, and did not really decline until 2007, shortly after the yield curve inverted. In contrast, Phase 2 returns were exceptionally weak in the prolonged period between 1994 and 2000. In this instance, corporate profit growth actually fell below corporate debt growth in 1998, well before the yield curve inverted in 2000. This reinforces that both the stance of monetary policy and the trend in corporate leverage matter for corporate bond returns. The latter is discussed in the next section of this report. Another interesting result shown in Table 1 is that the pattern of stock market excess returns over Treasuries is the mirror image of the pattern in corporate bond excess returns. The stock market tends to perform better in Phase 2 than in Phase 1, and often even performs well in Phase 3 after the yield curve has inverted. This means that multi-asset investors should consider paring exposure to corporate bonds relative to Treasuries before they think of reducing exposure to the stock market. Bottom Line: Restrictive monetary policy is one condition that must be met before we reduce exposure to corporate bonds in our recommended portfolio. The first indication of this will likely be the re-anchoring of long-maturity TIPS breakeven inflation rates in a range between 2.3% and 2.5%. We will start paring exposure to corporate bonds when that occurs. The slope of the yield curve is already at levels that are consistent with very low excess returns. Though we demonstrate that an inverted yield curve is historically linked to even lower returns. Conviction that the yield curve is about to invert will be another trigger to further reduce corporate bond exposure in the future. Condition 2: Rising Leverage The second condition that will cause us to take even more credit risk off the table is when gross leverage for the nonfinancial corporate sector - calculated as total debt over pre-tax profits - enters an uptrend. Chart 4 shows that periods of spread widening almost always coincide with rising gross leverage, or put differently, periods when the rate of debt growth exceeds the rate of profit growth. Profit growth has kept pace with debt growth during the past few quarters, causing leverage to flatten-off and allowing corporate spreads to narrow. Going forward, the outlook for top-line corporate revenue growth (a.k.a. net value added) remains favorable, owing to an ISM index that is well above the 50 boom/bust line and still climbing (Chart 5). But on the expense side of the ledger, employee compensation - the largest expense for the corporate sector - is also poised to increase in the months ahead. Unit labor costs jumped sharply in the fourth quarter of 2017 (Chart 5, panel 2), and with the unemployment rate at 4.1% and the economy still adding jobs at a robust pace - nonfarm payrolls have increased by an average of +211k during the past six months - a further acceleration in employee compensation is likely this year. Chart 4Corporate Leverage Has Flattened Off Corporate Leverage Has Flattened Off Corporate Leverage Has Flattened Off Chart 5Wage Growth Will Hamper Profits Wage Growth Will Hamper Profits Wage Growth Will Hamper Profits The key question then becomes whether corporations will be able to offset rising compensation costs by lifting prices. This remains uncertain, but early indications are not favorable. Our Profit Margin Proxy - the growth in the corporate sector's implicit selling price deflator relative to the growth in unit labor costs - does an excellent job tracking pre-tax profits (Chart 5, bottom panel). At the moment, this indicator signals that profit growth will moderate in the coming quarters. Bottom Line: The outlook for top-line corporate revenue growth is strong, but employee compensation costs will also rise this year. We are doubtful that corporate profit growth will keep pace with debt growth for the remainder of year. A decline in the rate of profit growth to below the rate of corporate debt growth will be another signal to reduce exposure to corporate bonds. The Bond Map Back-Test Last week we introduced the BCA Bond Map, a graphical depiction of the current risk/reward trade-off on offer from the different sectors of the U.S. bond market.4 To summarize, in our excess return Bond Map we plot the number of days of average spread tightening required for each sector to earn 100 bps of excess return on the vertical axis, and the number of days of average spread widening required for each sector to lose 100 bps versus Treasuries on the horizontal axis (Chart 6). The diagram is then split into four quadrants based on the location of the Bloomberg Barclays Aggregate index, which we have modified to also include junk bonds. The upper-left quadrant, which we label "Best Bets", contains those sectors that offer less risk and greater excess return potential than the benchmark. The upper-right quadrant, which we label "Exciting", contains those sectors that offer higher risk than the benchmark but also higher potential returns. The bottom-left ("Boring") quadrant contains those sectors with low risk of losses but also low probability of gains, and the bottom-right ("Avoid") quadrant contains those sectors with higher risk than the benchmark and lower expected returns. As can be seen in Chart 6, the current excess return Bond Map shows that Local Authorities, Foreign Agencies and investment grade corporate bonds offer the best combination of risk and expected return. No sectors currently plot in the "Avoid" quadrant. Chart 6Excess Return Bond Map (As Of April 20, 2018) As Good As It Gets For Corporate Debt As Good As It Gets For Corporate Debt This week, we publish the results of a back-test of the real time performance of our Bond Map. To do this we produced the Bond Map at the beginning of each calendar year starting in 2006 and then calculated average excess returns for each quadrant. For example, if three sectors were in the "Best Bets" quadrant at the beginning of the year, we calculated 12-month excess returns for each sector and then averaged them together to get an excess return for "Best Bets" sectors that year.5 Table 2 shows the average and standard deviation of calendar year excess returns for each quadrant, using a sample that spans from 2006-2017. As would be expected, the "Exciting" quadrant displays the highest average excess return, but also the highest standard deviation. Conversely, the "Boring" quadrant delivers the lowest average return and the lowest risk. The performance of the "Best Bets" quadrant is somewhere in between, delivering a greater average return than the "Boring" quadrant with less risk than the "Exciting" quadrant. Although the Sharpe Ratio for the "Best Bets" quadrant turns out to be worse than the Sharpe ratio for both the "Exciting" and "Boring" quadrants. This provides some support for the investment strategy of favoring either the "Exciting" or "Boring" quadrants depending on your assessment of the macro environment. The "Avoid" quadrant actually delivered negative excess returns on average, with elevated risk. Table 2Excess Return Bond Map Track Record (2006-2017) As Good As It Gets For Corporate Debt As Good As It Gets For Corporate Debt For comparison we also show the average and standard deviation of excess returns for the Bloomberg Barclays Aggregate index, augmented with High-Yield. The benchmark delivered excess returns only slightly greater than the "Boring" quadrant, with significantly more risk. The total return version of the Bond Map is shown in Chart 7. This is identical to the excess return Bond Map, except it shows the number of days of average increase/decrease in yields for each sector to lose/earn 5% total return. We perform the identical back-test as with the excess return map, and display the results in Table 3. Chart 7Total Return Bond Map (As Of April 20, 2018) As Good As It Gets For Corporate Debt As Good As It Gets For Corporate Debt Table 3Total Return Bond Map Track Record (2006-2017) As Good As It Gets For Corporate Debt As Good As It Gets For Corporate Debt Here we see the interesting result that the average total returns are higher in the "Best Bets" quadrant than in the "Exciting" quadrant, but strangely the "Best Bets" quadrant also delivered greater volatility. The "Boring" quadrant delivered the best Sharpe Ratio, while the "Avoid" sector delivered both lower average returns and greater volatility than the "Boring" quadrant. For comparison, the average total returns for the Aggregate index (plus High-Yield) were lower than the total returns from any of the four quadrants, but also with less volatility. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 We define the "turn" in the credit cycle as when corporate defaults start to occur and corporate spreads enter a sustained widening phase. 2 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 3 For the Phase 1 period in Cycle 2 we use an interval of June 1983 to July 1988 because High-Yield excess returns are only available starting in June 1983. In reality, the Phase 1 period should have started when the prior recession ended in December 1982. Using the correct interval (starting in December 1982) investment grade corporate bond excess returns are +131 bps and the stock-to-bond ratio returns are +5.19%, both annualized. 4 Please see U.S. Bond Strategy Weekly Report, "Back To Basics", dated April 17, 2018, available at usbs.bcaresearch.com 5 We started our back-test sample in 2006 even though our sector data goes back to 2000. Because our bond map relies on historical estimates of spread/yield volatility, we wanted a sample of at least five years of data before starting the test. With each passing year more back-data is incorporated into our spread/yield volatility estimates, which should improve the Bond Map's accuracy over time. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy Expensive valuations leave no room to maneuver in the S&P real estate index that has to contend with a higher interest rate backdrop and deteriorating cash flow growth fundamentals. Trim to underweight. In contrast, capital markets stocks are firing on all cylinders and the return of animal spirits, the capex upcycle, booming M&A activity and a brighter operating backdrop auger well for this highly cyclical financials sub-index. Stay overweight. Recent Changes S&P Real Estate - Downgrade to underweight today. Table 1 Earnings Juggernaut Earnings Juggernaut Feature Equities rebounded in the past two weeks, as earnings took center stage and they delivered beyond expectations. Impressively, the blended Q1 EPS growth rate is running at 20% (versus 18.5% expected on April 1) with roughly 18% of the S&P 500 constituents reporting profit numbers. This earnings validation served as a catalyst for the SPX to briefly reclaim the key 50-day moving average and, most importantly, the Advance/Decline (A/D) line hit fresh all-time highs. Historically, the A/D line and the S&P 500 move hand-in-hand and there is a high chance that the SPX will follow suit in the coming quarters (top panel, Chart 1). Our upbeat cyclical 9-12 month equity market view remains intact, as the odds of a recession are close to nil. Despite fears of a generalized global trade war, global trade volumes have been resilient vaulting to multi-year highs on a short-term rate of change basis (middle panel, Chart 2). While a global growth soft patch cannot be ruled out, as long as manufacturing PMIs can stay above the 50 boom/bust line, synchronized global growth will remain the dominant macro theme. Chart 1New Highs Ahead? New Highs Ahead? New Highs Ahead? Chart 2What Slowdown? What Slowdown? What Slowdown? The IMF concurred in its April, 2018 World Economic Outlook: "The global economic upswing that began around mid-2016 has become broader and stronger. This new World Economic Outlook report projects that advanced economies as a group will continue to expand above their potential growth rates this year and next before decelerating, while growth in emerging market and developing economies will rise before leveling off." 1 The bond market is also not sending a distress signal as very sensitive junk bond spreads have nosedived of late (shown inverted, bottom panel, Chart 1). Under such a backdrop, EPS will continue to shine and underpin stocks (Chart 2). Nevertheless, steeply decelerating money supply growth is slightly disconcerting. This is not only a U.S. only phenomenon, but G7 money supply growth is also losing momentum. Chinese and overall emerging markets money growth numbers are also stuck in a rut (Chart 3). While this could be the precursor to a global growth slowdown, we would expect commodity prices to be the first to sniff it out (Chart 4). Clearly this is not the case as commodities spiked last week. Moreover, keep in mind that money growth tends to peak before recessions and what we are currently observing is likely a typical late cycle phenomenon. We will continue to closely monitor money growth around the globe, as this steep deceleration represents a risk to our sanguine equity market view. This week we are updating our corporate pricing power indicators. Chart 5 shows that our corporate sector pricing power proxy and our diffusion index are holding on to recent gains. On the labor front, the business sector's overall wage inflation and associated diffusion index from the latest BLS employment report ticked lower (fourth panel, Chart 5). Chart 3Money Growth Yellow Flag... Money Growth Yellow Flag... Money Growth Yellow Flag... Chart 4... But Commodities Are Resilient ... But Commodities Are Resilient ... But Commodities Are Resilient Chart 5No Margin Trouble Yet No Margin Trouble Yet No Margin Trouble Yet However, the spread between job switchers and stayers (courtesy of the Atlanta Fed Wage Growth Tracker) suggests that wage inflation should pick up steam in the coming months. While rising pay would eat into profit margins and thus dent profits ceteris paribus, this would be problematic only if businesses failed to lift selling prices in the coming months. We assign low odds to this outcome as domestic (and global) final demand is firm, suggesting that companies will manage to pass on rising input prices either down the supply channel, to the government and/or the consumer. Table 2Industry Group Pricing Power Earnings Juggernaut Earnings Juggernaut Table 2 summarizes the sectorial results. We calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Chart 6Cyclicals Have The Upper Hand Cyclicals Have The Upper Hand Cyclicals Have The Upper Hand Over 83% of the industries we cover are lifting selling prices, and 45% are doing so at a faster clip than overall inflation. This is a slight improvement compared with our late-January report The number of outright deflating sectors dropped by three to 10 since our last update. Encouragingly, only 7 industries are experiencing a downtrend in selling price inflation, on par with our most recent report. Impressively, deep cyclicals/commodity-related industries continue to dominate the top ranks, occupying the top 7 slots (top panel, Chart 6). Improving global trade dynamics and sustained softness in the greenback are behind the commodity complex's ability to increase prices. In contrast, tech, telecom, autos and airlines populate the bottom ranks of Table 2. In sum, firming corporate sector pricing power will continue to boost sales growth for the rest of the year. Tack on operating leverage kicking into higher gear at this stage of the cycle, especially for the high fixed cost deep cyclical businesses, and still modest wage inflation, and profit margins and EPS growth will remain upbeat. This week we downgrade a niche interest rate-sensitive sector and update our view on a very cyclical financials sub-sector. DowngREITing There are good odds that laggard REITs will suffer the same fate as telecom services and utilities stocks and plumb relative all-time lows, breaching the early 2000s nadir (Chart 7). A higher interest rate backdrop, a key BCA theme for 2018, along with deteriorating profit fundamentals compel us to downgrade the niche S&P real estate sector to an underweight stance. Real estate stocks are behaving like fixed income proxied equities, given that, by construction, REITs are high dividend yielding. Thus, a tightening monetary backdrop serves as a noose around their necks (top panel, Chart 8). Not only is the Fed slated to raise interest rates two or three more times this year, but FOMC median projections also assume an additional two to three hikes in 2019. At the margin, competing higher yielding risk free assets will eat into demand for REITs. On the operating front, a number of indicators we track are sending an outright bearish signal for the commercial real estate (CRE) sector. The occupancy rate has crested just shy of 90% or 160bps below the previous cycle's peak. Rising vacancies are emblematic of decreasing rents and thus CRE related cash flows (middle panel, Chart 8). Chart 7New Lows Looming New Lows Looming New Lows Looming Chart 8Rental Deflation Alert Rental Deflation Alert Rental Deflation Alert Importantly, CRE prices continue to defy gravity and are steeply deviating from our petered out occupancy rate composite (bottom panel, Chart 8). This supply/demand imbalance typically resolves itself via deflating prices. Industry overbuilding explains this disequilibrium, as ZIRP and loose credit standards encouraged a construction boom. Overall non-residential construction is probing all-time highs and multi-family housing starts are expanding close to 400K/annum, a level that has coincided with previous peaks in the CRE market (third & fourth panels, Chart 9). This industry oversupply should weigh heavily on rents especially given the slackening demand backdrop, according to the message from our REITs Demand Indicator (RDI). The softening RDI reading also bodes ill for CRE price inflation (bottom panel, Chart 10). The latest Fed Senior Loan Officer Survey (FSLOS) corroborates that demand for CRE loans is in a steady decline and bankers are not willing extenders of CRE credit, exerting a downward pull on CRE prices (middle panel, Chart 10). Chart 9Rents Are Under Attack Rents Are Under Attack Rents Are Under Attack Chart 10CRE Prices Skating On Thin Ice CRE Prices Skating On Thin Ice CRE Prices Skating On Thin Ice Historically, demand for CRE loans as per the FSLOS has been an excellent leading indicator of actual CRE loan growth, and the current message is grim (second panel, Chart 11). It would be unprecedented for another upleg to take root in the CRE market with the absence of credit growth to fuel such an overshoot phase. Worrisomely, there is no valuation cushion to absorb the plethora of possible CRE mishaps. Cap rates have troughed for the cycle and a rising interest rate backdrop warns that a de-rating in expensive valuations is looming (third panel, Chart 11). While CRE credit quality shows no signs of deterioration, at this stage of the cycle and given weak industry profit fundamentals we would caution against extrapolating such good times far into the future (bottom panel, Chart 11). Adding it all up, our S&P real estate profit growth model does an