Market Returns

Dear Client, Alongside this week's report we are also sending you a fascinating short Special Report written by Jennifer Lacombe of our Global ETF Strategy sister service. The report, which demonstrates the use of ETF flows as a leading indicator of FX trends, points to downside for the EUR/USD and GBP/USD this year. I trust you find the piece informative. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights A debate over slack is raging within the ECB. We tend to side with President Draghi, and believe there is more labor market slack in the euro area than suggested by the OECD's measures. Arguing in favor of this case is the presence of hidden labor market slack, the paucity of wage gains, even in Germany, and the potential for NAIRU to decline in many large economies. With global and European growth slowing, this will limit how hawkish the ECB can be in the short term, and thus limits the euro's gains in 2018. However, on a long-term basis, the presence of slack today argues that the euro area's potential GDP is higher than if there were no slack, and therefore policy rates and the euro have more long-term upside. Feature The recent release of the European Central Bank's account of its March policy meeting was very revealing. The ECB is currently torn between two camps: one believing there is little slack in the euro area labor market, and the other, led by ECB President Mario Draghi and chief economist Peter Praet, arguing that the continent's job market is still replete with excess capacity. This debate has enormous implications for the path of the euro. If there is no slack left in the euro area, this would point to an immediate need for higher rates and a higher euro, but it would also suggest the scope for the terminal policy rate in Europe to rise is limited. The long-term upside in the euro would therefore also be small. If there is still a large amount of slack in the euro area labor market, this implies that policy rates do not have much scope to rise over the next 18 months, and that the euro will find it difficult to appreciate much over this time frame. However, it also suggests that the potential growth rate of the euro area is higher than would otherwise be the case and that terminal policy rates can rise more in the long-run - implying that on a long-term basis the euro still has meaningful upside. We side in the latter camp. Chart I-1No Slack In Europe? No Slack In Europe? No Slack In Europe? Hidden Labor Market Slack... The question of slack in the euro area has been ignited by a simple reality: both the OECD's measure of the European output gap and the difference between the official unemployment rate and the equilibrium unemployment rate calculated by the OECD (NAIRU) are close to zero (Chart I-1). This observation would vindicate the desire of some ECB members to increase rates sooner than later, since the absence of an unemployment gap should lead to both higher wages and higher inflation. But before making too prompt a judgment, the U.S.'s recent experience is illuminating. Only now that the unemployment rate is 0.5% below NAIRU are U.S. wages and core inflation showing some signs of life (Chart I-2). In the U.S., we observed that while the headline unemployment rate has been consistent with accelerating wages as early as in 2015, discouraged workers back then represented 0.4% of the working age population, and were in fact willing participants in the job market. Only now that this number has fallen back to 0.27% - levels associated with full-employment in the previous business cycle - are employment costs perking up. There is little reason to believe that the eurozone economy is very different from the U.S. in this respect. In fact, the euro area suffered a double-dip recession, the second leg of which ended only in 2013, suggesting Europe suffered a severe enough shock to also fall victim to the symptoms of hidden labor market slack. A simple comparison helps illustrates that Europe is likely to still be experiencing labor market slack. Chart I-3 shows various measures of total and hidden labor market slack in the U.S. and the euro area. To begin with, despite a sharp rise in the female participation rate, the euro area's employment-to-population ratio for prime-age workers is not only well below the level that currently prevails in the U.S., it is also below its 2008 peak by a greater extent than is the case on the other side of the Atlantic. This suggests there is greater total labor market slack in Europe than in the U.S. Additionally, discouraged workers and long-term unemployment remain much closer to post-crisis highs in the euro area than in the U.S. In the latter, these ratios have mostly normalized close to levels consistent with full employment. Chart I-2The U.S. Experience WIth##br## Hidden Labor Market Slack The U.S. Experience WIth Hidden Labor Market Slack The U.S. Experience WIth Hidden Labor Market Slack Chart I-3The Euro Area Still Has ##br##Plenty Hidden Slack The Euro Area Still Has Plenty Hidden Slack The Euro Area Still Has Plenty Hidden Slack Looking at some euro area-specific variables also dispels the idea that the European job market is near full employment and about to generate inflation: The ECB's labor underutilization measure1 still shows a high level of slack, especially in the European periphery (Chart I-4). Another problem for Europe is irregular work contracts. Europe, like Japan, is plagued with a dual labor market. On one hand, permanent employees are still protected by generous employment laws. On the other hand, employees under temporary work contracts are not. In Japan, this same disparity has been blamed for keeping wages down, as temporary employees are often willing to switch to positions offering the protection of regular job contracts for no wage increases. These workers are a form of hidden labor-market slack. Temporary employment in Europe remains at elevated levels, and contract work represents a record share of employment in Italy and France (Chart I-5), suggesting the same disease present in Japan also lingers in vast swaths of the European economy. Chart I-4The ECB's Metrics Also Show ##br##Elevated Labor Underutilization The ECB's Metrics Also Show Elevated Labor Underutilization The ECB's Metrics Also Show Elevated Labor Underutilization Chart I-5A Dual Labor Market Weighs ##br##On Wage Growth A Dual Labor Market Weighs On Wage Growth A Dual Labor Market Weighs On Wage Growth Labor reforms could also be creating labor market slack in Europe. As Chart I-6 shows, after Germany implemented its Hartz IV labor reforms in 2004, NAIRU collapsed. Spain, which has implemented equally draconian measures, could also witness its own equilibrium unemployment rate trend sharply lower over the coming years (Chart I-6, bottom panel). In France, timid reforms were implemented during the Hollande presidency, but President Macron is pushing an agenda of deep job market reforms. While Italy remains a laggard and its current political miasma offers little hope, the reality remains that much of Europe could also be experiencing a decline in NAIRU like Germany did last decade. Even Germany shows limited signs of an overheating labor market, despite an unemployment rate of 5.3%, the lowest reading ever in re-unified Germany: not only have German wages been unable to advance at a faster pace than the experience of the past 15 years, recent quarters have seen a slowdown in wage growth (Chart I-7). The presence of slack in the rest of Europe therefore appears to be limiting wage pressures even in that booming economy. Chart I-6The Impact Of Labor Reforms##br## On Full Employment The Impact Of Labor Reforms On Full Employment The Impact Of Labor Reforms On Full Employment Chart I-7No Wage Growth##br## In Germany No Wage Growth In Germany No Wage Growth In Germany Bottom Line: The euro area is likely to be under the same spell as the U.S. was a few years ago. Traditional metrics portend a labor market at full employment, but broader measures in fact highlight that there is still plentiful slack. Additionally, the implementation of labor market reforms in key European economies in recent years could imply that Europe's NAIRU is lower than the OECD's estimate and may further decline in coming years. ... And Slowing Global Growth It is one thing for Europe to be experiencing hidden labor market slack, but if growth is set to accelerate further, this would mean that this slack could nonetheless dissipate fast enough to allow for a more hawkish ECB in the short run. However, this is not the case. The European economy is very sensitive to global growth gyrations, and signs are accumulating that the global synchronized boom is petering out. As we have already highlighted, the diffusion index of the OECD global leading economic indicator has plummeted well below the boom/bust line, pointing to a sharp slowdown in the LEI itself (Chart I-8, top panel). EM carry trades have been underperforming, which normally leads a slowdown in global industrial activity (Chart I-8, middle panel). Additionally, Japanese export growth is decelerating sharply (Chart I-8, bottom panel). In a previous report we attributed major responsibility for this slowdown to monetary, fiscal and regulatory tightening in China. Europe is not immune to this malaise. European exports growth and foreign orders are all slowing sharply, but interestingly domestic factors are also at play. As the top panel of Chart I-9 illustrates, the European credit impulse is now contracting, suggesting domestic demand is set to slow. In fact, this has already begun as the growth of German domestic manufacturing orders is in negative territory (Chart 9, bottom panel). Chart I-8Global Growth Is Slowing Clouds##br## Hanging Over Global Growth Global Growth Is Slowing Clouds Hanging Over Global Growth Global Growth Is Slowing Clouds Hanging Over Global Growth Chart I-9Euro Area Domestic##br## Growth Is Flagging Euro Area Domestic Growth Is Flagging Euro Area Domestic Growth Is Flagging No matter the source, the end result for Europe is the same: the torrid pace of European growth is set to slow, not accelerate. Not only have European economic surprises fallen precipitously (Chart I-10, top panel), but the Ifo survey - a key bellwether of German activity - has also peaked. Moreover, the Sentix survey points to a sharp slowdown in the manufacturing PMIs (Chart I-10, bottom panel). Because there is slack in the European economy and growth is set to slow, there is a good reason for the Draghi-led ECB to remain very cautious in the coming quarters before sounding hawkish. As a result, the euro faces strong headwinds over the next six months or so, especially as the Federal Reserve faces milder handicaps than the ECB: U.S. economic slack has dissipated and U.S. inflation is rising. These inflationary pressures could even intensify thanks to U.S. President Donald Trump's late-cycle fiscal stimulus. Relative growth dynamics also support the dollar this year as euro area industrial production is already lagging behind the U.S. (Chart I-11). This trend is set to continue for the coming quarters because the U.S. economy is less exposed to a global growth slowdown and U.S. households' are experiencing sharply accelerating disposable income growth, a support for domestic demand. Chart I-10Weakening European ##br##Growth Outlook Weakening European Growth Outlook Weakening European Growth Outlook Chart I-11European Growth Will ##br##Underperform The U.S. Further European Growth Will Underform The U.S. Further European Growth Will Underform The U.S. Further Bottom Line: Not only is there still slack in the euro area labor market, global growth is showing signs of a slowdown. This is likely to have a deleterious impact on European growth as the eurozone credit impulse is already contracting. As a result, European growth is likely to lag that of the U.S., an economy where there is no more slack, and where inflation is perking up. This combination represents a potent headwind for the euro over the next six months or so. The Euro Cyclical Bull Market Is Far From Over The combination of slowing global growth and labor market slack in the euro area suggests the euro may depreciate by six to eight cents over the next six months, but it does not sound the death knell of the euro's cyclical rally. To the contrary, the presence of slack in Europe suggests the euro still has significant cyclical upside. Historically, the euro performs well when the U.S. business cycle enters the last two years of expansion (Chart I-12). This is because European growth begins to outperform U.S. growth in the late stages of the economic cycle, allowing investors to upgrade their assessment of the path of long-term monetary policy in the euro area relative to the U.S. This time an additional impetus could emerge. If there is more slack in the euro area than traditional unemployment metrics imply, the euro area's potential GDP is also higher than these traditional metrics would submit - i.e. trend growth in Europe could be higher than once thought. The impact of labor market reforms in France and Spain further bolster this possibility. A consequence of a higher trend growth rate would also be a higher than originally assessed level for euro area neutral interest rates, or the so-called r-star. The European five-year forward 1-month OIS could therefore have significant upside from current levels (Chart I-13, top panel). This would also imply that expected rates in Europe have room to increase versus the U.S., lifting the euro in the process (Chart I-13, bottom panel). Chart I-12The Euro Rallies Late##br## In The Business Cycle The Euro Rallies Late In The Business Cycle The Euro Rallies Late In The Business Cycle Chart I-13European Slack Today Means ##br##Higher Rates Tomorrow European Slack Today Means European Slack Today Means European Slack Today Means European Slack Today Means Bottom Line: The presence of slack in Europe suggests that its potential GDP is higher than once thought. Hence, Europe could still have a few more years of robust growth in front of her. The following paradox ensues: if the presence of slack limits the upside for European interest rates today, it also suggests that European policy rates can rise much more in the future than if there was no slack today. Therefore, while this limits the capacity of the euro to rise further this year, the euro cyclical bull market has much more upside than if there was no slack in Europe today. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 This underutilization measure is based on the number of unemployed and underemployed, those available to work but not seeking a job and those seeking a job but not available for one. 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 decent: Retail sales ex. Autos increased at a 0.2% monthly pace, in line with expectations; Housing starts and building permits both beat expectations, coming in at 1.319 million and 1.354 million, respectively; Industrial production grew by 0.5% at a monthly pace, beating expectations; Capacity utilization also increased to 78%; Continuing and initial jobless claims both came out higher than expected; U.S. data continues to generally beat expectations, especially when contrasted with European data, representing a sharp reversal from last year's environment. The yield curve has flattened which has weighed on the greenback preventing the USD from rallying despite an outperforming U.S. economy. Report Links: U.S. Twin Deficits: Is The Dollar Doomed? - April 13, 2018 More Than Just Trade Wars - April 6, 2018 Do Not Get Flat-Footed By Politics - March 30, 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 has been disappointing: German Wholesale price index increased by only 1.2%, less than the expected 1.5%; European industrial production grew at a 2.9% yearly pace, less than expectations of 3.8%; The ZEW Economic Sentiment and Current Situation Survey for Germany disappointed; European headline inflation disappointed, coming in at 1.3%, while core was in line with expectations of 1%. Signs of a slowdown are now emerging in European data, however the euro has yet to follow. The euro area's leading economic indicator is rolling over, suggesting that cyclical factors could drag the euro down in the coming months. The waning of inflationary pressures across the euro area is likely prompt a dovish tone in upcoming ECB communications, which will induce a downward revision in rate expectations by investors. 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 negative: Exports yearly growth underperformed expectations, coming in at 2.1%. Moreover, imports yearly growth also surprised to the downside, coming in at -0.6%. Finally industrial production yearly growth also disappointed, coming in at 1.6%. USD/JPY has remained relatively flat this week. Overall, we expect that the yen will continue to appreciate, as global geopolitical risks are on the rise and a potential slowdown in China's growth could will likely lead to a pick-up in FX market volatility. On the other hand, the yen remains at risk in the long term, given that economic data continues to underperform due to the strong yen and Japan's great exposure to global growth. This means that the BoJ will have to keep policy easy in order to support the economy. 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 mixed: Headline inflation underperformed expectations, coming in at 2.5%. Moreover, core inflation also surprised negatively, coming in at 2.3%. Retail prices yearly growth also underperformed, coming in at 3.3%. However, the ILO unemployment rate surprised positively, coming in at 4.2%. After being up nearly 1.4% this week, GBP/USD fell more than a percentage point following the disappointing inflation numbers. Overall, the data follows our prediction from a couple of weeks ago: inflation in the U.K. is set to decline substantially despite a tightening labor market. This is because inflation in the U.K. is mainly driven by previous currency movements. Therefore, given the steep appreciation of the pound since 2017, prices will likely fall, causing the hawkishly-priced BOE to tighten less than expected, hurting the pound in the process. 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 The Aussie has traded in a wave pattern against the greenback since the beginning of 2016. This week, AUD once again rebounded off the trough of the wave, catalyzed by higher prices in the metals space. Recent announcements by Anglo-Australian group BHP Billiton about curtailing production forecasts provided a boost to iron ore prices. This was coupled with the PBOC's decision to cut banks' reserve requirements which is raising the specter of a potential reflation wave in China. While, for now, external factors are proving to be positive for the Antipodean economy and its currency, the domestic story remains the same: labor market slack, high debt loads, and not enough wage inflation. Recent employment figures confirm this reality: employment grew by only 4,900, driven by a decline in full-time employment of 19,900. 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 food price index month-on-month growth came in at 1%. Meanwhile, headline inflation came in at 1.1%, in line with expectations. NZD/USD has fallen by nearly 1.3% this week. Overall, we expect that the NZD will suffer in the current environment of rising volatility and geopolitical risks. Moreover, on a long term basis, the kiwi continues to be at risk, given that the new populist government is set to decrease immigration and implement a dual mandate for the RBNZ; both factors would lower the real neutral rate. 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 This year's disappointing first quarter GDP growth of 1.7% QoQ growth was regarded as an important factor in the BoC's decision this week to hold interest rates unchanged. The statement recognized the weaker housing market and flailing exports as the two culprits in this development. Bank officials denoted the tight capacity utilization as a constraint to further export growth, stating that growth will not be sufficient "to recover the ground lost during recent quarters". While this was an overall dovish policy statement, the Bank still continues to see robust growth going forward, revising their 2019 growth forecast from 1.6% to 2.1%. Importantly, this revision widened the output gap as the potential growth rate was revised higher. In terms of monetary policy, investors still predict two more rate hikes this year, bringing the benchmark rate to 1.75%, which is still below the Bank's estimated neutral rate of 2.5% - 3.5%. This means that if NAFTA is not abrogated in any major way - our base case scenario for the current negotiations - there is still plenty of upside for Canadian rates, and therefore, the CAD. 