Sectors

Neutral In our July 3rd Weekly Report, we made good on our recent upgrade alerts and raised the S&P pharma and biotech groups to neutral from underweight, locking in relative gains of 14.5% and 13.9%, respectively. In our report, we highlighted five key drivers for our more sanguine view, namely firming operating metrics, late cycle dynamics, likelihood of pricing power regulatory relief, the rising U.S. dollar and investor and analyst capitulation. With respect to the first of these, our pharma productivity proxy (industrial production / employment) is putting in its best performance of the past several years, implying that earnings seem likely to exceed the pessimistic sell-side estimates (second panel). This seems particularly likely as the pace of improvement in drug shipments exceeds inventory growth by a fairly wide margin (third and bottom panels). Bottom Line: Lift the S&P pharma and S&P biotech indexes to a benchmark allocation and remove the S&P pharma group from the high-conviction underweight list; see our Weekly Report for more details. The ticker symbols for the stocks in the S&P biotech and S&P pharma indexes are: BLBG: S5BIOTX - ABBV, AMGN, GILD, CELG, BIIB, VRTX, REGN, ALXN, INCY and BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO, NKTR, respectively. Operating Improvements Could Cure Pharmas Ills Operating Improvements Could Cure Pharmas Ills

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Ryan Swift, Vice President U.S. Bond Strategy Highlights Chart 1Inflations Expectations Hard To Shake Inflations Expectations Hard To Shake Inflations Expectations Hard To Shake Low inflation expectations are proving difficult to shake. Year-over-year core PCE inflation moved to within 5 bps of the Fed's 2% target in May, but long-maturity TIPS breakeven inflation rates barely budged (Chart 1). Instead, breakevens are taking cues from commodity prices which are being held down by flagging global growth (bottom panel). The minutes from the June FOMC meeting revealed that "one participant" advocated postponing rate hikes in an attempt to re-anchor inflation expectations, but we do not expect the Fed to pursue this course. Instead, the Fed will continue to lift rates at a pace of 25 bps per quarter until a risk-off episode in financial markets prompts a delay, hoping that the incoming inflation data are strong enough to send TIPS breakevens higher in the meantime. Ultimately we think that strategy will be successful, but Fed hawkishness in the face of weakening global growth threatens the near-term performance of corporate credit. We recommend only a neutral allocation to spread product versus Treasuries, while maintaining a below-benchmark duration bias. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 60 basis points in June, dragging year-to-date excess returns down to -181 bps. Value is no longer stretched in the investment grade corporate bond market, though it is not attractive enough to compensate for being in the late stages of the credit cycle or for the looming collision between a hawkish Fed and decelerating global growth. These factors led us to reduce exposure to corporate bonds two weeks ago.1 With inflation running close to the Fed's 2% target and the 2/10 Treasury slope between 0 bps and 50 bps, our research shows that small positive excess returns are the best case scenario for corporate bonds. The likelihood that leverage will rise in the second half of this year is also a concern (Chart 2). Profit growth is only just keeping pace with debt growth and will soon have to contend with rising wage costs and the drag from recent dollar strength. The Fed's staunch hawkishness in the face of decelerating global growth is reminiscent of 2015. Then, the end result was a period of spread widening that culminated in the Fed pausing its rate hike cycle. In recent weeks we also explored how to position within the investment grade corporate bond sector, considering both the maturity spectrum and the different credit tiers.2 We concluded that in the current environment investors should favor long maturities and maintain a balanced or slightly up-in-quality bias (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Deflationary Mindset The Deflationary Mindset Table 3BCorporate Sector Risk Vs. Reward* The Deflationary Mindset The Deflationary Mindset High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 40 basis points in June, bringing year-to-date excess returns up to +76 bps. The average index option-adjusted spread widened 1 bp on the month, and currently sits at 365 bps. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses has widened to 262 bps, just above its long-run mean (Chart 3). This tells us that if default losses during the next 12 months are in line with our expectations, we should expect excess high-yield returns of 262 bps over duration-matched Treasuries, assuming also that there are no capital gains/losses from spread tightening/widening. However, we showed in last week's report that the default loss expectations embedded in our calculation are extremely low relative to history (panel 4).3 Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.03% during the next 12 months. The only historical period to show significantly lower default losses was 2007, a time when corporate balance sheets were in much better shape than they are today. While most indicators suggest that default losses will in fact remain low for the next 12 months, historical context clearly demonstrates that the risks to that forecast are to the upside. It will be critically important to track real-time indicators of the default rate such as job cut announcements, which remain low relative to history but have perked up in recent months (bottom panel), for signals about whether current default forecasts are overly optimistic. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in June, bringing year-to-date excess returns up to -24 bps. The conventional 30-year zero-volatility MBS spread widened 1 bp on the month, driven entirely by a 1 bp widening of the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) held flat. The MBS option-adjusted spread has widened since the beginning of the year (Chart 4), though by much less than the investment grade corporate bond spread (panel 3). The year-to-date OAS widening has been offset by a contraction in the option cost component of spreads, and this has kept the overall nominal MBS spread flat at very tight levels (bottom panel). Going forward, rising interest rates will limit mortgage refinancing activity and this will ensure that MBS spreads remain low. In other words, while MBS valuation is not attractive, the downside is limited. Our Bond Maps show an unfavorable risk/reward trade-off in the MBS sector. This analysis, based on volatility-adjusted breakeven spreads, shows that only 7 days of average spread widening are required for the MBS sector to lose 100 bps versus duration-matched Treasuries. While this speaks to the low spread buffer built into current MBS valuations, the message from the Bond Map must be weighed against the macro outlook which suggests that the odds of significant spread widening are quite low. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 5 basis points in June, bringing year-to-date excess returns up to -35 bps. Sovereign debt outperformed the Treasury benchmark by 33 bps on the month, bringing year-to-date excess returns up to -210 bps. Foreign Agencies outperformed by 10 bps on the month, bringing year-to-date excess returns up to -46 bps. Local Authorities underperformed by 9 bps on the month, dragging year-to-date excess returns down to +28 bps. Supranationals outperformed by 5 bps on the month, bringing year-to-date excess returns up to +7 bps. Domestic Agency bonds underperformed by 7 bps, dragging year-to-date excess returns down to zero. The escalating tit-for-tat trade war and increasing divergence between U.S. and non-U.S. growth is a clear negative for USD-denominated Sovereign debt. Relative valuation also shows that U.S. corporate bonds are more attractive than similarly rated Sovereigns (Chart 5). Maintain an underweight allocation to Sovereign debt. Within the universe of Emerging Market Sovereign debt, we showed in a recent report that only Russian debt offers an attractive spread relative to the U.S. corporate sector.4 In contrast, the Foreign Agency and Local Authority sectors continue to offer a favorable risk/reward trade-off compared to other fixed income sectors (please see the Bond Maps). Maintain overweight allocations to these two sectors. The Bond Maps also show that the Supranational and Domestic Agency sectors are very low risk, but offer feeble return potential compared to other sectors. The Supranational and Domestic Agency sectors should be avoided. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 10 basis points in June, bringing year-to-date excess returns up to +120 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio fell 1% in June to reach 85%, close to one standard deviation below its post-crisis mean. It is also only slightly higher than the average 81% level that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. The technical picture remains favorable for Muni / Treasury yield ratios. Fund inflows increased in recent weeks, and visible supply has contracted substantially compared to this time last year (Chart 6). State & local government credit fundamentals are also fairly robust. Net borrowing is on the decline and this should ensure that municipal ratings upgrades continue to outpace downgrades (bottom panel). Despite relatively tight valuation compared to history, the Total Return Bond Map on page 16 shows that municipal bonds offer a fairly attractive risk/reward trade-off compared to other U.S. fixed income sectors, particularly for investors exposed to the top marginal tax rate. Given the favorable reading from our Bond Map and the steadily improving credit fundamentals, we recommend an overweight allocation to Municipal bonds. Treasury Curve: Favor 7-Year Bullet Over 1/20 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened in June. The 2/10 Treasury slope flattened 10 bps and the 5/30 slope flattened 7 bps. At present, the 2/10 slope sits at 29 bps, its flattest level of the cycle. The yield curve has flattened relentlessly in recent months as the impact of Fed rate hikes at the short-end of the curve have not been offset by higher inflation expectations at the long end. As explained in a recent report, we think it is unlikely that curve flattening can maintain this rapid pace.5 At 2.34%, the 1-year Treasury yield is already priced for 100 bps of Fed rate hikes during the next 12 months, assuming no term premium. Meanwhile, long-maturity TIPS breakeven inflation rates remain below levels that are consistent with the Fed's 2% inflation target. While curve flattening will proceed as the Fed lifts rates, higher breakeven inflation rates at the long-end of the curve will offset some flattening pressure during the next few months. With that in mind, we continue to recommend a position long the 7-year bullet and short the duration-matched 1/20 barbell. According to our models, this butterfly spread currently discounts 41 bps of 1/20 curve flattening during the next six months (Chart 7). This is considerably more than what is likely to occur. Table 4 of this report shows the output from our valuation models for each butterfly combination across the entire yield curve, as explained in a recent Special Report.6 Table 4Butterfly Strategy Valuation (As Of July 6, 2018) The Deflationary Mindset The Deflationary Mindset TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 35 basis points in June, bringing year-to-date excess returns up to +129 bps. The 10-year TIPS breakeven inflation rate increased 4 bps on the month and currently sits at 2.12%. The 5-year/5-year forward TIPS breakeven inflation rate increased 5 bps and currently sits at 2.16% (Chart 8). Both the 10-year and 5-year/5-year TIPS breakeven inflation rates remain below the range of 2.3% to 2.5% that has historically been consistent with inflation expectations that are well-anchored around the Fed's 2% target. We expect breakevens will return to that target range as investors become increasingly convinced that the risk of deflation has faded. Consistent inflation prints at or above the Fed's 2% target will be the deciding factor that eventually leads to this upward re-rating of inflation expectations. In that regard, the current outlook is promising. Core PCE inflation has printed above the 0.17% month-over-month level that is consistent with 2% annual inflation in four of the past five months (panel 4). Year-over-year trimmed mean PCE inflation is at 1.84% and should continue to rise based on the 2.03% reading from the 6-month trimmed mean PCE (bottom panel). Finally, our Pipeline Inflation Indicator continues to point toward mounting inflationary pressures in the economy (panel 3). Maintain an overweight allocation to TIPS relative to nominal Treasury securities. We will reduce exposure to TIPS once long-maturity TIPS breakeven inflation rates return to our 2.3% to 2.5% target range. ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 1 basis point in June, bringing year-to-date excess returns up to -2 bps. The index option-adjusted spread for Aaa-rated ABS widened 2 bps on the month and now stands at 43 bps, 16 bps above its pre-crisis low. The Bond Maps show that consumer ABS continue to offer relatively attractive return potential compared to other low-risk spread products. However, we maintain only a neutral allocation to this space because credit quality trends are moving against the sector. The household debt service ratio on consumer credit ticked down slightly in the first quarter, but its multi-year uptrend remains intact (Chart 9). Consumer credit delinquency rates follow the household debt service ratio with a lag. Meanwhile, banks are noticing the decline in credit quality and have begun tightening lending standards (bottom panel). Tighter lending standards tend to coincide with upward pressure on delinquencies and spreads. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 11 basis points in June, dragging year-to-date excess returns down to +61 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 4 bps on the month and currently sits at 74 bps (Chart 10). The gap between decelerating commercial real estate prices and tight CMBS spreads continues to send a worrying signal for CMBS (panel 3). However, delinquencies continue to decline and banks recently started to ease lending standards on nonfarm nonresidential loans (bottom panel). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 6 basis points in June, dragging year-to-date excess returns down to +6 bps. The index option-adjusted spread widened 2 bps on the month and currently sits at 51 bps. The Bond Maps show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this defensive sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of July 6, 2018) The Deflationary Mindset The Deflationary Mindset Chart 12Total Return Bond Map (As Of July 6, 2018) The Deflationary Mindset The Deflationary Mindset Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, for further details on positioning across different credit tiers. Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, for further details on positioning across the maturity spectrum. Both reports available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Threats & Opportunities In Emerging Markets", dated June 12, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

A number of factors have fallen into place, allowing an exploitable market- and industry-neutral opportunity to surface by going long the S&P homebuilding index/short the S&P REITs index. Our thesis is supported by four key pillars: Favorable macro tailwinds for residential vs. commercial real estate (prices, credit, interest rates), Firm relative demand dynamics, Supportive relative supply backdrop, Compelling relative valuations and technicals. With respect to the first of these, we show in our chart at the side that real commercial real estate (CRE) prices have overtaken the previous top, whereas house prices deflated by inflation remain significantly below the 2006 zenith. In nominal terms, CRE prices are one standard deviation above the previous high, while residential real estate prices just recently made all-time highs. The implication is that the pricey CRE sector is relatively more vulnerable to a downturn. Bottom Line: We initiated a long S&P homebuilding/short S&P REITs pair trade yesterday. Please see Monday's Special Report for more details. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME - LEN, PHM, DHI and BLBG: S5REITS - IRM, MAA, AMT, BXP, PLD, ESS, CCI, PSA, O, VTR, VNO, WY, EQIX, DLR, EXR, DRE, FRT, WELL, SBAC, HCP, GGP, KIM, EQR, UDR, REG, MAC, HST, SPG, AVB, AIV, SLG, ARE, respectively. UnReal Estate Opportunity UnReal Estate Opportunity

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA’s Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA’s 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA’s Geopolitical Strategy (GPS) in 2012. It is the financial industry’s only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers’ options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA’s Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating “geopolitical alpha;” Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant “war games,” which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Anastasios Avgeriou, Vice President U.S. Equity Strategy An exploitable market- and industry-neutral opportunity has surfaced to generate alpha by going long the S&P homebuilding index/short the S&P REITs index. This ratio has only recently reclaimed its upward sloping long-term time trend, leaving ample room for additional gains as the business cycle is long in the tooth (Chart 1). Chart 1Ratio Is Only Back To Trend Line Ratio Is Only Back To Trend Line Ratio Is Only Back To Trend Line Four key pillars form the thesis for this intra-real estate pair trade: Favorable macro tailwinds for residential vs. commercial real estate (prices, credit, interest rates), Firm relative demand dynamics, Supportive relative supply backdrop, Compelling relative valuations and technicals. Of Prices, Credit And Rates... Commercial real estate (CRE) is in a slightly different stage of the real estate cycle than its brethren, the residential real estate sector. Chart 2 shows that real CRE prices have overtaken the previous top, whereas house prices deflated by inflation remain significantly below the 2006 zenith. In nominal terms, CRE prices are one standard deviation above the previous high, while residential real estate prices just recently made all-time highs. This makes the CRE sector extremely vulnerable, as there is no cushion for any potential mishap. Importantly, our CRE occupancy rate composite has peaked for the cycle and is actually contracting, warning that CRE prices will likely suffer the same fate (bottom panel, Chart 3). The residential occupancy rate is the mirror image of the CRE one. Not only are new plus existing home inventories extremely tight by historical standards in the housing market, but the ultra-low vacancy rate is also a harbinger of additional house price gains in the coming months (top two panels, Chart 3). Chart 2Trade Opportunity In Diverging... Trade Opportunity In Diverging... Trade Opportunity In Diverging... Chart 3...Real Estate Markets ...Real Estate Markets ...Real Estate Markets As with every bubble, ultra-cheap credit has fueled the excesses in the CRE sector. Total CRE credit outstanding has ballooned to over $2.1tn, and comprises more than half of the commercial banks' overall real estate loan portfolios (Chart 4). While CRE loan growth is no longer galloping north of 10%/annum, it is still expanding. The stock of residential real estate loans on U.S. commercial bank's balance sheets also hit fresh all-time highs recently, but CRE dwarfs its residential cousin both in growth and level terms. Real estate investors know all too well that, ultimately, rising interest rates prick bubbles and the specter of tightening monetary policy concentrates minds. While both sectors will suffer from rising interest rates, given that the excesses this cycle are concentrated in CRE, in a relative sense, residential real estate is more insulated from a hawkish Fed (Chart 5). Keep in mind that housing was at the epicenter of the Great Recession, a once in a life time crisis, whose ramifications are still reverberating across the financial system one decade later. We doubt another big bust looms large in the residential real estate market. Chart 5 also shows that relative share prices are not only positively correlated with the fed funds rate, but also with the 10-year Treasury yield. True, rising 10-year interest rates filter right through to 30-year fixed mortgages denting housing affordability, but homebuilders are less sensitive to interest rates than REITs. Thus, a rising interest rate backdrop, which remains one of BCA's key themes for the year, is not detrimental to the relative share price ratio, but conducive to relative gains. In more detail, rising interest rates are likely to cause more pain in CRE than in the residential market, given the different starting points for delinquencies. Chart 6 shows a steep divergence between the two real estate sectors in their respective delinquency rates. In fact, since data is available, the CRE delinquency rate has never been lower than its current 0.75%. The Fed continues to raise interest rates, but some CRE borrowers are having trouble serviving this debt as rental income growth (for more details refer to the supply section below) is under pressure. Thus, delinquency rates, charge-offs and foreclosures will shoot higher. Chart 4CRE Excesses This Cycle CRE Excesses This Cycle CRE Excesses This Cycle Chart 5Higher Interest Rates Are A Boon For The Ratio Higher Interest Rates Are A Boon For The Ratio Higher Interest Rates Are A Boon For The Ratio Chart 6Unsustainably Low CRE Delinquencies Unsustainably Low CRE Delinquencies Unsustainably Low CRE Delinquencies What About Relative Demand... On the demand front, our comparative demand proxy also corroborates the positive correlation of relative share prices with interest rates. Rising interest rates deal a blow to refinancing mortgage applications, but do not prohibit first-time homebuyers from making one of the largest purchase decisions of their lives (Chart 7). Moreover, there is a preference switch that is gaining steam on the horizon. The own versus rent dilemma has likely hit a multi-decade nadir. Rising job certainty and wages at a time when the economy is at full employment argue for a switch out of rent and into home ownership. Already, the ratio of home owners to renters has gone from 1.7 to 1.8 in the past 18 months; yet, it is still hovering near a generationally low level. Put differently, only 64.2% of the housing stock are owners and 35.8% are renters. This differential remains depressed and if there is a modest renormalization toward the historical mean, the ratio would have to revert closer to 1.9, and thus further lift relative share prices (Chart 8). Chart 7Relative ##br##Demand... Relative Demand... Relative Demand... Chart 8...Gauges Favor Residential Vs.##br## Commercial Real Estate ...Gauges Favor Residential Vs. Commercial Real Estate ...Gauges Favor Residential Vs. Commercial Real Estate ...And Supply Backdrops? The relative supply backdrop also favors homebuilders versus REITs. Multi-family housing starts have been running near previous cyclical peak levels and 33% above the historical mean for the better part of the past five years adding roughly 2mn apartment units in aggregate. In contrast, single family home construction has been in recovery mode and continues to trail its historical average, with single family housing starts also adding a similar amount of units since 2013. To put this number in perspective, on average single family home construction should be triple multi-family starts (Chart 9). This construction backdrop does not bode well for CRE prices relative to residential real estate prices. Another related source of CRE pricing pressures are CRE rents. Rental income is in danger of stalling from this massive multi-family supply overhang and so is REITs cash flow growth. The opposite is happening in residential housing. Household formation is still running higher than housing starts, underscoring that recent house price inflation rests on a solid foundation. Chart 9Mind The Massive CRE Supply Overhang Mind The Massive CRE Supply Overhang Mind The Massive CRE Supply Overhang Chart 10Alluring Entry Point Alluring Entry Point Alluring Entry Point Compelling Entry Point One final reason why we are warming up to this pair trade is valuations and technicals. Relative value has been restored with our Valuation Indicator correcting to one standard deviation below the historical mean, offering investors a great reward/risk tradeoff. Similarly, technicals are no longer waving a red flag; our Technical Indicator has also unwound extremely overbought conditions and recently sunk below the neutral line (Chart 10). Risks To Monitor Chart 11Monitor This Risk Monitor This Risk Monitor This Risk Nevertheless, there are two key risks that can put our thesis, and thus the relative share price ratio, offside. While both sectors are 100% domestically geared and appear insulated from all the trade war / protectionism risks, homebuilders have to contend with rising input costs both in terms of building materials (lumber in particular, as well as concrete and steel), but also with rising construction-related wage inflation. REITs, in contrast, are free of both such risks. Most importantly, the Fed's Senior Loan Officer Survey is waving yellow flags. Both in terms of demand for respective loans and bankers' willingness to extend credit, CRE has the upper hand. While loan officers are tightening standards in CRE and mortgage loans, they are more prudent with credit origination in residential housing than in CRE. Similarly in a relative sense, bankers are reporting a steeper decline in demand for residential mortgages than for CRE loans (Chart 11). Adding it up, four key drivers - favorable macro tailwinds for residential versus commercial real estate on the price, credit and interest rate fronts, firming relative demand dynamics, supportive relative supply backdrop and appealing relative valuations and technicals - argue for opening a long S&P homebuilders/short S&P REITs pair trade. Bottom Line: Initiate a long S&P homebuilding/short S&P REITs pair trade today. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME - LEN, PHM, DHI and BLBG: S5REITS - IRM, MAA, AMT, BXP, PLD, ESS, CCI, PSA, O, VTR, VNO, WY, EQIX, DLR, EXR, DRE, FRT, WELL, SBAC, HCP, GGP, KIM, EQR, UDR, REG, MAC, HST, SPG, AVB, AIV, SLG, ARE, respectively. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA’s Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA’s 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA’s Geopolitical Strategy (GPS) in 2012. It is the financial industry’s only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers’ options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA’s Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating “geopolitical alpha;” Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant “war games,” which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Peter Berezin, Chief Global Strategist U.S. Housing Will Drive The Global Business Cycle... Again Highlights Housing is the main channel through which changes in U.S. monetary policy affect the real economy. The U.S. housing sector is in good shape, which means that the Fed will be able to raise rates more than the market anticipates. The Fed's tightening efforts are coming at a time when cyclical factors are raising the neutral rate of interest. Higher U.S. rates will push up the dollar, which will adversely affect emerging markets. Stay overweight developed market equities relative to their EM peers, while underweighting deep cyclical sectors relative to defensives. Feature U.S. Housing Back In The Spotlight The Global Financial Crisis began in the U.S. and quickly spread to the rest of the world. The U.S. housing market was at the epicenter of the last crisis and it could be the main source of global financial turbulence once again. Unlike ten years ago however, the problem is not that U.S. housing has become too vulnerable to a downturn. Rather, the problem, as we explain below, is that housing has become too resilient. Housing starts were slow to recover after the Great Recession. To this day, they are still 40% below their 2006 peak (Chart 1). As a result, the homeowner vacancy rate stands at only 1.5%, the lowest level since 2001. Mortgage lenders remain guarded. The ratio of mortgage debt-to-disposable income is 31 percentage points below where it stood in 2007. Mortgage-servicing costs, expressed as a share of disposable income, are near all-time lows. FICO scores among new borrowers are well above pre-crisis levels. The Urban Institute's Housing Credit Availability Index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, remains in extremely healthy territory (Chart 2). Chart 1No Oversupply Of U.S. Homes No Oversupply Of U.S. Homes No Oversupply Of U.S. Homes Chart 2Mortgage Lenders Are Being Prudent Mortgage Lenders Are Being Prudent Mortgage Lenders Are Being Prudent Housing And The Monetary Transmission Mechanism Chart 3Residential Investment Collapsed ##br##In Response To Higher Interest Rates##br## In The Early 80s... While Business Investment ##br##Was Barely Affected Residential Investment Collapsed In Response To Higher Interest Rates In The Early 80s... While Business Investment Was Barely Affected Residential Investment Collapsed In Response To Higher Interest Rates In The Early 80s... While Business Investment Was Barely Affected Housing is the main channel through which the Federal Reserve affects the real economy. When the Fed hiked rates in the early 1980s, residential investment collapsed but business investment barely contracted (Chart 3). "Housing is the business cycle," as Ed Leamer likes to say. To quote Leamer's timely 2007 Jackson Hole paper:1 Of the components of GDP, residential investment offers by far the best early warning sign of an oncoming recession. Since World War II we have had eight recessions preceded by substantial problems in housing and consumer durables. Housing did not give an early warning of the Department of Defense Downturn after the Korean Armistice in 1953 or the Internet Comeuppance in 2001, nor should it have. By virtue of its prominence in our recessions, it makes sense for housing to play a prominent role in the conduct of monetary policy. Neutral Rate: Structural Versus Cyclical Chart 4Market Expectations Versus The Fed Dots Market Expectations Versus The Fed Dots Market Expectations Versus The Fed Dots The market is pricing in only 90 basis points in rate hikes between now and the end of 2020 (Chart 4). Yet, if U.S. housing is in as good shape as it appears, what is stopping the Fed from hiking rates much more than investors currently anticipate? The answer, one presumes, is that most investors share Larry Summers' view that the neutral rate of interest is very low. We have a great deal of sympathy for Summers' position. In fact, we ourselves have argued many times that a variety of secular factors are pushing down the neutral rate of interest. These include slower potential GDP growth, the shift to a capital-lite economy, and high levels of income inequality. That said, it is critical to distinguish between the secular and cyclical determinants of the neutral rate. While secular factors are pushing down the neutral rate, cyclical factors are pushing it up. Credit And Household Wealth On The Upswing Credit is one such cyclical factor. Private credit is now growing faster than GDP. The ratio of nonfinancial private debt-to-GDP has increased by an average of 1.2 percentage points during the past three years, which is close to its historic trend (Chart 5). Not all the new credit is used to finance domestic spending - some of it can flow into imports as well as the purchase of financial assets - but if one assumes that every additional dollar of credit boosts domestic demand by 50 cents, today's pace of credit growth is adding 0.6% of GDP to aggregate demand relative to a situation where the ratio of credit-to-GDP is stable.2 In addition, housing and equity wealth have been rising much more quickly than GDP. Household real estate wealth fell from a peak of 182% of GDP in 2006 to 115% of GDP in 2012. It has since clawed its way back to 142% of GDP, equivalent to where it stood in 2002. Equity wealth reached nearly 150% of GDP earlier this year, on par with the prior peak set in 2000. Historically, there has been a robust relationship between the ratio of household net worth-to-disposable income and the personal savings rate (Chart 6). At present, the former stands at an all-time high. This helps explain today's low savings rate. All things equal, a lower savings rate implies more desired spending which, in turn, implies a higher neutral rate of interest.3 Chart 5Rising Household Credit And Wealth Rising Household Credit And Wealth Rising Household Credit And Wealth Chart 6High Net Worth Explains Today's Low Savings Rate U.S. Housing Will Drive The Global Business Cycle... Again U.S. Housing Will Drive The Global Business Cycle... Again Loose Fiscal Policy Warrants A Higher Neutral Rate U.S. fiscal policy has also become extremely stimulative. The IMF estimates that the cyclically-adjusted primary budget deficit will reach 4.2% of GDP in 2019, a deterioration from a deficit of 1.7% of GDP in 2015. That is more accommodative than Japan, which is set to have a deficit of 2.7% of GDP next year; or the euro area, which is expected to record a surplus of 0.8% of GDP (Chart 7). Assuming a fiscal multiplier of one, fiscal policy will add a whopping 5% more to aggregate demand in the U.S. than in the euro area next year. If one combines this fact with all the other reasons we have listed for why the neutral rate is higher in the U.S. than the euro area, the market's expectation that the ECB will be hard-pressed to raise rates by very much over the next few years is probably not far from the mark.4 An Overheated Economy Will Lift The Neutral Rate The fact that the U.S. jobless rate has fallen below most estimates of full employment means that the Fed may have to bring rates above their neutral level for a while to cool the economy. An overheated economy may also push up the neutral rate itself, at least temporarily. Chart 8 shows that labor's share of income rose during the late 1990s, as businesses were forced to pay higher wages to attract workers. Workers tend to spend more of every dollar of income than companies. Thus, any shift in the distribution of income towards the former raises aggregate demand. Chart 7U.S. Fiscal Policy Is More Stimulative Than Abroad U.S. Fiscal Policy Is More Stimulative Than Abroad U.S. Fiscal Policy Is More Stimulative Than Abroad Chart 8Tight Labor Market And Rising Labor Share Of Income: ##br##A Replay Of The 1990s? Tight Labor Market And Rising Labor Share Of Income: A Replay Of The 1990s? Tight Labor Market And Rising Labor Share Of Income: A Replay Of The 1990s? Today, employers are complaining about a "shortage" of qualified workers. While the business press usually takes such comments at face value, the word "shortage" is highly misleading. Except in a few isolated cases, the number of workers a company employs is much smaller than the number of qualified workers it could theoretically hire. Even the internet giants compete for the same well-educated, tech-savvy workers. When companies say they cannot find good workers, what they usually mean is that they do not want to raise wages to entice good workers to move from competing firms. Fortunately for potential job-switchers, that is starting to change. The difference between wage growth among job switchers and job stayers in the Atlanta Fed's Wage Growth Tracker has risen to close to where it was in 2000 (Chart 9). Surveys suggest that companies are increasingly willing to raise wages (Chart 10). Higher wages and falling unemployment will boost spending, raise consumer confidence, and probably further supercharge the housing market. Chart 9Things Are Perking Up For Job Switchers Things Are Perking Up For Job Switchers Things Are Perking Up For Job Switchers Chart 10Surveys Show Employers More Willing To Raise Compensation Surveys Show Employers More Willing To Raise Compensation Surveys Show Employers More Willing To Raise Compensation Investment Considerations The 30-year U.S. prime mortgage rate has risen from a low of 3.78% last September to 4.55% at present, but still remains more than 2.5 percentage points below where it stood in 2006. In real terms, today's mortgage rate is significantly lower than the average rate since 1980 (Chart 11). For the first time in a decade, the Federal Reserve wants to slow GDP growth to prevent the economy from overheating. This means the Fed must tighten financial conditions. If housing does not buckle as the Fed raises rates, the tightening in financial conditions must come through a stronger dollar, higher corporate borrowing costs, and lower equity prices. We remain long the dollar and recently downgraded global equities from overweight to neutral. We also recommended that clients cut exposure to credit. Chart 12 shows that a rising dollar usually corresponds to wider high-yield corporate bond spreads. Chart 11U.S. Mortgage Rates Are Still Low U.S. Mortgage Rates Are Still Low U.S. Mortgage Rates Are Still Low Chart 12Rising Dollar Usually Corresponds ##br##To Wider High-Yield Spreads Rising Dollar Usually Corresponds To Wider High-Yield Spreads Rising Dollar Usually Corresponds To Wider High-Yield Spreads The rest of the world will feel the repercussions of Fed tightening, perhaps even more so than the U.S. itself. Emerging market equities almost always fall when U.S. financial conditions are tightening (Chart 13). One can believe that EM stocks will go up; one can also believe that the Fed will do its job and tighten financial conditions in order to prevent the U.S. economy from boiling over. One cannot believe that both these things will happen at the same time. As a share of GDP, dollar-denominated debt in emerging markets is now back to late-1990s levels (Chart 14). Local-currency debt has also mushroomed (Chart 15). This puts emerging market policymakers in the unenviable position of having to decide whether to hurt domestic borrowers by hiking rates or keeping rates low and risking a steep devaluation of their currencies. Neither outcome would be good for EM assets. As such, equity investors should overweight developed market stocks over their EM peers. An underweight in global cyclical sectors relative to defensives is also appropriate at this juncture. Chart 13Tightening U.S. Financial Conditions ##br##Do Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Chart 14EM Dollar Debt Is High EM Dollar Debt Is High EM Dollar Debt Is High Chart 15EM Local Credit Is High Too EM Local Credit Is High Too EM Local Credit Is High Too Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Edward E. Leamer, "Housing Is The Business Cycle," Proceedings, Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, (2007). 2 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). Thus, credit growth affects GDP and, by extension, the change in credit growth (the so-called credit impulse) affects GDP growth. 3 Conceptually, one can see the relationship between the savings rate and the neutral rate of interest in the Solow Growth Model. For example, the neutral real rate of interest, r*, in the Model is equal to (a/s) (n + g + d), where a is the capital share of income, s is the savings rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. An increase in the savings rate reduces the neutral rate. 4 Please see Global Investment Strategy Weekly Report, "The U.S. Needs A Stronger Dollar," dated May 4, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA’s Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA’s 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA’s Geopolitical Strategy (GPS) in 2012. It is the financial industry’s only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers’ options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA’s Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating “geopolitical alpha;” Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant “war games,” which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Mathieu Savary, Foreign Exchange Strategist Highlights On a short-term basis, the dollar is massively overextended and is likely to experience a correction over the coming weeks. EM assets and currencies are the anti-dollar, and will benefit from these dynamics. As a result, oversold commodity currencies like the AUD, CAD, and NZD should be the main beneficiaries of a dollar correction within the G-10 FX space. However, this bout of dollar weakness is unlikely to mark the end of the greenback's 2018 rally. Global liquidity conditions remain very dollar bullish as the U.S. economy is absorbing liquidity from the rest of the world. This creates a scarcity of greenbacks in international markets. It is also dollar bullish because it weighs on the outlook for global growth, flattering the countercyclical nature of the USD. Gold should be the key gauge to judge whether these dynamics will be playing out as we foresee. Feature The last quarter was dominated by the dollar's strength and weakness in EM bonds; weakness that has now spread to EM equities. After such violent moves, it is now time to reflect and to try to understand what the second half of the year may have in store for the dollar. In our view, the dollar move has become overextended. As a result, we anticipate the dollar to experience a correction over the course of the coming months - a move that should benefit risk assets, and EM plays in particular. However, while this correction is likely to be playable for tactical traders, this does not spell the end of the dollar rally and EM selloff. The global liquidity backdrop supports a continuation of the trends seen over the past few months. Short-Term Momentum Extremes The vigor of the dollar rally this year along with the violence of EM bond, currency and equity selling has been eye-catching. However, we are seeing many signs that these moves may have become overdone on a short-term basis. Let's begin with EM assets. EM assets are very important due to their high sensitivity to global liquidity, global growth and the dollar. The market breadth of EM stocks is near its most oversold levels since the financial crisis. This suggests that commodity currencies are likely to experience a relief rally in the coming weeks (Chart I-1). In fact, both the MACD and 14-day RSI oscillators of EM stocks are corroborating this message, having hit some of their lowest levels since 2016 (Chart I-2). Such a rebound could be especially beneficial for the AUD, NZD, and CAD, as speculators have accumulated large short positions in these currencies (Chart I-3). Chart I-1EM Are ##br##Oversold EM Are Oversold EM Are Oversold Chart I-2EM Oscillators Point##br## To A Rebound EM Oscillators Point To A Rebound EM Oscillators Point To A Rebound Chart I-3More Reasons For The AUD ##br##And His Friends To Rebound More Reasons For The AUD And His Friends To Rebound More Reasons For The AUD And His Friends To Rebound The key for this rally to unfold will be U.S. dollar weakness - a correction that we feel is likely to materialize. From a technical perspective, our dollar capitulation index is currently flagging massively overbought conditions, a picture that our intermediate-term indicator also highlights (Chart I-4). Looking at the euro - the largest constituent of the DXY dollar index - provides a mirror image. The EUR/USD's intermediate-term momentum measure is flagging deeply oversold levels, and the paucity of up days in this pair over the recent month is also congruent with a temporary bottom (Chart I-5). In fact, shorter-term indicators like the MACD and 14-day RSI oscillators have not only reached deeply oversold readings, but have also recently begun to form positive divergences with the price of EUR/USD itself (Chart I-6). Chart I-4The Dollar Should Correct The Dollar Should Correct The Dollar Should Correct Chart I-5Euro Is The Anti-Dollar Euro Is The Anti-Dollar Euro Is The Anti-Dollar Chart I-6Positive Divergences In The Euro Positive Divergences In The Euro Positive Divergences In The Euro What could be a catalyst for a dollar correction that would also help EM assets and thus provide a welcome boost to the euro, and even more so commodity currencies? China obviously plays a key role. One of the crucial ingredients behind the recent generalized USD strength and selloff in EM-related plays has been the rapid fall in the yuan against the dollar. As we argued last week, this remains a key risk for the remainder of the year. However, we also prophesized that Beijing is concerned by the speed of the recent decline, and could try to manage the pace of CNY's fall for now.1 Early this week, the People's Bank of China began "open-mouth" operations in an effort to support the RMB, which seems to be putting a temporary floor under the renminbi. As long as the dam resists, the DXY's rally will pause. Additionally, the speed of the divergence between U.S. growth and the rest of the world has probably reached a short-term peak that will temporarily get reversed. As Chart I-7 illustrates, European, Japanese and Australian economic surprises are attempting to form a bottom, while U.S. ones have just moved below the zero line. Finally, the dollar is likely to lose one of its key supports from last quarter: the U.S. Treasury. As Chart I-8 illustrates, when the Treasury rebuilds its cash balances, the dollar does well. Essentially, through 2017, the Treasury was draining its cash balance ahead of the debt-ceiling standoff. By spending its stash of cash, the U.S. federal government was injecting reserves - in effect liquidity - into the banking system. After the debt-ceiling extension last September, the Treasury proceeded to rebuild its pile of funds, draining reserves and liquidity out of the banking system. This process is now over, and therefore this support for the dollar will continue to fade. Chart I-7Economic Surprises And The Dollar: ##br##From Friends To Foes Economic Surprises And The Dollar: From Friends To Foes Economic Surprises And The Dollar: From Friends To Foes Chart I-8The U.S. Treasury Is Done Rebalancing##br## Its Cash Balance The U.S. Treasury Is Done Rebalancing Its Cash Balance The U.S. Treasury Is Done Rebalancing Its Cash Balance Altogether, these dynamics are likely to cause the dollar to soften in the near term, especially since, as Dhaval Joshi highlighted in BCA's European Investment Strategy, currency market players are displaying a high degree of groupthink - as measured by the trade-weighted dollar's fractal dimension - and could easily be panicked by a defusing of the growth divergence theme (Chart I-9). Chart I-9Group Think In The Dollar = Hightended Risk Of Countertrend Group Think In The Dollar = Hightended Risk Of Countertrend Group Think In The Dollar = Hightended Risk Of Countertrend Bottom Line: The dominant trends of the second quarter - a strong dollar, weak commodity currencies and EM plays - are now crowded trades. With the Chinese monetary authorities trying to limit the speed of the CNY's decline, with economic surprises outside the U.S. finding a floor, and with the U.S. Treasury backing away from reducing liquidity in the banking system, a countertrend move across the dollar, EM assets, and commodity currencies is a growing possibility. Why A Countertrend Move And Not A New Trend? Our view remains that global growth has further room to decelerate, that investors have fully anticipated an increase in global inflation, and that the renminbi has greater downside. All these support our expectation that if a period of weakness in the dollar were to materialize this summer, it would be temporary.2 However, another factor plays a big role: The evolution of liquidity flows in the global economy. Essentially, at the core of this argument lies the fact that we worry that the continued growth outperformance of the U.S. along with the revival of animal spirits in this enormous economy will suck in dollar liquidity from the rest of the world. Not only will this create a scarcity of dollars, thus bidding up the price of the greenback in the process, but it will also hurt highly indebted EM economies - nations that have high dollar debts and thus need dollar liquidity to stay afloat (Chart I-10). To begin with, U.S. banks have been slowly increasing their lending to the U.S. private sector. The upsurge in business confidence, with the NFIB small business survey and the Duke CFO survey near record highs, along with the increase in U.S. capex, confirms the durability of this rebound. Additionally, U.S. households also have the wherewithal to increase their borrowings. Not only is household debt as a percentage of disposable income near a 15-year low but, most importantly, debt servicing costs as a percentage of disposable income remain at levels last seen in the early 1980s (Chart I-11). Moreover, banks are still easing their lending standards on mortgages - which represent nearly 70% of household credit - and mortgage quality as measured by FICO scores are still well above levels that prevailed prior to the financial crisis. Chart I-10EM Dollar Debt Is High EM##br## Have A Lot Of Dollar Debt EM Dollar Debt Is High EM Have A Lot Of Dollar Debt EM Dollar Debt Is High EM Have A Lot Of Dollar Debt Chart I-11U.S. Households Have The ##br##Wherewithal To Take On Debt U.S. Households Have The Wherewithal To Take On Debt U.S. Households Have The Wherewithal To Take On Debt This is important, because when banks increase their loan books, they run down their liquidity (Chart I-12). To be more specific, rising loan issuance results in banks selling securities on their balance sheets and running down their cash balances. As Chart I-13 illustrates, when the cash and security inventories of U.S. commercial banks decrease, the U.S. dollar rallies. This relationship was very strong from 1980 to 2008 but loosened for two years during the financial crisis. Since 2010, it has re-established itself. The probability is therefore high that it will remain in place, and be a dollar-bullish factor over the medium term. Chart I-12Rapid Loan Growth Means Less Liquid Rapid Loan Growth Means Less Liquid Rapid Loan Growth Means Less Liquid Chart I-13The Dollar Abhors Liquid Bank Balance Sheets The Dollar Abhors Liquid Bank Balance Sheets The Dollar Abhors Liquid Bank Balance Sheets Moreover, by looking at the holdings of securities on banks' balance sheets, we can see that since 2012, they have even provided a leading signal on the dollar. This relationship currently points toward additional dollar strength (Chart I-14). The tighter relationship between securities holdings and the dollar than between total liquidity on banks' balance sheets and the dollar is due to the fact that securities can be re-hypothecated, and therefore can create a much greater supply of dollars in offshore markets than cash alone. The dollar-bullish liquidity backdrop is not limited to banks' balance sheets alone. Long-term portfolio flows into the U.S. have increased substantially in recent months, but still remain well below previous peaks (Chart I-15, top panel). Moreover, as the U.S.'s growing energy independence has prevented the trade deficit from expanding, the American basic balance of payments is now back in positive territory (Chart I-15, bottom panel). This too suggests that the U.S. is absorbing more dollars than it is supplying to the global economy. Chart I-14Declining Security Holdings Of Banks##br## Point To A Surge In The Dollar Declining Security Holdings Of Banks Point To A Surge In The Dollar Declining Security Holdings Of Banks Point To A Surge In The Dollar Chart I-15Money Is Flowing##br## Out Of The U.S. Money Is Flowing Out Of The U.S. Money Is Flowing Out Of The U.S. This reality is mirrored by the link between the bond issuance of U.S. firms and the dollar. When U.S. businesses increase their issuance of bonds, this tends to result in a strong dollar and weak majors (Chart I-16). The vigor of the U.S. economy and the deregulatory tendencies of the Trump administration suggest that U.S. companies could continue to issue more bonds, which will drag more liquidity out of the rest of the world and support the dollar in the process. The profit repatriation initiated by President Trump's tax reform is also supportive of the dollar. As Chart I-17 illustrates, when U.S. entities repatriate funds from abroad, the dollar tends to strengthen. Today, they are doing so with more gusto than ever. It is important to remember that this is not a reflection of American firms necessarily buying dollars directly. After all, a lot of their foreign earnings are already held in USD. Instead, it reflects the fact that when U.S. firms bring back their dollars into the U.S., the supply of high-quality collateral available in offshore markets declines, which means that acquiring dollars becomes more expensive.3 Chart I-16Rising Bond Issuance Helps The Dollar Rising Bond Issuance Helps The Dollar Rising Bond Issuance Helps The Dollar Chart I-17Trump's Tax Repatriation Is Dollar Bullish Trump's Tax Repatriation Is Dollar Bullish Trump's Tax Repatriation Is Dollar Bullish Finally, this decline in dollar liquidity is starting to be felt abroad, a phenomenon magnified by the slowdown in global trade. Global reserves are not increasing as fast as they were in 2017. As a result, a key component of global dollar-based liquidity, the Federal Reserve's accumulation of custodial holdings of securities, is also declining fast - a decrease exacerbated by the fact that the Fed is curtailing the size of its own balance sheet (Chart I-18). Historically, a decline in dollar-based liquidity is not only associated with lower global growth and a stronger greenback, but also with falling EM asset prices, EM currencies, and commodity currencies. Gold prices will provide insight on whether global liquidity remains favorable to the dollar and negative for EM assets. As Chart I-19 illustrates, gold has already broken down an intermediate upward sloping trend line, but is rebounding against the primary trend in place since the early days of 2016. If this rebound peters off and gold breaks below this primary trend line, it will be a clear indication that the decline in liquidity outside the U.S. is having a nefarious impact on global growth. This headwind to global economic activity will support additional dollar strength and asset price weakness. Chart I-18Declinning Dollar Bond Liquidity Declinning Dollar Bond Liquidity Declinning Dollar Bond Liquidity Chart I-19Litmus Test For Liquidity Litmus Test For Liquidity Litmus Test For Liquidity Bottom Line: The dollar faces near-term downside risk, but this move is likely to prove to be countertrend in nature as the global liquidity backdrop remains dollar bullish. The U.S. economy is currently sucking in global liquidity from the rest of the world, which is creating a scarcity of dollars in offshore markets. Not only is this scarcity inherently dollar bullish, but it also weighs on global growth, further flattering the dollar - a currency that performs well when global growth softens. As a result, while short-term investors should hedge some of their long-dollar exposure over the coming weeks, longer-term investors should use this correction to accumulate more dollars in order to benefit from another leg of the dollar's rally this fall. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "What Is Good For China Doesn't Always Help The World", dated June 29, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Reports, titled "What Is Good For China Doesn't Always Help The World", dated June 19, 2018, "Inflation Is In The Price", dated June 15, 2018, and "This Time Is NOT Different", dated May 25, 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, titled "It's Not My Cross To Bear", dated October 27, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was mixed: ISM manufacturing increased to 60.2 from 58.7; ISM prices paid declined to 76.8 from 79.5; Continuing and initial jobless claims both increased, disappointing expectations; Factory orders grew by 0.4% in monthly terms. After hitting deeply overbought levels, the dollar is losing momentum and risks correcting as economic surprises in the U.S. continue to decline while global ones are finding a floor, for now. Even if the dollar were to correct, budding inflationary pressures and higher growth in the U.S. are likely to prompt the Fed to hike at a faster rate than the rest of the developed world, providing the greenback with substantial upside. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 This Time Is NOT Different - May 25, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data was mixed: Manufacturing PMI improved for Italy, declined for France and remained unchanged for Germany, while decreasing for the euro area as a whole; Euro area retail sales increased by 1.4%, less than the expected 1.5%; Speculations about the ECB's actions are causing substantial movements in markets. The French 5/30 yield curve flattened by about 30 bps at rumors of an "Operation Twist" by the ECB, following the end of the APP in December. However, the euro has remained stable for around a month now, suggesting that markets have already discounted a substantially easier monetary policy. Despite this, the current slowdown in global growth is likely to have a further detrimental effect on the euro. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Housing starts yearly growth surprised to the upside, coming in at 1.3%. However, the Markit Services PMI came in at 51.4, underperforming expectations. Moreover, consumer confidence surprised to the downside, coming in at 43.7. USD/JPY has rallied by roughly 0.5% this past week. Overall we continue to be positive on the yen tactically, given that trade tensions as well as tightening in China should continue to create a risk-off environment where the yen thrives. However, on a longer term basis we maintain our bearish stance, as the BoJ will keep its ultra-dovish monetary policy in order to kick start Japan's moribund inflation. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 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 positive: Mortgage approvals outperformed expectations, coming in at 64.526 thousand. Moreover, Construction PMI surprised to the upside, coming in at 53.1. Finally, Markit Services PMI also outperformed expectations, coming in at 55.1. GBP/USD has risen by roughly 1% since last week. Overall, we expect that cable will continue to depreciate, as any pullback in the dollar will likely be temporary. Nevertheless, the pound should outperform the euro, given that Europe will likely suffer more from emerging market weakness than the U.K. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was disappointing: The AiG Performance of Manufacturing Index declined slightly from 57.5 to 57.4; RBA Commodity Index in SDR terms grew by 6.6% only, less than the expected 7.5%; Building permits contracted by 3.2% on a monthly basis; The trade balance came out less than expected at AUD 827 million. In its latest monetary policy statement, the RBA highlighted that Australian monetary conditions have tightened, noting lower housing credit growth and tighter lending standards. As 85% of home loans are variable-rate mortgages, the highly indebted Australian households are extremely susceptible to a direct tightening in interest rates. Furthermore, wage growth at 2.1% and inflation at 1.9% implies a paltry 0.2% real wage growth, adding additional risk to household financial conditions. Alongside a clouded global growth outlook, the RBA is therefore unlikely to hike in this environment anytime soon. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 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 The kiwi has been relatively flat this week. Overall, even if a short-term bounce is likely over the coming weeks, we continue to be bearish on this cross, as commodity currencies like the NZD or the AUD should suffer in the current risk-off environment where liquidity is scarce. However, the New Zealand dollar will probably outperform the Australian dollar. After all, Australia is more exposed to the Chinese Industrial Cycle than New Zealand, being a large base metals exporter. Meanwhile, we remain bearish on the NZD on a longer term basis, as the new government will restrict immigration and implement a dual mandate for the RBNZ, both measures which will lower the neutral rate in New Zealand. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Despite the rapid increase in oil prices, the Canadian dollar has not been able to keep up. NAFTA tensions are placing downward pressure on the loonie, despite the Canadian economy's rosy conditions. The most recent Business Outlook Survey by the BoC shows increasing economic activity with a robust sales outlook. In addition, capacity utilization is becoming ever tighter, with the amount of firms finding it difficult to meet unexpected demand at the highest level since the history of the data. Furthermore, the labor market continues to tighten, as hiring plans continue to trend upward. This is likely to keep the BoC somewhat hawkish, despite trade worries. The strength of the Canadian economy is therefore likely to lift the CAD above other G10 currencies this year, except against the greenback. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: The KOF leading indicator outperformed expectations, coming in at 101.7. Moreover, the SVME PMI index also surprised to the upside, coming in at 61.6. However, retail sales yearly growth underperformed expectations, coming in at -0.1%. Finally, headline inflation came in line with expectations, coming in at 1.1%. EUR/CHF has risen by roughly 0.5% this week. Overall, we continue to be bullish on a tactical basis on the franc, given that trade tensions and the policy tightening in China should ultimately keep the current risk-off in place. That being said we are cyclically bearish on the CHF, as the SNB will continue to maintain an extraordinarily easy monetary policy stance in order to prevent an appreciating franc to prevent the Swiss central bank from reaching its inflation target. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been positive: Retail sales growth outperformed expectations, coming in at 1.8%. Moreover, registered unemployment continued to be very low at 2.2%, in line with expectations. USD/NOK has fallen by nearly 1% since last week, partly due to the rise in oil price, caused by a large draw in inventories. Overall we continue to be bullish on this cross, given that we maintain that the U.S. dollar will continue rising. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 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 shift in stance at the Riksbank has been the major force behind the SEK's appreciation of around 2% against both USD and EUR in the past couple of days. The upward revision of CPIF inflation from 1.9% to 2.1% in both 2018 and 2019, and the downward revision of the unemployment rate were particularly important. In addition, three policymakers expressed hawkish views: Deputy Governors Flodén and Skingsley suggested a hike in October or December, while Ohlsson advocated for a higher repo rate of 25 bps now in response to stronger economic growth in both Sweden and abroad. Consistently, these members expressed similar opinions on the termination of foreign exchange interventions, as inflation is near its target. However, the underlying dovish intonations of Stegan Ingves still lurk within the Riksbank, presenting possible downside risk in the short-term. Nevertheless, these views support our longer-term bullish view of the SEK vis-à-vis the euro, based on diverging rate differentials. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Domino dynamics continue escalating within the EM universe confirming that a major bear market is underway. Several global cyclical market segments have recently experienced technical breakdowns. This confirms that global growth is slowing. It is not too late to short/sell EM risk assets. We reiterate the long Indian / short Chinese banks equity trade. Feature The selloff in global risk assets continues to exhibit a pattern of falling dominos. It began with the breakdown in the weakest spots of the EM world, Turkey and Argentina, and then spread to Brazil and Indonesia. Only weeks later it hit other vulnerable EM markets such as South Africa. During this period, north Asian stocks and currencies - Chinese, Korean and Taiwanese - displayed resilience. It was tempting to argue that the EM selloff was being driven by idiosyncratic risks and was limited to current account deficit countries vulnerable to U.S. Federal Reserve tightening. However, in recent weeks these north Asian markets have plunged - making the EM selloff largely broad-based and pervasive. In our June 14 report,1 we argued that major and drawn-out financial market downturns usually occur in phases and often resemble a domino effect. Since then, the domino effect has escalated confirming our bias that EMs are in a major bear market. Several important markets and cyclical market segments have recently broken down, and investors should heed messages from them: Copper prices fell below their 200-day moving average; they have also broken down the trading range that had persisted since last September (Chart I-1, top panel). The precious metals price index seems to be sliding through the floor of its trading range of the past 18 months (Chart I-1, bottom panel). Global cyclical equity sectors and sub-sectors such as mining, steel, chemicals and industrials have also broken their 200-day moving averages in absolute term (Chart I-2). They have also been underperforming the global equity index, which is consistent with the global trade slowdown that is beginning to escalate. Chart I-1Breakdown in Metals Prices Breakdown in Metals Prices Breakdown in Metals Prices Chart I-2Global Equities: Cyclicals Have Broken Down Global Equities: Cyclicals Have Broken Down Global Equities: Cyclicals Have Broken Down Although Chinese PMI data have not been particularly weak, anecdotal evidence from the ground suggests that the credit tightening of the past 18 months is taking its toll on China's financial system and economy. There are numerous reports about bankruptcies of Peer-to-peer lending platforms and struggles in other parts of the shadow banking system. The selloff in Chinese onshore A shares confirms this. Presently, this market has become less driven by retail investors as it was back in 2015. Hence, one can argue that portfolio managers on the mainland are selling their stocks because they believe economic conditions are worsening. Meanwhile, international investors have so far been more sanguine. Importantly, EM corporate and sovereign U.S. dollar bond yields are rising, heralding lower share prices (Chart I-3). Bond yields are shown inverted on this chart. The top panel is for EM overall and the bottom panel is for Asia only. Chart I-3EM Credit Markets Entail More Downside In EM Share Prices EM Credit Markets Entail More Downside In EM Share Prices EM Credit Markets Entail More Downside In EM Share Prices Chart I-4EM Versus U.S.: New Lows Lie Ahead EM Versus U.S.: New Lows Lie Ahead EM Versus U.S.: New Lows Lie Ahead Finally, the resilience of the U.S. equity index and corporate spreads has been due to robust domestic demand - the slowdown in global trade has not affected the U.S. However, odds are that the current global selloff continues to develop in a typical domino fashion. If so, the U.S. markets - equities and credit - will be the last dominos to fall but they will outperform their global peers. It is very unlikely that American stocks and credit markets will be able to sail through this EM storm unscathed. Notably, the resilience of the S&P 500 can be attributed to 10 large-cap stocks that are extremely overbought and likely expensive. This gives us more confidence to argue that this EM riot will meaningfully affect U.S. equity and credit markets. The link will be the U.S. dollar. The greenback will continue its unrelenting rally, which will trim U.S. multinationals' profits and weigh on the S&P 500. Bottom Line: EM risk assets are in a major bear market, and there is still a lot of downside. It is not too late to sell or underweight EM. This is despite EM's relative performance versus the S&P 500 is back to its early 2016 lows, as is the JP Morgan EM currency index (Chart I-4). News lows lie ahead. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EM: Sustained Decoupling, Or Domino Effect?" dated June 14, 2018 available on page 17. Chart II-1More Upside In Long Indian/Short ##br##Chinese Bank Stocks More Upside In Long Indian/Short Chinese Bank Stocks More Upside In Long Indian/Short Chinese Bank Stocks Reiterating Long Indian / Short Chinese Banks Trade This week we revisit our long Indian / short Chinese banks trade that we initiated on January 17.1 The trade is up only 5.7% since inception (Chart II-1), and with more monetary policy easing occurring in China and the recent sharp rise in non-performing loans (NPL) in India, it is appropriate to reassess this recommendation. Having updated the stress tests on the largest public banks in both countries and performed a new stress test on five Indian private banks, we are reiterating our strategy of being long Indian / short Chinese banks. A Perspective On Credit Cycles In India And China Both India and China have gone through major credit binges over the past 10-15 years, albeit over different time periods (Chart II-2A and Chart II-2B). Chart II-2ACredit Boom Was Smaller In India...Than In China Credit Boom Was Smaller In India...Than In China Credit Boom Was Smaller In India...Than In China Chart II-2BCredit Boom Was Smaller In India...Than In China Credit Boom Was Smaller In India...Than In China Credit Boom Was Smaller In India...Than In China India's public banks have, in recent years, recognized bad loans and provisioned meaningfully for them. Non-performing loans (NPLs) for Indian public banks now stand at a whopping 15% of total outstanding loans, while provisioning levels have spiked to 7% of total loans (Chart II-3). Chart II-3NPLs And Their Provisions: India And China NPLs And Their Provisions: India And China NPLs And Their Provisions: India And China By comparison, Chinese public banks - the largest five banks, excluding policy banks, where the central government owns 70-80% of equity - are at the early stages of dealing with their troubled assets. Their NPLs and provisions stand at mere 1.8% and 3.3% of total outstanding loans, respectively (Chart II-3). Does such a wide disparity in NPL ratios between Chinese and Indian banks make sense? We do not think so. It is unlikely that Indian public banks are more poorly managed vis-a-vis Chinese public banks. All are run by government-appointed officials and are equally prone to politically driven and inefficient lending. Further, the magnitude of the Chinese credit boom since 2009 was considerably greater than India's during the 2003-2012 period. It is therefore highly unlikely that the resulting NPLs are substantially smaller in China than in India. In fact, several cases of Chinese banks hiding bad assets have recently been publicized.2 We strongly believe this phenomenon is widespread on the mainland, and that NPLs among Chinese public banks are being grossly underreported. It's All About Regulation The true vindication for this disparity lies in the drastically different stances that financial regulators in both countries have adopted to deal with the non-performing and stressed assets that their banks sit on. The Chinese authorities have been exhibiting greater forbearance with their commercial banks. For instance, in March, they lowered the provision coverage ratio for commercial banks. This is ameliorating Chinese commercial banks' short-term profitability and capitalization ratios. In brief, Chinese regulators have been very accommodative by allowing commercial banks to pursue "window dressing" of their financial statements and ratios. Indian regulators, by contrast, have been exerting relentless pressure on their banks to swiftly deal with their stressed assets at the cost of short-term profitability. For instance, the Reserve Bank of India (RBI) recently introduced an extremely stringent framework for the recognition and resolution of NPLs. Indian commercial banks now have to immediately recognize stressed assets and find a resolution within 180 days. Failure to resolve a stressed account forces banks to take the defaulter to court in order to initiate bankruptcy procedures. Bottom Line: India has taken painful measures to push its banks to clean up their balance sheets. By comparison, China has so far been kicking the can down the road with respect to its banking system. As a result, the banks' balance sheet cleansing cycle is much more advanced in India than in China. Public Banks Stress Tests Below we present our updated stress tests which we performed on India's top seven public banks and China's top five public commercial banks (excluding policy banks). We used the following assumptions in our analysis (Tables II-1 and II-2): Table II-1Stress Test Of Top 7 Indian Public Banks Mind The Breakdowns Mind The Breakdowns Table II-2Stress Test Of Top 5 Chinese Public Banks Mind The Breakdowns Mind The Breakdowns Indian non-performing risk-weighted assets (NPA) to rise to 16% (optimistic), 18% (baseline), and 19% (pessimistic), up from 15% currently. For China, we assume NPAs to rise to 10% (optimistic), 12% (baseline), and 13% (pessimistic), up from 1.6% currently. Provided the magnitude and duration of China's credit boom has considerably surpassed that of India, the assumption of this stress test that NPAs will rise to 12% in China but 18% in India implies that Chinese public banks allocated credit much better than their Indian peers. Hence, this exercise in no way favored Indian banks over Chinese ones. We used risk-weighted assets to calculate losses. Risk-weighting adjusts bank assets for their riskiness which in turn makes comparisons between the two banking systems more sensible. Finally, we assumed a 30% recovery ratio (RR) for both countries. The RR on Chinese banks' NPLs from 2001 to 2005 was 20%. This occurred amid much stronger nominal and real growth. Thus, a 30% RR rate today is not low. The outcome of the tests are as follows: Under the baseline scenario of 18% NPA in India and 12% NPA in China, losses post recovery and provisions amount to 1.8 trillion rupees in the former (1.3% of GDP) and RMB 3.3 trillion in the latter (3.9% of GDP) (Tables II-1 and II-2, column 6). These losses would impair 41% of equity capital in India and 44% in China (Tables II-1 and II-2, column 7). Adjusting the current price-to-book value (PBV) ratios for public banks in both countries to the equity impairment under the baseline scenario lifts their PBV ratios to 1.5 in India and 1.7 in China (Tables II-1 and II-2, column 8). Assuming a 1.3 fair PBV ratio3 for banks in both countries, Indian banks appear overvalued by 15% and Chinese banks by 29% (Tables II-1 and II-2, last column). In other words, after the recognition and provisioning of reasonable levels of NPA, Indian public banks appear less overvalued than their Chinese counterparts. These results make sense to us; Indian public banks have been provisioning aggressively for their troubled assets, and bad news is somewhat discounted in their share prices. Chart II-4Loan Write-Offs Have Been Much ##br##Greater In India Than In China Mind The Breakdowns Mind The Breakdowns Remarkably, Indian public banks have also been writing off more bad loans than their Chinese counterparts. Chart II-4 shows cumulated write-offs of these public banks in India and China since 2010. Bad asset write-offs have so far amounted to RMB 1.2 trillion in China and 3 trillion rupees in India. This is equivalent to 2% and 8% as a share of current risk-weighted assets, respectively. Another way to compare and analyze NPA cycles between two countries is to assess the progress that each country has made toward resolving the full amount of outstanding bad assets - i.e. a full NPA cycle. We define a full NPA cycle in the following way: Total NPA losses under our baseline scenario, plus cumulated past write-offs. In order to measure progress toward resolving the full NPA cycle, we take the ratio of the stock of provisions plus cumulated write-offs and divide that by the full NPA cycle losses (i.e. [provisions + write-offs] / full NPA cycle losses). In India, assuming that NPAs on its largest public banks reach 18% of risk weighted assets - then the full NPA cycle for India would amount to 9.4 trillion rupees, or 26% of current risk-weighted assets (i.e. 6.4 trillion rupees in NPA remaining plus 3 trillion in write-offs made). Meanwhile, India's public banks' progress amounts to 5.6 trillion rupees. This is equal to 60% of India's full NPA cycle. By contrast, Chinese public banks' full NPA cycle would amount to RMB 8 trillion (or 14% of risk-weighted assets) under our baseline scenario. Further, China's banks progress amounts to RMB 2.6 trillion. This is equivalent to only 33% of the full NPA cycle in China. Hence, Indian public banks are closer to their peak NPA cycle versus their Chinese counterparts. Note that this particular analysis assumes no recovery in bad loans in either country. Further, the above analysis does not attune for the fact that Chinese banks have more risky off-balance sheet assets than their Indian peers. Incorporating off-balance sheet assets and liabilities would make the stress tests much more favorable for Indian public banks relative to China. Stress Test For India's Private Banks Private banks are a part of our long Indian / short Chinese banks trade. Indian private banks are also not insulated from regulatory clean-up efforts. In recent years, these lenders significantly boosted their credit to the consumer and service sectors. Higher than normal defaults have not yet transpired but this is a scenario that cannot be ruled out given the frantic pace of lending (Chart II-5). We performed a stress test on five4 large Indian private banks as well (Table II-3): Chart II-5India: Consumer And Service ##br##Credit Is Booming India: Consumer And Service Credit Is Booming India: Consumer And Service Credit Is Booming Table II-3Stress Test Of 5 Large Indian Private Banks Mind The Breakdowns Mind The Breakdowns We assumed the following NPA scenarios: 6% (optimistic), 8% (baseline), and 9% (pessimistic), up from 5% currently. Similar to the above analysis, we used risk-weighted assets to calculate asset losses, though we used a recovery ratio of 50% for private banks instead of 30% for public banks. The basis is that private banks' lending has been concentrated on consumer loans and mortgages and the recovery ratio on these loans will likely be higher - especially taking into consideration the quality of collateral. Our results are as follows: Under the baseline scenario of an 8% NPA ratio, 7% of these private banks' equity would be impaired (Table II-3, column 7). The adjusted PBV would move to 3.9. This compares to a fair value of 3.3 for Indian private banks (Table II-3, column 8), which is the historical PBV mean of private banks in India. In other words, Indian private banks are overvalued by 18% - slightly more than their public peers (Table II-3, column 9). Bottom Line: Indian private banks are overvalued too but less so than Chinese public banks. Investment Conclusions We reiterate our long Indian / short Chinese banks equity trade, initiated on January 17. We track the performance of this recommendation using the BSE's Bankex index for India and the MSCI Investable bank index for China in common currency terms - currency unhedged. In addition, among Chinese-listed banks, we maintain our short small / long large banks (Chart II-6). Smaller banks are more leveraged as well as exposed to non-standard assets and regulatory tightening than large public banks. Finally, the Indian bourse's relative performance against the EM equity benchmark negatively correlates with oil prices - the oil price is shown inverted on this chart (Chart II-7). Chart II-6Stay Short Chinese Small / Long Large Banks Stay Short Chinese Small/Long Large Banks Stay Short Chinese Small/Long Large Banks Chart II-7India's Relative Equity Performance To EM And Oil Prices India's Relative Equity Performance To EM And Oil Prices India's Relative Equity Performance To EM And Oil Prices Given BCA's Emerging Markets Strategy service expects oil prices to drop meaningfully in the second half of this year,5 this should help Indian equities outperform their EM peers. Besides, Indian banks are more advanced than many of their EM peers in terms of bad assets recognition and provisioning and that should also help the Indian bourse outperform the EM overall equity index in common currency terms. We reiterate our overweight stance on Indian equities within a fully invested EM equity portfolio. In contrast, we are neutral on China's investable stock index's relative performance versus the EM stock index. The main reason why we have not underweighted the Chinese bourse - despite our negative view on China - is the exchange rate; the potential downside in the value of the RMB versus the U.S. dollar in the next six months is less than potential downside in many other EM exchange rates. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "Long Indian / Short Chinese Banks" dated January 17, 2018 available at ems.bcaresearch.com. 2 Please see the following article: http://www.scmp.com/business/banking-finance/article/2139904/pressure-chinas-banks-report-bad-debt-good-news-foreign 3 It is the average PBV ratio for EM banks since 2011. 4 HDFC Bank, ICICI Bank, Axis Bank, Yes Bank, and IDFC Bank. 5 Please see Emerging Markets Strategy Special Report "China's Crude Oil Inventories: A Slippery Slope" dated June 21, 2018 available on page 17. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

The GAA DM Equity Country Allocation model is updated as of June 29, 2018. The model has reduced weights in Italy, the U.S., the Netherlands and France to beef up weights in Spain, Australia, Canada, Switzerland and Germany. After these adjustments, Australia is now upgraded to overweight from neutral and Italy is downgraded to neutral from overweight, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights GAA Quant Model Updates GAA Quant Model Updates As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model outperformed its benchmark by 34 bps in June, largely driven by the Level 2 model which outperformed its benchmark by 87 bps. The Level 1 model performed in line with its benchmark in June. Since going live, Level 2 and Level 1 have outperformed their respective benchmarks by 171 bps and 5bps, resulting in overall model outperformance of 47 bps. Table 2Performance (Total Returns In USD %) GAA Quant Model Updates GAA Quant Model Updates Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) GAA U.S. Vs. Non U.S. Model (Level 1) GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Mode (Chart 4) is updated as of June 30, 2018. Chart 4Overall Model Performance Overall Model Performance Overall Model Performance Table 3Allocations GAA Quant Model Updates GAA Quant Model Updates Table 4Performance Since Going Live GAA Quant Model Updates GAA Quant Model Updates Following our Quarterly Update that was released yesterday, the model corroborates the defensive stance with an aggregate underweight of 5.8% in cyclical sectors. The switch to a defensive mode was driven by a weaker growth outlook. The upgraded sectors were consumer staples and health care. Additionally, the model has turned more negative on the two largest sectors - financials and technology. Resources-based sectors remain unattractive on the back of weaker growth outlook. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," dated July 27, 2016, available at https://gaa.bcaresearch.com.

Highlights Portfolio Strategy Five key drivers - late cycle dynamics, likelihood of pricing power regulatory relief, the rising U.S. dollar, firming operating metrics and investor and analyst capitulation- all suggest that it no longer pays to be bearish the S&P pharma and S&P biotech indexes. Lift to neutral. This also raises the S&P health care sector exposure to neutral, as these two heavyweight health care sub-indexes command a 49% weighting in the sector. Recent Changes Act on the upgrade alert and lift the S&P pharma and S&P biotech indexes to neutral today for a profit of 14.5% and 13.9%, respectively since inception (we are also removing the S&P pharma index from our high-conviction underweight list). Lock in gains in the S&P health care sector of 5.3% since inception and upgrade exposure to a benchmark allocation today. Table 1 Recalibrating Recalibrating Feature Stocks continued to wrestle with escalating geopolitical threats last week, but remained resilient. While the global trade soft patch could morph into a steep contraction if protectionism proliferates, our working assumption is that the executive branch's bark will be worse than its bite. The SPX is in the midst of a recalibration to a cooling in EPS momentum in calendar 2019 as we have been highlighting in recent research, and were the U.S. dollar to continue its ascent in the back half of the year, the sell-side's calendar 2019 almost 10% growth estimate will sink like a stone. This remains our number one downside risk that we are closely monitoring, though it should be reasonably contained by mounting signs of a healthier corporate sector and an easing in financial stress (Chart 1). This week we are updating our corporate pricing power proxy that has reaccelerated. Importantly, the breadth of the surge has gone parabolic, which bodes well for its staying power (second panel, Chart 2). This firming corporate inflation backdrop suggests that businesses have been successful in passing on skyrocketing input costs down the supply chain, and thus implies that final demand remains robust. Chart 1Reset Reset Reset Chart 2Pricing Power Flexing Its Muscles Pricing Power Flexing Its Muscles Pricing Power Flexing Its Muscles On the flip side, rising labor costs have stabilized. Compensation growth remains contained, and according to our diffusion index, just over half of the 44 industries we track have to contend with rising wages. In addition, the Atlanta Fed Wage Growth Tracker switcher/stayer index provides a reliable leading indication for the trend in overall labor expenses and it recently ticked down. In other words, pricing power is rising on a broad basis while wage inflation is moving laterally. Consequently, there are decent odds that upbeat forward operating margin expectations are attainable, further prolonging the near two year margin expansion phase (bottom panel, Chart 2). Delving deeper into our corporate pricing power update is revealing. Table 2 summarizes the results. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Table 2Industry Group Pricing Power Recalibrating Recalibrating 80% of the industries we cover are lifting selling prices, and 45% are doing so at a faster clip than overall inflation. This is on a par with our late-April report. Chart 3Cyclicals Come Out On Top Cyclicals Come Out On Top Cyclicals Come Out On Top Outright deflating sectors increased by two to 12 since our last update. Encouragingly, only 7 industries are still experiencing a downtrend in selling price inflation, in line with our most recent report. Impressively, deep cyclicals/commodity-related industries continue to dominate the top ranks, occupying the top 7 slots (top panel, Chart 3). Despite the ongoing global export jitters, escalating trade war fears and year-to-date gains in the greenback, the commodity complex's ability to increase prices is extraordinary. In contrast, airlines, soft drinks, telecom, autos and tech populate the bottom ranks of Table 2. In sum, accelerating business sector selling prices will continue to underpin top line growth in the back half of the year. Recent evidence of a slight letdown in wage inflation is welcome news for corporate sector profit margins and earnings. In fact, it will be critical for labor costs to remain tame or at least continue to trail pricing power gains, otherwise profit margins will be at risk of a squeeze. This week we are locking in gains and lifting a defensive sector to a benchmark allocation by acting on our recent upgrade alert on two of its key subcomponents. Upgrade Pharma & Biotech To Neutral... We are pulling the trigger on our recent upgrade alerts and are upgrading the S&P pharma and biotech groups to neutral from underweight, locking in relative gains of 14.5% and 13.9%, respectively since inception, and we are also removing the S&P pharma index from our high-conviction underweight list. As a reminder, we set the heavyweight S&P pharmaceuticals and S&P biotech indexes on upgrade alert, and thus the overall S&P health care sector, on May 22nd following the insight from our Special Report titled 'Portfolio Positioning For A Late Cycle Surge'. In more detail, health care stocks excel in both phases we examined - ISM peak-to-SPX peak and SPX peak-to-recession commencement (Tables 3, 4 & 5). This is largely due to the high-beta biotech sub-sector outperforming early with the more defensive pharma sub-group sustaining the outperformance following the SPX peak. Table 3Health Care Outperforms In The Late Cycle Recalibrating Recalibrating Table 4High Beta Stocks Outperform Early... Recalibrating Recalibrating Table 5...Defensive Stocks Beat Late Recalibrating Recalibrating Moreover, recent pricing power developments point to a softer than previously expected blow to drug pricing practices revealed in the President's recent speech. This is music to the ears of Big Pharma executives and can serve as a catalyst to unlock latent buying power in this traditionally considered defensive sector. While no bill has been drafted yet and we are awaiting more details, at the margin, this is a net positive for pharma and biotech top line growth at least from a cyclical perspective (Chart 4). The thesis we postulated last July was that the easy pricing power gains were behind the pharma and biotech industries and likely a secular decline in the ability of these groups to raise prices at a faster pace than overall inflation was in order (Chart 5). While this thesis remains intact from a structural perspective, in the next 9-12 months there is scope for some relief. Chart 4Overdone Cyclically... Overdone Cyclically... Overdone Cyclically... Chart 5...But Structural Issues Remain ...But Structural Issues Remain ...But Structural Issues Remain Beyond these two drivers, the trade-weighted U.S. dollar's year-to-date gains also signal that it no longer pays to be bearish this safe haven group. Chart 6 shows that relative pharma profits are positively correlated with the greenback as Big Pharma's domestically-derived earnings dwarf foreign sourced EPS. Keep in mind that the industry still dictates terms to the U.S. government, a key end-market. The opposite is true with regard to other governments around the world, especially in the key European markets, where the industry is a price taker. This partially explains the positive correlation with the currency. On the operating front, there are also signs of a bottom. Not only are pharmaceutical factories humming, but also our pharma productivity proxy (industrial production / employment) is gaining steam, underscoring that profits can surprise to the upside (second panel, Chart 7). Chart 6Appreciating Dollar Helps Appreciating Dollar Helps Appreciating Dollar Helps Chart 7Bullish Operating Metrics Bullish Operating Metrics Bullish Operating Metrics With regard to demand, pharma retail sales are expanding nicely and overall industry shipments are also rising at a healthy clip, at a time when inventories are whittled down (third and bottom panels, Chart 7). This represents a positive pharma pricing power backdrop in the coming quarters. In terms of investor and analyst sentiment, a near full capitulation has taken root. Relative share price momentum is steeply contracting close to 15%/annum, a rate that has previously coincided with cyclical troughs (second panel, Chart 4). Sell-side pessimism reigns supreme as pharma profits are slated to trail the broad market by a wide margin both for the next year and on a 3-5 year time frame. In fact, the latter just sunk to all-time lows (Chart 8). Analyst gloom is pervasive as relative top line growth expectations also call for a contraction in the coming twelve months. Valuations are as good as they get with the relative forward price-to-earnings ratio trading way below par and the historical mean (bottom panel, Chart 8). Finally, the S&P pharma and S&P biotech indexes are more alike than different, as biotech stocks have long had blockbuster billion dollar selling drugs and therefore have substantial earnings (unlike 78% of the NASDAQ biotech index that do not even have forward earnings) and are really disguised pharma outfits hiding under the biotech label. The biotech index also offers a near 2% dividend yield, on par with the SPX, but still trailing the S&P pharma index roughly by 70bps (Chart 9). As such, there is an inverse correlation of both indexes with interest rates. Not only are higher interest rates punitive to growth stocks, but also fierce competitors to fixed income proxies. The implication is that if the broad equity market reset continues for a while longer and the 10-year Treasury yield continues to fall, relative share prices will likely come out of their recent funk (Chart 10). Chart 8Full Capitulation Full Capitulation Full Capitulation Chart 9Close Siblings... Close Siblings... Close Siblings... Chart 10...That Despise Higher Rates ...That Despise Higher Rates ...That Despise Higher Rates Adding it up, five key drivers - late cycle dynamics, likelihood of pricing power regulatory relief, the rising U.S. dollar, firming operating metrics and investor and analyst capitulation- all suggest that it no longer pays to be bearish the S&P pharma and S&P biotech indexes. Bottom Line: Lock in profits of 14.5% and 13.9% in the S&P pharma and S&P biotech indexes respectively since inception and lift to a benchmark allocation. Also remove the S&P pharma group from the high-conviction underweight list. The ticker symbols for the stocks in the S&P biotech and S&P pharma indexes are: BLBG: S5BIOTX - ABBV, AMGN, GILD, CELG, BIIB, VRTX, REGN, ALXN, INCY and BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO, NKTR, respectively. ...Which Lifts Health Care To A Benchmark Allocation The S&P pharma and biotech indexes command roughly a 50% weighting in the S&P health care sector. As a result, their profit fortunes are closely tied and relative share prices tend to move in lockstep (Chart 11). Today's upgrade to a benchmark allocation in both of these sub-groups also lifts the health care sector to a neutral portfolio weighting. Relative share prices have been in correction mode for the better part of the past year and may now have found support near their upward sloping long-term trend line (top panel, Chart 12). Importantly, our S&P health care EPS growth model is making an effort to trough (bottom panel, Chart 12), and if the Trump Administration does not clamp down on pharma pricing power as initially feared and recently hinted at, then overall health care sector profits will likely overwhelm. Keep in mind that the bar for upward surprises is extremely low as analysts have thrown in the towel on the sector. Similar to the S&P pharma index, health care long-term EPS growth expectations have never been lower in the history of the I/B/E/S/ data. This is contrarily positive (third panel, Chart 13). Chart 11Joined At The Hip Joined At The Hip Joined At The Hip Chart 12EPS Model Says Trough Is Near EPS Model Says Trough Is Near EPS Model Says Trough Is Near Chart 13Underappreciated And Unloved Underappreciated And Unloved Underappreciated And Unloved We would not hesitate to lift exposure further to overweight were the Trump Administration to put forth a bill with minimal damage inflicted upon drug prices, were the green back to keep on appreciating and were a steep 'risk off' phase to grip the broad equity market. Bottom Line: We are acting on our May 22nd upgrade alert and lifting the S&P health care sector to neutral, crystalizing relative profits of 5.3% since the July 31st, 2017 inception. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Recommended Allocation Quarterly - July 2018 Quarterly - July 2018 Risks to equities and credit are now evenly balanced. We downgrade both to neutral. We are worried that desynchronized growth will further push up the dollar, damaging emerging markets, especially since U.S. inflation will remove the Fed "put". The trade war is nowhere near over, and China shows signs of slowing growth. To de-risk, we raise U.S. equities to overweight, cut the euro zone to neutral, and increase our underweight in EM. We move overweight in cash, rather than fixed income because, with inflation still rising, we see U.S. 10-year rates at 3.3% by year-end. We turn more cautious on equity sectors (reducing the pro-cyclicality of our recommendations by raising consumer staples and cutting materials) and suggest less pro-risk tilts for alternative assets, shifting to hedge funds and away from private equity. Overview Lowering Risk Assets To Neutral Since last December we have been advising risk-averse clients, who prioritize capital preservation, to turn cautious, but suggested that professional fund managers who need to maximize quarterly performance stay invested in risk assets. With U.S. equities returning 3% in the first half of the year and junk bonds 0% (versus -1% for U.S. Treasury bonds), that was probably a correct assessment. Now, however, our analysis indicates that the risk/reward trade-off has deteriorated. Although we still do not expect a global recession until 2020, risks to the global equity bull market have increased. The return outlook is asymmetrical: a last-year bull market "melt-up" could give 15-20% upside, but in bear markets over the past 50 years global equities have seen peak-to-trough declines of 25-60% (Table 1). We think it better to turn cautious too early. A key to successful asset allocation is missing the big drawdowns - but getting the timing of these right is a near impossibility. Table 1How Much Stocks Fall In Bear Markets Quarterly - July 2018 Quarterly - July 2018 Chart 1Growth Is Becoming More Desynchronized Growth Is Becoming More Desynchronized Growth Is Becoming More Desynchronized What are the risks we are talking about? Global growth is slowing and becoming less synchronized (Chart 1). Fiscal stimulus and a high level of confidence among businesses are keeping U.S. growth strong, with GDP set to grow by close to 3% this year and S&P 500 earnings by 20%. But the euro zone and Japan have weakened, and these growing divergences are likely to push the dollar up further, which will cause more trouble in emerging markets. EM central banks are reacting either by raising rates to defend their currencies (which will hurt growth) or by staying on hold (which risks significant inflation). With the U.S. on the verge of overheating, the Fed will need to prioritize the fight against inflation. Lead indicators of core inflation suggest it is likely to continue to rise (Chart 2). The FOMC's key projections seem incompatible with each other: it sees GDP growth at 2.7% this year (well above trend), but unemployment barely falling further, bottoming at 3.6% by end-2018 (from 3.8% now) and core PCE inflation peaking at 2.1% (now: 2.0%). A further rise in inflation means that the Fed "put option" will expire: even if there were a global risk-off event, the Fed might not be able to put tightening on hold. It will take only one or two more hikes for Fed policy to be restrictive - something we have previously flagged as a key warning signal (Chart 3). Chart 2U.S. Inflation Could Pick Up Further U.S. Inflation Could Pick Up Further U.S. Inflation Could Pick Up Further Chart 3Fed Policy Is Close To Being Restrictive Fed Policy Is Close To Being Restrictive Fed Policy Is Close To Being Restrictive There is no end in sight for the trade war. President Trump is unlikely to back down on imposing further tariffs on China, since the tough stance is proving popular with his support base. On the other hand, President Xi Jinping would lose face by giving in to U.S. demands. BCA's geopolitical strategists warn that we are not at peak pessimism, and do not rule out even a military dimension.1 China is unlikely to roll out stimulus, as it did in 2015. With the authorities focused on structural reform, for example debt deleveraging, the pain threshold for stimulus is higher than in the past. Recent moves such as reductions in banks' reserve requirement have had little impact on effective interest rates (Chart 4). More likely, China might engineer a weakening of the RMB, as it did in 2015. There are signs that it is already doing so (Chart 5). This would exacerbate political tensions. Chart 4China Has Not Eased Monetary Conditions... China Has Not Eased Monetary Conditions... China Has Not Eased Monetary Conditions... Chart 5...But It Might Be Depreciating The RMB ...But It Might Be Depreciating The RMB ...But It Might Be Depreciating The RMB As we explain in detail in the pages that follow, with risk now two-way, we cut our weighting in global equities to neutral. We are not going underweight since global economic growth remains above trend, and corporate earnings will continue to grow robustly (though no faster than analysts are already forecasting). We see upside risk if the Fed were to allow an overshoot of inflation amid strong growth. If the concerns highlighted above cause a 15% correction in equity markets - triggering the Fed to go on hold - we would be inclined to move back overweight (having in mind a scenario like 1987 or 1998, where a sell-off led to a last-year bull-market rally). More likely, however, we will move underweight at the end of the year, when recession signals, such as an inverted yield curve, appear. We have shifted our detailed recommendations to line up with this de-risking. We move overweight U.S. equities (which are lower beta, and where unhedged returns should benefit from a stronger dollar). We keep our overweight on Japan, since the Bank of Japan remains the last major central bank in fully accommodative mode. We increase our underweight in EM equities. Among sectors, we reduce pro-cyclicality by cutting materials to underweight and raising consumer staples to overweight. We remain underweight fixed income, since inflationary pressures point to the 10-year U.S. Treasury bond yield moving up to 3.3% before the end of this cycle. We remain short duration and continue to prefer inflation-linked securities over nominal bonds. Within fixed income, we cut corporate credit to neutral, in line with our de-risking. Finally, we recommend that investors move into cash rather than bonds, though we understand that, especially for European investors, this may mean accepting a small negative return.2 Still puzzled how markets may pan out over the next 12 months? Then join BCA's annual Conference in Toronto this September, where I will be chairing a panel on asset allocation, featuring two experienced Chief Investment Officers, Erin Browne of UBS Asset Management, and Norman Villamin of Union Bancaire Privée. Garry Evans, Senior Vice President garry@bcaresearch.com What Our Clients Are Asking How To Overweight Cash? Chart 6Sometimes Cas Is The Only Answer Sometimes Cas Is The Only Answer Sometimes Cas Is The Only Answer BCA's call to start to derisk portfolios includes a new overweight in cash. This is logical since, historically, cash often outperformed both equities and bonds early in a downturn, when growth was starting to falter (bad for equities) but inflation was still rising (bad for bonds) - though this last happened in 1994 (Chart 6, panel 1). Currently, a move to cash is easy for U.S. investors, who can invest in three-month Treasury bills yielding 1.9%, or USD money market funds, some of which offer just over 2%. But it is much harder for investors in the euro area, where three-month German government bills yield -0.55%. Also, in Japan cash yields -0.17% and in Switzerland -0.73%. Some European investors will be tempted to go into U.S. cash. Given our view of dollar appreciation over the next six months, this should pay off. But it clearly is risky, should we be wrong and the dollar decline. As theory predicts, the cost of hedging the U.S. dollar exposure wipes out any advantage (since three-month euro-dollar forwards are 2.7% lower on an annualized basis than EURUSD spot). Some investors will have to put up with a small negative return in nominal terms in order to (largely) protect their capital. More imaginative European fund managers might be able to come up with schemes to get cash-like returns but with a positive return. For example, Danish mortgage bonds yield 1.8% (in Danish krone, which is largely pegged to the euro) with little risk. U.S. mortgage-backed securities offer yields well over 3%, which should give a positive return after hedging costs (and relatively low risk, given the robust state of the U.S. housing market) - panel 3. Carefully-selected global macro hedge funds can give attractive Libor-plus returns.3 We still see attractiveness of catastrophe bonds,4 which have a high yield and no correlation to the economic cycle. How Seriously Should We Take The Risk Of A Trade War? Is this a full-blown trade war? The answer is not yet. However, the risk is rising that the current spat will turn into one. President Trump has escalated tensions further by indicating that a 10% tariff would be placed on $200 billion of Chinese imports, in addition to the 25% tariff on $50 billion of imports announced in March and to be implemented on July 6. Trump's incentive to escalate the conflict is that a tough trade policy plays well with his support base (Chart 7). Ever since the trade issue hit the headlines early this year, his approval ratings have been on the rise. This means that he is unlikely to back down at least until the mid-term elections in November. Xi Jinping is also unlikely, for his own political reasons, to give in to U.S. demands. But China's retaliation will most likely come through non-tariff actions, since its imports from the U.S. total only about $130 billion (compared to $500 billion of Chinese exports to the U.S.). It could look to restrict imports, for example via quotas, or cause extra bottlenecks for U.S. businesses operating in China. Additionally, it could threaten to sell some of its holdings of U.S. Treasuries, or devalue the RMB. As Chart 8 shows, the RMB has already weakened against the dollar this year (though this was mainly due to the dollar's overall strength). There are suggestions that China might adjust the currency basket that it targets for the RMB, for example by adding more Asian currencies, to allow further depreciation against the dollar. Chart 7 Quarterly - July 2018 Quarterly - July 2018 Chart 8Sharp Rise In RMB This Year Sharp Rise In RMB This Year Sharp Rise In RMB This Year It is hard, then, to see a smooth outcome to this standoff. A further escalation could even have a military dimension, with the U.S. having recently opened a new "embassy" in Taiwan, and sailing navy vessels close to Chinese "islands" in the South China Sea. It is also a complication that President Trump has recently raised tensions with other G7 trading partners, rather than engaging their help in combatting China's perceived unfair trading practices. Is It Time To Buy Chinese A-Shares? In Q2 2018, MSCI China A-shares lost 19% in absolute terms, compared to a 3.5% gain for MSCI U.S. Some investors attribute this performance divergence to trade tension between the U.S. and China, and take the view that the Chinese government may step in to stimulate the economy and support the equity market, similar to what happened in 2015. We have no doubt that China will stimulate again if the economy appears to be heading for a deep slowdown. Given elevated debt levels and excess capacity in some parts of the economy and worries about pollution, however, the bar for a fresh round of stimulus is a lot higher than in the past. With the incremental inclusion of MSCI on-shore A-Shares into the MSCI China investible universe, A-shares are gaining more attention from international investors. However, the A-Share Index is very different from the MSCI China Index. First, the sector compositions are very different, as shown in Chart 9. The MSCI China index is not only dominated by the tech sector (40%), it's also very concentrated, with the top 10 names accounting for 56% of the index, while the top 10 names in the A-shares account for only about 20%. Second, even in the same sectors, the performance of the two indexes has diverged as shown in Chart 10. We see the reason for these divergences being that domestic investors are more concerned about growth in China than foreign investors are. Instead of buying A-Shares, investors should be more cautious on the MSCI China Index, for which we have a neutral view within MSCI EM universe. Chart 9 Quarterly - July 2018 Quarterly - July 2018 Chart 10ONE CHINA, TWO DIFFERENT EQUITY INDEXES ONE CHINA, TWO DIFFERENT EQUITY INDEXES ONE CHINA, TWO DIFFERENT EQUITY INDEXES What Are The Characteristics Of The Private Debt Market? Chart 11Private Debt Market Quarterly - July 2018 Quarterly - July 2018 Private debt (Chart 11) raised a record $115 billion through 158 funds in 2017, pushing aggregate AUM from $244 billion in 2007 to $664 billion in 2017. This explosive growth was driven by bank consolidation in the U.S., increased financial sector regulation, and the global search for yield. Private debt has historically enjoyed a higher yield and return, along with fewer defaults, than traditional public-market corporate bonds. Below are some of the key points from our recent Special Report:5 Private debt has returned an average net IRR of 13% from 1989 to 2015. This compares to an annualized total return of 7% and 7.2% for equities and corporate bonds respectively. Investors can diversify their sources of risk and return by giving access to more esoteric exposures such as illiquidity and manager skill. The core risk exposure in private debt comes from idiosyncratic firm-specific sources, which is not the case with publicly traded corporate credit. Investors can gain more tailored exposure to different industries and customized duration horizons. Additionally, private debt was the only group in the private space that did not experience a contraction in AUM during the financial crisis. Direct lending and mezzanine debt are capital preservation strategies that offer more stable returns while minimizing downside. Distressed debt and venture debt are more return-maximizing strategies that offer larger gains, but with a higher probability of losses. In the late stages of an economic cycle, investors should deploy capital defensively through first-lien and other senior secured debt positions. In contrast, a recession would create opportunities for distressed strategies and within deeper parts of the capital structure. Global Economy Overview: Growing divergences are emerging in global growth, with the U.S. producing strong data, but a cyclical slowdown in the euro area and Japan, and the risk of significantly slower growth in China and other emerging markets. This means that monetary policy divergences are also likely to increase, exacerbating the rise in the U.S. dollar and putting further pressure on emerging markets. Eventually, however, tighter financial conditions could start to dampen growth in the U.S. too. U.S.: Data has been very strong for the past few months, with the Fed's two NowCasts pointing to 2.9% and 4.5% QoQ annualized GDP growth in Q2. Small businesses are confident (with the NFIB survey at a near record high), which suggests that the capex recovery is likely to continue. With unemployment at the lowest level since 1969, wages should pick up soon, boosting consumption. But it is possible the data might now start to weaken. The Surprise Index (Chart 12, panel 1) has turned down. And a combination of trade war and a stronger dollar (up 8% in trade-weighted terms since April) might start to dent business and consumer confidence. Chart 12U.S. Growth Remains Strong... U.S. Growth Remains Strong... U.S. Growth Remains Strong... Chart 13...While Europe, Japan And EMs Start To Slow ...While Europe, Japan And EMs Start To Slow ...While Europe, Japan And EMs Start To Slow Euro Area: Euro area data, by contrast to the U.S., have turned down since the start of the year, with both the PMI and IFO slipping significantly (Chart 13, panel 1). This is most likely because the 6% appreciation of the euro last year has affected export growth, which has slowed to 3.1% YoY, from 8.3% at the start of the year. However, the PMI remains strong (around the same level as the U.S.) and, with a weaker euro since April, growth might pick up late in the year, as long as problems with trade and Italy do not deteriorate. Japan: Japan's growth has also slipped noticeably in recent months (Chart 13, panel 2), perhaps also because of currency strength, though question-marks over Prime Minister Abe's longevity and the slowdown in China may also be having an effect. The rise in inflation towards the Bank of Japan's 2% target has also faltered, with core CPI in April back to 0.3% YoY, though wages have seen a modest pickup to 1.2%. Emerging Markets: China is now showing clear signs of slowing, as the tightened monetary conditions and slower credit growth of the past 12 months have an effect. Fixed-asset investment, retail sales and industrial production all surprised to the downside in May. The authorities have responded to this (and to threat of trade disruptions) by slightly easing monetary policy, though this has not yet fed through to market rates, which have risen as a result of rising defaults. Elsewhere in EM, many central banks have responded to sharp declines in their currencies by raising rates, which is likely to dampen growth. Those, such as Brazil, which refrained from defensive rate hikes, are likely to see an acceleration in inflation Interest rates: The Fed has signaled that it plans to continue to hike once a quarter at least for the next 12 months. It may eventually have to accelerate that pace if core PCE inflation moves decisively above 2%. The ECB, by contrast, announced a "dovish tightening" last month, when it signaled the end of asset purchases in December, but no rate hike "through the summer" of next year. It can do this because euro zone core inflation remains around 1%, with fewer underlying inflationary pressures than in the U.S. The Bank of Japan is set to remain the last major central bank with accommodative policy, since it is unlikely to alter its yield-curve control any time soon. Global Equities Chart 14Neutral Global Equities Neutral Global Equities Neutral Global Equities A Bird In The Hand Is Worth Two In The Bush: After the initial strong recovery from the low in March 2009, global equity earnings have risen by only 20% from Q3 2011, and that rise mostly came after February 2016. In the same period, global equity prices, however, have gained over 80%, largely due to multiple expansion (Chart 14), supported by accommodative monetary and stimulative fiscal policies. Year-to-date, our pro-cyclical equity positioning has played out well with developed markets (DM) outperforming emerging markets (EM) by 8.8%, and cyclical equities outperforming defensives by 2.9%. As the year progresses, however, we are becoming more and more concerned about future prospects given the stage of the cycle, stretched valuations and the elevated profit margin.6 The three macro "policy puts", namely the Fed Put, the China Put and the Draghi Put, are all in jeopardy of disappearing or, at the very least, of weakening, in addition to the risk of rising protectionism. BCA's House View has downgraded global risk assets to neutral.7 Reflecting this change, within global equities we recommend investors to take a more defensive stance by reducing portfolio risk. We remain overweight DM and underweight EM; We upgrade U.S. equities to overweight at the expense of the euro area (see next page); Sector-wise, we suggest to take profits in the pro-cyclical tilts and become more defensive (see page 14). Please see page 21 for the complete portfolio allocation details. U.S. Vs. The Euro Area: Trading Places Chart 15Favor U.S. Vs. Euro Area Favor U.S. Vs. Euro Area Favor U.S. Vs. Euro Area In line with the BCA House View to reduce exposure in global risk assets, we are downgrading the euro area to neutral in order to fund an upgrade of the U.S. to overweight from neutral, for the following reasons: First, GAA's recommended equity portfolio has always been expressed in USD terms on an unhedged basis. Historically, the relative total return performance of euro area equities vs. the U.S. has been highly correlated with the euro/USD exchange rate. With BCA's House View calling for further strength of the USD versus the euro, we expect euro area total return in USD terms to underperform the U.S. (Chart 15, panel 1). Second, the euro area economy has been weakening vs. the U.S. as seen by the relative performance of PMIs in the two regions; this bodes ill for the euro area's relative profitability (Chart 15, Panel 2). Third, because euro area equities have a much higher beta to global equities than U.S. equities do, shifting towards the U.S. reduces the overall portfolio beta (Chart 15, Panel 3). Last, even though euro area equities are cheaper than the U.S. in absolute term, they have always traded at a discount to the U.S. On a relative basis, this discount is currently fair compared to the historical average. Sector Allocation: Become More Defensive Chart 16Sectors: Turn Defensive Sectors: Turn Defensive Sectors: Turn Defensive Year to date, our pro-cyclical sector positioning has worked very well, especially the underweights in telecoms, consumer staples and utilities, and the overweight of energy. The overweight in healthcare also has worked well, but the overweights in financials and industrials, as well as the underweight of consumer discretionary, have not panned out. Global economic growth has peaked, albeit at a high level. This does not bode well for the profitability of the economically sensitive sectors (industrials, consumer discretionary and materials) relative to the defensive sectors (healthcare, consumer staples and telecoms), as shown in Chart 16, top two panels. In addition, slowing Chinese growth will weigh on the materials sector, and rising tension in global trade will pressure the industrials sector. As such, we are upgrading consumer staples to overweight (from underweight) and telecoms to neutral, and downgrading materials to underweight (from neutral). Oil has gained 16% so far this year, driving energy equities to outperform the global benchmark by 6.2%. Going forward, however, the oil outlook is less certain as OPEC and Russia work to ease production controls, and demand is cloudy. This prompts us to close the overweight in the energy sector to stay on the sideline for now (Chart 16, bottom panel). We also suggest investors to reduce exposure in financials to a benchmark weighting due to our concerns on Europe and also the flattening of yield curves. After all these changes, we are now overweight healthcare and consumer staples while underweight consumer discretionary, utilities and materials. All other sectors are in line with benchmark weightings. Government Bonds Maintain Slight Underweight On Duration. BCA's house view has downgraded global risk assets to neutral and raised cash to overweight, while maintaining an underweight in fixed income.8 This prompts us to downgrade credit to neutral vs. government bonds (see next page). However, we still see rates rising over the next 9-12 months and so our short duration recommendation for the government bonds is unchanged. The U.S. Fed is on track to deliver a 25bps rate hike each quarter given robust business confidence and tight labor markets, and the ECB has announced it will stop new bond buying in its Asset Purchase Program after December this year. As such, bond yields are likely to move higher in both the U.S. and the euro area given the close relationship between 10-year term premium and net issuance (Chart 17). Chart 17Yields Will Rise Further Yields Will Rise Further Yields Will Rise Further Chart 18Favor Inflation-Linked Bonds Favor Inflation-Linked Bonds Favor Inflation-Linked Bonds Favor Linkers Vs. Nominal Bonds. The latest NFIB survey shows that wage pressure is on the rise, with reports of compensation increases hitting a record high (Chart 18, top panel). BCA's U.S. Bond Strategy still believes that the U.S. TIPS breakeven will rise to 2.4-2.5% around the time that U.S. core PCE inflation exceeds the Fed's 2% target rate (the Fed forecasts 2.1% by end-2018). Compared to the current breakeven level of 2.1%, this means 10-year TIPS has upside of 30-40bps, an important source of return in the low-return fixed income space (Chart 18, panel 2). Maintain overweight TIPS vs. nominal bonds. However, TIPS are no longer cheap. For those who have not already moved to overweight TIPS, we suggest "buying TIPS on dips". Inflation-linked bonds (ILBs) in Australia and Japan are also still very attractive vs. their respective nominal bonds (Chart 18, bottom panel). Overweight ILBs in those two markets also fits well with our macro themes. Corporate Bonds Chart 19Spreads Not Attractive Spreads Not Attractive Spreads Not Attractive We have favored both investment-grade and high-yield corporates (Chart 19) over government bonds for over two years. But, while monetary and credit conditions remain favorable, we think rising uncertainty and weakening corporate balance sheets in the coming quarters warrant a more cautious stance. We are moving to neutral on corporate credit. In Q1, outstanding U.S. corporate debt grew at an annualized rate of 4.4%, while pre-tax profits (on a national accounts basis) contracted by 5.7%, raising gross leverage from 6.9x to 7.1x. The benign default rates and tight credit spreads associated with robust economic growth are at risk now that leverage growth is soon poised to overtake cash flow growth, challenging companies' debt service capability. Finally, if labor costs accelerate, leverage will continue to rise in 2H18. Since February, our financial conditions index has tightened considerably driven by a combination of falling equity prices and a stronger dollar. As monetary policy shifts to an outright restrictive stance once inflation reaches the Fed's target later in 2018, corporates will suffer. The risk-adjusted returns to high yield (Chart 20) are no longer attractive relative to government bonds. Chart 20Junk Only Attractive If Defaults Stay Low Junk Only Attractive If Defaults Stay Low Junk Only Attractive If Defaults Stay Low Chart 21Rising Leverage Rising Leverage Rising Leverage Finally, valuations are expensive. Investment grade spreads have widened by 50bps from the start of the year, but junk spreads are still close to their post-crisis lows. As we are late in the credit cycle, we do not expect further contraction in spreads. For now monetary and credit quality indicators remain stable, but we are booking profits and moving both investment-grade and high-yield corporates to neutral. In the second half of the year, as corporate leverage (Chart 21) starts to deteriorate and monetary policy gets more restrictive, we will look to further review our allocations. Commodities Chart 22Strong Demand But Uncertain Supply In Oil Strong Demand But Uncertain Supply In Oil Strong Demand But Uncertain Supply In Oil Energy (Overweight): Underlying demand/supply fundamentals (Chart 22, panel 2) will continue to drive prices, as the correlation with the U.S. dollar breaks down. We expect the key OPEC countries to increase production by 800k b/d and over 210k b/d in 2H18 and 1H19 respectively. This will be offset by losses in the rest of OPEC of 530k b/d and 640k b/d in 2H18 and 1H19 respectively. Venezuelan production has dropped from a peak of 2.1m b/d to 1.4m b/d, and we expect it to reach 1.2m b/d by year end and 1.0m b/d by the end of 2019. Additionally, we expect Iranian exports to fall by 200k b/d to the end of 2018, and by another 300k b/d by the end of 1H19 as a result of sanctions. Demand seems to be holding up for now, but is conditional on developments in global trade. BCA's energy team forecasts Brent crude to average $70 in 2H18 and $77 in 2019. Industrial Metals (Neutral): China remains the largest consumer of metals, and so price action will react to underlying economic growth there and to the dynamics of its local metals markets. Additionally, a strengthening dollar will add downward pressure to prices and increase volatility. We expect a physical surplus in copper markets to emerge by year end, given slower demand growth and supply concerns due to restrictions on China's imports of scrap copper. Precious Metals (Neutral): Rising global uncertainties and geopolitical tensions driven by trade wars and divergent monetary policy will continue to keep market volatility high. During periods of equity market downturns, gold will continue to be an attractive hedge. Additionally, as inflationary pressures continue to rise, investors will continue to look for inflation protection in gold. However, rising interest rates and a strengthening dollar could limit price upside. We recommend gold as a safe-haven asset against unexpected volatility and inflation surprises. Currencies Chart 23Dollar Appreciation To Continue King Dollar Dollar Appreciation To Continue King Dollar Dollar Appreciation To Continue King Dollar U.S. Dollar: Following the recent strong economic data out of the U.S., the Fed is likely to maintain its moderately hawkish stance and follow its current dot plan of gradual rate hikes over the course of this year and next. For now the Fed is unlikely to accelerate the pace of hikes: it hinted that it could allow inflation to overshoot its target of 2% on core PCE. We expect the U.S. dollar to appreciate further over the coming months (Chart 23, panel 1). Euro: Disappointments in European economic data, in addition to political uncertainties in Italy, have led to a correction in the EUR/USD (Chart 23, panel 2). The ECB's indication that it will not raise rates through the summer of 2019 added further downward pressure on the currency. In addition, rising tension related to trade war and its impact on European growth is likely to dampen the euro's performance further. We look for EUR/USD to weaken to at least 1.12. JPY: The outlook for the yen is more mixed than for the euro. Japanese data over the past couple of months have been anemic, and interest rate differentials with the U.S. point to a weakening yen (Chart 23, panel 3). Moreover, the BoJ is still concerned with achieving its inflation target and so remains the last major central bank in full accommodative mode. However, escalating global tension is likely to be a positive factor for the JPY as a safe haven currency. It also looks far cheaper relative to PPP than does the euro. We see the yen trading fairly flat to the USD, but appreciating against the euro. EM Currencies: Tighter U.S. financial conditions, rising bond yields, and a strengthening dollar are all disastrous for EM currencies (Chart 23, panel 4). Additionally, the ongoing growth slowdown in China, and in EM as a whole, will add further downside pressures on most EM currencies. Alternatives Chart 24Turn Defensive On Alts Turn Defensive On Alts Turn Defensive On Alts Allocations to alternatives continue to rise as investors look for new avenues to preserve capital and generate attractive returns. We are turning more cautious on risk assets across all asset classes on the back of a possible growth slowdown and restrictive monetary policy. With intra-correlations between alternative assets reaching new lows (Chart 24), investors need to be especially careful picking the right category of alt investments. Return Enhancers: We have favored private equity over hedge funds since 1Q16, and this has generated an excess return of 20%. But, given our decision to scale back on risk assets on the back of a possible growth slowdown, we are turning cautious on private equity. Higher private-market multiples, stiff competition for buyouts from large corporates, and an uncertain macro outlook will make deal flow difficult. On the other hand, as volatility makes a comeback and markets move sideways, discretionary and systematic macro funds should fare better. We recommend investors pair back on their private equity allocations and increase hedge funds as we prepare for the next recession. Inflation Hedges: We have favored direct real estate over commodity futures since 1Q16; this position has generated a small loss of 1.4%. Total global commercial real-estate (CRE) loans outstanding have reached a record $4.3 trillion, 11% higher than at the pre-crisis peak. CRE prices peaked in late 2016, and are now flat-lining, partly due to the downturn of shopping malls and traditional retail. On the other hand, commodity futures have had a good run on the back of rising energy prices. We recommend investors reduce their real estate allocations, and put on modest positions in commodity futures as an inflation hedge. Volatility Dampeners: We have favored farmland and timberland over structured products since 1Q16, and this has generated an excess return of 6%. As noted in our Special Report,9 of the two, timberland assets tend to have a stronger correlation with growth, whereas farmland demand is relatively inelastic during times of a slowdown. Additionally, farmland returns tend to have lower volatility compared to timberland. Structured products will continue to suffer with rising rates. We recommend investors allocate more to farmland over timberland, and stay underweight structured products. Risks To Our View Chart 25What If China's Imports Weaken Sharply What If China's Imports Weaken Sharply What If China's Imports Weaken Sharply Our neutral view on risk assets implies that we see the upside and downside risks as evenly balanced. Could the macro environment turn out to be worse than we envisage? Clearly, there would be more downside for equities if the risks we highlighted in the Overview (slowing growth, U.S. inflation, trade war, Chinese policy) all come through. China and emerging markets are the key. China's import growth has been trending down for 12 months; could it turn significantly negative, as it did in 2015 (Chart 25)? Emerging markets look sensitive to further rises in U.S. interest rates and the dollar. The most vulnerable currencies have already fallen by up to 20% since the start of the year, but could fall further (Chart 26). We would not over-emphasize these risks, however. If growth were to slow drastically, China would roll out stimulus. Emerging markets are more resilient than they were in the 1990s, thanks to currencies that mostly are floating and generally healthier current account positions (though, note, their foreign-currency debt is bigger). Chart 26EM Currencies Could Fall Further EM Currencies Could Fall Further EM Currencies Could Fall Further Chart 27Is This An Excuse For The Fed To Be Dovish? Is This An Excuse For The Fed To Be Dovish? Is This An Excuse For The Fed To Be Dovish? On the positive side, the biggest upside risk comes from the Fed slowing the pace of rate hikes even though growth is robust. This might be because U.S. inflation remains subdued (perhaps for structural reasons) - or because the Fed allows an overshoot of inflation, either under political pressure, or because of arguments that its inflation target is "symmetrical" and that it has missed it on the downside ever since the target was introduced in 2012 (Chart 27). This would be likely to weaken the dollar, giving emerging markets a reprieve. It might lead to a 1999-like stock market rally, perhaps led again by tech - specifically, internet - stocks. 1 Please see What Our Clients Are Asking: How Seriously Should We Take The Risk Of A Trade War, on page 7 of this Quarterly for more analysis of this subject. 2 Please see What Our Clients Are Asking: How To Overweight Cash, on page 6 of this Quarterly for some suggestions on how to minimize this. 3 Please see Global Asset Allocation Special Report, "Hedge Funds: Still Worth Investing In?", dated June 16, 2017, available at gaa.bcaresearch.com 4 Please see Global Asset Allocation Special Report, "A Primer On Catastrophe Bonds", dated December 12, 2017, available at gaa.bcaresearch.com 5 Please see Global Asset Allocation Special Report, "Private Debt: An Investment Primer", dated June 6, 2018, available at gaa.bcaresearch.com 6 Please see Global Asset Allocation - Quarterly Portfolio Outlook, dated April 3, 2018, available at gaa.bcaresearch.com 7 Please see Global Investment Strategy - Special Report "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 20, 2018, available at gis.bcaresearch.com 8 Please see Global Investment Strategy - Special Report "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 20, 2018, available at gis.bcaresearch.com 9 Please see Global Asset Allocation - Special Report "U.S. Farmland & Timberland: An Investment Primer", dated October 24, 2017, available at gaa.bcaresearch.com GAA Asset Allocation