Sectors

Underweight (Upgrade Alert) It is a well-established rule that where jet fuel prices go, airline stock prices will go the opposite direction. Thus, it is no surprise that the most recent peak in the S&P airlines index coincided with the most recent trough in jet fuel prices in early 2017; the former has since fallen steeply as the latter has soared (fuel prices shown inverted in top panel). Easing oil prices are a likely catalyst for a significant rerating in depressed relative valuations. Fuel hedges no longer play a significant role in earnings and lower fuel costs would translate directly to the bottom line. As a reminder, nearly all major players reiterated their pledge to avoid kerosene hedging earlier this year. Adding it up, we think downside risks to airlines have abated considerably and are well reflected in beaten down valuations (bottom panel). We are therefore compelled to add this transportation sub-index to our upgrade watch list. If there is any letup in jet fuel prices, we would not hesitate to crystallize relative profits north of 21% since our underweight inception. Bottom Line: Stay underweight the S&P airlines index for now, but put in on upgrade alert; please see Monday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. Could Jet Fuel Be The Tailwind Airlines Need? Could Jet Fuel Be The Tailwind Airlines Need?

Overweight (High Conviction) The S&P software index is on the cusp of breaching the 2000 relative performance all-time peak, and we reiterate the high-conviction overweight status of this key tech sub-index, that is up over 11% versus the SPX since the late-November inception.1 BCA's synchronized global capex upcycle theme is the fundamental driver of our sanguine software industry view. Currently, software investment is outpacing overall capital outlays (second panel). These software capex market share gains on the back of a growing overall capex pie bode well for relative profit growth. Our S&P software EPS growth model corroborates this encouraging news (third panel), pointing to ongoing exceptionally strong earnings growth. Meanwhile, the S&P software index has a pristine balance sheet with virtually no net debt (bottom panel); if our virtuous capex upcycle thesis further bolsters software sales/profits in the coming months, then more gains are in store for the S&P software index that will likely grow into its pricey valuations. Bottom Line: We reiterate our high-conviction overweight status in the S&P software index. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, RHT, ADSK, CTXS, ANSS, SNPS, SYMC, TTWO, CDNS, CA. Stick With Software Stocks Stick With Software Stocks 1 Please see BCA U.S. Equity Strategy Weekly Report, "2018 High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com.

Highlights Chart 1Risks To The Bond Bear Market Risks To The Bond Bear Market Risks To The Bond Bear Market Two weeks ago we flagged that large net short positioning and elevated growth expectations left the Treasury market primed to benefit from any disturbance in the economic outlook. Since then the 10-year yield fell from a peak of 3.06% to 2.77%, before climbing back to 2.92%. With positioning still deeply net short and strong odds of a further decline in the economic surprise index (Chart 1), we continue to see an elevated risk that yields move lower on a 0-3 month horizon. But beyond that, less nimble investors should remain positioned for higher yields on a 6-12 month timeframe. The major risks in the global economy - Eurozone sovereign credit concerns and a strong dollar weighing on emerging market demand - are unlikely to put the Fed off its "gradual" pace of one rate hike per quarter unless they lead to a significant risk-off event in U.S. financial markets. Absent that sort of shock, the Fed will continue to lift rates "gradually" toward a neutral level near 3%, and eventually into restrictive territory. This rate hike path is consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%, well above current levels. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 45 basis points in May, dragging year-to-date excess returns down to -122 bps. Value has improved considerably since the start of the year. The 12-month breakeven spread for a Baa-rated corporate bond is back up to its 29th percentile relative to history (Chart 2). Market-derived inflation expectations also ebbed during the past month, with the 10-year and 5-year/5-year forward TIPS breakeven inflation rates now at 2.09% and 2.12% respectively. This is below the target range of 2.3% to 2.5% that would trigger a downgrade to our corporate bond allocation. The combination of more attractive value and a somewhat more supportive monetary environment (as evidenced by the decline in TIPS breakeven rates) increases the odds of near-term corporate bond outperformance, and we would not be surprised to see spreads tighten during the next few months. However, the longer run outlook for corporates remains negative. First quarter data showed a 5.7% annualized decline in pre-tax corporate profits, dragging the year-over-year growth rate down to 5.8% (bottom panel). As employee compensation costs accelerate in the second half of the year, we expect that corporate profit growth will fall sustainably below the pace of corporate debt growth leading to rising leverage (panel 4). Strong oil prices have caused the energy sector to outperform the overall index considerably since the middle of last year. Now, many energy sub-sectors no longer appear cheap on our model. We take this opportunity to downgrade a few energy sub-sectors from overweight to neutral, and adjust some other sector recommendations as well (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Bond Bear Still Intact Bond Bear Still Intact Table 3BCorporate Sector Risk Vs. Reward* Bond Bear Still Intact Bond Bear Still Intact High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 65 basis points in May, dragging year-to-date excess returns down to +36 bps. The average index option-adjusted spread widened 24 bps on the month, and currently sits at 356 bps. High-yield spreads are increasingly at odds with Moody's default rate projections. The latter call for the 12-month speculative grade default rate to fall to 1.5% by next April. The current 12-month trailing default rate is 3.7% (Chart 3). Using the Moody's default rate projection, and our own forecast for the recovery rate, we calculate the excess spread available in the Bloomberg Barclays High-Yield index to be 284 bps (after accounting for expected default losses). This is somewhat higher than the historical average of 248 bps. The current excess spread means that in an unchanged spread environment we would expect a High-Yield excess return (relative to duration-matched Treasuries) of +278 bps during the next 12 months. If the index spread were to tighten by 100 bps, we would expect an excess return of +675 bps. If the index spread were to widen by 100 bps we would expect an excess return of -120 bps (panel 3). If the excess spread were to simply revert to its historical average, then it would imply an excess High-Yield return of +427 bps. At the sector level, Moody's expects that most defaults during the next 12 months will come from the Media: Advertising, Printing & Publishing sector, followed closely by the Durable Consumer Goods and Retail sectors. Much of the projected improvement in the overall default rate results from a continued decline in Oil & Gas sector defaults compared to the past few years. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 5 basis points in May, dragging year-to-date excess returns down to -27 bps. The conventional 30-year zero-volatility MBS spread widened 4 bps on the month, driven entirely by a 4 bps increase in the compensation for prepayment risk (option cost). The option-adjusted spread held flat at 32 bps. Value in the MBS sector is by no means exciting. The nominal spread on a conventional 30-year MBS is near its all-time low, the option-adjusted spread is close to one standard deviation below its pre-crisis mean (Chart 4) and MBS no longer look very attractive compared to investment grade corporate credit (panel 3). The most compelling reason to hold agency-backed MBS is that mortgage refinancings are likely to remain very low, owing both to rising interest rates and the large number of homeowners that have already refinanced. Depressed refi activity should keep MBS spreads near historically low levels (bottom panel), even as stresses emerge in other spread product sectors, notably corporate bonds. We recently presented a method for calculating expected total returns for all different bond sectors, only using assumptions for the number of Fed rate hikes during the next 12 months and the expected change in spreads.1 Our results showed an expected total return of 2.9% for conventional 30-year MBS in a scenario where the Fed lifts rates by 100 bps and where spreads remain flat. The same scenario corresponds to 3.4% total return for the investment grade corporate index. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 33 basis points in May, dragging year-to-date excess returns down to -40 bps. Sovereign debt underperformed the Treasury benchmark by 158 bps on the month, dragging year-to-date excess returns down to -242 bps. Foreign Agencies underperformed by 37 bps on the month, dragging year-to-date excess returns down to -56 bps. Local Authorities underperformed by 22 bps on the month, dragging year-to-date excess returns down to +37 bps. Supranationals underperformed by 2 bps on the month, dragging year-to-date excess returns down to +2 bps. Domestic Agency bonds outperformed by 7 bps, bringing year-to-date excess returns up to +7 bps. Global growth divergences and a stronger U.S. dollar weighed on Sovereign bond returns in May (Chart 5). While value in the sector improved somewhat as a result, it remains expensive relative to investment grade corporate credit (panel 2). With dollar strength likely to persist in the near-term, we remain underweight Sovereign bonds. Conversely, we reiterate our overweight recommendations on Foreign Agency and Local Authority bonds. Those sectors still offer compelling valuations and are less sensitive to a strong U.S. dollar than the lower-rated Sovereign sector. Supranationals and Domestic Agency bonds are low risk but do not offer sufficient spread to warrant much attention. Better low-risk spread product opportunities are available in the Agency CMBS and Consumer ABS sectors. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 15 basis points in May, bringing year-to-date excess returns up to +110 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio declined 2% on the month and, at 86%, it is very close to its post-crisis low (Chart 6). It remains somewhat elevated compared to the average level of 81% that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. Technically, yield ratios have been supported by robust fund flows and subdued issuance (panels 2 & 3), while fundamentally our Municipal Health Monitor suggests that ratings upgrades will continue to outpace downgrades for the time being (not shown). The message from our Health Monitor is confirmed by the trend in state & local government net borrowing (bottom panel). First quarter data, released last week, showed a sizeable drop in net borrowing as state & local governments managed to grow revenues by $46 billion while growing expenditures by only $25 billion. This is consistent with governments working hard to repair their budgets, raising taxes and slowing spending growth, as we showed in a recent report.2 Given tight municipal valuations, we continue to see better opportunities in the corporate bond space than in municipal bonds. But we will look to upgrade munis at the expense of corporates as we approach the end of the credit cycle. Hopefully, from a more attractive entry point. 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 bull-flattened in May. The 2/10 Treasury slope flattened 3 bps to end the month at 43 bps. The 5/30 slope held steady at 32 bps. The short-end of the Treasury curve is still not adequately priced for the Fed's likely pace of one 25 basis point rate hike per quarter. Such a pace translates to a level of 100 bps on our 12-month discounter, which currently sits at only 73 bps (Chart 7). Similarly, the long-end of the Treasury curve is not adequately priced for the likely trend in inflation. The 10-year TIPS breakeven inflation rate is at only 2.09%, below the range of 2.3% to 2.5% that is consistent with well-anchored inflation expectations. We anticipate that higher TIPS breakevens at the long end of the curve will be roughly offset by loftier rate expectations at the short end of the curve, leaving the slope of the Treasury curve close to current levels during the next few months. In a recent report we introduced a framework for identifying the most attractively valued butterfly trades across the entire yield curve.3 The results, shown in Table 4, identify the 7-year bullet over the 1-year/20-year barbell as the most attractively valued butterfly trade that is geared toward curve steepening. According to our model, that trade is priced for 56 bps of 1/20 flattening during the next six months (panel 4). That seems excessive given the low level of long-maturity TIPS breakevens. Table 4Butterfly Strategy Valuation (As Of June 4, 2018) Bond Bear Still Intact Bond Bear Still Intact TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 65 basis points in May, dragging year-to-date excess returns down to +95 bps. The 10-year TIPS breakeven inflation rate fell 10 bps on the month and currently sits at 2.09%. The 5-year/5-year forward TIPS breakeven inflation rate fell 13 bps and currently sits at 2.12%. As we explained in a recent report, we view the first stage of the bond bear market as being driven by the re-anchoring of inflation expectations.4 We will consider inflation expectations well anchored when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are in a range between 2.3% and 2.5%, where they were the last time that inflation was well anchored around the Fed's target. Recent trends show that inflation is steadily making progress toward the Fed's 2% goal. The 12-month rate of change in the core PCE deflator is back up to 1.8%, from 1.5% in February. However, the core PCE deflator has only increased by 0.15% in each of the past two months. Consistent monthly prints above 0.165% are required to reach the Fed's 2% target (Chart 8). We expect tight labor markets and strong pipeline pressures (panel 3) to drive inflation higher in the months ahead. Although, as we discussed last week, the risk of a significant overshoot of the Fed's inflation target during the next 6-12 months is low.5 ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in May, bringing year-to-date excess returns up to -3 bps. The index option-adjusted spread for Aaa-rated ABS widened 1 bp on the month and now stands at 41 bps, 7 bps above its pre-crisis low. While consumer ABS offer reasonably attractive expected returns relative to other low-risk spread product (Agency CMBS, Domestic Agency bonds and Supranationals), credit risk is slowly starting to build in the sector. The New York Fed's Household Debt and Credit report showed that the 90+ day credit card delinquency rate rose above 8% in Q1 for the first time since 2015. Meanwhile, the overall consumer credit delinquency rate continues to increase alongside a rising debt service ratio (Chart 9). On the supply side, banks reported tightening credit card lending standards for the fourth consecutive quarter in Q1, while auto loan lending standards were tightened for the eighth consecutive quarter. Periods of tightening lending standards tend to coincide with rising delinquencies and wider spreads (bottom panel). In a recent report we forecasted 12-month total returns for each U.S. fixed income sector using inputs only for the path of spreads and the number of Fed rate hikes during the next year. In a scenario where spreads remain flat and the Fed lifts rates four times next year, we would expect Aaa-rated credit card ABS to return 2.3% and Aaa-rated auto loan ABS to return 2.4%.6 Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 1 basis point in May, bringing year-to-date excess returns up to +71 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 2 bps on the month and currently sits at 70 bps, close to one standard deviation below its pre-crisis mean. Banks eased lending standard on nonfarm nonresidential loans in Q1 for the first time since 2015, and continued easing could signal lower delinquencies in the future (Chart 10). Easier lending standards could also support commercial real estate prices, which have decelerated recently and currently pose a risk for spreads (panel 3). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 1 basis point in May, bringing year-to-date excess returns up to +13 bps. The index option-adjusted spread widened 1 bp on the month and currently sits at 48 bps. In a recent report we forecasted 12-month total returns for each U.S. fixed income sector using inputs only for the path of spreads and the number of Fed rate hikes during the next year. In a scenario where spreads remain flat and the Fed lifts rates four times next year, we would expect non-agency Aaa-rated CMBS to return 2.8% and Agency CMBS to return 2.6%.7 Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.54%. The drop in the model's fair value compared to last month stems from a decline in the global PMI from 53.5 to 53.1, and a rise in dollar bullish sentiment from 60% to 67%. While global growth has undoubtedly lost momentum in recent months, we also suspect that our 2-factor model is finally breaking down. The 2-factor model does not contain a variable to capture the degree of resource utilization in the economy. As resource slack dissipates, inflationary pressures mount and the same pace of global growth should be associated with a higher Treasury yield. This means that as we approach the end of the cycle, the 2-factor model will start producing fair value readings that are consistently too low. We can attempt to correct for this by incorporating a measure of resource slack into our model, in this case the employment-to-population ratio. A model for the 10-year Treasury yield based on the employment-to-population ratio and the Global PMI produces a fair value of 3.29% (Chart 11). As we move further toward the end of the cycle, and away from the zero-lower bound on the fed funds rate, we expect the regression coefficients shown in the bottom three panels will revert to their pre-crisis levels and Treasury fair value will revert closer to the one shown in the second panel. 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 Weekly Report, "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Profiting From A Higher LIBOR", dated March 20, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Breaking Points", dated May 29, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Pulling Back and Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Pulling Back and Looking Ahead", dated May 22, 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)