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 EUR/CHF has gone up by 1% this week. Overall, we continue to believe that the franc will continue to depreciate on a cyclical basis, given that Swiss inflationary pressures remain too weak and economic activity is still highly dependent on the easy monetary conditions brought about by the weak franc and low rates. Therefore, the SNB will remain very dovishly enclined in order to keep an appreciating franc from hurting the economy. Moreover, the Swiss franc continues to be expensive, putting further downward pressure on this currency. On a tactical basis however, this cross could have some downside in an environment of rising volatility and rising geopolitical risk. 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 USD/NOK has been relatively flat this week. We continue to be negative on the krone against the U.S. dollar, even in an environment of rising oil prices. This is because this cross is more correlated to real rate differential than it is to crude. Therefore, in an environment where the Fed hikes more than expected, real rates should move in favor of the U.S., helping USD/NOK in the process. That being said, the krone will likely outperform other commodity currencies like the AUD, as oil has a relatively lower beta than industrial metals to global growth and Chinese economic activity. 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 A slight economic slowdown is still being felt in the Scandinavian economy. As leading economic indicators in both Sweden and the euro area roll over, disinflationary winds continue to batter Swedish shores. As a result, EUR/SEK continues to trade at lofty levels, especially as global investors remain nervous about the risks of a global trade war. The Swedish yield curve has flattened 53 bps since January highs, which is one of the most severe moves in the G-10. It seems that Stefan Ingves' extreme dovishness is again being taken seriously by investors, especially as core CPI is at a mere 1.5%, despite CPIF clocking in at 2%. This core measure and global reflation will need to pick up for Ingves to change his view. While the SEK is cheap, and thus have limited downside from current levels, this economic backdrop suggests it is still risky for short-term investors to buy the SEK. Long-term players, however, should use current weaknesses as a buying opportunity. 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 The global economy is slowing. However, growth should stabilize at an above-trend pace over the next few months, as fiscal policy turns more stimulative and interest rates remain in accommodative territory. President Trump's macroeconomic policies are completely at odds with his trade agenda. Fortunately, Trump appears willing to cut a deal on trade, even if it is on terms that are not nearly as favorable to the U.S. as he might have touted. The recently renegotiated South Korea-U.S. Free Trade Agreement is a case in point. We remain cyclically overweight global equities, but acknowledge that valuations are stretched and the near-term market environment could remain challenging until leading economic indicators improve. Feature Global Equities: Near-Term Outlook Is Still Hazy We published a note on February 2nd entitled "Take Out Some Insurance" warning investors that the stock market had become highly vulnerable to a correction.1 The VIX spike began the next day. Although volatility has fallen and equities have rebounded so far in April, we are reluctant to sound the all-clear. The near-term signal from the beta version of our MacroQuant model has improved a bit but remains in bearish territory, as it has for over two months now (Chart 1). Chart 1MacroQuant Model Suggests Caution Is Warranted Growth, Trade, And Trump Growth, Trade, And Trump The model is highly sensitive to changes in growth. Starting early this year, it began to detect a weakening in a variety of leading economic indicators in the U.S. and, to an even greater degree, abroad. Most notably, global PMIs and the German IFO have dipped, Korean and Taiwanese exports have decelerated, Japanese machinery orders have fallen, and the Baltic Dry Index has swooned by 36% from its December high (Chart 2). The model also noted an increase in inflationary pressures, suggesting that monetary policy would likely end up moving in a less accommodative direction. The emergence of stagflationary concerns came at a time when bullish stock market sentiment stood at very elevated levels (Chart 3). Our empirical work has shown that equities perform worst when sentiment is deteriorating from bullish levels and perform best when sentiment is improving from bearish levels (Chart 4). Chart 2Growth Has Peaked Growth Has Peaked Growth Has Peaked Chart 3Stock Market Sentiment Was Very ##br##Bullish Earlier This Year Stock Market Sentiment Was Very Bullish Earlier This Year Stock Market Sentiment Was Very Bullish Earlier This Year Chart 4Swings In Sentiment And ##br##Stock Market Returns Growth, Trade, And Trump Growth, Trade, And Trump Waiting For The Economic Data To Stabilize The good news is that the drop in equity prices has caused sentiment to return to more normal levels. The bad news is that the activity data has continued to disappoint at the margin, as evidenced by the weakness in economic surprise indices and various "nowcasts" of real-time growth (Chart 5). Ultimately, we expect global growth to stabilize at an above-trend pace over the coming months, which should allow equities to grind higher. Monetary policy is still quite accommodative. The yield on the JP Morgan Global Bond Index has averaged 1.88% since the end of the Great Recession (Chart 6). We do not know where the "neutral" level of bond yields has been over this period. However, we do know that unemployment in the major economies has been falling, which suggests that monetary policy has been in expansionary territory. Despite the move away from quantitative easing by many central banks, the yield on the JP Morgan Global Bond Index is only 1.53% today. This implies a fortiori that bond yields today are well below restrictive levels. The conclusion is further strengthened if one assumes, as seems highly plausible, that the neutral bond yield has risen over the past few years, as deleveraging headwinds have abated and fiscal policy has turned more stimulative (Chart 7). Chart 5Unexpected Slowdown In Growth Unexpected Slowdown In Growth Unexpected Slowdown In Growth Chart 6Interest Rates Are Off Their Bottom, ##br##But Are Not Restrictive Interest Rates Are Off Their Bottom, But Are Not Restrictive Interest Rates Are Off Their Bottom, But Are Not Restrictive Chart 7Fiscal Policy Will Be Stimulative ##br##This Year And Next Growth, Trade, And Trump Growth, Trade, And Trump The Protectionism Bugbear Global growth has not been the only thing on investors' minds. The specter of a trade war has also loomed large. It is true that the standard early-19th century Ricardian model that first-year economics students learn predicts very small welfare losses from increased protectionism.2 The model, however, makes highly antiquated assumptions about how trade works. Trade today bears little resemblance to the world in which David Ricardo lived - the one where England exchanged cloth for Portuguese wine (the example Ricardo used to illustrate his famous principle of comparative advantage). Chart 8Trade In Intermediate Goods Dominates Growth, Trade, And Trump Growth, Trade, And Trump To an increasingly large extent, countries do not really trade with one another anymore. One can even go as far as to say that different companies do not really trade with each other in the way they once did. A growing share of international trade is between affiliates of the same companies. Trade these days is dominated by intermediate goods (Chart 8). The exchange of goods and services takes place within the context of a massive global supply chain, where such phrases as "outsourcing," "vertical integration" and "just-in-time inventory management" have entered the popular vernacular. This arrangement has many advantages, but it also harbors numerous fragilities. A small fire at a factory in Japan that manufactured 60 percent of the epoxy resin used in chip casings led to a major spike in RAM prices in 1993. Flooding in Thailand in 2011 wreaked havoc on the global auto industry.3 The global supply chain is highly vulnerable to even small shocks. Now imagine an across-the-board trade war. Equities represent a claim on the existing capital stock, not the capital stock that might emerge after a trade war has been fought. A trade war would result in a lot of stranded capital. It is not surprising that investors are worried. Trump's Dubious Trade Doctrine The psychology of a trade war today is not that dissimilar to that of an actual war among the great powers. It would be immensely damaging if it were to happen, but because everyone knows it would be so damaging, it is less likely to occur. How then should one interpret President Trump's tweet that "Trade wars are good, and easy to win?" One possibility is that he is bluffing. The U.S. exported only $131 billion in goods to China last year, which is less than the $150 billion in Chinese imports that Trump has already targeted for tariffs. China simply cannot win a tit-for-tat trade war with the United States. Unfortunately, there is also a less charitable interpretation, as revealed by the second part of Trump's tweet, where he said, "When we are down $100 billion with a certain country and they get cute, don't trade anymore - we win big. It's easy!" Trump seems to equate countries with companies: Exports are revenues and imports are costs. If a country is exporting less than it is importing, it must be losing money. This is deeply flawed reasoning. I run a trade deficit with the place where I eat lunch, but I don't go around complaining that they are ripping me off. One would think that Trump - whose businesses routinely spent more than they earned, accumulating debt in the process - would understand this. But apparently not. As we discussed two weeks ago, the U.S. runs a trade deficit mainly because its deep and open financial markets, along with a relatively high neutral rate of interest, make it an attractive destination for foreign capital.4 If a country runs a capital account surplus with the rest of the world - meaning that it sells more assets to foreigners than it buys from foreigners - it will necessarily run a current account deficit. Trump's Macro Policy Colliding With His Trade Policy In this respect, President Trump's macroeconomic policies are completely at odds with his trade agenda. By definition, the current account balance is the difference between what a country saves and what it invests. The U.S. fiscal position is set to deteriorate over the coming years, even if the unemployment rate continues to fall - an unprecedented occurrence (Chart 9). A bigger budget deficit will drain national savings. Chart 9The 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 Meanwhile, an overheated economy will cause capital spending to rise as firms run out of low-cost workers. If Trump succeeds in boosting infrastructure spending, aggregate U.S. investment will rise even more. The current account deficit is highly likely to widen in this environment. A Temporary Reprieve? Chart 10Trump's Protectionist Agenda Is A ##br##Popular One Among Republican Voters Trump's Protectionist Agenda Is A Popular One Among Republican Voters Trump's Protectionist Agenda Is A Popular One Among Republican Voters The prospect of a wider trade deficit means that Trump's protectionist wrath will not go quietly into the night. It may, however, go into remission for a little while. Trump's approval rating has managed to rise over the past few months because his protectionist agenda is popular with a large segment of the population (Chart 10). However, if the problems on Wall Street begin to show up on Main Street - as is likely to happen if stocks resume their decline - Trump will change his tune. This is especially true if a trade war threatens to hurt U.S. agricultural interests. Rural areas have been a key source of support for Trump's populist rhetoric. Trump has shown a willingness to cut a deal on trade even if the negotiated outcome falls well short of his bluster. Consider the agreement between the U.S. and Korea in late March to amend their existing trade pact. Trump had called the South Korea-U.S. Free Trade Agreement an "unacceptable, horrible deal" and a "job killer." After the agreement was renegotiated, the President described it as a "wonderful deal with a wonderful ally." What did Trump get that was so wonderful? The Koreans agreed to double the ceiling on the number of U.S. automobiles that can be exported to Korea without having to meet the country's tough environmental standards to 50,000. The problem is that the U.S. only shipped 11,000 autos to Korea last year, so the original quota was nowhere close to binding. The Koreans also agreed to reduce steel exports to the U.S. to about 70% of the average level of the past three years in exchange for a permanent exemption from Trump's 25% steel tariff. That may sound like a major concession, but keep in mind that only 12% of Korea's steel exports go to the United States. Korea also re-exports steel from other countries. These re-exports can be curtailed without causing major damage to Korea's steel industry. The shares of Korea's largest publicly-listed steel companies jumped by 1.7% on the first trading day after news of the deal broke, eclipsing the 0.8% rise in the KOSPI index. Investment Conclusions The global economy is going through a soft patch and this could weigh on stocks in the near term. However, if trade frictions fade into the background and global growth stabilizes over the coming months, as we expect will be the case, global equities should rally to fresh cycle highs. Granted, we are in the late stages of the business-cycle expansion. U.S. interest rates are likely to move into restrictive territory in the second half of 2019. Given the usual lags between changes in monetary policy and the real economy, this would place the next recession in 2020. By then, barring any fresh stimulus, the U.S. fiscal impulse will have dropped below zero. It is the change in the fiscal impulse that matters for growth. If growth has already slowed to a trend-like pace by late 2019 due to a shortage of workers, the economy could easily stall out in 2020. Given the still-dominant role played by U.S. financial markets, a recession in the U.S. would quickly be transmitted to the rest of the world. Stocks will peak before the next recession starts, but if history is any guide, this will only happen six months or so before the economic downturn begins (Table 1). This suggests that the equity bull market still has another 12-to-18 months of life left. The extent to which investors may wish to participate in any blow-off rally this year is a matter of personal preference. As was the case in the late 1990s, long-term expected returns have fallen to fairly low levels. A comparison between the Shiller P/E ratio and subsequent 10-year returns over the past century suggests that the S&P 500 will deliver a total nominal annualized return of only 4% during the next decade (Chart 11). A composite valuation measure incorporating both the trailing and forward P/E ratio, price-to-book, price-to-cash flow, price-to-sales, market cap-to-GDP, dividend yield, and Tobin's Q shows only modestly higher expected returns for stock markets outside the U.S. (Appendix A). Table 1Cyclically, It Is Too Soon To Get Out... Growth, Trade, And Trump Growth, Trade, And Trump Chart 11...But Long-Term Investors, Take Note ...But Long-Term Investors, Take Note ...But Long-Term Investors, Take Note As such, while we recommend overweighting global equities over a 12-month horizon, we would not fault long-term investors for taking some money off the table now. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Take Out Some Insurance," dated February 2, 2018. 2 Roughly speaking, the Ricardian model predicts that the welfare loss from protectionism will be one-half times the average percentage-point increase in tariffs times the change in the import-to-GDP ratio. Imports are about 15% of U.S. GDP. Consider a 10 percent across-the-board increase in tariffs. Assuming a price elasticity of import demand of 4, this would reduce trade by 1-0.96^10=0.33 (i.e., 33%), which would take the import-to-GDP ratio down from 15% to 10%. As such, the welfare loss would be 0.5*0.1*(15%-10%)=0.25%, or just one quarter of one percent of GDP. 3 James Coates, "Real Chip Shortage Or Just A Panic, Crunch Is Likely To Boost Pc Prices," Chicago Tribune, dated August 6, 1993. "Thailand Floods Disrupt Production And Supply Chains," BBC.com, dated October 13, 2011; Ploy Ten Kate, and Chang-Ran Kim, "Thai Floods batter Global Electronics, Auto Supply Chains," Reuters.com, dated October 28, 2011. 4 Please see Global Investment Strategy Weekly Report, "U.S.-China Trade Spat: Is R-Star To Blame?" dated April 6, 2018. APPENDIX A Chart 1Long-Term Real Return Prospects Are Slightly Better Outside The U.S. Growth, Trade, And Trump Growth, Trade, And Trump Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Oil markets could get even tighter, depending on fundamental "known unknowns." Chart of the WeekEM Import Volumes Continue Expanding,##BR##Reflecting Rising Incomes And Oil Demand EM Import Volumes Continue Expanding, Reflecting Rising Incomes And Oil Demand EM Import Volumes Continue Expanding, Reflecting Rising Incomes And Oil Demand The largest of these unknowns are the evolution of Iranian and Venezuelan oil output. With the May 12 deadline for U.S. President Donald Trump to waive trade sanctions against Iran fast approaching, and Venezuela's output in free fall, supply could contract dramatically. On the demand side, our short-term trade model is signaling EM imports continue to grow, which indicates continued income growth (Chart of the Week). EM growth drives oil demand growth. DM growth also will support commodity demand this year and next. The likelihood oil prices push toward - or exceed - $80/bbl this year is high. An extension of OPEC 2.0's production cuts into next year all but assures such excursions in 2019.1 Our forecast for 2018 remains at $74 and $70/bbl for Brent and WTI; we are leaving our 2019 forecasts at $67 and $64/bbl, respectively, but anticipate raising them as OPEC 2.0 forward guidance evolves. Energy: Overweight. Oil trade recommendations closed in 1Q18 were up an average 82%. The trades were initiated between Sep/17 and Jan/18. Base Metals: Neutral. LME aluminum's backwardation extends to end-2021, reflecting tighter physical markets. This supports our long S&P GSCI call, which is up 11.4% since Dec 7/17, when we recommended it. Precious Metals: Neutral. We are getting tactically long spot silver at tonight's close. Back-to-back physical deficits in 2016 and 2017, global income growth, and near-record speculative short positioning in COMEX silver - 79.8k futures contracts - are bullish. Ags/Softs: Underweight. Importers of U.S. sorghum into China now are required to post a 179% deposit with Chinese customs, according to Xinhuanet. The state-run news agency reported Ministry of Commerce findings of a surge in U.S. imports - from 317k MT in 2013 to 4.80mm MT in 2017 - which drove down local prices 31%, and "hurt local industries." Feature Our updated balances modeling indicates oil markets remain tight, and will continue to tighten this year, given our fundamental assumptions for supply and demand (Chart 2). We now estimate slightly lower crude oil production this year - 99.73mm b/d vs. our March estimate of 100.20mm b/d - with OPEC output at 32.12mm b/d, vs. 32.50mm b/d last month (Table 1). This is offset by non-OPEC supply growth, which continues to be led by rising U.S. shale-oil output (Chart 3). We expect production in the "Big 4" basins - Bakken, Permian, Eagle Ford and Niobrara - to average just over 6.44mm b/d this year, up 1.21mm b/d y/y, and 7.78mm b/d next year, up