excellent job encapsulating all of these forces, and it is currently sending an unambiguous sell signal (Chart 12). Chart 11Happy Days Are Over Happy Days Are Over Happy Days Are Over Chart 12Model Says Sell Model Says Sell Model Says Sell Bottom Line: Downgrade the niche S&P real estate index to a below benchmark allocation. Capital Markets: Stay The Bull Course We upgraded capital markets stocks to an above benchmark allocation mid-May last year. Our thesis, recovering overall market top and bottom line growth would prolong the overshoot phase in equities at a time when monetary conditions would stay sufficiently loose, has panned out and this hyper sensitive early-cyclical index has added alpha to our portfolio raising the question: is it time to book profits or are there more gains in store? The short answer is that it is too soon to crystalize gains. This financials sub-index thrives when animal spirits are rising, CEOs embrace an expansionary mindset, and investor risk appetites are healthy. The opposite is also true. We first started exploring the underappreciated global capex upcycle theme in mid-October2 and by late-November it became one of our two core themes for 2018 (rising interest rate backdrop is the other).3 The second panel of Chart 13 shows that capex intentions move in tandem with relative EPS and are pointing toward a profit reacceleration in the coming months. Bankers are also willing extenders of credit, a necessary fuel for the capex upcycle phase, and demand for loans is upbeat as per our commercial loans & leases model. Historically, such a macro backdrop has been a sweet spot for capital markets stocks (Chart 13). Not only business, but investor confidence is also sky high. Junk bond spreads have once again plumbed multi-year lows and even investment grade bond spreads are tight (high-yield spread shown inverted, Chart 1). Corporate bond issuance remains resilient. The Equity Risk Premium has also narrowed by 200bps since the end of the manufacturing recession (shown inverted, top panel, Chart 14), reducing the cost of equity capital. This is fertile ground both for IPOs and secondary stock offerings. Chart 13Solid Foundation Solid Foundation Solid Foundation Chart 14Enticing Operating Backdrop Enticing Operating Backdrop Enticing Operating Backdrop Meanwhile, the return of volatility has caused revenue generating equity trading desks to breathe a huge sigh of relief, as we had posited in early March,4 and this earnings season made abundantly clear. Trading volumes have soared and margin debt continues to climb both in absolute terms and relative to GDP (Chart 14). If volatility stays elevated as the year progresses, as we expect, then more gains are likely for investment bank trading desks. The upshot is that the capital markets' EPS upswing is in the early innings. Another key earnings driver, M&A activity, is booming around the globe. Still sloshing global liquidity with near generationally low interest rates is fueling an M&A spree. In the U.S. alone, M&A has hit a fresh cycle high and is running near $3.1Tn/annum. Even relative to output, M&A has returned to the previous cycle's peak (bottom panel, Chart 14), and is music to the ears of investment bankers. The implication is that a capital markets ROE expansion phase looms (bottom panel, Chart 15). On the operating front, capital markets employment is hyper-cyclical. Investment banks are quick to slash labor costs during a downturn and equally swift to expand headcount in anticipation of good times. Currently, industry payrolls are rising steadily and outpacing overall non-farm payroll growth, and represent a positive backdrop (Chart 16). Chart 15M&A Fever Is Positive... M&A Fever Is Positive... M&A Fever Is Positive... Chart 16...And So Is Rising Headcount ...And So Is Rising Headcount ...And So Is Rising Headcount Sell-side analysts have taken notice and EPS pessimism has violently swung into extreme optimism in the past 18 months. Granted, President Trump's election and tax reform euphoria are part of the slingshot recovery in EPS expectations. However, firming industry-specific EPS growth prospects are also driving analysts' upward revisions (bottom panel, Chart 16). Bottom Line: We recommend an above benchmark allocation in the still compellingly valued S&P investment banks & brokers index. The ticker symbols for the stocks in this index are: BLBG: S5INBK - ETFC, GS, MS, RJF, SCHW. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 http://www.imf.org/en/Publications/WEO/Issues/2018/03/20/world-economic-outlook-april-2018 2 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Special Report, "Top 10 Reasons We still Like Banks," dated March 5, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Stay neutral small over large caps (downgrade alert)