The GAA DM Equity Country Allocation model is updated as of May 31, 2018. No significant changes in the model's allocation this month, 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 Charts 1, 2 and 3, the overall model underperformed its benchmark by 111 bps in May, largely driven by Level 2 model which underperformed by 300 bps. The model's largest overweight, Italy, turned out to be the worst performer in May as a result of Italian politics, an event that is difficult for a quantitative model to capture. Level 1 model outperformed by only 7 bps in May. Consequently, since going live, the outperformance of the Level 2 model, which allocates funds among 11 non-U.S. countries, has reduced to 52 bps, while the overall model has performed in line with the MSCI World benchmark. 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 Model (Chart 4) is updated as of May 31, 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 The largest shift was a move from underweight to overweight in the materials sector, driven by improving momentum. On the other hand, the overweight in energy was reduced by 1.7 percentage points. The aggregate model now has a small overweight on cyclicals versus defensives, although this is entirely in commodity-related cyclicals. The only other overweight sector is utilities, which saw a small decrease in its weight in the model. 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 A virtuous software capex upcycle will continue to bolster industry sales/profits in the coming months. We reiterate our high-conviction overweight recommendation on the S&P software index. Depressed relative valuations signal that the weak airline profit margin backdrop is baked in the cake. Rising load factors and the possibility of an easing in jet fuel prices compel us to put this transportation sub-index on our upgrade watch list. Recent Changes Put the S&P Airlines Index on upgrade alert. Table 1 Unwavering Unwavering Feature Stocks took it on the chin early last week as geopolitical risks resurfaced in a big way, but managed to bounce smartly and end the week on a high note. Not only did Trump slap new tariffs reigniting trade war fears, but Italian political instability rocked global bond and stock markets. While this mini 'risk-off' phase has rattled investors, the key question hanging over markets is: will the current global growth soft patch prove transitory or morph into a severe global growth deceleration? We side with the former. While it is too early to call the end of the global growth lull, there are high odds that the U.S. will lift the world out of its year-to-date mini-slump in the back half of the year. The third panel of Chart 1 shows that the IHS Markit U.S. manufacturing PMI has been steeply diverging from the J.P. Morgan-calculated global manufacturing PMI. The latter has ticked up recently, and given recent U.S. economic greenshoots and America's heavy weighting in global output, it should pull global growth higher. Chart 1Too Soon To Bail Too Soon To Bail Too Soon To Bail Chart 2Monitor The Greenback's Impact On Profits Monitor The Greenback's Impact On Profits Monitor The Greenback's Impact On Profits Importantly, this leading U.S. economic growth indicator is also signaling that SPX momentum will resume its ascent in the coming months, a message corroborated by the latest ISM manufacturing survey print (second panel, Chart 1). What could push our still constructive cyclical 9-12 month equity view offside is a surge in the U.S. dollar. The greenback's trough coincided with last year's peak in global growth (bottom panel Chart 1), and further dollar appreciation - resulting from either stress in emerging markets or a further flare-up of Eurozone breakup risk - would necessitate downward revisions to calendar 2019 sell-side earnings forecasts (Chart 2). We are closely monitoring Eurozone geopolitical risks, and are also awaiting the ECB's response. If persistent turmoil causes the ECB to stay easier for longer than the market expects, then the euro will come under downward pressure against the dollar, especially if the Fed continues to hike as we expect. Last week alone BCA's months-to-hike gauge for the ECB jumped by five months, implying the first hike moved to mid-year 2020 (second panel, Chart 3). We recently showed the U.S. tech sector's hefty foreign sales exposure of roughly 60% of total revenues, greater than for any other GICS1 sector by a wide margin (please refer to Chart 8 from the April 9, 2018 Weekly Report titled "Buying Opportunity?"). As such the technology sector's profits serve as a great leading indicator of any U.S. dollar appreciation related blues. Up to now, tech net EPS revisions have not been sniffing out any currency related earnings trouble that could infiltrate overall SPX EPS (U.S. trade-weighted dollar shown inverted, third panel, Chart 4). Similarly, relative tech sector stock momentum and our tech sector EPS growth model are not waving any yellow flags (Chart 4). Chart 3Steadfast ##br##SPX Steadfast SPX Steadfast SPX Chart 4Tech Stocks Will Be The First To Sniff ##br##Out U.S. Dollar Profit Woes Tech Stocks Will Be The First To Sniff Out U.S. Dollar Profit Woes Tech Stocks Will Be The First To Sniff Out U.S. Dollar Profit Woes Netting it all out, there are high odds that the U.S. will lead global growth higher in the coming quarters and result in a recoupling higher of global growth, assuming the greenback stops appreciating. This would support low double digit calendar 2019 SPX profit growth. Under such a macro backdrop, it still pays to maintain a cyclicals over defensives portfolio bent. This week we are revisiting one tech sector high-conviction overweight and putting a transport sub-index on upgrade watch. Stick With Software Stocks The S&P software index is on the cusp of breaching the 2000 relative performance all-time peak, and we reiterate the high-conviction overweight status of this key tech sub-index, that is up over 11% versus the SPX since the late-November inception.1 Although this may appear exuberant, from a longer-term perspective, relative share prices only recently reclaimed the upward sloping historical time trend mean (top panel, Chart 5). The implication is that more gains are in store prior to the end of the business cycle. BCA's synchronized global capex upcycle theme is the fundamental driver of our sanguine software industry view. In the aftermath of the dotcom bust, tech investment in general and software in particular, went into hibernation for a whole decade. Currently, software investment is outpacing overall capital outlays (middle panel, Chart 5). These software capex market share gains on the back of a growing overall capex pie bode well for relative profit growth. Animal spirits remain upbeat with both consumer and most importantly CEO confidence probing multi-year highs. Tack on the still buoyant message from our capex indicator and software spending has more room to grow (second & third panels, Chart 6). In addition, the government sector may also increase spending on IT/software services on the back of easing fiscal policy and beefing up on cybersecurity (Chart 7). Chart 5Buy The Breakout Buy The Breakout Buy The Breakout Chart 6Even Uncle Sam Is Buying Software Even Uncle Sam Is Buying Software Even Uncle Sam Is Buying Software Chart 7Margin Expansion Phase Has Legs Margin Expansion Phase Has Legs Margin Expansion Phase Has Legs While our S&P software EPS growth model corroborates this encouraging news (bottom panel, Chart 5), sell side analysts do not share our optimism. In fact, software profits are forecast to trail the broad market by 500bps, a rather low hurdle. On the operating front, sales are accelerating at a time when labor costs remain contained. Importantly, software prices are on the verge of exiting deflation, underscoring that software demand is robust. Moreover, the secular advance in cloud computing and SaaS represent a long-term positive demand backdrop. The upshot is that the mini margin expansion phase in place since early-2016 has more legs (Chart 7). Meanwhile, the S&P software index has a pristine balance sheet with virtually no net debt, a high interest coverage ratio and galloping higher free cash flow (Chart 8). Unsurprisingly, this cash rich tech subsector has also been in the middle of an M&A frenzy. This supply reduction is not only bullish for industry pricing power, and thus profit growth, but it has also led to hefty M&A premia and a significant valuation rerating (bottom panel, Chart 9). Chart 8Pristine Balance Sheet Pristine Balance Sheet Pristine Balance Sheet Chart 9Software Will Grow Into Pricey Valuations Software Will Grow Into Pricey Valuations Software Will Grow Into Pricey Valuations If our virtuous capex upcycle thesis further bolsters software sales/profits in the coming months, then more gains are in store for the S&P software index that will likely grow into its pricey valuations. Bottom Line: We reiterate our high-conviction overweight status in the S&P software index. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, RHT, ADSK, CTXS, ANSS, SNPS, SYMC, TTWO, CDNS, CA. Could Jet Fuel Be The Tailwind Airlines Need? It is a well-established rule that where jet fuel prices go, airline stock prices will go the opposite direction. Thus it is no surprise that the most recent peak in the S&P airlines index coincided with the most recent trough in jet fuel prices in early 2017; the former has since fallen steeply as the latter has soared (top panel, Chart 10). This relationship has grown more acute as the industry, having been burned when fuel prices collapsed in 2014, has all but abandoned fuel hedging. The timing for rising jet fuel prices could scarcely be less opportune; historically, airlines have been able to pass through rising fuel costs. Now, in the midst of an industry price war, pricing power and fuel costs are diverging (second panel, Chart 10). The impact is apparent on industry margins, which have been in decline for nearly two years and more pain likely lies ahead (second panel, Chart 11). The head of airline industry group International Air Transport Association (IATA), recently noted that rising oil prices would significantly bite into airline profitability next year; IATA is widely expected to lower its industry benchmark profit forecast this week. Chart 10Mind The Gap Mind The Gap Mind The Gap Chart 11Acute Margin Trouble... Acute Margin Trouble... Acute Margin Trouble... The source of industry conflict has been an uptick in capacity growth. Airlines are adding capacity faster than the economy is growing (third and fourth panels, Chart 11) and the only relief valve to preserve market share is to cut prices. In this context, it is difficult to understand analysts' 20%+ EPS growth forecast for next year, significantly outpacing the S&P 500 (bottom panel, Chart 11). However, the news is not all bad. Despite the competitive headwinds, the industry has been successful at moving unit revenues higher and airlines have been doing so at an aggressive pace in 2018 (second panel, Chart 12). Further, industry load factors (in essence, the percentage of filled seats) are near their highest level ever, indicating capacity growth is being met with lower price-induced demand growth (bottom panel, Chart 12). Rising load factors are typically a precursor to price (and profit) increases. Investors appear to have capitulated. Airlines trade at roughly half the market multiple on an EV/EBITDA basis and a substantial discount on a price/book basis (second & third panels, Chart 13). From a valuation perspective, airlines look set to take off. Chart 12...But Demand is Firming... ...But Demand is Firming... ...But Demand is Firming... Chart 13...And Most Bad News Is Likely Priced In ...And Most Bad News Is Likely Priced In ...And Most Bad News Is Likely Priced In Easing oil prices are a likely catalyst for a significant rerating in depressed relative valuations. Fuel hedges no longer play a significant role in earnings and lower fuel costs would translate directly to the bottom line. As a reminder, nearly all major players reiterated their pledge to avoid kerosene hedging earlier this year. Adding it up, we think downside risks to airlines have abated considerably and are well reflected in beaten down valuations. We are therefore compelled to add this transportation sub-index to our upgrade watch list. If there is any letup in jet fuel prices, we would not hesitate to crystallize relative profits north of 21% since our underweight inception. Bottom Line: Stay underweight the S&P airlines index for now, but put in on upgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "2018 High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Overweight Defense stocks have been range-bound in the last week as geopolitical maneuvering has seen probabilities of conflict on the Korean peninsula swinging wildly back and forth. Using this conflict to value defense equities seems fraught with forecast risk and we would argue that focusing on domestic rearmament is a better use of investors' time. In last month's data release, Department of Defense outlays showed the longest streak of increases this decade, pointing to a continued acceleration in defense spending (second panel). This is mirrored by surging government investment in defense, now at its highest level in 5 years (third panel). The Trump administration's commitment to rearmament has now made it into the federal budget; the Congressional Budget Office (CBO) estimates defense outlays will approximate wartime levels in 2019 (bottom panel). Net, we expect earnings visibility will peak through the fog of war and be the ultimate driver of stock market returns; stay overweight. The ticker symbols for the stocks in the BCA Defense index are: LMT, GD, RTN, NOC, LLL. Defense Spending Showing No Signs Of Slowing Defense Spending Showing No Signs Of Slowing

Dear Client, I will be visiting clients next week. Instead of our Weekly Report, we will be sending you a Special Report written by my colleagues Matt Gertken and Ray Park. The report addresses the North Korean situation and argues that a positive, if not perfect, diplomatic solution will result from U.S.-North Korean negotiations. Best regards, Peter Berezin, Chief Global Strategist Highlights The U.S. can withstand further rate hikes. Neither economic nor financial imbalances are especially elevated, while fiscal stimulus will offset much of the sting from tighter monetary policy. Unfortunately, America's resilience to higher rates does not extend to the rest of the world. A stronger dollar is undermining emerging markets, which are already under pressure from slower Chinese growth and the looming prospect of trade wars. The crisis in Italy will further restrain the ECB from withdrawing monetary support. Investors focused on capital preservation should remain underweight Italian bonds. More speculatively-minded investors could consider opening a long position in BTPs versus bunds, but not before the Italian 10-year yield has reached 4%. EUR/USD came within a whisker of our 1.15 target this week. We will book profits on our long DXY trade recommendation if the dollar index reaches 96. A defensive posture is appropriate for now, but risk assets should recover later this year as the global economy finds its footing. This could set the scene for a blow-off rally in stocks. Feature Gauging The Pain Threshold From Higher Rates Chart 1Market Expectations Slightly Below Fed Dots Market Expectations Slightly Below Fed Dots Market Expectations Slightly Below Fed Dots After the recent turbulence, the market is pricing in 100 basis points of Fed rate hikes between now and the end of 2020 (Chart 1). Such a pace of rate hikes would be quite slow by historic standards. In past tightening cycles, the Fed would typically raise rates by about 50 basis points per quarter. Investors expect the real fed funds rate to peak at around 1%, well below the historic average of 3%-to-5%. Underlying these expectations is the presumption that the neutral rate of interest - the rate consistent with full employment and stable inflation - is quite low, and that the Fed will not have to raise rates much above neutral to cool the economy. According to the April FOMC minutes, "a few" participants thought that the fed funds rate was already close to its equilibrium level. There are many reasons to think that R-star has fallen over time, but in practice, the margin of error around estimates of the neutral rate is huge. Thus, rather than getting bogged down over technical issues, investors would be well served by taking a more practical approach and asking what they should be on the lookout for to determine whether interest rates have moved into restrictive territory. The State Of The U.S. Housing Market Housing has historically been the most important interest rate-sensitive sector, so much so that Ed Leamer entitled his 2007 Jackson Hole symposium paper "Housing Is The Business Cycle."1 Given the recent runup in mortgage yields, it is not too surprising that the latest data on U.S. housing has been on the weak side (Chart 2). Mortgage applications for purchase have come off their highs. Housing starts, building permits, and new and existing home sales all declined in April. Homebuilder sentiment improved a tad, but this was due to an increase in the current sales component; future