just over 1.34mm b/d. Chart 2Oil Markets Will Tighten Further Oil Markets Will Tighten Further Oil Markets Will Tighten Further Chart 3Lower OPEC Production Offset By U.S. Shales Lower OPEC Production Offset By U.S. Shales Lower OPEC Production Offset By U.S. Shales Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Tighter Balances Make Oil Price Excursions To $80/bbl Likely Tighter Balances Make Oil Price Excursions To $80/bbl Likely We are leaving our consumption growth estimate for this year unchanged at 1.70mm b/d, bringing demand to 100.32mm b/d in 2018 on average, and raising our expectation for 2019 to 1.70mm b/d growth, which will take it to 102.00mm b/d on average (Chart 4). Global inventories will continue to drain on the back of these bullish fundamentals, falling somewhat more than we expected last month (Chart 5). We would note the trajectory of inventory growth likely will be altered once we have definitive 2019 production guidance from OPEC 2.0 - i.e., we expect some production cuts to be maintained next year, keeping inventories closer to end-2018 levels. These fundamentals leave our price forecasts unchanged at $74 and $70/bbl for Brent and WTI this year, and $67 and $64/bbl, respectively, next year (Chart 6). Again, we caution clients we fully expect to raise our 2019 forecast as OPEC 2.0 forward guidance evolves. Ministers of the coalition met this month in New Delhi and Riyadh, presumably to discuss institutionalizing their confederation.2 Chart 4Oil Demand##BR##Remains Stout Oil Demand Remains Stout Oil Demand Remains Stout Chart 5Bullish Fundamentals##BR##Drain Inventories Bullish Fundamentals Drain Inventories Bullish Fundamentals Drain Inventories Chart 6Price Forecast Unchanged,##BR##But Upside Risks Are Rising Price Forecast Unchanged, But Upside Risks Are Rising Price Forecast Unchanged, But Upside Risks Are Rising Once Again With "Known Unknowns"3 Supply-Side "Known Unknowns" A critical juncture in the evolution of the oil markets is fast approaching: The May 12 deadline for U.S. President Donald Trump to waive trade sanctions against Iran, and a determination on whether the U.S. will impose sanctions directly against Venezuela's oil industry. We have no advance knowledge of what the administration will do, but the signaling from the Trump White House has us inclined to believe the Iran sanctions will not be waived this time around. Action against Venezuela also is difficult to predict, but, of late, markets are sourcing alternative crude streams against a growing likelihood such sanctions will be imposed.4 Approaching the deadline for waiving Iranian sanctions, we have Iranian crude production at ~ 3.85mm b/d in 2H18, and a little over 3.90mm b/d next year. Prior to sanctions being lifted in January 2016, Iran was producing 2.80mm b/d. It is difficult to determine what will happen if sanctions are not waived by the U.S. - critically, whether U.S. allies will support such a move - so it is difficult to determine how deeply Iranian production and exports will be affected, if at all. S&P Global's Platts service noted a former Obama administration official estimated as much as 500k b/d of Iranian exports could be lost to the market, should the sanctions be restored. Other estimates range as high as 1mm b/d.5 We are carrying Venezuelan crude production at 1.52mm b/d for March, and have it declining to just over 1.40mm b/d by December. Last year, production averaged just over 1.90mm b/d. The government of Nicolas Maduro has run the economy and the state oil company, PDVSA, into the ground. Inflation came in at 454% in 1Q18, leaving prices up 8,900% in the year ended in March, according to Reuters.6 Presently, oil workers are fleeing PDVSA in a "stampede," according to Reuters, leaving the company woefully short of experienced personnel.7 The company lacks the wherewithal to pay for basic additives (diluents) to make its crude oil marketable. It is possible some of the company's creditors in Russia or China will step in to take over operations, but so far nothing has been announced. Demand-Side "Known Unknowns" Our demand estimates are premised on continued global growth this year and next, consistent with the IMF's latest global economic assessment.8 The Fund expects global GDP growth of 3.9% this year and next, which we incorporate into our modeling. Aside from the usual litany of long-term economic ills plaguing DM and EM economies - high debt levels, aging populations, falling labor-force participation rates, low productivity growth, and the need for diversification among commodity-exporting EM economies - trade tensions have become a more prominent risk. The Fund notes increasing trade tensions - set off by the U.S. imposition of tariffs on aluminum and steel imports - have the potential to "undermine confidence and derail global growth prematurely." These tensions have been stoked by tit-for-tat tariff announcements by the U.S. and China over the past month or so. Our own research supports this concern, which we believe is particularly acute for EM economies, where income growth, trade and commodity demand are inextricably entwined. Continued EM trade growth is essential for commodity demand growth, particularly for oil: A 1% increase in EM import volumes has translated into roughly a 1% increase in Brent and WTI prices since 2000. These variables all are linked: EM economic growth correlates with higher incomes, higher commodity demand and higher import volumes.9 EM growth accounts for slightly more than three-quarters of the overall oil-demand growth we expect this year and next - ~ 1.30mm b/d of the 1.70mm b/d of growth we are forecasting. While the odds of a full-blown trade war remain low, in our estimation, we could begin to see the erosion of confidence and the potential for growth to be derailed affecting investment, trade volumes and EM growth generally, which would be bearish for oil demand growth. That said, we share the view articulated by our colleagues in BCA's Global Investment Strategy last week: "Just as investors were overly complacent about protectionism a few months ago, they have become overly alarmist now." "Both the U.S. and China have a strong incentive to reach a mutually-satisfying agreement over trade. President Trump has been able to shrug off the decline in equities because his approval rating has actually risen during the selloff ... . However, if the problems on Wall Street begin to show up on Main Street - as is likely to happen if stocks continue to fall - Trump will change his tune."10 A Note On Permian Basis Differentials WTI - Midland differentials recently weakened considerably, as take away capacity out of the basin became strained (Chart 7). Weakness in the Light Houston Sweet differentials, which measure the spread between the producing and consuming markets for WTI produced in the Permian, traded as wide as -$9.00/bbl. This market has experienced similar such widening of the basis, which can be seen in the WTI-Midland vs. WTI - Cushing differentials, which widened considerably when Permian production increased (Chart 8).11 These basis blowouts typically incentivize additional pipeline capacity. Indeed, earlier this year, some 2.4mm b/d of new takeaway capacity had been proposed by pipeline operators.12 Once this capacity is online, we expect to see WTI exports from the Gulf increasing. Chart 7Growing Pains In The Permian:##BR##Takeaway Capacity Constraints Growing Pains In The Permian: Takeaway Capacity Constraints Growing Pains In The Permian: Takeaway Capacity Constraints Chart 8Permian Crude Oil Production##BR##Exceeded Takeaway In The Past Permian Crude Oil Production Exceeded Takeaway In The Past Permian Crude Oil Production Exceeded Takeaway In The Past Bottom Line: We are maintaining our $74 and $70/bbl prices forecasts for Brent and WTI in 2018, and expect to revise our 2019 forecasts of $67 and $64/bbl, respectively, once we get definitive forward guidance from OPEC 2.0. We continue to monitor supply-side risk - chiefly re Venezuela and Iran - and trade-war threats to the demand side, for any information that could cause us to substantially revise our forecasts. 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. Member states pledged to remove 1.80mm b/d of production from the market, of which some 1.2mm b/d is believed to be actual production cuts, while the remainder is comprised of involuntary losses from Venezuela and other producers unable to offset decline curve losses. 2 Please see S&P Platts OPEC Guide of April 16, 2018, entitled "OPEC MAR CRUDE OIL PRODUCTION TUMBLES TO 32.14 MIL B/D, DOWN 250,000 B/D FROM FEB: PLATTS SURVEY," which reports on the OPEC 2.0 ministerial meetings this month in New Delhi and Riyadh. 3 "Known Unknowns" is a phrase popularized by Donald Rumsfeld, a former U.S. Secretary of Defence in the administration of George W. Bush, at a press conference. Please see the U.S. Department of Defence "News Transcript" of February 12, 2002, at http://archive.defense.gov/Transcripts/Transcript.aspx?TranscriptID=2636 4 Please see "A U.S. Ban On Crude Imports," published by vessel tracker KPLER April 13, 2018. 5 Please see "US foreign policy turn could take 1.4 million b/d off global oil market: analysts," published by S&P Global Platts March 20, 2018. 6 Please see "Venezuela inflation 454 percent in first quarter: National Assembly," published by reuters.com on April 11, 2018. 7 Please see "Under military rule, Venezuela oil workers quit in a stampede," published by uk.reuters.com on April 17, 2018. 8 Please see "Global Economy: Good News for Now but Trade tensions a Threat," published on the Fund's blog April 17, 2018. 9 Please see "Trade Tensions Cloud Oil Outlook," in the March 8, 2018, issue of BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 10 Please see "Is China Heading For A Minsky Moment?" in the April 13, 2018, issue of BCA Research's Global Investment Strategy. It is available at gis.bcaresearch.com. 11 LHS data is limited, as it only recently emerged as a benchmark for the Houston refining market. 12 Please see "Operators Race to Build Pipelines As Permian Nears Takeaway Capacity," in the March 2018 issue of Pipeline & Gas Journal. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Tighter Balances Make Oil Price Excursions To $80/bbl Likely Tighter Balances Make Oil Price Excursions To $80/bbl Likely Trades Closed in 2018 Summary of Trades Closed in 2017 Tighter Balances Make Oil Price Excursions To $80/bbl Likely Tighter Balances Make Oil Price Excursions To $80/bbl Likely

Highlights U.S. Treasury Curve: The U.S. Treasury curve has flattened to new cyclical lows as the market has moved to fully price in the Fed's interest rate forecasts. Inflation expectations must rise further for those forecasts to be fully realized, however. Expect renewed U.S. curve steepening through higher inflation expectations and longer-term Treasury yields in the next 3-6 months. UST-Bund Spread Update: Stay in our recommended 10yr UST-Bund spread widening trade. as Treasury yield increases will not be matched in Bunds given slowing euro area economic momentum and a more balanced tone from the ECB. Global IG Corporate Sector Allocation: Our investment grade (IG) sector allocations, taken from our relative value models, have added positive performance since our last update in August. Feature The unpredictable, and at times unruly, behavior of financial markets over the first few months of 2018 has been exhausting for investors. A calm January was followed by the early February volatility spike and, more recently, huge intraday swings based on the ebb and flow of news on U.S. trade and foreign policy. Yet when looking at the year-to-date returns for various asset classes, the numbers do not seem unusually alarming given the amount of surrounding noise. Chart of the WeekA Long Road Back From The VIX Spike A Long Road Back From The VIX Spike A Long Road Back From The VIX Spike The S&P 500 index is only down -0.7%, while both equities in both the euro area and emerging markets (EM) equities are up +1.8% and +1.1%, respectively (using MSCI data in U.S. dollar terms). Credit markets are also delivering rather boring performance so far in 2018, from U.S. high-yield (+1.2% excess return over government debt) to euro area investment grade and EM hard currency corporates (both with an -0.1% excess return in U.S. dollar terms). Admittedly, these numbers look far less flattering considering the robust rally in risk assets in January. Yet the year-to-date returns simply do not line up with our impression of how investors' feel about how this year has gone so far. The perception is much gloomier than the actual outcome. Right now, markets are looking for guidance and direction and finding little of both. A big problem is that global bond yields, most notably in the U.S., have not fallen much from the highs for the year - even with global growth clearly losing some steam in the first quarter of 2018. The reason? Global inflation is in a mild cyclical upswing, a product of persistently tight labor markets and rising oil prices (Chart of the Week). The "leadership" in government bond markets has shifted away from accelerating global growth and an upward repricing of future central bank tightening, to rising inflation and unchanged monetary policy expectations. The notion of central bankers not being friendly to the markets remains our key theme for this year. We continue to expect that policymakers will not respond to the latest softer patch of economic data and will focus more on the reacceleration of inflation. This is especially true with risk assets stabilizing and volatility measures like the U.S. VIX index continuing to drift lower and, more importantly, the "volatility of volatility" (as measured by the VVIX index) now back to the levels that prevailed before the early February volatility spike (bottom panel). Although as BCA's strategists discussed at our View Meeting yesterday, volatility can quickly return with a vengeance given softer global growth momentum, and with the geopolitical calendar heating up next month (the U.S. government must make its final decision on the China trade tariffs and investment restrictions).1 This led the group to downgrade our recommended global equity exposure and upgrade our global bond exposure on a tactical (0-3 months) basis, although our more medium-term cyclical allocations (6-12 months) were unchanged (overweight stocks versus bonds). From the point of view of global bond markets, we may now be in period of mild "stagflation" with softening growth and rising inflation. We remain of the view that the former is temporary and the latter is not. This backdrop will keep global bond yields under upward pressure for at least the next few months, with better expected performance of corporate debt over governments - albeit with the potential for higher volatility given more elevated geopolitical risks. What Next For The U.S. Treasury Curve? The Treasury curve flattened to a new cyclical low last week, with the spread between 2-year and 10-year bonds now sitting at 45bps. On the surface, this flattening seems consistent with a Fed that is maintaining a "cautiously hawkish" message and that its rate hike plans for 2018 are unchanged despite more volatile financial markets. Chart 2This UST Curve Flattening Is Different This UST Curve Flattening Is Different This UST Curve Flattening Is Different What makes this current episode different from other bouts of Treasury curve flattening over the past five years, however, is the starting point for the absolute of bond yields. According to our two-factor valuation model for the 10-year Treasury yield, yields are now just a touch above fair value, which is currently 2.78%. That yield valuation was at least +25bps before the previous flattening episodes between 2014 and 2017 (Chart 2). That distinction is critical in differentiating a bull flattener from a bear flattener. Simply put, longer-dated Treasuries are not yet cheap enough to suggest that investors should extend duration risk to benefit from any additional curve flattening from here. In fact, we see a greater risk that Treasury curve re-steepens a bit from here, as there is more room for longer-term inflation expectations to move higher than there is for the front-end of the curve to reprice an even more hawkish Fed. The recent softening of cyclical global economic data has been occurring while realized inflation rates have been slowly rising from depressed levels (Chart 3). Yet in the U.S., the slowing of growth seen in the first quarter of the year remains very modest compared to that seen in Europe or Japan, while core inflation rates (for both the CPI index and the PCE deflator) have accelerated back to 2%. The Atlanta Fed's GDPNow forecasting model is calling for Q1/2018 growth of 1.9%, while the New York Fed's Nowcast model is predicting Q1 growth of 2.8%. While both forecasts are a deceleration from the 3% rates seen in the previous three quarters in 2017, neither is below U.S. potential GDP growth, which the U.S. Congressional Budget Office now estimates to be 1.9%. Even in China, where the economy had been slowing as policymakers have aimed to tighten monetary policy and slow credit growth, cyclical indicators such as the Li Keqiang index (the preferred indicator of our China strategists) have shown a bit of a rebound of late. Right now, underlying U.S. growth and inflation momentum are still pointing towards the Fed delivering on its current projection of an additional 50bps of rate hikes in 2018, taking the funds rate to 2.25%, with even a chance of an additional hike if inflation continues to accelerate. This is essentially fully priced with a 2-year Treasury yield just under 2.4%, however, and the real funds rate is now at neutral according to measures like the Fed's r-star. Therefore, additional flattening pressures from the front end of the curve are unlikely unless the Fed is willing to signal a faster pace of rate hikes than currently laid out in its economic projections (the "dots"). At the same time, the 10-year TIPS inflation breakeven remains 25-35bps below the 2.4-2.5% range that would be consistent with the market expecting U.S. inflation to sustainably return to the Fed's 2% inflation target on the headline PCE deflator. Hence, a steeper Treasury curve is far more likely than a flatter Treasury curve from current levels. Where could this view go wrong? Perhaps the Trump administration's trade skirmishes with China could broaden into a full-on trade war that could cause deeper damage to U.S. equities, dampen growth expectations and drive longer-term yields lower. Coming at a time when there is a significant short position in the U.S. Treasury market, this could look similar to the prolonged bull-flattening seen in 2015-16. During that episode, duration exposure flipped from a big net short to very net long according to measures like the J.P. Morgan Duration Survey (Chart 4, top panel), while the market priced out all expected Fed rate hikes (2nd panel). However, that also occurred alongside a 50bp decline in inflation expectations (3rd panel) and a big deceleration of U.S. growth (bottom panel), both related to a weakening global economy and collapsing oil prices. It is uncertain if the current U.S.