sales expectations were flat on the month. The share of respondents who indicated that now was a good time to buy a home in the latest University of Michigan Consumer Sentiment survey declined to 69% in May, continuing its slide from a peak of 83% in December 2014. Still, we would not fret too much about the state of the U.S. housing market (Chart 3). Construction activity has been slow to increase this cycle, which has pushed vacancies to ultra-low levels. Home prices have been rising briskly, but are still 13% below their 2006 peak once adjusted for inflation. On both a price-to-rent and price-to-income basis, home prices do not appear overly stretched. Mortgage servicing costs, expressed as a share of disposable income, are near all-time lows. The homeownership rate has also been trending higher, thanks to faster household formation and an improving labor market. Chart 2U.S. Housing: Higher Mortgage##br## Rates Are A Headwind... U.S. Housing: Higher Mortgage Rates Are A Headwind... U.S. Housing: Higher Mortgage Rates Are A Headwind... Chart 3...But Don't##br## Fret Yet ...But Don't Fret Yet ...But Don't Fret Yet Household Debt Is Not Yet At Worrying Levels Lenders also remain circumspect (Chart 4). Mortgage debt has barely grown as a share of disposable income throughout the recovery, and is still 31 percentage points below 2007 levels. The average FICO score for new mortgages stands at a healthy 761, well above pre-recession standards. The Urban Institute Housing Credit Availability Index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, is nowhere close to dangerous levels. This is particularly the case for private-label mortgages, whose default risk has hovered at just over 2% during the past few years, down from a peak of 22% in 2006. A dwindling share of loan originations since the financial crisis has involved adjustable rate mortgages (Chart 5). This has made the housing market more resilient to Fed rate hikes. Other parts of the household credit arena look more menacing, but not so much that they threaten to short-circuit the economy. Banks have been tightening lending standards on auto loans since Q2 of 2016 and credit card loans since the second quarter of last year. This should help moderate the increase in default rates that has been observed in those categories (Chart 6). Chart 4Mortgage Debt Is Not ##br##A Cause For Concern Mortgage Debt Is Not A Cause For Concern Mortgage Debt Is Not A Cause For Concern Chart 5Housing Market: More Resilient To ##br##Rate Hikes Than It Used To Be Housing Market: More Resilient To Rate Hikes Than It Used To Be Housing Market: More Resilient To Rate Hikes Than It Used To Be Chart 6Lenders Are More ##br##Circumspect These Days Lenders Are More Circumspect These Days Lenders Are More Circumspect These Days Student debt has continued to trend higher, but the vast majority of these loans is backstopped by the government. While the Treasury's own finances are on an unsustainable trajectory, this is more of a long-term concern than a short-term problem. If anything, fiscal stimulus over the next two years will allow the Fed to raise rates more than it could otherwise without endangering the economy. Corporate Borrowing: High But Not Extreme Like a river, market liquidity tends to flow along the path of least resistance, rather than towards those who happen to be the most thirsty. While the household sector was piling on debt during the 2001-2007 boom, the U.S. corporate sector was still recovering from the hangover produced by the capex boom in the late 1990s. A decade later, corporate balance sheets were in good shape. Spurred on by ultra-low interest rates, corporate debt levels began to rise. Today, the ratio of corporate debt-to-GDP is near a record high. Valuations for corporate assets have reached lofty levels. In inflation-adjusted terms, commercial real estate prices are 4% above their pre-recession peak (Chart 7). U.S. equities also trade at a historically elevated multiple to earnings, sales, and book value (Chart 8). There are bright spots, however (Chart 9). Thanks to lofty corporate profits, the ratio of corporate debt-to-EBITDA is in the middle of its post-1990 range based on national accounts data. Interest payments-to-EBIT are near historic lows. Corporate bonds now represent 60% of total corporate liabilities. Bonds tend to have much longer maturities than bank loans, which provides a buffer against default risk. Although the picture is not as benign if one performs a bottom-up analysis of publicly-listed companies, the overall message is that the U.S. corporate sector can handle higher rates. Corporate stresses will eventually rise, but it will likely take a recession for this to happen, which we don't expect until 2020. Chart 7Commercial Real Estate Prices: ##br##Above Pre-Recession Levels Commercial Real Estate Prices: Above Pre-Recession Levels Commercial Real Estate Prices: Above Pre-Recession Levels Chart 8U.S. Equities##br## Are Overvalued U.S. Equities Are Overvalued U.S. Equities Are Overvalued Chart 9Corporate Debt Is High,##br## But So Are Profits Corporate Debt Is High, But So Are Profits Corporate Debt Is High, But So Are Profits Cyclical Spending Still Subdued The discussion above suggests that U.S. interest rate-sensitive sectors can withstand further rate hikes. This conclusion is buttressed by the observation that the cyclical sectors of the economy - the ones that tend to weaken the most during recessions - have yet to reach levels that make them vulnerable to a sharp retrenchment. Chart 10 shows that the sum of business capital spending, residential and commercial construction, and consumer discretionary goods purchases is still well below levels that have preceded past recessions. Along the same lines, the private sector financial balance - the difference between what the private sector earns and what it spends - is currently in surplus to the tune of 2.2% of GDP. This compares to deficits of 5.4% of GDP in 2000 and 3.8% of GDP in 2006 (Chart 11). Further monetary tightening, to the extent that it prevents any brewing imbalances in the real economy and financial markets from worsening, may be just what the doctor ordered. Chart 10Cyclical Spending Still Below Levels##br## Preceding Past Recessions Cyclical Spending Still Below Levels Preceding Past Recessions Cyclical Spending Still Below Levels Preceding Past Recessions Chart 11U.S. Private Sector Financial##br## Balance Is Healthy U.S. Private Sector Financial Balance Is Healthy U.S. Private Sector Financial Balance Is Healthy The Sneeze Felt Around The World The U.S. is not an island unto itself. Even if a bit outdated, the old adage which says that when the U.S. sneezes the rest of the world catches a cold, still rings true. As such, focusing on the neutral rate only as it pertains to the U.S. is a bit too parochial. There may be a lower "shadow" neutral rate which, if breached, causes pain outside the U.S. before it causes pain in the U.S. itself. Emerging markets are particularly sensitive to changes in U.S. financial conditions. About 80% of EM foreign-currency debt is denominated in dollars. A stronger dollar and higher U.S. interest rates make it more difficult for EM borrowers to service their debts. While EM foreign-currency debt has declined as a share of total debt outstanding, this is only because the past decade has seen a boom in local debt issuance (Chart 12). As a share of GDP, exports, and international reserves, U.S. dollar debt is at levels not seen in over 15 years (Chart 13). Most emerging markets entered 2018 with strong growth momentum. Recent tracking estimates point to some deceleration in GDP growth, but nothing too alarming (Chart 14). That could begin to change. EM financial conditions have started to tighten, which is likely to weigh on activity. BCA's Emerging Market and Geopolitical Strategy teams have flagged the prospect of policy-inducing tightening in China. Trade tensions also seem to be escalating again following President Trump's decision this week to curb Chinese investment in the U.S., impose a 25% tariff on $50 billion of Chinese imports, and slap tariffs on foreign steel. All this could put an additional dent in global growth. While this publication does not expect a full-blown EM crisis, a period of EM underperformance over the next few months is likely. Chart 12EM Borrowers Like Local Credit, ##br##But Don't Dislike Foreign-Currency Debt EM Borrowers Like Local Credit, But Don't Dislike Foreign-Currency Debt EM Borrowers Like Local Credit, But Don't Dislike Foreign-Currency Debt Chart 13EM Dollar##br## Debt Is High EM Dollar Debt Is High EM Dollar Debt Is High Chart 14EM Growth Decelerating,##br## But Not Dramatically... Yet EM Growth Decelerating, But Not Dramatically... Yet EM Growth Decelerating, But Not Dramatically... Yet Italy: If You Are Gonna Do The Time, You Might As Well Do The Crime Even if emerging markets avoid another major crisis, one can always count on Europe to try to fill the void. The Italian 10-year bond yield is up over 100 basis points since the middle of April. Assuming a fiscal multiplier of one, a standard Taylor Rule equation says that Italy would need 2% of GDP in fiscal stimulus per year to offset the tightening in financial conditions brought upon by the recent increase in borrowing costs.2 That is 20% of GDP in stimulus over the next decade to pay for a fiscal package that has yet to be implemented by a government that does not yet (and may never) exist. At this point, investors are basically punishing Italy for a crime – defaulting and possibly jettisoning the euro – it has yet to commit. If you are going to get reprimanded for something you have not done, you have more incentive to do it. The market realizes this, which is why it is locked in a vicious circle where rising yields make default more likely, leading to even higher yields (Chart 15). The fact that GDP per capita in Italy is no higher now than when the country adopted the euro in 1999, and Italian public support for euro area membership is lower than elsewhere, has only added fuel to investor concerns (Chart 16). Chart 15When A Lender Of Last Resort Is Absent, Multiple Equilibria Are Possible Who Suffers When The Fed Hikes Rates? Who Suffers When The Fed Hikes Rates? Chart 16Italy: Neither Divine Nor A Comedy Italy: Neither Divine Nor A Comedy Italy: Neither Divine Nor A Comedy As we go to press, rumours are swirling that the Five Star Movement and Lega may be able to form a government after agreeing to appoint a less euroskeptic finance minister than the one the Italian President previously rejected. Regardless of whether this happens, investors are likely to remain on edge. Support for Lega has risen by seven percent since voters went to the polls in March. Populism is here to stay. All this suggests that the brewing crisis in Italy will not blow over easily. Investors focused on capital preservation should remain underweight Italian bonds. More speculatively-minded investors should consider opening a long position in BTPs versus bunds, but not before the Italian 10-year yield reaches 4%. At that point, the risk-reward trade-off from owning Italian debt would be too good to ignore. Until the Italian bond market reaches a capitulation point, the euro will remain under pressure. The Italian sovereign debt market is the biggest in Europe and the fourth largest in the world after the U.S., Japan, and China. If foreign investors continue to shun Italian debt, that will reduce capital inflows into the euro area. This means less demand for the common currency. Investment Conclusions The softening of global growth this year, along with tensions in emerging markets and Italy, have lit a fire under the dollar. Our long DXY trade is up 10.7% inclusive of carry. We continue to think that the path of least resistance for the dollar is up, but we will be looking to book gains on our trade recommendation once the dollar index reaches 96. That's roughly 2% above current levels. Slower global growth is bad news for cyclical equities. European and Japanese equities have a greater tilt towards cyclical sectors, so it is likely that their stock markets will underperform the U.S. over the next few months. This is particularly the case for Europe, where banks have come under pressure due to slower domestic growth, rising bond yields in Italy and Spain, and heightened exposure to emerging markets. For now, our MacroQuant model, which is designed to capture short-term movements in the stock market, is recommending a somewhat below-benchmark allocation to equities. Looking further out, our 12-month cyclical view on stocks remains modestly constructive, reflecting our expectation that the next major recession in developed markets is still two years away. Keep in mind that even the EM crisis in the 1990s did not plunge the U.S. into recession. On the contrary, the crisis restrained the Fed from raising rates too quickly. The resulting dose of liquidity led to a massive blow-off rally in equities, which took the S&P 500 up 68% between October 1998 and March 2000. European stocks did even better during that period, outperforming their U.S. peers by 40% in local-currency terms. We may be heading for a similar sequence of events. 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 The original Taylor Rule introduced by John Taylor in 1992 assigns a coefficient of 0.5 on the output gap. Thus, a one hundred basis-point rise in interest rates would be necessary to offset a 2% of GDP increase in output. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Neutral Relative share price gains for the S&P managed health care index are nearly exhausted. In Tuesday's Weekly Report, we acted on our late-March downgrade alert and took profits of 28% versus the S&P 500 since inception. At the margin, macro drivers have turned from a tailwind to a mild headwind. If relative health care spending has troughed for the cycle, then there are high odds that the decade long relative bull market has run its course and a major top is in place (top panel). Industry revenue growth is fraying around the edges. The second panel shows that the hiring plans subcomponent of the NFIB survey of small business owners has sunk recently. The implication is that enrollment may also be nearing a peak. Finally, the recent industry M&A frenzy is ebbing, signaling that the M&A premia may soon come out of relative valuations, which are already trading one standard deviation above the historical mean (bottom panel). Bottom Line: Downgrade the S&P managed health care index to neutral. Please see our Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC. Managed Health Care - Do Not Overstay Your Welcome Managed Health Care - Do Not Overstay Your Welcome

Highlights The global trade slowdown will intensify, even if U.S. domestic demand remains robust. The large emerging Asian bourses will recouple to the downside with their EM peers. Market-neutral EM equity portfolios should consider going long consumer staples while shorting banks. In Chile, receive 3-year swap rates. Continue to overweight stocks relative to the EM benchmark. Short the Colombian peso versus the Russia ruble. Stay neutral on Colombian equities and local bonds but overweight sovereign credit within their respective EM universes. Feature Performance of large equity markets in north Asia - Korean, Taiwanese and Chinese investable stocks -- has been relatively resilient compared with other EM bourses. Specifically, the EM ex-China, Korea and Taiwan equity index has already dropped 16% in U.S. dollar terms, while the market cap-weighted index of investable Chinese, Korean and Taiwanese stocks is down only 8% from its peak in late January.1 These three markets account for 60% of the MSCI EM stock index. A pertinent question is whether these North Asian markets will de-couple from or re-couple with the rest of EM. Our bias is that they will re-couple to the downside. Global equity portfolios should continue to underweight Asian stocks versus the DM bourses in general, and the S&P 500 in particular. That said, dedicated EM equity portfolios should overweight Korea and Taiwan and maintain a neutral stance on China and Hong Kong relative to the EM and Asian equity benchmarks. The Global Trade Slowdown Will Intensify Emerging Asian stock markets are very sensitive to global trade cycles. Slowing global trade is typically negative for them. There is growing evidence that the global trade deceleration will intensify: The German IFO index for business expectations in German manufacturing - a good leading indicator for global trade - is pointing to a further slowdown in global exports (Chart I-1). Chart I-1Global Trade Slowdown Will Persist Global Trade Slowdown Will Persist Global Trade Slowdown Will Persist Export volume growth has already slowed across manufacturing Asia (Chart I-2). The most recent data points for these series are as of April. Asia's booming tech/semiconductor industry is also slowing. Both Taiwan's export orders growth and Singapore's technology PMI new orders-to-inventory ratio have relapsed (Chart I-3). Chart I-2Asian Exports Growth: Heading Southward Asian Exports Growth: Heading Southward Asian Exports Growth: Heading Southward Chart I-3Asian Tech: Feeling The Pinch Asian Tech: Feeling The Pinch Asian Tech: Feeling The Pinch One of the causes of weakness in the global semiconductor cycle could be stagnating global auto sales (Chart I-4). The latter are being weighed down by weakness in auto sales in China and the U.S. Cars require a significant amount of semiconductors, and lack of improvement in global auto sales will suppress semiconductor demand. So far, China has not been at the epicenter of investors' concerns, but this will soon change as its growth slowdown intensifies. Credit conditions continue to tighten in China, which entails downside risks to mainland capital spending and consequently imports. China's imports are set to slump considerably, reinforcing the global trade downturn.2 First, China's bank loan approvals have dropped considerably in the past 18 months, suggesting a meaningful slowdown in bank financing and in turn the country's investment expenditures (Chart I-5). Chart I-4Global Auto And Semiconductor Sales Global Auto And Semiconductor Sales