-China trade skirmish would have an equivalent impact on both the U.S. economy and the Treasury curve, especially given a starting point of stronger global growth a far more positive demand/supply balance in world oil markets. Chart 3A Whiff Of Stagflation? A Whiff Of Stagflation? A Whiff Of Stagflation? Chart 42018 Is Not 2015/16 2018 Is Not 2015/16 2018 Is Not 2015/16 In sum, we are sticking to our view that the Treasury curve is more likely to bear-steepen through higher longer-term yields than flatten bearishly through more discounted Fed hikes or flatten bullishly through much weaker growth and inflation. We continue to recommend a below-benchmark duration stance in the U.S., within an underweight allocation in a currency-hedged global government bond portfolio. We are also are sticking with our tactical trade of staying short the 10-year U.S. Treasury versus the 10-year German Bund, even with the spread now looking a bit too wide on our fundamentals-based valuation model (Chart 5). The unrelenting string of disappointing economic data in the euro area has already resulted in a far more cautious tone from European Central Bank (ECB) officials regarding the potential for quick rate hikes after the expected end of the asset purchase program at the end of this year. The gap between the U.S. and euro area data surprise indices has proven to be a good directional indicator for the Treasury-Bund spread (Chart 6, bottom panel). Given our views on the potential for renewed bear-steepening in the Treasury curve, which is unlikely to be matched in the German curve in the next 3-6 months, we see no reason to take profits yet on our spread trade. Chart 5UST-Bund Spread Now A Bit Too Wide... UST-Bund Spread Now A Bit Too Wide... UST-Bund Spread Now A Bit Too Wide... Chart 6...But Too Soon For Spread Tightening ...But Too Soon For Spread Tightening ...But Too Soon For Spread Tightening Bottom Line: The U.S. Treasury curve has flattened to new cyclical lows as the market has moved to fully price in the Fed's interest rate forecasts. Inflation expectations must rise further for those forecasts to be fully realized, however. Expect renewed U.S. curve steepening through higher inflation and longer-term Treasury yields in the next 3-6 months. Stay in our recommended 10-year Treasury-Bund spread widening trade, as Treasury yield increases will not be matched in Bunds given slowing euro area economic momentum and a more balanced tone from the ECB. A Brief (And Belated) Performance Update For Our Corporate Bond Sector Allocations It has been some time (August 2017) since we last published a performance update for our investment grade (IG) corporate sector allocations for the U.S., euro area and U.K. As a reminder, those allocations come from our relative value model, which is designed to measure the valuation of each individual sector compared to the overall Barclays Bloomberg corporate bond index for each region. The methodology takes each sector's individual option-adjusted spread (OAS) and regresses it in a panel regression with all the other sectors in each region, as a function of the sector's duration, convexity (duration squared) and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and the fair value OAS is our valuation metric from the model for each region. The latest output from the models can be found in the tables and charts in the Appendix starting on Page 14. We also show the duration-times-spread (DTS) for each sector in those tables, using that as our primary way to measure the volatility of each sector. The scatterplot charts in the Appendix show the tradeoff between the valuation residual from our model and each sector's DTS. Chart 7Performance Of Our IG Sector Allocations Stagflation-ish Stagflation-ish We then apply individual sector weights based on the model output and our desired level of overall spread risk that we wish to take in our recommended credit portfolio. At our last update in August 2017, we made a decision to keep the overall (weighted) DTS of our sector tilts roughly equal to the overall IG corporate DTS for each region. With credit spreads looking tight at the time, credit spread curves flat relative to history, and with the Fed in the midst of a tightening cycle, we did not see a case for taking aggressive spread risk (i.e. having a high aggregate DTS) in the portfolio. The performance of our latest sector recommendations since our last update in August 2017, and in the first quarter of 2018, are shown in Chart 7. We show both the total return and excess return of each sector versus duration-matched government bonds. Since that last review, our U.K. sector allocations have performed the best, delivering an additional 12bps of total return and 10bps of excess return versus the U.K. IG corporate index. Our euro area corporate allocations have added 2bps of total return and 3bps of excess return, while our U.S. allocations have modestly underperformed both on total return (-1bp) and excess return. We also show the performance numbers for just the first quarter of 2018 in Chart 7, and we will present the return numbers on this quarterly basis in the future as part of our regular model bond portfolio performance reviews. The sector allocations offered a modest underperformance in Q1 2018, with -5bps of total return and -8bps of excess return coming mostly from euro area and U.K. allocations. The U.S. allocations actually outperformed by +3bps on a total return basis in Q1. The return numbers for our U.S. sector allocations can be found in Table 1. Since our last update in August, the best performing sectors (in excess return terms) for our U.S. portfolio allocation were the overweights to all Energy sub-sectors (+35bps combined), Cable & Satellite (+4bps) and Banks (+4bps). Of those names, only the Independent Energy sub-sector delivered a positive excess return (+3bps) in Q1 2018. Table 1U.S. Investment Grade Performance Stagflation-ish Stagflation-ish The return numbers for our euro area sector allocations can be found in Table 2. Since our last update in August, the best performing sectors (in excess return terms) for our euro area portfolio allocation were the overweights to Financials (+35bps, coming mainly from Banks, Senior Debt and Insurance) and Integrated Energy (+13bps). Those overweights also delivered small positive excess returns (+3bps and +1bps, respectively) in Q1 2018. The return numbers for our U.K. sector allocations can be found in Table 3. Since our last update, the best performing sector (in excess return terms) was the overweight to Financials (+6bps, coming mostly from Banks). Looking ahead, credit spread curves remain very flat by historical standards (Chart 8), which suggests there is not enough spread compensation for extending credit risk to lower quality tiers. Thus, we are sticking with keeping our target DTS for our combined sector allocations equal to that of the overall IG index for each region. We will update our sector allocations in an upcoming Weekly Report. Table 2Euro Area Investment Grade Performance Stagflation-ish Stagflation-ish Table 3U.K. Investment Grade Performance Stagflation-ish Stagflation-ish Chart 8Credit Quality Curves Remain Very Flat Credit Quality Curves Remain Very Flat Credit Quality Curves Remain Very Flat Bottom Line: Our investment grade (IG) sector allocations, taken from our relative value models, have added positive performance since our last update in August. We continue to recommend a cautious approach to sector allocation, targeting index levels of spread risk (in aggregate) in the U.S. euro area and U.K. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility", dated April 11, 2018, available at gps.bcaresearch.com. Appendix Appendix Chart 1U.S. Corporate Sector Valuation And Recommended Allocation* Stagflation-ish Stagflation-ish Appendix Chart 1U.S. Corporate Sector Risk Vs. Reward* Stagflation-ish Stagflation-ish Appendix Table 2Euro Area Corporate Sector Valuation And Recommended Allocation* Stagflation-ish Stagflation-ish Appendix Chart 2Euro Area Corporate Sector Risk Vs. Reward* Stagflation-ish Stagflation-ish Appendix Table 3U.K. Corporate Sector Valuation And Recommended Allocation* Stagflation-ish Stagflation-ish Appendix Chart 3U.K. Corporate Sector Risk Vs. Reward* Stagflation-ish Stagflation-ish Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Stagflation-ish Stagflation-ish Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration & The Fed: With market rate expectations still not as elevated as the Fed's projections, the outlook for Treasury price return during the next 12 months is poor. Maintain a below-benchmark duration stance. Duration & The CBO: The scope for further upward revisions to potential GDP growth forecasts is limited. This will cap the market's expected equilibrium fed funds rate and ultimately the pace of Fed rate hikes. The Bond Map: This week we introduce a framework for quickly comparing the risk/reward tradeoff on offer from each U.S. bond sector. Feature If we had to choose a fundamental first principle of bond investing, it would be that investors should determine what change in the short-term interest rate is currently priced into the market and then decide whether the central bank will move the interest rate by more or less than what is discounted. Using a 12-month investment horizon, Chart 1 shows that the difference between market expectations for the change in the federal funds rate and the actual change in the federal funds rate closely tracks the price return from the Bloomberg Barclays Treasury index.1 It also shows that the market has underestimated the Fed's hawkishness since early 2016, leading to a negative price return for Treasuries. This stands in stark contrast to earlier in the recovery when the market consistently anticipated more rate hikes than were ultimately delivered (Chart 2). Chart 1The Fundamental Question The Fundamental Question The Fundamental Question Chart 2Investors Have Been Surprised By Fed Investors Have Been Surprised By Fed Investors Have Been Surprised By Fed With all that in mind, in this week's report we consider whether the Fed will continue to deliver hawkish surprises during the next 12 months. Or whether market expectations have finally caught up with reality. The Near-Term Rate Hike Outlook The first step in our "back to basics" bond analysis is to assess what rate hike outlook is currently priced into the yield curve. Using overnight index swap (OIS) forwards, we calculate that the market expects the federal funds rate to be 68 basis points higher in one year's time. Alternatively, we can calculate that the market expects a federal funds rate of 2.23% by the end of this year, 2.63% by the end of 2019, and 2.69% by the end of 2020 (Chart 3). The federal funds rate is currently 1.69%. Adopting the 12-month time horizon used in Chart 1, we can say that the market expects 2-3 rate hikes between now and next April. This is slightly below the Fed's current projections. As of the March FOMC meeting, 12 out of 15 FOMC participants anticipated delivering either 2 or 3 more rate hikes before the end of the year. With another 2-3 hikes anticipated in 2019, it is clear that the FOMC is somewhat more hawkish than the market. But even with a more hawkish outlook than the market, the FOMC still expects core inflation to modestly overshoot its 2% target during the next two years (Chart 4). We view this as a reasonable expectation. While core PCE inflation increased at a year-over-year pace of only 1.6% through February, we showed last week that base effects will cause it to jump sharply in March.2 A month-over-month increase of 0.1% in March translates to a year-over-year growth rate of 1.85%. A month-over-month increase of 0.2% translates to a year-over-year growth rate of 1.95%. As long as the economic recovery is sustained it is not far-fetched to expect that inflation will reach the Fed's target before the end of the year. Chart 3Market Versus Fed Dots Market Versus Fed Dots Market Versus Fed Dots Chart 4Fed Projects An Inflation Overshoot Fed Projects An Inflation Overshoot Fed Projects An Inflation Overshoot Once inflation reaches (or exceeds) the Fed's 2% target, it will necessitate a change in communication from the central bank. Specifically, with the Fed's inflation goal having been achieved, it would be inappropriate for it to maintain an "accommodative" monetary policy. The Fed discussed this eventuality for the first time at the March FOMC meeting, as evidenced by this passage from the minutes: Some participants suggested that, at some point, it might become necessary to revise statement language to acknowledge that, in pursuit of the Committee's statutory mandate and consistent with the median of participants' policy rate projections in the SEP, monetary policy eventually would likely gradually move from an accommodative stance to being a neutral or restraining factor for economic activity.3 The bottom line is that with inflation quickly approaching the 2% target, the Fed is unlikely to deviate from its gradual pace of rate hikes. With market rate expectations still not as elevated as the Fed's projections, the outlook for Treasury price return during the next 12 months is poor. Maintain a below-benchmark duration stance. The Importance Of The Equilibrium Fed Funds Rate Chart 5Potential GDP Growth ##br##Revisions Are Cyclical Potential GDP Growth Revisions Are Cyclical Potential GDP Growth Revisions Are Cyclical Another factor that will govern the cyclical outlook for Fed rate hikes is the equilibrium level of the federal funds rate. That is, the level of interest rates that is consistent with neither an accommodative nor a restrictive policy stance. The level that is expected to keep inflation more or less stable. From the most recent Summary of Economic Projections we know that most FOMC members think that the equilibrium fed funds rate is in the vicinity of 3%, while the bottom panel of Chart 3 shows that market prices embed a somewhat lower forecast. The importance of the equilibrium rate is that if it turns out to be higher than the market expects, then the central bank will be forced to deliver more rate hikes than are anticipated, leading to negative bond price returns, as shown in Chart 1. But how do we judge the appropriate level of the equilibrium fed funds rate? One way is to recognize that the equilibrium fed funds rate is theoretically linked to the rate of potential GDP growth. In fact, we observe that market expectations for the equilibrium fed funds rate - as measured by the 5-year/5-year forward OIS rate - closely track the Congressional Budget Office's (CBO) forecast for potential GDP growth during the next 5 years (Chart 5). Notice that the increase in the 5-year/5-year OIS rate since mid-2016 coincides with upward revisions to the CBO's potential GDP growth projections. Chart 6Determinants Of The Growth##br## Of Real Potential GDP Back To Basics Back To Basics This brings up another important point. Because potential GDP growth is not easily measurable, it is often revised higher during periods when GDP growth strengthens and lower during periods of weaker growth (Chart 5, bottom 2 panels). This raises the possibility of further upward revisions if GDP growth remains strong. We certainly wouldn't rule out that possibility, but we also view the scope for further upward revisions to potential GDP growth as fairly limited. Chart 6 shows the breakdown of the CBO's potential GDP growth forecast between its two components: The size of the labor force Labor force productivity The CBO currently projects potential GDP growth of 2% (annualized) for the next 5 years, split between 0.6% annual growth in the size of the labor force and 1.4% annual growth in labor force productivity. Since projections for the size of the labor force are largely driven by slow-moving demographic factors, they are less subject to revision than are projections for the more nebulous productivity component. But with the CBO already embedding a forecast of 1.4% for annual productivity growth, how much higher can we reasonably expect it to be revised? The current forecast is already consistent with the productivity growth that was realized during the 2002-07 period. Any further upward revisions would cause productivity growth to approach the 2% level that was realized during the I.T. revolution of the 1990s. That seems overly optimistic. Bottom Line: The scope for further upward revisions to potential GDP growth forecasts is limited. This will cap the market's expected equilibrium fed funds rate and ultimately the pace of Fed rate hikes. A Quick Note On The Tactical House View Yesterday morning, BCA strategists decided to downgrade our tactical (0-3 month) view on global equities from overweight to neutral, while simultaneously upgrading the tactical view on global bonds from underweight to neutral.4 All cyclical (6-12 month) views remain unchanged. The two main reasons for the tactical shift are the moderation in global growth, which was flagged in this publication last week, and the long list of potential geopolitical risks that could roil markets in May and June.5 Of course any flare-up of geopolitical risk would lead to a near-term spread widening and a flight-to-quality into Treasury bonds. But while investors should certainly be aware of the near-term risks, we are not altering our cyclical portfolio recommendations. Unanticipated inflation remains the number one risk for bond markets. A re-anchoring of the 10-year TIPS breakeven inflation rate will apply 17 bps to 27 bps of upward pressure to the nominal 10-year Treasury yield, and we are likewise inclined to wait for inflation expectations to re-normalize before positioning for any sustained widening in corporate spreads. Navigating The Bond Map This week we introduce a new framework for judging the relative risk/reward trade-off between different sectors of the U.S. bond market. We dub this framework the Bond Map, as it gives us a quick glimpse of how different sectors stack up against one another. In this section we describe how the Bond Map is created, and we will introduce further applications of the Bond Map in the coming weeks. The Total Return Bond Map Chart 7 presents our Total Return Bond Map. The vertical axis of the Map represents the potential reward available in each sector. Specifically, the numbers on the vertical axis correspond to the number of days of average yield decline that are required for each sector to earn a total return of 5% over a 12-month period. For example, it would take 10 days of average yield decline for the Treasury index to deliver a 5% return, it would only take 4 days for the investment grade Corporate index to deliver the same return. Therefore, unsurprisingly, the potential for reward is greater in the investment grade corporate bond index than in the Treasury index. To calculate the number of days to earn 5%, we start with the following formula that relates the total returns for the index to its average yield, duration and convexity. Total Return = Yield - Duration * (Change in yield) + 0.5*Convexity*(Change in yield)2 We set the total return threshold to 5% and use 1-year trailing yield volatility as an estimate for the squared change in yields. This allows us to calculate the change in yields required for the index to return 5%. Lastly, we adjust the change in yields by the yield volatility of each index. Starting in 2000, we look at a sample consisting only of days when the average yield of the index declined, and we calculate the average magnitude of the yield decline on those days. We then divide the yield change required to gain 5% by the average magnitude of the daily yield decline. The result is a measure of the probability of earning a 5% return that should be roughly comparable between different bond sectors. The horizontal axis is the mirror image of the vertical axis. It is the number of days of average yield increase required for the index to lose 5%. This is calculated using the same process described above, except we use a total return target of -5% and calculate average daily yield changes using only days when yields increase. Once again, the result is a measure of the probability of losing 5% that is roughly comparable between different sectors. One way to interpret the Total Return Bond Map is to split it into quadrants centered on the Bloomberg Barclays U.S. Aggregate Index. Sectors that plot in the upper-right quadrant are exciting sectors that provide a high probability of earning 5% but also a high probability of losing 5%. Conversely, sectors in the bottom-left quadrant are the boring sectors that provide a low probability of losses, but also a low probability of gains. More interesting are those sectors that plot in the upper-left and bottom-right quadrants. Those sectors in the upper-left (High-Yield bonds and Municipal bonds adjusted for the top marginal tax rate) provide both a higher probability of gains and a lower probability of losses than the Aggregate. Conversely, those sectors in the bottom-right quadrant (Treasuries) provide both a lower probability of gains and a higher probability of losses. One counterintuitive result that springs from the Total Return Bond Map is that the High-Yield index appears less risky than the Treasury index. But upon closer inspection the reason for this appears obvious. The average yield on the junk index needs to rise by approximately 250 bps for the index to lose 5%. Because of its lower carry buffer, the average Treasury index yield needs to rise by only about half as much. At the same time, while the volatility of junk yields is higher than the volatility of Treasury yields, it is not twice as high and therefore does not fully offset the yield advantage in high-yield bonds. The main reason for this is the negative correlation between Treasury yields and high-yield spreads. Usually when Treasury yields are rising, high yield spreads are tightening, and vice-versa. This moderates the volatility in junk yields. To see how the sectors in the Total Return Bond Map move around over time, Chart 8 presents what the Total Return Bond Map looked like on January 1, 2010. We see that high-yield bonds looked even more attractive in early 2010, as did 30-year conventional MBS and Aaa-rated non-Agency CMBS. Chart 7Total Return Bond Map (As Of April 12, 2018) Back To Basics Back To Basics Chart 8Total Return Bond Map (As Of January 1, 2010) Back To Basics Back To Basics The Excess Return Bond Map Chart 9 presents the same Bond Map as above, except now we consider excess returns relative to duration-matched Treasuries rather than total returns for each index. We also set our excess return threshold for gains and losses at +/- 100 bps, rather than the 5% we used for total returns. All other calculations remain the same, except that we use spreads and spread volatilities as our inputs rather than yields. Chart 9 shows that the investment grade corporate, local authority and foreign agency sectors look most attractive in excess return space. While no sectors plot in the bottom-right "avoid" quadrant relative to the Bloomberg Barclays Aggregate. Chart 10 once again shows the same Bond Map as of January 1, 2010, and once again the attractiveness of Aaa-rated non-Agency CMBS is apparent. Meanwhile, conventional 30-year MBS looked unattractive in excess return space in early 2010. In the Excess Return Bond Map, you will notice that some sectors actually have a negative number of days of spread tightening required to earn +100 bps. This simply means that spreads could actually widen somewhat and, because of the large carry buffer, the sector would still produce excess returns of +100 bps. Bottom Line: This week we introduced a framework for quickly comparing the risk/reward tradeoff on offer from each U.S. bond sector. While this framework does not impose a macro view, it does seem to provide a good starting point for assessing relative risk-adjusted value in U.S. bonds. We will continue to refine the approach and search for applications in the coming weeks. Chart 9Excess Return Bond Map (As Of April 12, 2018) Back To Basics Back To Basics Chart 10Excess Return Bond Map (As Of January 1, 2010) Back To Basics Back To Basics Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Market expectations are calculated from the overnight index swap curve. 2 Please see U.S. Bond Strategy Weekly Report, "Risk Review", dated April 10, 2018, available at usbs.bcaresearch.com 3 SEP = Summary of Economic Projections 4 A summary of all BCA house views can be accessed here: www.bcaresearch.com/trades/ 5 For details on the trend in global growth please see U.S. Bond Strategy Weekly Report, "Risk Review", dated April 10, 2018, available at usbs.bcaresearch.com. For details on potential geopolitical risks during the next few months please see Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility", dated April 11, 2018, available at gps.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Markets have been uneasy recently; last month saw the Fed raise rates, combined with language indicating a steeper path for interest rate moves in the coming two years. As of writing, markets are currently assigning a nearly 75% probability of at least two further rate hikes this year alone. However, amidst the Fed's tightening, the government has been embarking on fiscal largess. The recent tax cuts, budget announcements and potential infrastructure bill mean that we have entered a fairly rare period of loose fiscal policy and tight monetary policy; in our October 9th, 2017 Weekly Report, we highlighted seven such periods since the Second World War (shaded in Chart 1). Another two-year period of fiscal easing and tight money is upon us. Bull Markets Don't Die Of Old Age... To complete the adage above, "Bull markets don't die of old age, they are killed by higher interest rates". Thus the focus of roiled markets should be whether tight monetary policy can be offset by loose fiscal policy. In other words, can the government be stimulative enough to cushion the blow from higher interest rates and extend the business cycle? With all seven iterations of simultaneous fiscal easing and monetary tightening noted above resulting in positive stock market returns and the SPX rising by 16% on average, the answer appears to be a resounding yes (Table 1). Chart 1Loose Fiscal Policy Offsets##br## Tight Monetary Conditions Loose Fiscal Policy Offsets Tight Monetary Conditions Loose Fiscal Policy Offsets Tight Monetary Conditions Table 1SPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening Further, the infrastructure bill has not yet become part of the fiscal thrust in this current bull market, meaning that there is still dry powder in the stock market's battle against higher rates. Depending on the timing of the infrastructure bill (and the further away, the better for sustaining the equity market blow off phase), there are good odds that this bull market could be the longest in history (Table 2). Using months without an inverted yield curve as an alternative measure, we are already there as the current streak of 131 months beats the 104 month streak of much of the '90s (Chart 2). Table 2Bull Markets Since World War II Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening Chart 2Longest Positive Yield Curve Streak In 50 Years Longest Positive Yield Curve Streak In 50 Years Longest Positive Yield Curve Streak In 50 Years Look To Earnings For Direction Our view remains that earnings will have to take up the mantle to drive the SPX higher.1 At this stage in the bull market's life, the SPX is no longer discounting many years of future growth and higher rates weigh on this growth rate. The implication is a forward P/E multiple that should drift sideways to lower leaving profits to do all the heavy lifting and largely explaining the S&P 500's return (bottom panel, Chart 3). Importantly, the combination of synchronized global growth and a soft U.S. dollar underpin EPS. Tack on the effect of tax reform (at least this year) and the 20% and 10% EPS growth rates penciled in by the sell side for 2018 and 2019, respectively, are achievable, barring a recession. Considering that stocks and EPS growth move together (top panel, Chart 3), the path of least resistance is higher still for the SPX. This positive equity backdrop warrants a positioning update. Accordingly, we have analyzed the GICS1 industry groups and their average annualized performance in each of the most recent five periods for which we have data of loose fiscal and tight monetary policy. The results presented in Table 3, however, are nuanced. Chart 3Stocks And EPS Are Joined At The Hip Stocks And EPS Are Joined At The Hip Stocks And EPS Are Joined At The Hip Table 3Sector Relative Performance In Tight Monetary/Loose Fiscal Conditions Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening In the left column, our raw data suggests that technology is dominant in the periods we have examined. However, this is skewed by the 1998-99 iteration when this sector went parabolic as the dotcom bubble was inflating, making virtually all other sectors underperform, dramatically in most cases. We have adjusted for this exceptional period in the right column. The adjusted results are telling as cyclicals and positive interest rate sensitive sectors (the S&P financials and energy indexes) are the top performers. Conversely, defensives and negative interest rate sensitive sectors (the S&P utilities and real estate indexes) are the worst performers. Such a result is intuitive; loosening fiscal policy during expansions tends to extend/prolong the business cycle and may also arrive in late/later stages of the cycle where equity returns go parabolic and deep cyclicals roar. In addition, when the Fed raises rates, financials tend to benefit and competing fixed income proxies suffer. Further, there is a positive feedback loop in these actions as loose fiscal policy in good times is typically inflationary, especially when the economy is at full employment, which thus pushes the Fed to continue to or even accelerate its tightening mode. We note that we maintain a preference for cyclicals over defensives in our portfolio, based on our key investment themes for 2018: synchronous global capex growth and rising interest rates. Our analysis here serves to confirm our hypothesis. The purpose of this report is to identify winners and losers in times of easy fiscal and tight money phases, and provide a roadmap of how sector returns may pan out in the coming two year period of fiscal expansion and liquidity withdrawal, if history at least rhymes. Accordingly, what follows is an analysis of the two adjusted top and bottom performers noted above. Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And 'Nothing Else Matters'," dated December 18, 2017, available at uses.bcaresearch.com. Financials Are A Top Pick Financials benefit from both sides of a monetary tightening/fiscal loosening environment. Rising interest rates are a boon to sector EPS as the increasing price of credit translates directly into top line growth. The higher cost of borrowing should typically result in a slowdown in borrowing and consumption. With fiscal largesse serving to at least offset any natural demand declines, the result should be a banker's dream: simultaneous capital formation and better terms on the existing book of business. The benefits of monetary tightening and fiscal easing are not exclusive to businesses either; such an environment has typically been synonymous with soaring consumer confidence, keeping loan demand high (second panel, Chart 4). Further, low unemployment has historically meant peaking credit quality, implying a margin tailwind to the already-rising top lines of lenders (third panel, Chart 4. Chart 4RS2 Financials Are In A Goldilocks Scenario Financials Are In A Goldilocks Scenario Financials Are In A Goldilocks Scenario As operating cash flows are soaring, it is likely that financials will increasingly embark upon shareholder friendly activities. The GFC saw lenders in particular shore up weakened balance sheets with enormous equity issues; the reversal in fortunes (especially given the record number of banks passing Fed stress tests) will see accelerated equity retirement, yet another benefit to EPS growth. In sum, S&P financials should be a core holding during periods of monetary tightening and fiscal easing, (see appendix, Chart 1A); we reiterate our overweight recommendation on financials and our high-conviction overweight on the key S&P banks sub index. Energy Is Just Getting Warmed Up As noted above, one of BCA's key investment themes for 2018 is synchronized global capex, of which the S&P energy sector is a key beneficiary, at least in part fueled by lower taxes and the upcoming infrastructure bill. Recently, the capital expenditures part of the Dallas Fed manufacturing outlook survey hit its highest level in a decade, and capex intentions in the coming six months are also probing multi-year highs. The overall message is that the budding recovery in energy capital budgets will likely gain steam (second panel, Chart 5). Chart 5Energy Should Benefit From High Capex Energy Should Benefit From High Capex Energy Should Benefit From High Capex Equally importantly, the recovery in the global economy has kept a solid floor underneath oil prices, which are pushing up against 3-year highs (top panel, Chart 5). Pricing power in energy is rising at its fastest pace this decade and (for now) the sector wage bill is continuing to contract (bottom panel, Chart 5), implying not only top line gains but also a much better margin profile. Still, monetary tightening represents a headwind for the sector. Higher interest rates tend to suppress investment demand and support the U.S. dollar which could put downward force on the price of oil. Our analysis suggests the stimulative effects from fiscal easing should more than offset any pressure from monetary tightening (see appendix, Chart 1B). Accordingly, we reiterate our high-conviction overweight recommendation on the S&P energy index. Be Cautious With Utilities We recently upgraded the beaten-down S&P utilities index to a benchmark allocation, based largely on a modest improvement in operating metrics, lifted by BCA's key 2018 capex growth investment theme; expansionary fiscal thrust should only enhance these metrics. Nat gas prices appear to have mostly stabilized and, as the marginal price setter for utilities, should support the nascent turnaround in industry pricing power (second panel, Chart 6). Further, the rebound in electricity production has peaked but remains comfortably in expansionary territory (third panel, Chart 6). Chart 6Higher Rates Offset Better Fundamentals Higher Rates Offset Better Fundamentals Higher Rates Offset Better Fundamentals Notwithstanding the operational positives, we think BCA's key theme of higher interest rates present a hefty offset. Utilities, a high dividend yielding sector, suffer when Treasury bond yields move higher, as competing risk free assets become more appealing (bottom panel, Chart 6). We suspect this fixed income-proxy characteristic is why the S&P utilities sector is historically the worst performer as the Fed is tightening monetary policy (see appendix, Chart 1C). Still, the sector has harshly sold down already and we think the positives and negatives are broadly in balance; we reiterate our neutral recommendation on the S&P utilities index. Real Estate Is Not Immune From Monetary Tightening Much like the S&P utilities index, the S&P real estate sector trades as a fixed income proxy. Accordingly, the anticipated advance in Treasury yields should weigh heavily on REIT prices (top panel, Chart 7), regardless of the underlying fundamentals; fortunately, there is some good news there. Chart 7CRE Prices Are Rising But ##br##How Much Further Can They Go? CRE Prices Are Rising But How Much Further Can They Go? CHART 10 CRE Prices Are Rising But How Much Further Can They Go? CHART 10 Lending standards had been tightening from 2013 until the middle of last year; since then, they have been loosening as fears of a second real estate recession gave way to general economic optimism. Given the tight correlation between lending standards and commercial property prices, a loosening of the former bodes well for the latter (second panel, Chart 7). Still, with commercial real estate prices approaching two standard deviations above the 30-year trend (bottom panel, Chart 7), the longevity of the good times should be questioned. Regardless of the modestly improving industry fundamentals, particularly in the context of the fiscal largesse that will certainly be stimulative, monetary tightening headwinds should at least provide an offset (see appendix, Chart 1D). On balance, we reiterate our neutral recommendation on the S&P real estate index. Appendix Chart 1A CHART 1A CHART 1A Chart 1B CHART 1B CHART 1B Chart 1C CHART 1C CHART 1C Chart 1D CHART 1D CHART 1D

Highlights Apart from rising geopolitical tensions, our main macro themes remain a growth slowdown in China and a rise in U.S. core inflation. This combination bodes ill for EM financial markets. Continue underweighting EM stocks, credit and currencies versus their DM peers. Subsiding NAFTA risks argue for overweighting Mexican stocks within an EM equity portfolio. This is in line with our recent upgrade of Mexican local and U.S. dollar sovereign bonds as well as the peso's outlook versus their EM peers. A new trade: Fixed-income trades should bet on yield curve steepening in Mexico by paying 10-year swap rates and receiving 2-year rates. Close overweight Russian markets positions in the wake of escalating U.S. sanctions. Feature Before discussing Mexico and Russia, we offer an update on our thoughts on the overall market outlook. EM: Looking Under The Hood Investor sentiment remains buoyant on global risk assets, and the buy-on-dips mentality remains well entrenched. On the surface, investors are not finding enough reasons to turn negative on global or EM risk markets. Nevertheless, when looking under the EM hood, we see several leading and coincident indicators that are beginning to flash red. Not only do geopolitics and the U.S.-China trade confrontation pose downside risks, there are also several macro developments that are turning from tailwinds to headwinds for EM risk assets. Specifically: EM manufacturing and Asian trade cycles have probably topped out. The relative total return (carry included) of three equally weighted EM1 (ZAR, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc - has relapsed since early this year, coinciding with the rollover in the EM manufacturing PMI index (Chart I-1). This currency ratio is herein referred to as the risk-on/safe-haven currency ratio. Chart I-1Risk On / Safe-Haven Currency Ratio And EM Manufacturing PMI bca.ems_wr_2018_04_12_s1_c1 bca.ems_wr_2018_04_12_s1_c1 The risk-on/safe-haven currency ratio also correlates with the average of new and backlog orders components of China's manufacturing PMI (Chart I-2). The latter does not herald an upturn in this currency ratio at the moment. Share prices of global machinery, chemicals and mining companies have so far underperformed the overall global equity index in this selloff, as exhibited in Chart I-3. Chart I-2China's Industrial Cycle Has Rolled Over bca.ems_wr_2018_04_12_s1_c2 bca.ems_wr_2018_04_12_s1_c2 Chart I-3Global Cyclicals Have Underperformed, Though Not Tech Global Cyclicals Have Underperformed, Though Not Tech Global Cyclicals Have Underperformed, Though Not Tech Potential trade wars, the setback in technology stocks and a resurgence of volatility in global equity markets have recently dominated news headlines. Yet, the underperformance of China-exposed global sectors and sub-sectors signifies that beneath the surface Chinese growth is weakening. Meanwhile, global tech stocks have not yet underperformed much (Chart I-3, bottom panel), implying the selloff has not been driven by this high-flying sector. The combination of weakening global trade amid still-robust U.S. domestic demand bodes well for the U.S. dollar, at least against EM and commodities currencies. U.S. and EU imports account for only 13% and 11% of global trade, respectively (Chart I-4). Meanwhile, aggregate EM including Chinese imports account for 30% of world imports. Hence, global trade can slow even with U.S. and EU domestic demand remaining robust. We addressed the twin deficit issue in the U.S. in our February 21 report,2 and will add the following: If U.S. fiscal stimulus coincides with abundant global growth, the greenback will weaken. If on the contrary, the U.S. fiscal expansion overlaps with weakening global trade, U.S. growth will be priced at a premium and the U.S. dollar will appreciate especially against the currencies of economies where growth will fall short. The majority of EM exchange rates will likely be in the latter group. The relative performance of EM versus DM stocks correlates with the relative volume of imports between China and the DM (Chart I-5). The rationale is that EM countries and their publically listed companies are much more leveraged to China's business cycle than DM. The opposite is true for DM-listed companies. Our view is that China's industrial recovery and growth outperformance versus DM since early 2016 is about to end. This, if realized, should undermine EM equities and currencies versus their DM counterparts. Last week, we published a Special Report on the Chinese real estate market.3 We documented that despite a drawdown in housing inventories over the past two years, both residential and non-residential inventories remain very elevated. This, along with poor affordability and the implementation housing purchase restrictions for investors, will dampen housing sales, which in turn will lead to a contraction in property development and construction activity. Chart I-4Global Trade Is More Leveraged To EM Not DM Global Trade Is More Leveraged To EM Not DM Global Trade Is More Leveraged To EM Not DM Chart I-5EM Underperforms When Chinese Imports Lag DM Ones EM Underperforms When Chinese Imports Lag DM Ones EM Underperforms When Chinese Imports Lag DM Ones Combined with a slowdown in infrastructure investment due to tighter controls on local government finances, this poses downside risks to China's demand for commodities, materials and industrial goods. This is the main risk to EM stocks and currencies, and the primary reason we continue to maintain our negative stance on EM risk assets. Last but not least, it is widely believed that Chinese households are not indebted and that there is a lot of pent-up demand for household credit. Chart I-6 reveals that this conjecture is simply not true - the household debt-to-disposable income ratio has surged to 110% of disposable income in China. The same ratio is currently 107% in the U.S. Given borrowing costs in general and mortgage rates in particular are higher in China than in the U.S. (the mortgage rate is 5.2% in China versus 4.4% in the U.S.), interest payments on debt account for a larger share of households' disposable income in China than in America right now. In the U.S., the surprise on the macro front in the coming months will likely be both rising wage growth and core inflation. Chart I-7 highlights that average hourly earnings in manufacturing and construction have been accelerating. This underscores that wages are rising fast in these cyclical sectors. This will spread to other sectors sooner rather than later. Core inflation in America is rising and has already moved above 2% (Chart I-8). The rise is broad-based as all different core consumer price measures are rising and heading toward 2%. Chart I-6Chinese Households Are As Leveraged As Americans Chinese Households Are As Leveraged As Americans Chinese Households Are As Leveraged As Americans Chart I-7U.S. Wages Are Accelerating U.S. Wages Are Accelerating U.S. Wages Are Accelerating Chart I-8U.S. Core Inflation Is Above 2% U.S. Core Inflation Is Above 2% U.S. Core Inflation Is Above 2% While this does not entail that the U.S. is heading into runaway inflation, rising core inflation and wage growth will likely lead many investors to believe that the Federal Reserve cannot back off too fast from rate hikes, particularly when the U.S. fiscal thrust remains so positive, even if the drawdown in share prices persist. This may especially weigh on EM risk assets, where growth will be subsiding due to their links with Chinese imports. Bottom Line: Our main macro themes remain a slowdown in China and a rise in U.S. core inflation. This combination bodes ill for EM financial markets. Continue underweighting EM stocks, credit and currencies versus their DM peers. Upgrade Mexican Equities To Overweight In our March 29 report,4 we upgraded our stance on the Mexican peso, local currency bonds and U.S. dollar sovereign credit from neutral to overweight. The main rationale was receding odds of NAFTA abrogation and the country's healthy macro fundamentals. In addition, we instituted a new currency trade: long MXN / short BRL and ZAR. Continuing with this theme, we today recommend upgrading Mexican stocks to overweight within an EM equity portfolio: The odds of NAFTA retraction are rapidly subsiding as the U.S. is shifting its focus to China. Hence, chances are that NAFTA negotiations will be completed this summer, and a deal will be signed off before Mexico's presidential elections on July 1st. A more benign outcome together with an early end to NAFTA negotiations will reduce uncertainty and the risk premium priced into Mexican financial markets. This will help the latter outperform their EM peers. A final note on Mexican politics: The leftist presidential candidate Andres Manuel Lopez Obrador has high chances of winning the presidential elections in July. Yet Our colleagues at BCA's Geopolitical Strategy service believe political risks are overstated.5 The basis is that Obrador will balance the left-leaning preferences of his electorate with the prudent policies needed to produce robust growth. While political uncertainty in Mexico is subsiding, it is rising in many other EM countries such as Russia, China and Brazil. In brief, geopolitical dynamics favor Mexico versus the rest of EM. We expect dedicated EM managers across various asset classes to rotate into Mexico from other EM countries. We outlined two weeks ago that a stable exchange rate will bring down inflation, opening a door for the central bank to cut interest rates no later than this summer. As local interest rate expectations in Mexico continue to subside both in absolute terms as well as relative to EM, Mexican share prices will outpace their EM peers (Chart I-9). Consistently, tightening Mexican sovereign credit spreads versus EM overall should also foster this nation's equity outperformance (Chart I-10). Chart I-9Relative Equity Performance Tracks Relative ##br##Local Bond Yields Relative Equity Performance Tracks Relative Local Bond Yields Relative Equity Performance Tracks Relative Local Bond Yields Chart I-10Relative Equity Performance Tracks Relative ##br##Sovereign Spreads Relative Equity Performance Tracks Relative Sovereign Spreads Relative Equity Performance Tracks Relative Sovereign Spreads Domestic demand growth has plunged following monetary and fiscal tightening in the past two years (Chart I-11). As both fiscal and monetary policy begin to ease, domestic demand will recover later this year. Chances are that share prices will sniff this out and begin their advance/outperformance sooner than later. Consumer staples and telecom stocks together account for 50% of the MSCI Mexico market cap, while the same sectors make up only 11% of overall EM market cap. Hence, Mexico's relative equity performance is somewhat hinged on the outlook for these two sectors in general and consumer staples in particular. EM consumer staple stocks have massively underperformed the EM benchmark since early 2016 (Chart I-12, top panel), and odds are this sector will outperform in the next six to 12 months as defensive sectors outperform cyclicals. This in turn heralds Mexico's relative outperformance versus the EM benchmark, which seems to be forming a major bottom (Chart I-12, bottom panel). Chart I-11Mexico: Economic Downturn Is Well Advanced Mexico: Economic Downturn Is Well Advanced Mexico: Economic Downturn Is Well Advanced Chart I-12Mexican Bourse Is A Play On Consumer Staples Mexican Bourse Is A Play On Consumer Staples Mexican Bourse Is A Play On Consumer Staples Unlike many EM countries, the Mexican economy is much more leveraged to the U.S. than to China. One of our major themes remains favoring U.S. growth plays versus Chinese ones. Finally, Mexican equity valuations have improved quite a bit both in absolute terms and relative to EM. Chart I-13 shows our in-house CAPE ratios for Mexican stocks in absolute terms and relative to the EM overall benchmark: Mexican equity valuations are not cheap but they are no longer expensive. Consistent with upgrading our economic outlook on Mexico, fixed-income investors should bet on yield curve steepening in local rates. We initiated this strategy on January 31 but hedged the NAFTA risk by complementing it with a yield curve flattening leg in Canada. Now, we are closing that trade and initiating a new one: fixed-income traders should consider paying 10-year swap rates and receiving 2-year swap rates. The yield curve is as flat as it typically gets (Chart I-14, top panel). Moreover, 2-year swap rates are not yet pricing enough rate cuts (Chart I-14, bottom panel) but will soon begin gapping down pricing in a large (potentially close to 200 basis points) rate cut cycle. Chart I-13Mexican Equities Are No Longer Expensive Mexican Equities Are No Longer Expensive Mexican Equities Are No Longer Expensive Chart I-14Bet On Yield Curve Steepening In Mexico Bet On Yield Curve Steepening In Mexico Bet On Yield Curve Steepening In Mexico Bottom Line: In line with our recent upgrade of Mexican local and U.S. dollar bonds as well as the currency outlook versus their EM peers, this week we recommend EM dedicated equity portfolios shift to an overweight position in Mexican stocks. Fixed-income trades should bet on yield curve steepening by paying 10-year swap rates and receiving 2-year rates. Investors who are positive on global risk assets should consider buying Mexican local bonds outright. Russia: Geopolitics Trumps Economics Chart I-15Russian Assets Relative To EM Benchmarks:##br## Various Asset Classes Russian Assets Relative To EM Benchmarks: Various Asset Classes Russian Assets Relative To EM Benchmarks: Various Asset Classes The sudden crash in Russian financial markets this week following the imposition of new U.S. sanctions has reminded us that geopolitics can often eclipse economics. Our overweight recommendation on Russian assets versus their EM peers was based on two pillars: (1) healthy and improving macro fundamentals and an unfolding cyclical economic recovery; and (2) easing tensions between Russia and the West. Clearly, the second part of our assessment is wrong, or at least premature. While BCA's Geopolitical Service team maintains that on a 12-month horizon tensions between Russia and the West will subside, the near-term risks are impossible to assess. For this reason we are closing our overweight allocation in Russian financial markets and recommend downgrading it to neutral. In particular, we are shifting Russia to a neutral allocation within the EM equity, sovereign and corporate credit and local currency bonds portfolios (Chart I-15). Consistently, we are closing the following trades: Long Russian / short Malaysian stocks (27.6% gain); Long Russian energy / short global energy stocks (2.8% gain); Long RUB / short MYR (3.1% loss); Short COP / long basket of USD & RUB (16.2% loss); Long RUBUSD / short crude oil (29.1% loss). Sell Russian 5-year CDS / buy South African 5-year CDS (317 basis points gain); Long Russian and Chilean / short Chinese Corporate Credit (12% gain); Long Russian 5-year bonds / short Brazilian 5-year bonds (flat). Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 We have removed the Russian ruble from the version of this chart shown in March 29, 2018 EMS report to assure that the recent idiosyncratic developments - the selloff triggered by the U.S. sanctions - in Russia's financial markets do not impact the reading of this indicator. 2 Pease see Emerging Markets Strategy Weekly Report "EM Local Bonds And U.S. Twin Deficits", dated February 21, 2018, Page 14. 3 Pease see Emerging Markets Strategy Weekly Report "China Real Estate: A Never-Bursting Bubble?", dated April 6, 2018, Page 14. 4 Pease see Emerging Markets Strategy Weekly Report "EM: Perched On An Icy Cliff", dated March 29, 2018, available at ems.bcaresearch.com. 5 Pease see Geopolitcial Strategy Weekly Report "Expect Volatility... Of Volatility", dated April 11, 2018, available at gps.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Capacity cuts in China's steel and aluminum industries over the winter produced little in the way of output reductions, confounding our expectations. The resulting unintended inventory accumulation in Asian markets, reflecting high production relative to demand, and slowing Chinese steel exports are a downside risk to our neutral view. U.S. sanctions against Russian oligarchs close to President Putin could tighten the aluminum market, countering the unintended inventory accumulations. For now, we remain neutral base metals. Energy: Overweight. We are closing our long put spread position in Dec/18 Brent options at tonight's close. The fast-approaching May 12 deadline for President Trump to renew sanctions waivers against Iran shifts the balance of price risks to the upside. Base Metals: Neutral. COMEX copper rallied above $3.10/lb on the back of Chinese President Xi's remarks at the Boao Forum earlier this week, which re-hashed plans to open China's economy to imports. Precious Metals: Neutral. Gold likely becomes better bid as the May 12 deadline to waive Iran sanctions nears. Our long gold portfolio hedge is up 8.9%. Ags/Softs: Underweight. European buyers are scooping up U.S. soybeans, as Chinese purchases of Brazilian beans makes U.S.-sourced crops relatively cheaper, according to Reuters.1 China also announced plans to start selling corn stocks from state reserves this week, offering an alternative protein for animals to partially offset the price impact of tariffs on their imports of U.S. soybeans. Feature Chart of the WeekAluminum Rebounds On U.S. Sanctions Aluminum Rebounds On U.S. Sanctions Aluminum Rebounds On U.S. Sanctions Despite much-ballyhooed capacity reductions in China's steel and aluminum capacity, these markets - both in China and globally - remained relatively well supplied over the winter. Higher global supplies, and falling Chinese steel exports, will result in unintended inventory accumulation, which already is showing up in Shanghai Futures Exchange (SHFE) inventories. While we remain neutral base metals, continued unintended inventory accumulation could cause us to downgrade the sector. The MySteel Composite Index we use to track steel prices is down more than 10% since the beginning of the year (Chart of the Week). Similarly, the first-nearby primary aluminum contract on the LME was down ~ 12% year-to-date (ytd) early last week, before regaining most of these losses on news of U.S. sanctions against Russian oligarchs, which hit shares of Rusal very hard. Given that these sanctions will restrict access to up to 6% of global aluminum supply, ex-China supply dynamics will dominate the aluminum market this year making the outlook relatively favorable, putting a floor beneath the London Metal Exchange Index (LMEX).2 Ex-Post Winter Production Production cuts over the winter - when Chinese mills in 28 smog-prone northern cities were ordered to reduce capacity by up to 50% - did not live up to our expectations.3 China's steel and aluminum sectors have undergone major supply-side reforms, particularly re the removal of outdated capacity, most of which has been completed. In addition to the winter capacity cuts, past reforms that have already been implemented, and have shaped current market conditions, are as follows: In an effort to eliminate outdated and unlicensed facilities, China removed an estimated 3-4 mm MT of annual capacity in 2017 - amounting to approximately 10% of total aluminum smelting capacity. In the case of steel, Beijing announced plans to shut down 150 mm MT of annual steel capacity between 2016 and 2020. To date, 115 mm MT of capacity have already been eliminated. Another estimated 80-120 mm MT of induction furnace capacity was shuttered in 1H17. Going forward, China's steel and aluminum markets will be driven by: An estimated 3-4 mm MT of updated aluminum capacity is expected to come on line this year, offsetting constraints from last year's supply cuts. 30 mm MT of steel capacity shutdowns are planned this year, putting Beijing on track to meet its five-year target two years ahead of schedule. The Chinese National Development and Reform Commission (NDRC) has communicated its resolve to keep shuttered capacity offline. Major steelmaking cities in Hebei province - accounting for 22% of 2017 Chinese crude steel output - have announced plans to extend the capacity cuts to November 2018. The mid-November to mid-March capacity cuts implemented this past season are expected to be a recurring event. Winter Shutdowns Minimally Impact China's Steel Output ... According to steel production data released by the World Steel Association (WSA), winter capacity closures in China did not significantly affect overall output levels. Crude steel output from China was up 3.9% year-on-year (y/y) in the November to February period (Chart 2). At the same time, production from the rest of the world increased by 3.6% y/y in the November to February. Thus global crude steel supply remained in excess over the winter season, as global steel output increased 3.8% y/y. A caveat to these data: China does not account for the historical output of induction furnaces, which produced an estimated ~30-50 mm MT of steel in 2016. As mentioned in our previous research, the output of these furnaces was illegal and thus not carried in statistics we use to track supply.4 These data problems mean it is possible that actual output in the November 2016 to February 2017 period was higher than suggested by the data, and as a result, actual output during this year's winter season may actually be lower than last year. As induction-furnace data lie in the statistical shadows, we cannot ascertain this with certainty. Nevertheless, a buildup in China inventories - which we discuss below - indicates an oversupplied market. It is also likely producers - incentivized by high steel prices earlier this year - kept capacity utilization at maximum levels throughout the winter. ... And Aluminum Output According to International Aluminum Institute data, primary aluminum output in China fell 2.3% y/y in the November to February period, suggesting the winter cuts likely had an impact on aluminum supply (Chart 3). Data from the World Bureau of Metal Statistics (WBMS) show an even sharper decline in winter aluminum output: primary production in China fell 8.7% y/y in the November to January period. Chart 2Steel Output Grew##BR##Amid Winter Cuts Steel Output Grew Amid Winter Cuts Steel Output Grew Amid Winter Cuts Chart 3China Aluminum Market In Surplus##BR##Despite Production Decline China Aluminum Market In Surplus Despite Production Decline China Aluminum Market In Surplus Despite Production Decline Both sources reveal an especially pronounced contraction in November, at the onset of the winter cuts. Despite reduced supply, WBMS data indicate a positive Chinese aluminum market balance throughout the winter. A large contraction in demand offset the supply shortfall, and kept primary aluminum in a physical surplus throughout the winter, ultimately leading to a buildup in domestic inventories. A Look At The Trade Data Despite our disappointment regarding the impact of the winter cuts on steel and aluminum markets, trade data increasingly suggests China's steel exports have peaked. Aluminum exports from China, on the other hand, are likely to continue rising. Chinese Steel Exports Continue To Fall ... Chinese steel product net exports have been falling since mid-2016, and have continued falling in y/y terms throughout the winter. According to Chinese customs data, steel product net exports fell 35.1% y/y in the November to February period, driven by both falling exports as well as rising imports (Chart 4). Steel product exports plunged 30% y/y in the November to February period, more or less in line with the 2017 average. The decline mirrors the 2017 contraction in domestic supply, bringing exports to their lowest level since 2012. This indicates fears of a China slowdown leading to a flood of metal onto global markets have not materialized, at least not yet. In fact, Customs data show a 1.7% y/y increase in Chinese steel imports during the November to February period - a reversal from falling imports prior to the winter season. The conclusion we draw from this is that, while in the past, China was a source of supply for the world, ongoing capacity cuts and production controls could mean China will lack the ability to ramp up output in case of a global physical supply deficit. If this becomes the new normal, price volatility will likely increase. This trend is important, especially given our expectation of strong world ex-China demand this year. As such, global steel prices may find support amid this new normal. ... But Aluminum Exports Move Higher In the case of aluminum, Chinese net exports were up 28.7% y/y during the winter, continuing their upward trend. Customs data show a 14.8% y/y increase in aluminum exports in November to February, bringing exports in this period to their highest level since 2014/15 (Chart 5). At the same time, imports of aluminum have come down during this period - by 37.2% y/y. According to China customs data, 2017 imports over these winter months registered their lowest level since 1994. Chart 4Steel Exports Continue Falling ... Steel Exports Continue Falling ... Steel Exports Continue Falling ... Chart 5...While Aluminum Exports Are On the Uptrend ...While Aluminum Exports Are On the Uptrend ...While Aluminum Exports Are On the Uptrend The combination of growing exports amid falling imports puts China's net exports in expansionary territory. This will be especially true given the planned increase in capacity this year amid weak Chinese demand. All in all, ceteris paribus global supply of aluminum looks set to increase. However, we do not live in a ceteris paribus world and, as we explore below, sanctions against the top aluminum producer outside of China will have massive implications on the global aluminum supply chain. Are Inventories Due For A Turnaround? Chart 6Larger Than Expected##BR##Seasonal Inventory Buildup Larger Than Expected Seasonal Inventory Buildup Larger Than Expected Seasonal Inventory Buildup China Iron and Steel Association data indicate that since the beginning of the year, steel product inventories have been re-stocked to levels last seen in 1Q14. Inventories of the five main steel products we track have more than doubled since the beginning of the year (Chart 6). Although the Q1 build is seasonal, the re-stocking since the beginning of the year has been especially pronounced. This buildup occurred in an environment of stable supply - with minimal impact from the winter capacity cuts - amid weak exports, indicating domestic demand for the metal was subdued. However, steel inventories have turned around, and we expect further destocking as demand accelerates post the Chinese New Year. The question remains whether this destocking will bring inventories back down to their 5-year average. Aluminum inventories on the SHFE show similar dynamics. However in this case, it is part of the larger trend of rising stocks since the beginning of last year. Aluminum inventories at SHFE warehouses are up more than nine-fold - or 0.87 mm MT - since the end of 2016. In fact, the pace of buildup seems to have accelerated: the average weekly build of 16.6k MT of aluminum coming into warehouse inventories since the beginning of the year stands above the 2017 average weekly build of 12.6k MT. This brought SHFE aluminum inventories to almost 1 mm MT, more than double their previous record in 2010. Although the Chinese physical aluminum surplus weighed down on prices in 1Q18, we expect global aluminum prices to remain supported from here due to the impact of U.S. sanctions on world ex-China aluminum supply. U.S. Russian Sanctions Could Be A Game-Changer Chart 7Sanctions Will Restrict##BR##Marketable Aluminum Supply Chinese Steel, Aluminum Markets Well Supplied Despite Winter Capacity Cuts Chinese Steel, Aluminum Markets Well Supplied Despite Winter Capacity Cuts Last Friday, the U.S. announced sanctions on Russian oligarchs close to President Vladimir Putin. Among those sanctioned is Oleg Deripaska who controls EN+ Group, which owns a controlling interest in top aluminum producer United Company Rusal. Given that UC Rusal accounts for ~6% of global aluminum production, we view this move as significant to global aluminum markets. As the top producer of the metal outside China, Rusal aluminum likely makes up the majority of Russian supply, which account for 14% of U.S. imports (Chart 7). In fact, almost 15% of Rusal's revenues comes from its business with the U.S. While it is clear that these sanctions will, in effect, terminate aluminum trade between Russia and the U.S., more significant are the implications on the global supply chain. A clause in the U.S. Treasury Department's order extending the restrictions to non-U.S. citizens dealing with U.S. entities means the impact could be far-reaching, requiring a major re-shuffle in global aluminum trade. Earlier this week, the LME announced that it will no longer accept Rusal aluminum produced after April 6, effectively preventing the company's products from being delivered on the LME. These sanctions will likely turn global aluminum buyers off from Rusal products, as they can no longer deliver it to the LME. The net effect will be a contraction in global usable aluminum supply. Furthermore, these sanctions will likely disrupt supply chains as aluminum users scramble to avoid purchasing metal from the Russian producer. While the details of these restrictions are still unclear, the sanctions are a game changer in the global aluminum market - effectively restricting access to a major source of the metal. As such, primary aluminum on the LME is up more than 10% since the announcement last Friday. Bottom Line: While China's crude steel output increased y/y during government-mandated output cuts over the winter, seasonally weak demand meant that the metal piled up in inventories. Falling exports indicates that at least for now, the domestic surplus is not flooding global markets. The main risk to our neutral view here is that demand in China remains weak, and that this will lead to the offloading of Chinese metal to global markets, i.e. a pickup in exports. This has not yet materialized, so we are holding on to our neutral view for now. China's primary aluminum production declined y/y during the winter cuts. However the decline in domestic demand was greater - likely due to the decline in auto production and sales following the loss of tax credit incentives. Consequently, China's aluminum market remained in surplus throughout the winter. Some of the excess supply was exported, but SHFE inventories continued building. Our outlook on the aluminum market had been bearish, due to additional capacity coming online this year amid an uncertain China demand environment. However, the sanctions on Rusal could be a game changer, putting a floor beneath aluminum prices. This improves our near term outlook for the aluminum market. This makes our outlook on aluminum prices much more favorable. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see "As U.S. and China trade tariff barbs, others scoop up U.S. soybeans," published by reuters.com on April 8, 2018. 2 The six non-ferrous metals represented in the LMEX and their respective weights are as follows: aluminum: 42.8%, copper: 31.2%, zinc: 14.8%, lead: 8.2%, nickel: 2.0%, and tin: 1.0%. 3 China's winter smog "battle plan" targeted polluting industries in the northern China region by mandating cuts on steel, cement and aluminum production during the smog-prone mid-November to mid-March months. Steel and aluminum production cuts targeted a range between 30-50% during this period. This event is expected to be an annually recurring event until 2020. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "China's Environmental Reforms Drive Steel & Iron Ore," dated January 11, 2018, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Chinese Steel, Aluminum Markets Well Supplied Despite Winter Capacity Cuts Chinese Steel, Aluminum Markets Well Supplied Despite Winter Capacity Cuts Trades Closed in 2018 Summary of Trades Closed in 2017 Chinese Steel, Aluminum Markets Well Supplied Despite Winter Capacity Cuts Chinese Steel, Aluminum Markets Well Supplied Despite Winter Capacity Cuts

Highlights Q1 Performance Breakdown: The GFIS recommended model bond portfolio returned -0.55% (hedged into U.S. dollars) in the first quarter of 2018, underperforming the custom benchmark index by -11bps. The overweight to U.S. corporate bonds was the main drag on performance. Stress Test & Scenario Analysis: We introduce a simple framework to conduct scenario analysis and stress testing of the model bond portfolio. Our conclusion is that some shifting in our corporate bond allocations - reducing exposure to U.S. investment grade, increasing exposure to euro area and emerging market corporates - can actually help eliminate expected losses in scenarios that run counter to our base case. Feature This week, we present our regular quarterly report on the performance of the BCA Global Fixed Income Strategy (GFIS) model bond portfolio. As a reminder to existing readers (and for new clients), the portfolio is a part of our service that is a departure from the usual BCA macro analysis of global fixed income markets. The model portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors, by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. This framework also gives us a vehicle to discuss many of the typical bond portfolio management issues that our clients face on a daily basis. In that vein, we are introducing a new element to our framework in this report - estimating future portfolio performance using scenario analysis, and conducting stress testing of outcomes that are contrary to our base case expectations for global bond markets. Q1/2018 Model Portfolio Performance Breakdown: An Unexpected Hit From U.S. Corporates Chart of the WeekShifting Correlations Hurt##BR##The Model Portfolio In Q1 Shifting Correlations Hurt The Model Portfolio in Q1 Shifting Correlations Hurt The Model Portfolio in Q1 The surge in global market volatility in the first quarter of the year weighed on the returns for the GFIS model bond portfolio. The portfolio had a total return of -0.55% (hedged into U.S. dollars), which lagged that of our custom benchmark index by -11bps.1 The quarter started out on a good note, with the portfolio outperforming by +12bps in January, as gains from our below-benchmark duration stance offset some underperformance from our overweight on global spread product. The story changed in early February, however, as the U.S. wage inflation "scare" and the associated VIX spike resulted in wider U.S. corporate bond spreads. This counteracted the gains on the government bond side of the portfolio as bond yields continued to climb. After yields peaked in mid-February, the portfolio gave back much of the outperformance from duration, with no recovery of the early February losses from spread product (Chart of the Week). In terms of the breakdown between the government bond and spread product allocations in our model portfolio, the former generated +9bps of outperformance versus our custom benchmark index while the latter underperformed by -19bps (Table 1). The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. The main individual sectors of the portfolio that drove the excess returns were the following: Biggest outperformers Underweight U.S. Treasuries (+16bps) Underweight emerging market (EM) U.S. dollar (USD) denominated corporate debt (+5bps) Overweight Japanese government bonds (JGBs) with maturities of ten years or less (+4bps) Underweight EM USD-denominated sovereign debt (+2bps) Biggest underperformers Overweight U.S. investment grade (IG) Financials (-14bps) Overweight U.S. IG Industrials (-8bps) Underweight JGBs with maturities beyond ten years (-8bps) Overweight U.S. Ba-rated high-yield (HY) corporates (-4bps) Table 1GFIS Model Bond Portfolio Q1-2018 Overall Return Attribution GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start Chart 2GFIS Model Bond Portfolio Q1-2018 Government Bond Performance Attribution By Country GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start Chart 3GFIS Model Bond Portfolio Q1-2018 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start The hits from the overweight positions in U.S. corporate debt were the most surprising, given that the U.S. economy and corporate profits are still expanding at a solid pace. That would typically keep corporate credit spreads well-behaved, especially when U.S. Treasury yields are rising or stable as was the case in the first quarter. Yet volatility has spiked and stayed elevated in response to heightened uncertainty over slowing global growth momentum, rising U.S. inflation and worries about future U.S. trade policy. Investors have demanded moderately higher credit risk premiums in the U.S. as a result, to the detriment of U.S. corporate bond performance. This can be seen in Chart 4, which presents the returns of the individual countries and spread product sectors in the GFIS model bond portfolio. The returns are hedged into U.S. dollars (we do not take active currency risk in this portfolio) and also adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market.2 On this "apples-for-apples" basis, U.S. IG corporates were the worst performing fixed income market in the first quarter of 2018. Chart 4Ranking The Winners & Losers From The Model Portfolio In Q1 GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start Looking ahead, we see no need yet to get out of our recommended overweight in global spread product or underweight in global government bond exposure (Chart 5). While there are some signs of slowing growth momentum in major economies (euro area, China), a deeper slowdown is not being heralded by leading economic indicators, which continue to rise. Much of the global economy continues to operate at or beyond full employment, which will continue to put moderate upward pressure on inflation rates. This will force central banks to maintain a relatively hawkish bias, despite more elevated financial market volatility. The most likely outcomes are still more bearish for government bonds than for corporate credit. Chart 5We're Sticking With Our##BR##Spread Product Overweight GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start Having said that - the higher volatility environment does argue for some reduction in the size of the spread product overweight in the model portfolio. Especially after we consider some scenario analysis on returns, as we discuss in the next section. Bottom Line: The GFIS recommended model bond portfolio returned -0.55% (hedged into U.S. dollars) in the first quarter of 2018, underperforming the custom benchmark index by -11bps. The overweight to U.S. corporate bonds was the main drag on performance, thanks to the more elevated level of market volatility and spread widening during the quarter. Stress Tests & Scenario Analysis A common analytical tool used by professional fund managers is to perform "stress tests" on their portfolios. This is done to estimate the size of potential losses that could occur after major market moves, typically those that went against current positioning in a portfolio. Those estimates are critical to the effective risk management of a portfolio. As part of the ongoing development of the infrastructure for our model bond portfolio framework, we are introducing scenario analysis and stress testing of our current recommended allocations. The goal is to determine the magnitude of potential returns that could be expected under our base case and alternative scenarios. This is meant to complement the main risk management tool that we added last year, a "risk budget" based on the tracking error (i.e. volatility difference) of the portfolio versus our custom benchmark.3 We have deliberately been targeting a modest tracking error for our model portfolio, given the historical richness (low yields, tight spreads) of so many parts of the global bond universe. Yet our estimate of the GFIS model bond portfolio's tracking error has fallen even below the low end of the 40-60bp range that we have been targeting (Chart 6).4 Chart 6Lower Tracking Error Through Higher##BR##Corporate Bond Volatility Lower Tracking Error Through Higher Corporate Bond Volatility Lower Tracking Error Through Higher Corporate Bond Volatility This appears to be due to an odd development. The model bond portfolio's volatility was running below that of its benchmark index over the past year, but with the increase in the return volatility of U.S. IG corporate debt - the biggest overweight within spread product - the portfolio's volatility has been converging to that of the benchmark from below, hence lowering the tracking error. In other words, being overweight U.S. IG was a portfolio diversifier last year, but that is no longer the case. This obviously highlights some of the limitations of using tracking error as the sole risk management tool for a bond portfolio. Shifting cross-asset correlations and volatilities can wreak havoc on any "guesstimate" of a portfolio's underlying risk. A more simple solution is to conduct scenario analysis of expected returns, then shock the analysis for changes in the underlying assumptions. The key is having a reasonable framework for estimating returns for various asset classes. For our purposes in the model portfolio, we are using a simple approach to forecast the expected returns. We use a factor-based framework that models changes in global bond yields as a function of changes in the following four variables: the U.S. dollar, the price of oil, the fed funds rate and the VIX index. We show the regression results of our factor-based modeling of yield changes for each spread sector in our model bond portfolio in Table 2A. We ran the regressions for different time horizons, but we decided on using the post-crisis period since 2009 in all cases. We also attempted to model the yield changes of government bonds using those same four factors, but the R-squareds for all those regressions were far too low to make them useful. We instead used a simple approach of calculating the beta since 2009 of changes in individual bond yields to changes in U.S. Treasury yields for each corresponding maturity bucket. We present those yield betas in Table 2B. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start Table 2BEstimated Government Bond Yield Betas To U.S. Treasuries GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start With these tools, we can forecast returns for each bond sector under different scenarios. We can then use those forecasts to predict the expected return for our model bond portfolio under those same scenarios. In Tables 3A & 3B. We show three differing scenarios, with all the following changes occurring over a one-year horizon: Table 3AScenario Analysis For The GFIS Model Portfolio GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start Table 3BU.S. Treasury Yield Assumptions For The Scenario Analysis GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start Our Base Case: the Fed delivers another 75bps of rate hikes, the U.S. dollar rises by 5%, oil prices rise by 20% (the non-consensus view of BCA's commodity strategists), the VIX index stays unchanged at current elevated levels and there is a modest bear steepening of the U.S. Treasury curve. A Very Hawkish Fed: the Fed delivers 150bps of rate hikes, the U.S. dollar rises by 10%, oil prices fall by 10%, the VIX index increases by ten points from current levels and there is a sharp bear flattening of the U.S. Treasury curve. Chart 7U.S. IG Corporates Have A##BR##High Yield Beta (a.k.a. Duration) U.S. IG Corporates Have A High Yield Beta (a.k.a. Duration) U.S. IG Corporates Have A High Yield Beta (a.k.a. Duration) A Very Dovish Fed: the Fed only hikes rates by 25bps, the U.S. dollar falls by 5%, oil prices fall by 5%, the VIX index increases by five points from current levels and there is a modest bull steepening of the U.S. Treasury curve. In Table 3A, we also show the expected yield changes generated by our regressions for each spread product sector and the yield betas to U.S. Treasuries for each government bond market. This produces expected returns for the GFIS model bond portfolio, which are shown in the top part of the table. In our base case, the portfolio is expected to outperform the benchmark by +42bps, but underperform by nearly equivalent amounts in both alternative scenarios. In the bottom part of the table, we show expected returns where we reduce our large overweight to U.S. IG corporates. The latter has a high sensitivity to rising global government bond yields compared to some of our other significant overweights like Japanese government debt and U.S. high-yield (Chart 7). We then take that reduced U.S. IG weighting and increase the exposure to euro area and EM corporate bonds. This adjusted portfolio results in higher excess returns not only in our base case (now +78bps) but even in the "very hawkish Fed" scenario (now +8bps). The "very dovish Fed" scenario produces a similar loss in this scenario (now -37bps), but that is to be expected since this includes a fall in global bond yields that would hurt our current underweight duration stance (Chart 8). Importantly, this adjusted portfolio would not alter the positive carry of the model portfolio (i.e. the portfolio yield remains at 16bps above that of the custom benchmark index, Chart 9) Chart 8Flattening Yield Curves##BR##Have Also Hurt Returns Flattening Yield Curves Have Also Hurt Returns Flattening Yield Curves Have Also Hurt Returns Chart 9Some Help From##BR##Positive Carry Some Help From Positive Carry Some Help From Positive Carry Based on this scenario analysis, we are going to implement the changes in the bottom half of Table 3A. We are cutting our overweight to U.S. IG corporates in half (which still leaves us overweight), raising euro area IG and HY corporate exposure to neutral and reducing the size of our EM corporate underweight. The changes to the model portfolio can be found on Page 14. These changes will reduce our exposure to a sector that not only has become riskier, but which also looks relatively expensive to U.S. high-yield (Chart 10) and which has been underperforming euro area (Chart 11) and EM equivalents (Chart 12). Chart 10U.S. IG Looks More##BR##Expensive Than U.S. HY U.S. IG Looks More Expensive Than U.S. HY U.S. IG Looks More Expensive Than U.S. HY Chart 11An Unexpected Underperformance##BR##Of U.S. IG vs. European Corporates An Unexpected Underperformance Of U.S. IG vs. European Corporates An Unexpected Underperformance Of U.S. IG vs. European Corporates Chart 12An Unexpected Underperformance##BR##Of U.S. IG Vs. Versus EM Corporates An Unexpected Underperformance Of U.S. IG Vs. Versus EM Corporates An Unexpected Underperformance Of U.S. IG Vs. Versus EM Corporates Bottom Line: We introduce a simple framework to conduct scenario analysis and stress testing of the model bond portfolio. Our conclusion is that some shifting in our corporate bond allocations - reducing exposure to U.S. investment grade, increasing exposure to euro area and emerging market corporates - can actually help eliminate expected losses in scenarios that run counter to our base case. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 For Italy & Spain, the bars have two colors since the portfolio weights were changed in mid-February, when we upgraded Italian debt to neutral at the expense of a reduction in Spanish government bond exposure. 3 Please see BCA Global Fixed Income Strategy Special Report, "Adding A Risk Management Framework To Our Model Bond Portfolio", dated June 20th 2017, available at gfis.bcaresearch.com. 4 In general, we aim to target a tracking error no greater than 100bps. We think this is reasonable for a portfolio where currency exposure is fully hedged and less than 5% of the portfolio benchmark is in bonds with ratings below investment grade. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Q1 earnings season looks robust, but trade policy is an uncertainty. Sizeable shifts in equity technicals and sentiment since the start of the year; valuation still stretched. Global growth may have peaked but fiscal, monetary and legislative backdrop remains supportive. The market is coming to terms with President Trump's willingness to put his policies where his campaign rhetoric was, at least on trade policy. Feature Chart 1Despite Setback In March, ##br## U.S. Labor Market Remains Strong Despite Setback In March, U.S. Labor Market Remains Strong Despite Setback In March, U.S. Labor Market Remains Strong U.S. equity prices fell last week as trade policy remained on the front pages. Gold was one of the few beneficiaries of the tariff talk. Investors hope to turn the page this week as the Q1 2018 earnings season kicks into high gear, but trade-related market volatility is here to stay. The bar is high for 2018 earnings growth, and the focus may shift to the prospects for 2019 sooner rather than later. The modest selloff in the S&P 500 since late January led to a shift in sentiment, but the technical picture for U.S. equities is mixed. Global growth may be rolling over, but we find that risk assets perform well anyway, if fiscal, monetary and legislative policy is aligned. Trump's actions on tariffs do not mean that we are necessarily headed for a trade war. The tariffs proposed but both sides have not yet been implemented and there is still time for compromise. We do not see March's modest 103,000 increase in non-farm payrolls as signaling a weaker labor market. First, the monthly data can be volatile. The soft increase in March follows an outsized 326,000 gain in February. The 3-month average, more reflective of the underlying trend, is a solid 202,000. Second, average hourly earnings increased by 0.3% m/m, which nudged the annual wage inflation rate to 2.7% from 2.6%. Firming earnings growth is a sign of a strong labor market (Chart 1). Despite the soft increase in March payrolls, the U.S. labor market and economy are on a firm footing. Aggregate hours worked increased by 2.0% at a quarterly annualized rate in Q1. Such a pace is consistent with about 3% GDP growth. Firm growth will allow inflation to head back to the 2% target and allow the Fed to continue with its gradual rate hikes. S&P 500 Earnings: Q1 2018 The consensus expects an 18% year-over-year increase in the S&P 500's EPS in Q1 2018 versus Q1 2017, and 20% in 2018. Energy, materials, financials and technology will lead the way in earnings growth in Q1, while real estate and consumer discretionary will struggle. Excluding the energy sector, the consensus expects a stout 17% increase in profits. The robust profit environment for Q1 2018 and the year ahead reflects sharply higher oil prices compared with early 2017 and the impact of last year's Tax Cut and Jobs Act. Moreover, improved global growth and still modest labor costs will support the Q1 results. Trade policy will likely replace tax cuts as a key topic when corporate managements report Q1 outcomes and provide guidance for Q2 and beyond. While no tariffs have yet been imposed, analysts will want to understand the impact that the proposed actions will have on input costs and margins. Moreover, investors must gauge to what extent trade policy-related uncertainty is weighing on business sentiment (details below in "Trade Skirmish...Or Trade War?"). Market volatility, rising interest rates and the modest upswing in U.S. labor costs will also be discussed during the Q1 earnings calls. As always, guidance from corporate leaders for Q2 2018 and ahead are more important than the actual results for Q1 2018. The markets probably have already priced in a robust 2018 earnings profile due to the Tax Cut and Jobs Act, and are looking ahead to 2019 (Chart 2). Investors typically stay focused on the current calendar year's EPS through to at least Q3 before turning their attention to the next year. However, this year may be different. The consensus is looking for 10% EPS growth in 2019, a sharp deceleration from the 20% increase expected this year. Chart 2The Bar Is High For 2018 EPS, But The Focus Is On 2019 The Bar Is High For 2018 EPS, But The Focus Is On 2019 The Bar Is High For 2018 EPS, But The Focus Is On 2019 Chart 3 shows that elevated readings on the ISM provide a very favorable backdrop for EPS in 2018. As indicated in Chart 4, industrial production (IP), a proxy for S&P 500 sales, is poised to advance in 2018 and lift corporate profits. Industrial production growth may be peaking, but we don't expect it to soften much on a year-over-year basis. Chart 3Elevated ISM Good News For 2018 EPS Growth Elevated ISM Good News For 2018 EPS Growth Elevated ISM Good News For 2018 EPS Growth Chart 4Stout Readings On IP Support S&P 500 Revenue Gains Stout Readings On IP Support S&P 500 Revenue Gains Stout Readings On IP Support S&P 500 Revenue Gains Global GDP growth estimates for 2018 and 2019 continue to move steadily higher in sharp contrast with prior years when forecasters relentlessly lowered GDP estimates (Chart 5). Chart 5U.S. And Global Growth Estimates Are Still Accelerating... ##br## But For How Much Longer? U.S. And Global Growth Estimates Are Still Accelerating... But For How Much Longer? U.S. And Global Growth Estimates Are Still Accelerating... But For How Much Longer? Chart 6The Dollar Should Not Be A Big Concern ##br## In Q1 Earnings Season The Dollar Should Not Be A Big Concern In Q1 Earnings Season The Dollar Should Not Be A Big Concern In Q1 Earnings Season The greenback should not be an issue for corporate results in Q1 2018 based on minimal references to a robust dollar in the past six Beige Books. This significantly differs from 2015 and early 2016 when there were surges in Beige Book mentions (Chart 6). The last time that six consecutive Beige Books had so few remarks about a strong dollar was in late 2014. BCA's stance is that the dollar will move modestly higher in 2018. The appreciation would trim EPS growth by roughly 1 to 2 percentage points, although most of this would occur next year due to lagged effects. Movements in the U.S. dollar also explain the divergent paths of profits, sales and margins of domestically focused corporations versus globally oriented ones. In recent quarters, a modestly weaker dollar has allowed profit and sales gains of global firms to rebound and outpace those of domestic businesses (Chart 7). Margins for U.S. companies have been steady at record heights since 2014, while margins for global businesses dipped along with oil prices in 2014-2016, but rebounded last year and are higher than margins of domestic companies. Nonetheless, a slowdown in growth outside the U.S. may reverse these trends (Please read below, "Global Growth Has Peaked, Now What?"). Investors are skeptical that margins can advance in Q1 2018 for the seventh consecutive quarter. BCA's view is that we are in a temporary sweet spot for margins, which should continue for the next couple of quarters. However, the secular mean reversion of margins will resume beyond that time as wage pressures begin to percolate. Chart 7Global EPS, Margins Outpacing Domestic Global EPS, Margins Outpacing Domestic Global EPS, Margins Outpacing Domestic Chart 8Strong S&P Growth Ahead, Will Start To Slow Soon Strong S&P Growth Ahead, Will Start To Slow Soon Strong S&P Growth Ahead, Will Start To Slow Soon Bottom Line: BCA expects that the earnings backdrop will be supportive of equity prices in 2018 (Chart 8). However, investors may have already priced in the benefits of the Tax Cut and Jobs Act on corporate results and are focused on 2019 figures. EPS growth will be more of a headwind for stock prices as we enter 2019 (Chart 8). Stay overweight stocks versus bonds. Technical, Sentiment And Valuation Update BCA's Technical Indicator is not at an extreme (Chart 9, panel 1) and the 7.8% pullback in the S&P 500 since January 26, 2018 leaves the index in the middle of its recovery trend channel (panel 2). The failure of the index to break out of this channel earlier this year suggests that a period of consolidation for equities awaits. Moreover, the upward slope in the NYSE advance/decline line (panel 3) is in jeopardy. The final panel of Chart 9 shows that stocks are no longer extremely overvalued, but they remain overvalued nonetheless. Stretched valuations say more about medium- and long-term returns than near-term performance.1 Chart 9Technicals And Valuations For U.S. Equities Technicals And Valuations For U.S. Equities Technicals And Valuations For U.S. Equities Chart 10Bullish Sentiment Took A Hit In Early 2018 But Is Still Elevated Bullish Sentiment Took A Hit In Early 2018 But Is Still Elevated Bullish Sentiment Took A Hit In Early 2018 But Is Still Elevated The shift in the equity sentiment since the market top in January is notable. BCA's investor sentiment composite index, which hit an all-time high at the end January, has pulled back in the past few months (Chart 10, panel 1). However, this metric has not yet returned to its long-term average (solid line on top panel of Chart 10). The drop in sentiment is broadly based; individual investors and advisors who serve them (panels 2 and 4) along with traders (panel 3) have lately curtailed their bullishness. Recent shifts in several other sentiment surveys are also worth noting: The American Association of Individual Investors, a contrary indicator of sentiment, turned bullish in recent weeks. The percentage of respondents who were bearish moved above 30%, while the percentage of bulls dipped to 32%. Neither measure is at an extreme (Chart 11). The National Association of Active Investment Managers (NAAIM) says that active managers have reduced equity risk since the beginning of Q4 2017 (Chart 12). At 52%, the average equity exposure of institutional investors is at the lowest level since March 2016 and is nearly half the 102% exposure at the start of 2017. In contrast, the March 2017 reading was the highest since 2007, just before the S&P 500 peak in October 2007. As in previous bear markets, BCA's equity speculation index moved into "high speculation" territory in early 2017 and has remained there. The index is at its highest point since the 2000 market peak (Chart 13, panel 1). Moreover, net speculative positions of S&P 500 stocks are roughly in balance, but have turned net short in recent weeks. Nonetheless, this metric is not at an extreme (panel 3). Chart 11Individual Investors Have Turned More Bearish Individual Investors Have Turned More Bearish Individual Investors Have Turned More Bearish Chart 12Active Managers Still Overweight Equities... Active Managers Still Overweight Equities... Active Managers Still Overweight Equities... Chart 13Equity Speculation Is High... Equity Speculation Is High... Equity Speculation Is High... Chart 14Pullback Has Relieved Some Technical Pressure Pullback Has Relieved Some Technical Pressure Pullback Has Relieved Some Technical Pressure The S&P 500 is close to its 200-day moving average. In late 2017, this indicator was at the upper end of its post-2000 range (Chart 14, panel 1). BCA's composite technical measure is in the middle of the 2007-2017 range and is not a concern (Chart 14, panel 5). Moreover, the percentage of NYSE stocks above their 10- and 30-week highs are below average and at the low end of their recent ranges. Furthermore, new highs minus new lows is at neutral (panel 2). Bottom Line: The 7.8% pullback in the S&P 500 since January 26 has relieved some technical pressure on the market, and sentiment levels are less stretched than at the late January 2018 peak. Moreover, institutions have cut their equity exposures. Nonetheless, stock speculation is rampant and valuations are elevated, which suggests lower returns in the coming decade. Moreover, a slowdown in global growth in ongoing trade tensions suggest that the risk/reward balance for equities has deteriorated. Global Growth Has Peaked, Now What? Chart 15Is Global Growth Peaking? bca.usis_wr_2018_04_09_c15 bca.usis_wr_2018_04_09_c15 In last week's report we stated that while BCA expects global growth to be solid this year, there are signs that global growth may near a top.2 March's PMI data support that view. Chart 15 shows that the Markit Global PMI dipped to 53.4 in March from 54.1 in February; the 0.7 drop was the largest since February 2016 (panel 2). Last month,3 we discussed 5 episodes in the past 35 years when global growth surged and fiscal, monetary and regulatory policies were aligned to boost the U.S. economy. The current episode of synchronized policy commenced in January 2016. Risk assets perform well when these policy tailwinds are in place, but these assets tend to struggle for 12 months after the tailwinds abate. BCA expects the ongoing era of pro-growth policies to end next year as the Fed raises rates into restrictive territory. However, some investors wonder if the peak in global growth changes our view of how risk assets will perform during periods of harmonized policy. We do not expect the peak in global growth to lead to a recession this year or next. Chart 16 and Table 1 show the performance of U.S.-based financial assets, gold, oil, the dollar and S&P 500 earnings when Fed, fiscal and legislative policies are stimulative and global growth is rolling over but still positive. There has been only a handful of such episodes, so investors should be cautious when interpreting these results. The S&P 500 beats Treasuries, investment-grade and high-yield credit outperforms Treasuries, and small caps outpace large caps. Gold and oil perform well in these periods, perhaps aided by a weaker dollar. S&P 500 earnings are positive. Chart 16Positive Policy Backdrop As Global Growth Is Rolling Over Positive Policy Backdrop As Global Growth Is Rolling Over Positive Policy Backdrop As Global Growth Is Rolling Over Table 1Three Periods Where Global Growth Rolled Over But Policy Backdrop Was Stimulative Policy Peril? Policy Peril? Bottom Line: A peak in global growth reduces the risk/reward balance for risk assets, and provides another reason to be cautious. Equity valuation, although improved recently, is still stretched. Central banks are slowly removing the punchbowl, margins have limited upside and the economic cycle is at a late stage. Long-term investors should already be scaling back on risk. Short-term investors should stay overweight risk for now, on the view that fiscal stimulus will provide a tailwind for earnings for the remainder of the year. Trade Skirmish...Or Trade War? BCA's Geopolitical Strategy service notes4 that the market is coming to terms with President Trump's willingness to put his policies where his campaign rhetoric was, at least on trade policy. U.S. equities are down by 5.7% since the White House announced tariffs on steel and aluminum and 2.34% since it declared impending levies against China. Although we have cautioned clients since November 2016 that protectionism is a real risk to global growth and risk assets, the U.S. demands on China justify the moniker of a trade skirmish, rather than a full-on war. In view of our position, we think the 5.7% drawdown is appropriate, if a bit sanguine. President Trump remains unconstrained on trade policy, giving him leeway to be tougher than the market expects. Therefore, it is appropriate for the market to price in a 20%-30% probability of a trade war developing. Given that the market drawdown in such a scenario could be 20% or more, the market is appropriately discounting the risks. Why would a trade war between the U.S. and China elicit a bear market in U.S. equities when a similar confrontation in the 1980s between Japan and the U.S. did not? First, the overvaluation of stocks is much greater today. Secondly, interest rates are much lower, restricting how much policymakers can react to adverse risks. Thirdly, supply chains are much more integrated, both globally and between China and the U.S. The U.S. Administration's trade policy is not haphazard. President Trump and U.S. Trade Representative Robert Lighthizer are on the same page: they have made China, and not NAFTA trade partners or South Korea, the target of U.S. protectionism (Chart 17). Chart 17China, Not NAFTA, In The Crosshairs China, Not NAFTA, In The Crosshairs China, Not NAFTA, In The Crosshairs Table 2U.S. Gradually Exempting Allies From Tariffs Policy Peril? Policy Peril? The rapid pace at which the Administration pivoted from global tariffs to targeting China is an indication of what lies ahead. The U.S. uses the threat of tariffs to cajole its allies into tougher trade enforcement against China (Table 2). This strategy can work, as outlined last week,5 but there is plenty of room for mistakes. Trump also wants to change the U.S. policy on immigration and he may use NAFTA negotiations to gain leverage over Mexico. Therefore, there is a slight probability that Trump may trigger Article 2205 to leave NAFTA, but we believe the risk has declined substantively since our 50% estimate in November 2017. Bottom Line: The Trump Administration has pursued a well-considered but tough trade policy toward China. Nonetheless, Trump's actions do not mean that we are necessarily headed for a trade war. The tariffs proposed by both sides have not yet been implemented and there is still time for compromise. The U.S. Treasury will release a list of exemptions on May 1. On May 21, Treasury will reassess its list of China's investments in the U.S. and China will likely retaliate. June 5 marks the end of a 60-day negotiation period when the Administration must decide whether to implement the announced tariffs. There still is a 30% chance that the trade skirmish will morph into a trade war. Trump could significantly escalate matters if he declares a national emergency on trade in June. Expect more trade-related volatility in U.S. financial markets until that time. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Global Asset Allocation Special Report, "What Returns Can You Expect?", dated November 15, 2017, available at gaa.bcaresearch.com. 2 Please see BCA U.S. Investment Strategy Weekly Report, "Has Global Growth Peaked?", dated April 2, 2018, available at usis.bcaresearch.com. 3 Please see BCA U.S. Investment Strategy Weekly Report, "Policy Line Up", dated March 12, 2018, available at usis.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China", dated April 4, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Taiwan Is A Potential Black Swan", dated March 30, 2018, available at gps.bcaresearch.com.