Global Auto And Semiconductor Sales Chart I-5China: Bank Loan Approval And Capex China: Bank Loan Approval And Capex China: Bank Loan Approval And Capex Second, not only are bank loan standards tightening but costs of financing are also rising. The share of loans extended above the prime lending rate has risen to a 15-year high (Chart I-6, top panel). This represents marginal tightening. Finally, onshore corporate bond yields as well as offshore U.S. dollar-denominated corporate bond yields have broken to new highs in this cycle (Chart I-6, bottom panels). Mounting borrowing costs and tighter credit standards in China point to further deceleration in credit-sensitive spending such as investment expenditures and property purchases. On the whole, rising interest rates and material currency depreciation in EM ex-China and credit tightening in China will prompt a considerable slump in imports, depressing world trade. EM including Chinese imports account for 30% of global imports, while the U.S. and EU together make up 24% of global imports values. Hence, global trade will disappoint if and as EM and Chinese imports stumble. A final word on the history of de-coupling among EM regions is in order. There have been a few episodes when emerging Asian and Latin American stocks de-coupled: In 1997-'98, the home-grown Asian crisis devastated regional markets, but Latin American stocks continued to rally until mid-1998 - when they plummeted (Chart I-7, top panel). Chart I-6China: Rising Borrowing Costs China: Rising Borrowing Costs China: Rising Borrowing Costs Chart I-7De-coupling Between Asia And Latin America De-coupling Between Asia And Latin America De-coupling Between Asia And Latin America In 2007-'08, emerging Asian equities tumbled along with the S&P 500, but Latin American bourses fared well until the middle of 2008 due to surging commodities/oil prices (Chart I-7, middle panel). Finally, the bottom panel of Chart I-7 illustrates that in early 2015, Asian stocks performed well, supported by the inflating Chinese equity bubble. Meanwhile, Latin American stocks plunged. In all of these episodes, the de-coupling between Asia and Latin America proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside. Bottom Line: Global trade is set to head southward, even if U.S. demand remains robust. China's growth slump will be instrumental to this global trade slowdown. Consequently, Chinese, Korean and Taiwanese equities will be vulnerable. Heeding To Market Signals Financial markets often move ahead of economic data, and simply tracking data is not always helpful in gauging turning points in business cycles. By the time economic data change course, financial markets would typically have already partially adjusted. Besides, past economic and financial market performance is not a guarantee of future performance. This is why we rely on thematic fundamental analysis and monitor intermediate- and long-term trends in financial markets to navigate through markets. There are presently several important market signals that investors should be heeding to: EM corporate bond yields are surging, which typically foreshadows falling EM share prices (Chart I-8). Meanwhile, there is no robust correlation between EM equities and U.S. bond yields. Chart I-8EM Share Prices Always Decline When EM Corporate Bond Yields Rise EM Share Prices Always Decline When EM Corporate Bond Yields Rise EM Share Prices Always Decline When EM Corporate Bond Yields Rise The basis: So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate bond yields decline and EM share prices rally. But when EM corporate (or sovereign) yields rise, irrespective of whether this is due to rising U.S. Treasury yields or widening EM credit spreads, EM equity prices come under considerable selling pressure. Lately, both EM credit spreads have been widening, offsetting the drop in U.S. bond yields. Hence, a drop in U.S. bond yields is not in and of itself sufficient to halt a decline in EM share prices. So long as EM corporate and sovereign credit spreads are widening by more than the decline in U.S. Treasury yields, EM corporate and sovereign bond yields will rise, heralding lower EM share prices. The ratio of total return (including carry) of six commodities currencies relative to safe-haven currencies3 is breaking below its 200-day moving average after having bounced from this technical support line several times in the past 12 months (Chart I-9). This could be confirming that the bull market in EM risk assets is over, and a bear market is underway. Chinese property stocks listed onshore have broken down, and those trading in Hong Kong seem to be forming a head-and-shoulder pattern (Chart I-10). In the latter case, such a technical formation will likely be followed by a considerable down-leg. Chart I-9An Important Breakdown bca.ems_wr_2018_05_31_s1_c9 bca.ems_wr_2018_05_31_s1_c9 Chart I-10Chinese Property Stocks Look Very Vulnerable Chinese Property Stocks Look Very Vulnerable Chinese Property Stocks Look Very Vulnerable Further, China's onshore A-share index has already dropped by 15% from its cyclical peak in late January. Finally, both emerging Asia's relative equity performance against developed markets, as well as the emerging Asian currency index versus the U.S. dollar (ADXY) seem to be rolling over at their long-term moving averages (Chart I-11). The same technical pattern is presenting itself for global energy and mining stocks in absolute terms, and also in the overall Brazilian equity index (Chart I-12). Chart I-11Asian Equities And Currencies Are ##br##At Critical Juncture Asian Equities And Currencies Are At Critical Juncture Asian Equities And Currencies Are At Critical Juncture Chart I-12Commodity Equities And Brazil ##br##Are Facing Technical Resistance Commodity Equities And Brazil Are Facing Technical Resistance Commodity Equities And Brazil Are Facing Technical Resistance The failure of these markets to break above their long-term technical resistance levels may be signalling that their advance since early 2016 has been a cyclical - not structural - bull market, and is likely over. These technical chart profiles so far confirm our fundamental analysis that the EM and commodities rallies since early 2016 did not represent a multi-year secular bull market. If correct, the downside risks to EM including Asian markets are substantial, and selling/shorting them now is not too late. Bottom Line: EM including Asian stocks, currencies and credit markets are at risk of gapping down. Absolute-return investors should trade these markets on the short side. Asset allocators should underweight EM markets relative to DM in general and the U.S. in particular. A complete list of our currency, fixed-income and equity recommendations is available on pages 20-21. An EM Equity Sector Trade: Long Consumer Staples / Short Banks EM consumer staples have massively underperformed banks as well as the overall EM index since January 2016 (Chart I-13). The odds are that their relative performance is about to reverse. Equity investors should consider implementing the following equity pair trade: long consumer staples / short banks: Consumer staples are a low-beta sector because their revenues are less cyclical. As EM growth downshifts, share prices of companies with more stable revenue streams will likely outperform. Bank stocks are vulnerable as local interest rates in many EMs rise in response to the selloff in their respective currencies (Chart I-14). Consumer staples usually outperform banks when local borrowing costs are rising. Chart I-13Go Long EM Consumer Staples / ##br##Short EM Banks Go Long EM Consumer Staples / Short EM Banks Go Long EM Consumer Staples / Short EM Banks Chart I-14EM Banks Stocks Are Inversely Correlated With##br## EM Local Bond Yields EM Banks Stocks Are Inversely Correlated With EM Local Bond Yields EM Banks Stocks Are Inversely Correlated With EM Local Bond Yields We expect more currency depreciation in EM, which will exert further upward pressure on local rates, including interbank rates. Further, growth weakness in EM economies typically leads to rising non-performing loan (NPL) provisions. Chart I-15A and Chart I-15B demonstrates that weakening nominal GDP growth (shown inverted on the charts) leads to higher provisioning. Hence, a renewed EM growth slowdown will hurt bank profits. Chart I-15AWeaker Nominal GDP Growth Entails ##br##Higher NPL Provisions Weaker Nominal GDP Growth Entails Higher NPL Provisions Weaker Nominal GDP Growth Entails Higher NPL Provisions Chart I-15BWeaker Nominal GDP Growth Entails ##br##Higher NPL Provisions Weaker Nominal GDP Growth Entails Higher NPL Provisions Weaker Nominal GDP Growth Entails Higher NPL Provisions Our assessment is that banks in many EM countries have provisioned less than what is probably necessary following years of a credit boom. Indeed, in the last 12-18 months or so, many banks have even been reducing their NPL provisions to boost profits. Hence, a reversal of these dynamics will undermine banks' earnings. Bottom Line: Market-neutral EM equity portfolios should consider going long consumer staples while shorting banks. This is in addition to our long-term strategy of shorting EM banks versus U.S. banks as well as shorting banks in absolute terms in individual markets such as Brazil, Turkey, Malaysia and small-cap banks in China. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 These calculations are done using MSCI investible stock indexes in U.S. dollars terms. 2 Please see Emerging Markets Strategy Weekly Report, "The Dollar Rally And China's Imports", dated May 24, 2018, available at ems.bcaresearch.com. 3 Average of cad, aud, nzd, brl, clp & zar total returns (including carry) relative to average of jpy & chf total returns (including carry). Chile: Stay Overweight Equities, Receive Rates 31 May 2018 Chart II-1Chilean Equities Relative Performance And Copper Prices Chilean Equities Relative Performance And Copper Prices Chilean Equities Relative Performance And Copper Prices It is often assumed that Chilean financial markets are a play on copper. While this largely holds true for the Chilean peso, it is not always correct regarding its stock market's relative performance to its EM peers. Chile has outperformed in the past amid declining copper prices (Chart II-1). Despite our negative view on copper prices, we are reiterating our overweight allocation to this bourse within an EM equity portfolio. There are convincing signs that growth in the Chilean economy is moving along fine for now (Chart II-2). While weakness in global trade will weigh on the economy, the critical variable that makes Chile stand out from other commodities producers in the EM universe is its ability to cut interest rates amid currency depreciation. Chart II-3 illustrates that interest rates in Chile can and do fall when the peso depreciates. This stands in stark contrast with many others economies in the EM universe. There are a number of factors that suggest inflationary pressures will remain dormant for some time. This will allow the Central Bank of Chile (CBC) to cut rates as and when required. Chart II-2Chile: Economic Conditions Chile: Economic Conditions Chile: Economic Conditions Chart II-3Interest Rates In Chile Can Fall When Peso Depreciates Interest Rates In Chile Can Fall When Peso Depreciates Interest Rates In Chile Can Fall When Peso Depreciates First, the output gap is negative and has been widening, which has historically led to falling core inflation (Chart II-4). Second, a wide range of consumer inflation measures - services and trimmed-mean inflation rates - are very low and remain in a downtrend (Chart II-5). Chart II-4Chile: Output Gap And Inflation Chile: Output Gap And Inflation Chile: Output Gap And Inflation Chart II-5Chile: Inflation Is Very Low And Falling Chile: Inflation Is Very Low And Falling Chile: Inflation Is Very Low And Falling Finally, there are no signs of wage inflation, which is the key driver of genuine inflation. In fact, wage growth is decelerating sharply (Chart II-6). Odds are that this disinflationary rout will go on for longer, given Chile's demographic and labor market dynamics. The country's labor force growth has accelerated and the economy does not seem able to absorb this excess labor supply (Chart II-7). Consistently, our labor surplus proxy - calculated as the number of unemployed looking for a job divided by the number of job vacancies - has surged to all-time highs (Chart II-8). Chart II-6Chile: Wage Growth Is Very Weak Chile: Wage Growth Is Very Weak Chile: Wage Growth Is Very Weak Chart II-7Chile: Rising Labor Force Chile: Rising Labor Force Chile: Rising Labor Force Chart II-8Chile: Excessive Labor Supply... Chile: Excessive Labor Supply... Chile: Excessive Labor Supply... Interestingly, this is not happening because of weak employment. Chart II-9 shows that the employment-to-working population ratio is at a record high, while employment growth is robust. This upholds that decent job growth is not sufficient to absorb the expanding supply of labor. All in all, a structural excess supply of labor as well as a cyclical slowdown in global trade and lower copper prices altogether will likely warrant a decline in interest rates in Chile. Consequently, we recommend a new fixed income trade: Receive 3-year swap rates. The recent rise provides a good entry point (Chart II-10). Chart II-9...Despite Robust Employment Growth ...Despite Robust Employment Growth ...Despite Robust Employment Growth Chart II-10Chile: Receive 3-Year Swap Rates Chile: Receive 3-Year Swap Rates Chile: Receive 3-Year Swap Rates The ability to cut interest rates will mitigate the effect of weaker exports on the economy. We recommend dedicated EM investors maintain an overweight allocation in Chile in their equity, local currency bond and corporate credit portfolios. For absolute return investors, the risk-reward profiles for Chilean stocks and the currency are not attractive. The peso will depreciate considerably, and shorting it versus the U.S. dollar will prove profitable. Consistent with our negative view on copper prices, we have been recommending a short position in copper with a long leg in the Chilean peso. This allows traders to earn some carry while waiting for copper prices to break down. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Colombia: The Currency Will Be A Release Valve The structural long-term outlook for Colombia is positive, as a combination of pro-market orthodox policies and reform initiatives amid positive tailwinds from demographic should ensure a reasonably high potential GDP growth rate. In the first round of presidential elections held last weekend, the gap between right wing candidate Ivan Duque and left-wing candidate Gustav Petro came out large enough to make a Duque victory highly likely in the second round to be held on June 17. His election would entail a positive backdrop for the reform agenda and business investment over the coming years. Yet despite the positive structural backdrop, Colombia is still facing a major imbalance - excessive reliance on oil in sustaining stable balance of payments (BoP) dynamics. The trade balance deficit - including oil - is $8 billion, while excluding oil it stands at $20 billion, or 7.5% of GDP (Chart III-1). Hence, if oil prices drop materially in the second half of this year - as we expect - Colombia's balance of payments will be strained. Consequently, the currency will come under depreciation pressure. The peso is presently fairly valued as the real effective exchange rate based on unit labor costs is at its historical mean (Chart III-2). Chart III-1Colombia's Achilles' Hill: Trade Balance Excluding Oil Colombia's Achilles' Hill: Trade Balance Excluding Oil Colombia's Achilles' Hill: Trade Balance Excluding Oil Chart III-2The Colombian Peso Is Fairly Valued The Colombian Peso Is Fairly Valued The Colombian Peso Is Fairly Valued The central bank has adopted a "hands-off" approach toward the exchange rate, and is likely to allow the peso to depreciate if the BoP deteriorates. Weak economic conditions will likely prevent it from hiking interest rates to bolster the peso: Even though the central bank has reduced its policy rate by 350 basis points since the end of 2016, lending rates remain restrictive when compared with the nominal GDP growth rate (Chart III-3, top panel). Fiscal policy has been tight, with government expenditures subdued and the primary deficit narrowing (Chart III-3, bottom panel). This is unlikely to change for now if conservative candidate, Ivan Duque, wins the election. Consumer and business demand has failed to pick up, and shows little sign of recovery (Chart III-4). Non-performing loans (NPL) continue to rise, forcing banks to raise their NPL provisioning (Chart III-5). Weak nominal GDP growth suggests provisions may rise further. Chart III-3Colombia: Little Sign Of Recovery Colombia: Little Sign Of Recovery Colombia: Little Sign Of Recovery Chart III-4Colombia: Little Sign Of Recovery Colombia: Little Sign Of Recovery Colombia: Little Sign Of Recovery Chart III-5Colombian Banks: NPL And NPL Provision Continue Rising bca.ems_wr_2018_05_31_s3_c5 bca.ems_wr_2018_05_31_s3_c5 Overall, banks' balance sheets remain impaired, hampering their ability to extend loans. Investment Recommendations Despite a favorable structural outlook, Colombia's cyclical growth and financial market outlooks remain poor. Chances are that the peso will come under selling pressure as the external environment deteriorates - i.e., the currency will act as a release valve. We recommend staying neutral on Colombian stocks and local bonds relative to their EM peers, and to overweight Colombian sovereign credit within an EM credit portfolio. The basis is that sound and tight fiscal policies and a continuation of supply side reforms will benefit this credit market. To capitalize on potential currency depreciation while hedging for the uncertainty of oil price decline, we recommend shorting the peso against the Russian ruble. Although Colombia's structural outlook is more promising than Russia's, the latter's BoP dynamics is healthier and its cyclical growth outlook is better than Colombia's. Andrija Vesic, Research Analyst AndrijaV@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations