Sectors

Overweight (High-Conviction) The S&P software index caught a bid last week, led by heavyweight Microsoft (representing a bit more than 50% of the index) following a positive sell-side report that put a one-year price target implying a $1 trillion market cap. The basis for the (very) high expectations was Microsoft's dominant position in cloud computing and its rapid adoption in the marketplace; we are very much in agreement as we believe software spending is in the early days of an acceleration. CEO confidence, despite having peaked, remains near decade-highs, typically a precursor of greater software spending (second panel). Bank loan growth, another leading indicator of loosening purse strings, has just turned a corner (third panel). Our optimism is clearly shared by the analyst consensus view as earnings revisions have reached a seven-year high (bottom panel). Adding it up, we think more outperformance is in store for this technology subsector; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5SOFT-MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, ADSK, RHT, SYMC, SNPS, ANSS, CDNS, CTXS, TTWO, CA, CDNS. The Race To $1 Trillion The Race To $1 Trillion

Feature Japan's economic experience in the post bubble era is often described as a fate to avoid at all costs. We would like to turn this common notion on its head. Rather than something to avoid, Japan's post bubble experience is a fate that other major economies should actively try to emulate, at least in parts. This report focusses on three specific lessons for European investors. Japan's so-called 'lost decades' describe the weak growth in its nominal GDP since the mid-1990s. But this emphasis on aggregate nominal income is grossly misleading. Standards of living do not depend on nominal GDP. What matters is real GDP per head combined with the absence of extreme income inequality. Real income must grow and this growth must benefit the majority, rather than a small minority. Since the late 1990s, the growth in Japan's real GDP per head has outperformed every other major economy (Chart Of The Week). And unlike other major economies, income inequality in Japan has not increased, remaining amongst the lowest in the developed world (Chart I-2). This is not surprising. Credit booms inflate bubbles in financial assets, which exacerbate income and wealth inequalities. Chart Of The WeekJapan Has Outperformed Everybody Japan Has Outperformed Everybody Japan Has Outperformed Everybody Chart I-2Income Inequality In Japan Has Not Increased Income Inequality In Japan Has Not Increased Income Inequality In Japan Has Not Increased Admittedly, the government has been running persistent deficits, but this is to counterbalance private sector de-levering. Total indebtedness as a share of GDP has not been rising. In the post credit boom era, Japan's real growth has come entirely from productivity improvements. Mankind's persistent ability to learn, experiment, and innovate produces more and/or better output from a fixed set of inputs. Unlike the unsustainable growth that is fuelled by credit booms and asset bubbles, real growth that comes from productivity improvements is sustainable. Genuine Price Stability: Something To Celebrate, Not Fear Japanese consumer prices are at the same level today as they were in 1992, meaning that Japan has experienced genuine price stability for two and a half decades (Chart I-3). But this is neither new, nor alarming - Britain enjoyed genuine price stability for two and a half centuries! At the height of the British Empire in 1914, consumer prices were little different to where they stood at the end of the English Civil War in 1651 (Chart I-4). Chart I-3Japan Has Experienced Genuine Price ##br## Stability For Two And A Half Decades... Japan Has Experienced Genuine Price Stability For Two And A Half Decades... Japan Has Experienced Genuine Price Stability For Two And A Half Decades... Chart I-4...But Britain Experienced Genuine Price Stability For Two And A Half Centuries! ...But Britain Experienced Genuine Price Stability For Two And A Half Centuries! ...But Britain Experienced Genuine Price Stability For Two And A Half Centuries! Nevertheless, central banks continue with the deception that price stability means an inflation rate of 2%. This is clearly nonsense. Think about it - if prices rise by 2% a year, then your money will lose a quarter of its purchasing power every decade. And after a typical working life, your money will have lost two-thirds of its value.1 How exactly does that qualify as price stability?2 Still, we frequently hear a strong counterargument - in a highly indebted economy, inflation and growth in nominal GDP do matter. As debt is a nominal amount, it is nominal incomes that determine the ability to service and repay the high level of debt. So given a free choice, policymakers would prefer to have inflation at 2% rather than at zero; and nominal GDP growth at 3.5% rather than at 1.5%. Unfortunately, policymakers do not have this free choice. Contrary to what central bankers promise, inflation and nominal GDP growth cannot be dialled up or down at will to hit a point target. As we explained a while back in The Case Against Helicopters, inflation is a non-linear phenomenon which is extremely difficult, if not impossible, to point target.3 Look at the standard identity of monetary economics: MV = PT M is the broad money supply, V is its velocity of circulation, P is the price level and T is the volume of transactions. PT is effectively nominal GDP. The big problem is that both the broad money supply M and its velocity V - whose product determines nominal GDP - are highly non-linear. Chart I-5The Money Multiplier Is Non-Linear The Money Multiplier Is Non-Linear The Money Multiplier Is Non-Linear M is non-linear because the commercial banking system money multiplier - the ratio of loans to bank reserves - is non-linear. At a tipping point of inflation, the onus suddenly flips from lending as little as possible to lending as much as possible (Chart I-5). Admittedly, the central bank (in cahoots with the government) could by-pass the commercial banking system to control the money supply M directly. But it can do nothing to change the extreme non-linearity of the other driver of nominal GDP, the velocity of money V. Again, at a tipping point, the onus suddenly flips to spending money - both newly created and pre-existing balances - as fast as possible. At this point, nominal GDP growth and inflation suddenly and uncontrollably phase-shift from ice to fire with little in between. What is the Japanese lesson for Europeans? Simply that just like the BoJ, the ECB will keep moving the 2% inflation goalpost further and further into the future, as it realises the impossibility of achieving and sustaining the 2% point target. So even with inflation in the 1-2% channel, the ECB will create a loophole to exit NIRP and ZIRP very soon after it exits QE. This will structurally support the euro. Do Not Own Banks For The Long Term (Or Now) Japanese financial sector profits stand at less than half their peak level in 1990. For euro area financial sector profits which peaked in 2007, the interesting thing is that they are tracking the Japanese experience with a 17-year lag. If euro area financial profits continue to follow in Japan's footsteps, expect no sustained growth through the next 17 years (Chart I-6). Chart I-6Euro Area Financial Profits May Experience No Sustained Growth Euro Area Financial Profits May Experience No Sustained Growth Euro Area Financial Profits May Experience No Sustained Growth In a post credit boom era, banks lose the lifeblood of their business: credit creation. This loss becomes a multi-decade headwind to financial sector profit growth and share price performance. Bank profits are dependent on two other drivers. One is operational leverage - the amount of equity held against the balance sheet. More stringent European regulation will make this a headwind too. Banks will have to hold more equity capital against assets, diluting their profitability. The other driver is the net interest margin - the difference between rates received on loans and rates paid on deposits, effectively a function of the yield curve slope. However, this is a cyclical driver, and as explained last week in Market Turbulence: What Lies Ahead? this driver is unlikely to be positive in the coming months.4 What is the Japanese lesson for Europeans? Simply that euro area financials is not a sector to buy and hold for the long term. Rather, it is a sector to play during periodic strong countertrend rallies, albeit now is not the time for such a cyclical play. A Surge In Female Participation Chart I-7Sales Of Personal Products Have Boomed Sales of Personal Products Have Boomed Sales of Personal Products Have Boomed Over the past twenty years, Japanese sales of skin cosmetics and beauty products have almost tripled (Chart I-7). This has helped the personal products sector to outperform very strongly. The personal products sector is dominated by female spending. So it is significant that in 1995, the Japanese government introduced a raft of policies to encourage women to join the labour force: paid maternity leave, subsidised childcare, and paid parental leave for both parents. Today in Japan, both mothers and fathers can take more than a year of paid parental leave at an average rate of 60% of earnings. The policies had their desired effect. The proportion of Japanese women in the labour force has surged from 57% to 67%, while the male labour participation rate has held at 85%. Therefore, all of the growth in the Japanese labour force through the past twenty years has come from women. Europe tells a similar tale. Through the past couple of decades, parental leave policies have become steadily more generous. Unsurprisingly, the proportion of European women in the labour force has also surged from 57% to 67%, while the male labour participation rate has held at 78%. So just as in Japan, all of the growth in European labour force participation through the past twenty years has come from women (Chart I-8). But for the ultimate end-point in the European trend, look to the Scandinavian countries which have had generous parental leave policies since the 1970s. As a result, labour force participation for Swedish women is almost identical to that for men: 80% versus 83%. If the EU eventually reaches the Scandinavian end-point, it would mean another 20 million women in the EU labour force. What is the Japanese lesson for Europeans? While Japanese financial profits have halved since 1990, Japanese personal products profits have quintupled. Once again, the useful thing is that euro area personal product profits are uncannily tracking the Japanese experience with a 17-year lag (Chart I-9). If euro area personal product profits continue to follow in Japan's footsteps, expect them to almost triple over the next 17 years. Stay overweight the European personal products sector. Chart I-8A Surge In Female Participation A Surge In Female Participation A Surge In Female Participation Chart I-9Personal Products Profits Set To Grow Very Strongly Personal Product Profits Set To Grow Very Strongly Personal Product Profits Set To Grow Very Strongly Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Assuming you work for 50 years. 2 Admittedly, measured inflation probably overstates true inflation. However, estimates put this measurement error at no more than 0.3-0.5 percentage points. 3 Please see the European Investment Strategy Weekly Report 'The Case Against Helicopters' published on May 5 2016 and available at eis.bcaresearch.com 4 Please see the European Investment Strategy Weekly Report 'Market Turbulence: What Lies Ahead?' published on March 29 2018 and available at eis.bcaresearch.com Fractal Trading Model* This week’s trade recommendation is to go long the Australian dollar versus the Norwegian krone. The profit target is 2% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 AUD / NOK AUD / NOK * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Hong Kong's leverage burden is a corporate sector rather than a household sector problem. But this corporate sector debt is highly concentrated in the finance and real estate industries, meaning that investors should be legitimately concerned over Hong Kong's extremely elevated debt service ratio. Our BCA Hong Kong Debt Risk Monitor serves as an important tool to help investors gauge the risk of a serious credit-driven downturn in the region. While the risk from excessive leverage is real, the current message from our DRM is that the odds of a deleveraging event over the coming year are low. Due to the importation of U.S. monetary policy, Hong Kong may "enjoy" easy monetary policy on a permanent basis. This suggests that Hong Kong's private sector may continue to leverage itself even in the face of rising interest rates, setting up the potential for a cataclysmic future recession. Stay neutral Hong Kong stocks versus the global benchmark over the coming 6-12 months. While equities may rise in relative terms if earnings momentum converges with that of the global benchmark, it is not a sufficiently compelling prospect to outweigh the significant structural risk facing the region. Feature Hong Kong has appeared in the headlines of the financial press for two reasons over the past few months. The first is due to the recent weakness in the Hong Kong dollar (HKD), a topic that we addressed last week.1 The second was prompted by the BIS' March 2018 Quarterly Review, which noted that mainland China, Hong Kong, and Canada stood out among 26 jurisdictions as being the most vulnerable to a banking crisis according to their research. The BIS's warning is rooted in the fact that Hong Kong is a highly leveraged economy, but there are two additional reasons for investors to be cautious about the region: China's industrial sector is slowing, and monetary policy is tightening due to the region's direct link to U.S. interest rates. While Hong Kong has avoided the full brunt of rising U.S. rates over the past year thanks to plentiful interbank liquidity (which has limited the rise in 3-month HIBOR), we noted in last week's report that the weakness in the HKD likely means that gap between interbank rates and the base rate cannot get much wider. This means that further Fed rate hikes over the coming year are likely to feed more fully into tighter Hong Kong monetary conditions. In this report we review the extent and disposition of Hong Kong's indebtedness, and develop an indicator for investors to monitor in order to gauge the risk of a serious private sector deleveraging event. We conclude that while it is too early to position aggressively against Hong Kong stocks, the risk from excessive leverage is real and is very likely to eventually cause a serious credit-driven downturn. For now, however, that appears to be a story for another day, and as we explain below, potentially a distant one. Breaking Down Hong Kong's Debt Chart 1 presents the basis for concern about Hong Kong's debt. The chart shows the BIS' nonfinancial private sector debt service ratio ("DSR", which includes both households and nonfinancial corporations) for the G10 countries alongside that of China, Hong Kong, and Canada. The chart shows that Hong Kong's DSR has risen nearly to 26%, a full 10 percentage points higher than the G10 average, and is now the highest among the 32 economies that the BIS has debt service data for. One important point to note is that among the three countries that the BIS recently singled out for concern, the disposition of Hong Kong's private sector debt is more similar to that of China than Canada. Chart 2 highlights that the private sector debt in China and Hong Kong is predominantly owed by the nonfinancial corporate sector, whereas in Canada the debt is more equally split among the two sectors, with households owing more in total. Chart 1Hong Kong's Debt Burden Hits##br## A New High Hong Kong's Debt Burden Hits A New High Hong Kong's Debt Burden Hits A New High Chart 2Unlike In Canada, Hong Kong's Leverage##br## Is A Corporate Sector Problem Unlike In Canada, Hong Kong's Leverage Is A Corporate Sector Problem Unlike In Canada, Hong Kong's Leverage Is A Corporate Sector Problem Normally we would be inclined to suggest that the skew in Hong Kong's debt towards the corporate sector makes it less risky than in other jurisdictions where elevated leverage is a household sector problem. The rationale is that while corporations can (and often do) misallocate their capital, firm borrowing is usually employed to acquire income-producing assets, with problems arising only when the value of those assets (or their potential to generate income) declines sharply. Household leverage problems, on the other hand, are almost always the result of a sharp rise in residential mortgage credit, and our view is that the purchase of residential property is fundamentally an act of consumption rather than a true investment. In addition, the past experiences of several countries have shown that housing-related leverage busts are particularly pernicious, in that the resulting recessions tend to be followed by long periods of subpar economic growth. But unlike in China where the majority of nonfinancial corporate sector debt is held on the balance sheets of state-owned enterprises, Hong Kong's corporate debt does not have de-facto state backing and appears to be enormously concentrated in the real estate and financial sector. Over 80% of Hong Kong's total nonfinancial sector debt (which includes households) is provided by domestic banks, and Chart 3 shows that among bank loans to firms, 35% have been granted to property building & construction companies and another 22% to "financial concerns" and stockbrokers. This high concentration of corporate sector debt in the real estate sector means that investors should be legitimately concerned over Hong Kong's extremely high DSR. On the household side, we have made the case in a previous report that a replay of another spectacular housing bust (similar to what occurred in 1997) is highly unlikely despite the fact that Hong Kong house prices have vastly outstripped income over the past decade2 (Chart 4). Chart 3Loans To Businesses Are Highly Concentrated ##br##And Exposed To Property Loans To Businesses Are Highly Concentrated And Exposed To Property Loans To Businesses Are Highly Concentrated And Exposed To Property Chart 4Lofty House Prices Are A Red Herring: ##br##The Risk Is On The Business Side Lofty House Prices Are A Red Herring: The Risk Is On The Business Side Lofty House Prices Are A Red Herring: The Risk Is On The Business Side This suggests that, despite extremely elevated residential property prices, investors should be more concerned about a shock that will destabilize the commercial real estate market. Hong Kong households would not likely escape the impact of such a shock, since commercial and residential real estate prices move strongly in tandem (Chart 5). But in terms of watching for a "tipping point" that could push Hong Kong's private sector into a balance sheet recession, the trigger seems more likely to occur in the market for the former, rather than the latter. Bottom Line: Hong Kong's leverage burden is a corporate sector rather than a household sector problem. But this corporate sector debt is extremely concentrated in the finance and real estate industries, meaning that investors should be legitimately concerned over Hong Kong's extremely high debt service ratio. Chart 5Still, Households Will Be Hurt##br## If CRE Prices Fall Still, Households Will Be Hurt If CRE Prices Fall Still, Households Will Be Hurt If CRE Prices Fall Chart 6The BIS' Warning Thresholds ##br##Don't Seem To Apply To Hong Kong The BIS' Warning Thresholds Don't Seem To Apply To Hong Kong The BIS' Warning Thresholds Don't Seem To Apply To Hong Kong Timing The Onset Of A Balance Sheet Recession Our analysis above supports the recent warnings from the BIS that the risk of a banking crisis / private sector deleveraging event in Hong Kong is nontrivial. This raises the obvious question of how to gauge the timing of such an event in order for investors to properly position their exposure towards Hong Kong's financial markets. The BIS has itself investigated this question, and has published several reports on its "Early Warning Indicator" (EWI) approach.3 Table 1 presents a list of these indicators for several countries, and highlights that the two of the most informative measures (the credit-to-GDP gap4 and the overall debt service ratio) are flashing red for Hong Kong. In fact, Table 1 served as the basis for the BIS' warning in their most recent Quarterly Review that we noted above. The BIS' EWI research has focused on identifying thresholds for these measures that can predict a banking crisis within a three-year window based on the historical record. But in the case of Hong Kong, it is not clear that these thresholds apply. Chart 6 shows the credit-to-GDP gap and overall private sector DSR along with the more stringent BIS threshold noted in Table 1, and highlights that these measures have been flashing red for 4-8 years. Based on this approach, Hong Kong should have experienced a banking crisis long ago. Table 1BIS Early Warning Indicators For Stress In Domestic Banking Systems Hong Kong's Private Sector Debt: There Will Be Blood, But Not Today Hong Kong's Private Sector Debt: There Will Be Blood, But Not Today Rather than relying on the BIS' framework, we have instead constructed our own private-sector debt risk monitor for Hong Kong. In contrast to the BIS' measures, which have been specifically constructed to predict a banking crisis, the goal of our indicator is to help predict a serious credit-driven downturn regardless of its character (i.e. we abstract from whether the result of the downturn is a full-blown financial crisis or simply a prolonged period of economic stagnation). Chart 7Low Risk Of A Serious Credit-Driven ##br##Downturn, For Now Low Risk Of A Serious Credit-Driven Downturn, For Now Low Risk Of A Serious Credit-Driven Downturn, For Now Chart 7 presents our BCA Hong Kong Debt Risk Monitor (DRM) and its five equally-weighted components, a summary of which is provided below. All series have been scaled such that an increase in the DRM represents higher risk. Alpha: We have highlighted the importance of examining the alpha as well as the beta of regional equity returns in a previous report,5 and we include a composite indicator of Hong Kong's rolling alpha versus the global benchmark as a measure of Hong Kong-specific stock performance that adjusts for Hong Kong's riskiness. While this component of our DRM was quite elevated in early-2016 (signaling weak Hong Kong stock performance), it is presently in line with its historical average, and thus is not flashing a warning sign. Property Prices: Given the high concentration of Hong Kong's corporate sector debt in the real estate sector, our DRM includes the deviation of office & retail property prices from their 9-month moving average. Similar to the first component of our indicator, Hong Kong property prices are roughly in line with their trend and are not signaling serious economic weakness. Credit Impulse: The third component of our DRM is a simple bank credit impulse, calculated as the flow of credit over the past year as a percent of GDP. While this component has fallen well into "low risk" territory, over the past year, there are some tentative signs of a reversal that investors should monitor. Monetary Policy Stance: The fourth component of our DRM is a structural variable that attempts to measure whether U.S. (and thus Hong Kong) interest rates are either consistent or out of alignment with economic conditions in Hong Kong. This component is an average of two measures of the stance of monetary policy: 1) the difference between U.S. 10-year government bond yields and Hong Kong nominal GDP growth, and 2) the difference between the base rate and a Taylor Rule estimate for the region (with the latter acting purely as an estimate of the cyclical equilibrium interest rate).6 The chart shows that despite the onset of tighter monetary policy in the U.S. over the past few years, our gauge of Hong Kong's policy stance suggests that conditions are still easy, and that material further increases would likely be required in order to see this component rise to +1 sigma territory. Debt Service Ratio: The final component of our DRM is the BIS' total private sector DSR shown in Chart 6, acting as a second structural variable that captures the underlying debt servicing risk that the BIS has warned about. We extent the BIS' series back to the early-1990s on a best efforts basis, by adjusting the product of Hong Kong's prime rate and the total private sector debt-to-GDP ratio to best align with the official DSR series over the course of its history. Our extended series suggests that Hong Kong's debt servicing burden is indeed the highest that it has been over the past three decades, underscoring that our DRM is likely to rise materially if the cyclical factors included in the indicator deteriorate. The overall message of our DRM is that a threat to Hong Kong's economy from excessive debt does not appear to be imminent, despite the underlying risks highlighted by the BIS. While the risk from excessive leverage is real and is very likely to eventually cause a serious credit-driven downturn, the odds of this occurring over the coming 6-12 months appear to be low. Bottom Line: Our BCA Hong Kong Debt Risk Monitor serves as an important tool to help investors gauge the risk of a serious credit-driven downturn in the region. While the risk from excessive leverage is real, the message from our DRM is that the odds of a deleveraging event over the coming year are low. The Spooky Implications Of The Natural Interest Rate Gap Interestingly, at least part of the benign reading of our DRM is due to the fourth component of the indicator, our gauge of Hong Kong's monetary policy stance, which suggests that there is ample room for further rate increases. In fact, in our view this observation carries much deeper significance than many may initially perceive, as it may explain why the BIS' early warning indicator thresholds have not worked in the case of Hong Kong, and why the region may avoid a debt crisis for a further significant period (but ultimately experience a much more painful collapse when it finally arrives). At root, the reason that U.S. 10-year Treasury yields remain exceedingly low relative to U.S. nominal GDP growth is because investors believe that real U.S. policy rates are likely to be much lower on average over the next 10-years than they have been historically (Chart 8). Abstracting from calendar-based cyclical considerations (such at the timing of the next U.S. recession), this fundamentally reflects the prevalent view among fixed-income investors that the U.S. natural rate of interest (or "r-star") has likely permanently declined. If true, this is of enormous importance for Hong Kong, as it suggests that the region will permanently "enjoy" easy monetary policy. This is because the substantial leveraging that has occurred in Hong Kong in response to low interest rates implies that there has been no impairment (yet) to Hong Kong's natural rate of interest (Chart 9). Chart 8A Low Estimate Of R-Star Has Depressed##br## U.S. Bond Yields A Low Estimate Of R-Star Has Depressed U.S. Bond Yields A Low Estimate Of R-Star Has Depressed U.S. Bond Yields Chart 9No Evidence Of A Low R-Star##br## In Hong Kong No Evidence Of A Low R-Star In Hong Kong No Evidence Of A Low R-Star In Hong Kong In some ways the dynamic we are describing is not new: the importation of easy monetary policy from the U.S. via competitive currency devaluation over the past decade has been a well-known phenomenon that was quite prominent during the early phase of the global economic recovery. But the fixed exchange rate regime in Hong Kong means that this process cannot be avoided without abandoning the peg, an event that itself could trigger a deleveraging event via a sharp decline in asset prices. The key point for investors is that if the U.S. natural rate of interest has indeed fallen materially and permanently below potential GDP growth, then Hong Kong will not experience tight monetary conditions even once the Fed has normalized short-term interest rates, unless it raises them well above equilibrium levels. This suggests that Hong Kong's private sector may perpetually leverage itself until debt service burdens reach some, as yet, unknown maximum level, precipitating what would likely become a cataclysmic recession. The fact that no crisis erupted in late-2015/early-2016 when the cyclical components of our DRM deteriorated significantly suggests that this level may be materially higher than is presently the case. Bottom Line: Due to the importation of U.S. monetary policy, Hong Kong may "enjoy" easy monetary policy on a permanent basis. This suggests that Hong Kong's private sector may continue to leverage itself even in the face of rising interest rates, setting up the potential for a cataclysmic future recession. Investment Implications: Stay Neutral, For Now Chart 10Room For A Rise In Relative Earnings Momentum Room For A Rise In Relative Earnings Momentum Room For A Rise In Relative Earnings Momentum The picture painted by our above analysis suggests that a benign cyclical outlook for Hong Kong is arrayed against a negative (and potentially horrific) structural outlook. How should investors position towards Hong Kong equities in response? First, as noted above, our Debt Risk Monitor does not signal that there is an imminent threat facing the Hong Kong economy that would herald the potential for a major deleveraging event over the near-term. Second, while Hong Kong's earnings momentum is stretched in absolute terms, Chart 10 highlights there is room for a catchup versus global stocks, which could boost relative performance over the coming year. Third, relative valuation and technical conditions are at neutral levels (Chart 11), and thus do not provide any compelling basis to avoid Hong Kong stocks. But to us, the weight of this modestly positive assessment over the coming year is overshadowed by the structural outlook, meaning that we continue to recommend a neutral allocation towards Hong Kong stocks over the coming 6-12 months. The most investment-relevant conclusion from our analysis is that investors will one day be able to earn significant risk-adjusted returns from underweighting / shorting Hong Kong stocks once a serious credit-driven downturn begins. As an example, Chart 12 shows the impact of the Asian financial crisis on Hong Kong's relative performance, a period where our DRM rose sharply and persistently into "high risk territory". It took 12½ years for Hong Kong to rise to a new high in relative total return terms, and it has yet to do so in price terms. Chart 11Neutral Relative Valuation And ##br##Technical Conditions Neutral Relative Valuation And Technical Conditions Neutral Relative Valuation And Technical Conditions Chart 12One Day, Shorting Hong Kong Stocks##br## Will Be Enormously Profitable One Day, Shorting Hong Kong Stocks Will Be Enormously Profitable One Day, Shorting Hong Kong Stocks Will Be Enormously Profitable So while the economic and financial market conditions are not yet in place to act on a bearish structural view, we will be closely watching our Debt Risk Monitor over the coming months and years for signs of a significant deterioration, as it will likely provide a major opportunity for investors to earn outsized returns. Stay tuned! Bottom Line: Stay neutral Hong Kong stocks versus the global benchmark over the coming 6-12 months. While equities may rise in relative terms if earnings momentum converges with that of the global benchmark, it is not a sufficiently compelling prospect to outweigh the significant structural risk facing the region. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Stocks: Trade Frictions Make For A Tenuous Overweight", dated March 28, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Weekly Report "Hong Kong Housing Bubble: A Replay Of 1997?", dated June 29, 2017, available at cis.bcaresearch.com. 3 For example, please see "Evaluating early warning indicators of banking crises: Satisfying policy requirements" by Mathias Drehmann and Mikael Juselius, BIS Working Paper No. 421, August 2013. 4 The BIS defines the credit-to-GDP gap as the difference between the credit-to-GDP ratio and its long-run trend, derived using a one-sided (i.e. backward-looking) Hodrick-Prescott (HP) filter. 5 Pease see China Investment Strategy Special Report "China: No Longer A Low-Beta Market", dated January 11, 2018, available at cis.bcaresearch.com. 6 Our Taylor Rule estimate for Hong Kong is constructed in a fashion similar to what we showed for China in our January 18 Weekly Report, using a neutral policy rate estimate of 5%. Cyclical Investment Stance Equity Sector Recommendations

Highlights Key Portfolio Highlights Our portfolio positioning remains firmly behind cyclicals over defensives, driven principally by our key 2018 investment themes: synchronized global capex growth (Chart 1A) and higher interest rates on the back of a pickup in inflation (Chart 1B). The positioning has been lifted by synchronized global growth and a soft U.S. dollar (Chart 1C), while the key risk to our portfolio of a hard landing in China looks to be mitigated (Chart 1D). A return of volatility, spurred on by Fed tightening (Chart 1E), caused an SPX pullback in February, and while the market pushed through that rough patch, it has since been replaced with fears of a trade war, exacerbated by musical chairs in the Trump administration (Chart 1F). Our buy-the-dip strategy remains appropriate on a cyclical time horizon (Chart 1G), given a dearth of evidence of a recession in the next year. SPX forward EPS estimates still show near-20% increases this calendar year (corroborated by our EPS growth model, Chart 1H) which should underpin outsized equity returns in the absence of a major valuation rerating. Still, the return of volatility warrants a review of our macro, valuation and technical indicators. The best combination in our review is S&P financials (Overweight) with an elevated and accelerating cyclical macro indicator (CMI), fed by both of our key capex growth and rising interest rate themes, combined with a modest undervaluation. The worst combination is S&P telecom services (Underweight, high-conviction), whose CMI recently touched a 30-year low as sector deflation hit acute levels. Valuations make the sector look cheap, but every indication is that telecoms are a value trap. Chart 1AGlobal Trade Is Rising... Global Trade Is Rising... Global Trade Is Rising... Chart 1B...But So Too Is Inflation ...But So Too Is Inflation ...But So Too Is Inflation Chart 1CA Weaker Dollar Is A Boon To Growth A Weaker Dollar Is A Boon To Growth A Weaker Dollar Is A Boon To Growth Chart 1DSoft Landing In China Seems Likely Soft Landing In China Seems Likely Soft Landing In China Seems Likely Chart 1EThe Return Of Vol May Spoil The Party... The Return Of Vol May Spoil The Party... The Return Of Vol May Spoil The Party... Chart 1F...And Policy Uncertainty Doesnt Help ...And Policy Uncertainty Doesnt Help ...And Policy Uncertainty Doesnt Help Chart 1GBuy The Dip Has Worked Out Nicely Buy The Dip Has Worked Out Nicely Buy The Dip Has Worked Out Nicely Chart 1HHeed The Message From A Booming EPS Model Heed The Message From A Booming EPS Model Heed The Message From A Booming EPS Model Feature S&P Financials (Overweight) Our financials cyclical macro indicator (CMI, Chart 2) has climbed to new cyclical highs with significant upward momentum, driven by broad improvement in virtually all of its underlying components. More than any other variable, rising yields and the accompanying higher price of credit are a boon to financials. Higher interest rates is one of BCA's key themes for 2018 and an ongoing selloff in the bond market bodes well for profits in the heavyweight banks sub-index and should deliver the next up leg in bank stocks performance (top panel, Chart 3). Another of BCA's key themes for 2018 is a global capex upcycle; higher demand for capital goods should drive outsized capital formation in the year to come. Our U.S. commercial banks loans and leases model echoes this positive outlook, pointing to the best loan growth of the past 30 years (middle panel, Chart 3). Lastly, a low unemployment rate drives both expanding consumer credit and much better credit quality. At present, the unemployment rate is testing all-time lows, sending an unambiguously positive message for financials profitability (bottom panel, Chart 3). Despite the much-improved cyclical outlook and a revival of overall animal spirits, our valuation indicator (VI) suggests that financials are modestly undervalued. At this point in the cycle, we would expect a modest overvaluation; the implication is that financials should be a core portfolio overweight. Our technical indicator (TI) has approached overbought levels several times over the course of this bull market, though history suggests it can stay at elevated levels for a considerable time. Chart 2S&P Financials (Overweight) S&P Financials (Overweight) S&P Financials (Overweight) Chart 3RS1 Rising Yields Are A Boon To Financials Earnings RS1 Rising Yields Are A Boon To Financials Earnings RS1 Rising Yields Are A Boon To Financials Earnings S&P Industrials (Overweight) Our industrials CMI (Chart 4) has gone vertical and is very near its all-time high. A combination of a supportive currency, a recovery in commodity prices and synchronized global growth are responsible for the rise. A falling U.S. dollar and capital goods producers' top line growth acceleration have historically moved hand-in-hand as this group is one of the most international of the S&P 500. The trade-weighted U.S. dollar has fallen by more than 10% from its most recent peak at the end of 2016 which suggests U.S. industrials should have a leg up in sales for the year to come (top panel, Chart 5). The slide in the U.S. dollar is coming at an opportune time; global growth is remarkably synchronized (and remains a key BCA theme for 2018) and has proven an excellent harbinger of industrials margins (bottom panel, Chart 5). Overall, an expanding top line and widening margins imply solid relative EPS gains. Our valuation gauge is near the neutral zone, where it has been for much of the past 3 years as the market has failed to capture the sector's outlook strength. Our TI echoes the neutral message, having unwound a significant overbought position at the beginning of last year. Chart 4S&P Industrials (Overweight) S&P Industrials (Overweight) S&P Industrials (Overweight) Chart 5Global Euphoria Should Lift Industrials Global Euphoria Should Lift Industrials Global Euphoria Should Lift Industrials S&P Energy (Overweight) Our energy CMI (Chart 6) has maintained its upward trajectory after bouncing off all-time lows last year. Importantly, the relative share performance does not yet reflect the drastically improved cyclical conditions, underpinning our overweight recommendation. Falling oil inventories and rising prices (top and second panel, Chart 7) combined with solid gains in domestic production underlie the CMI recovery. Our key themes for 2018 of a global capex expansion and synchronized global growth should be the most important drivers for energy stocks this year. With respect to the former, the capex intentions from the Dallas Fed survey hit their highest level in a decade, which usually presages domestic oil patch expansion and energy stock outperformance (third panel, Chart 7) With respect to global growth, emerging markets/Chinese demand is the swing determinant of overall oil demand, and non-OECD demand has been moving higher for most of the past year (bottom panel, Chart 7). Our VI has retreated far into undervalued territory, a result of the aforementioned failure of stocks to react to the enticing macro outlook. The TI too is in deeply oversold levels, suggesting that an oversold bounce could soon occur at a time when valuations are so appealing. Chart 6S&P Energy (Overweight) S&P Energy (Overweight) S&P Energy (Overweight) Chart 7Energy Share Prices Have Trailed Oils Recovery Energy Share Prices Have Trailed Oil's Recovery Energy Share Prices Have Trailed Oils Recovery Energy Share Prices Have Trailed Oil's Recovery Energy Share Prices Have Trailed Oils Recovery S&P Consumer Staples (Overweight) Our consumer staples CMI (Chart 8) has turned up recently, following a two year decline. Strong employment gains and positive retail sales are the key pillars underlying the modest recovery. The euphoric consumer continues to push our consumer staples EPS model higher, now pointing to the best earnings growth of the past 5 years (middle panel, Chart 9). Overall industry exports are expanding at a healthy clip as a consequence of a softening U.S. dollar and robust European and rebounding emerging markets demand. Deflating raw food commodity prices are offsetting rising energy and labor input costs, heralding a sideways move to margins. Sell side analysts are also currently penciling in a lateral profit margin move (bottom panel, Chart 9). Investors have been vehemently avoiding staples stocks during the board market's uninterrupted run up, and have put our positioning offside. However, in the context of our cyclical over defensive portfolio bent we refrain from putting all our eggs in one basket, and prefer to keep consumer staples as our sole defensive sector overweight. Further, our VI is waving a green flag as consumer staples are now nearly two standard deviations below their 30-year mean valuation. Technical conditions too are completely washed out, signaling widespread bearishness, which is positive from a contrary perspective. Chart 8S&P Consumer Staples (Overweight) S&P Consumer Staples (Overweight) S&P Consumer Staples (Overweight) Chart 9Robust Consumer Confidence Bodes Well Robust Consumer Confidence Bodes Well Robust Consumer Confidence Bodes Well S&P Utilities (Neutral) Our utilities CMI (Chart 10) has spent the last decade in a long-term downtrend, albeit one with periodic countertrend moves. The key underlying factors are natural gas prices and relative spending on utilities, both of which have been retreating since 2008 (middle panel, Chart 11). Encouragingly, the sector's wage bill has slowed from punitively high levels, though pricing power has followed it down, implying muted margin changes (bottom panel, Chart 11). Like other defensive sectors, utilities have underperformed cyclical sectors in the last year; utilities equities trade as fixed income proxies, and a rising interest rate environment is punitive. As a result of the underperformance and relatively constant earnings, valuations have collapsed to the neutral zone. We reacted by booking solid gains and upgrading to a benchmark allocation earlier this year; synchronized global growth and higher interest rates are headwinds for this niche defensive sector and prevent us from lifting positions further. Our TI has fallen steeply over the past year and is now closing in on two standard deviations below the 30-year average. Chart 10S&P Utilities (Neutral) S&P Utilities (Neutral) S&P Utilities (Neutral) Chart 11Pricing Is Falling But Margins Look Neutral Pricing Is Falling But Margins Look Neutral Pricing Is Falling But Margins Look Neutral S&P Real Estate (Neutral) Our real estate CMI (Chart 12) has been in decline since its most recent peak at the end of 2016. This is confirmed by a darkened outlook for REITs; rents have crested while the vacancy rate found its nadir in 2016, suggesting further rent weakness on the horizon (top panel, Chart 13). Further, bankers appear less willing to extend commercial real estate credit, despite recent stability in underlying prices; declines in credit availability will directly impact REIT valuations (bottom panel, Chart 13). Our VI is consistent with BCA's Treasury bond indicator (not shown), indicating that both are at fair value. Our TI is starting to firm from extremely oversold levels, a positive indication for both 12- and 24-month relative performance. Chart 12S&P Real Estate (Neutral) S&P Real Estate (Neutral) S&P Real Estate (Neutral) Chart 13Peaking Rents and Tight Credit Are Headwinds Peaking Rents and Tight Credit Are Headwinds Peaking Rents and Tight Credit Are Headwinds S&P Materials (Neutral) Our materials CMI (Chart 14) has maintained its downward trajectory, largely due to the ongoing Fed tightening cycle. The heavyweight chemicals component of the materials index typically sees earnings (and hence stock prices) underperform as rates are moving higher (top panel, Chart 15). BCA's view remains that a sizable selloff in the bond markets is the most likely scenario in 2018, representing a substantial headwind to sector performance. Still, the news is not all negative. Exceptionally strong global demand growth has revitalized chemicals prices (bottom panel, Chart 15). Combined with the industry's relatively newfound restraint, capacity has not overextended and the resulting productivity gains bode well for earnings growth. Despite the improving outlook, valuations have been retreating for much of the past year and our VI has fallen back to the neutral zone. Our TI has been hovering near the neutral line for the past year, though a recent hook downward indicates a loss of momentum and downside relative performance risks. Chart 14S&P Materials (Neutral) S&P Materials (Neutral) S&P Materials (Neutral) Chart 15Rising Rates Are Offset By Improving Demand Rising Rates Are Offset By Improving Demand Rising Rates Are Offset By Improving Demand S&P Consumer Discretionary (Underweight) Our consumer discretionary CMI (Chart 16) has fallen back after reaching highs earlier in 2017, though remains elevated relative to the long term trend. Rising interest rates (top panel, Chart 17) are more than offsetting higher home prices and real wage growth, both have which have recently stalled. This rising short-term interest rate backdrop is not conducive to owning the extremely interest rate-sensitive equities that fall into the S&P consumer discretionary index. Both the household financial obligation ratio and household debt service payments have bottomed and are actually increasing. A higher interest rate backdrop will sustain the upward pressure on both and likely weigh on consumer discretionary relative share prices (third and bottom panels, Chart 17). This underpins our recent downgrade to a below benchmark allocation. Elevated valuations support our negative thesis as our valuation indicator has been rising recently out of the neutral zone. Our TI has fully recovered from oversold levels, and is now well into overbought territory, though historically this indicator has been excessively volatile. Chart 16S&P Consumer Discretionary (Underweight) S&P Consumer Discretionary (Underweight) S&P Consumer Discretionary (Underweight) Chart 17Higher Borrowing Costs Bode Ill For Consumer Discretionary Higher Borrowing Costs Bode Ill For Consumer Discretionary Higher Borrowing Costs Bode Ill For Consumer Discretionary S&P Health Care (Underweight) Our health care CMI (Chart 18) rolled over last year and has been treading water at these lower levels, driven by weak fundamentals in the key pharmaceuticals sector. Poor pricing power, a soft spending backdrop and a depreciating U.S. dollar have been pressuring the sector and keeping a tight lid on the CMI (top and second panels, Chart 19). Other non-pharma indicators are mixed as lower healthcare consumer spending is offset by a tick up in overall pricing power. Relative valuations have fallen deep into undervalued territory and are approaching one standard deviation below the 25 year average. Our TI too has reversed course and is well into oversold territory. However, the message from our health care earnings model is that sector earnings will continue to decelerate; this environment in not conducive for a sector re-rating (bottom panel, Chart 19). Chart 18S&P Health Care (Underweight) S&P Health Care (Underweight) S&P Health Care (Underweight) Chart 19Pharma Pricing Power Continues To Collapse Pharma Pricing Power Continues To Collapse Pharma Pricing Power Continues To Collapse S&P Telecommunication Services (Underweight) Our telecom services CMI (Chart 20), after moving sideways for much of the past decade, has recently fallen to a new 30-year low. Extreme deflation continues to reign in the beleaguered sector as relative consumer outlays on telecom services have nosedived (top panel, Chart 21) which is broadly matched by melting selling prices (middle panel, Chart 21) as demand contracts. This is reflected in our S&P telecom services revenue growth model, which remains deep in contractionary territory (bottom panel, Chart 21). The sector remains chronically cheap, exacerbated by the recent sell-off, and is currently as cheap as it has ever been. Still, given the brutal operating environment, we think such valuations have created a value trap. Our Technical Indicator has sunk but, like the VI, cycles deep in the sell zone have not proven reliable indicators that a relative bounce is in the offing. We recently downgraded the sector to underweight and added it to our high-conviction underweight list based on the factors noted above.1 Chart 20S&P Telecommunication Services (Underweight) S&P Telecommunication Services (Underweight) S&P Telecommunication Services (Underweight) Chart 21Telecom Services Remain A Value Trap Telecom Services Remain A Value Trap Telecom Services Remain A Value Trap S&P Technology (Underweight, Upgrade Alert) The technology CMI (Chart 22) has been falling for the past three years, driven by ongoing relative pricing power declines and new order weakness. However, the sector has proven resilient, at least until recently, as a handful of stocks (the FANGs, excluding the consumer discretionary components) and the red-hot semiconductor group have provided support. Still, market euphoria aside, tech stocks thrive in a disinflationary/deflationary environment and suffer during inflationary periods; inflation is gradually rising after a prolonged disinflationary period (bottom panel, Chart 23). Valuations, while still in the neutral zone, have reached their highest level in a decade. This may prove risky should inflation mount faster than expected; a de-rating phase in technology would likely follow. Our TI is extremely overbought, though it has been at this high level for several years. Chart 22S&P Technology (Underweight, Upgrade ALert) S&P Technology (Underweight, Upgrade ALert) S&P Technology (Underweight, Upgrade ALert) Chart 23Inflation Is No Friend To Tech Inflation Is No Friend To Tech Inflation Is No Friend To Tech Size Indicator (Neutral Small Vs. Large Caps) Our size CMI (Chart 24) has fallen back to the boom/bust line. Keep in mind that this CMI is not designed as a directional trend predictor, but rather as a buy/sell oscillator; the current message is neutral. Small company business optimism is near modern highs, as pricing and consumption vigor push domestic revenues higher (top panel, Chart 25). A smaller government footprint, i.e. fewer regulatory hurdles, and tax relief will disproportionately benefit SMEs. Earlier this year, we downgraded our recommendation on small caps vs. large caps to a neutral allocation, based on a deterioration in small cap margins and too-high leverage.2 Recent NFIB surveys would suggest this move was prescient; firms reporting planned labor compensation increases have steadied near a two decade high, while price increases are trailing far behind (middle panel, Chart 25). With "quality of labor" having overtaken "taxes" as the single most important problem facing businesses, labor compensation growth seems likely to continue moving up at an elevated pace and small cap margins should likely continue to trail large cap peers (bottom panel, Chart 25). Valuations have improved and small caps are relatively undervalued, though our TI echoes a neutral message. Chart 24Size Indicator (Neutral Small Vs. Large Caps) Size Indicator (Neutral Small Vs. Large Caps) Size Indicator (Neutral Small Vs. Large Caps) Chart 25Small Businesses Remain Exceptionally Confident Small Businesses Remain Exceptionally Confident Small Businesses Remain Exceptionally Confident Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Manic-Depressive?" dated February 12, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com.

Highlights Chart 1Inflation Pressures Mount Inflation Pressures Mount Inflation Pressures Mount Spread product underperformed equivalent-duration Treasuries for the second consecutive month in March. But last month's underperformance was different than February's in one important way. In February it was the fear of inflation and tighter Fed policy that prompted the sell-off in spread product. Investment grade corporate bonds underperformed Treasuries by 62 basis points, while the Treasury index provided a total return of -75 bps and TIPS outperformed nominals. In March, the sell-off in spread product coincided with Treasury returns of +94 bps and TIPS underperformed nominals. The negative correlation between yields and spreads re-asserted itself signaling that the sell-off was not driven by inflation, but by concerns about a potential slow-down in global growth. A severe slow-down in global growth is not imminent. But higher inflation and tighter Fed policy remain our chief concerns. With that in mind, core inflation printed higher again last month (Chart 1), and we think it is only a matter of time before our TIPS breakeven target range of 2.3% to 2.5% is met. That will trigger a reduction in our recommended allocation to corporate bonds. Stay tuned. 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 91 basis points in March, dragging year-to-date excess returns down to -81 bps. The sell-off of the past two months has returned some value to the investment grade corporate space, but spreads are still quite tight relative to history. The 12-month breakeven spread for a Baa-rated corporate bond has only been tighter 19% of the time since 1989.1 Our opinion of investment grade corporate bonds is unchanged. We continue to view value as relatively unattractive, and will reduce our overweight allocation once both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are above 2.3%. Corporate profit data for the fourth quarter of 2017 were released last week, and our measure of EBITD for the non-financial corporate sector grew at an annualized rate of 2.4%, slightly below the 3% annualized increase in corporate debt. Gross leverage for the non-financial corporate sector ticked higher as a result (Chart 2). In a recent report we showed that sustained periods of corporate spread widening almost always coincide with rising gross leverage.2 We also showed that while most leading profit indicators are still in good shape, a profit margin proxy based on the difference between corporate selling prices and unit labor costs is sending a warning sign. We expect profit growth to fall sustainably below debt growth later this year, driven by rising unit labor costs. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Old Habits Die Hard Old Habits Die Hard Chart 3BCorporate Sector Risk Vs. Reward* Old Habits Die Hard Old Habits Die Hard 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 114 basis points in March, dragging year-to-date excess returns down to -19 bps. The average index option-adjusted spread widened 18 bps on the month and currently sits at 354 bps. The 12-month trailing speculative grade default rate ticked up to 3.56% in February, its highest reading since last July, but Moody's still expects it to decline to 1.96% during the next year. Based on the Moody's default rate projection and our own estimate of the recovery rate, we forecast High-Yield default losses of 0.97% for the next 12 months. This translates to a 12-month excess return of 257 bps for the High-Yield index versus Treasuries, assuming an un-changed junk spread (Chart 3). One hundred basis points of spread widening would lead to an excess return of -149 bps during this time horizon, and 100 bps of spread tightening would lead to an excess returns of +664 bps. However, such a large amount of spread tightening is probably over-optimistic. As inflation continues to rise and the Fed applies the brakes, a floor will likely remain under the VIX index of implied equity volatility and this will prevent junk spreads from recovering their cycle lows (top panel). We continue to await a firmer signal from our inflation indicators before reducing our allocation to high-yield. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in March, dragging year-to-date excess returns down to -39 bps. The conventional 30-year zero-volatility MBS spread widened 7 bps on the month, split between a 4 bps widening in the option-adjusted spread (OAS) and a 3 bps widening in the compensation for prepayment risk (option cost). The widening in MBS OAS has not been as severe as the widening in investment grade corporate OAS. As a result, mortgages no longer appear cheap relative to investment grade corporates (Chart 4). But while the value proposition in mortgages is less alluring, we still see limited potential for spreads to widen during the next 6-12 months. Refinancing risk will remain muted as interest rates rise (bottom panel), and in past reports we showed that extension risk will likely be immaterial.3 In the structured product space, Agency MBS offer 11 bps less spread than Aaa-rated consumer ABS, but are supported by falling residential mortgage delinquencies and easing bank lending standards. In contrast, consumer credit (auto loan and credit card) delinquency rates have bottomed and banks have begun to tighten lending standards (see page 12 for further details). 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 20 basis points in March, dragging year-to-date excess returns down to +2 bps. Sovereign debt underperformed the Treasury benchmark by 58 bps on the month, while Foreign Agencies underperformed by 38 bps and Local Authorities underperformed by 33 bps. Domestic Agencies outperformed duration-equivalent Treasuries by 6 bps, and Supranationals underperformed by a single basis point. USD-denominated sovereign bonds have performed worse than Baa-rated U.S. corporate bonds during the past six months, despite persistent weakness in the U.S. dollar (Chart 5). However, we do not think recent dollar weakness will provide much support for sovereign bond returns going forward. Rather, it is more likely that the U.S. dollar will appreciate during the next 6-12 months as the distribution of global growth shifts toward the United States. This month's issue of the Bank Credit Analyst discusses the cyclical and structural outlook for the U.S. dollar in detail.4 Elsewhere, Foreign Agencies and Local Authorities continue to offer attractive spreads after adjusting for duration and credit rating. We remain overweight those segments of the Government-Related universe despite an overall underweight allocation. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 56 basis points in March, dragging year-to-date excess returns down to +29 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal/Treasury yield ratio widened 4% on the month, with short maturities performing somewhat worse than long maturities. The tax-adjusted yield for a 10-year municipal bond remains about 17 bps below the yield offered by an equivalent-duration corporate bond (Chart 6). As we have shown in prior research, investors typically get an opportunity to shift out of corporates and into munis at a positive spread differential before the end of the cycle.5 We will await this more attractive entry point before aggressively shifting our allocation in favor of munis. In a recent report we noted that state and local governments are still working to repair their budgets.6 More states enacted tax increases than decreases in fiscal year 2018 and the projected nominal budget increase across all states is a paltry 2.3%. Fortunately, our Municipal Health Monitor indicates that the hard work is paying off, and suggests that ratings upgrades should continue to outpace downgrades for the time being (bottom panel). Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve flattened in March, as long maturity yields fell quite sharply despite a small increase in yields out to the 2-year maturity point. The 2/10 slope flattened 15 basis points on the month and currently sits at 47 bps. The 5/30 slope flattened 7 bps on the month and currently sits at 41 bps. The trade-off between the pace of Fed rate hikes on the one hand, and the re-anchoring of long-dated TIPS breakeven inflation rates on the other will dictate the path for the yield curve during the next six months. Last month the Fed lifted rates for the sixth time this cycle, and signaled its desire to hike another 2-3 times before the end of the year. But just as further rate hikes will apply flattening pressure to the curve, the recent rebound in inflation will exert some offsetting steepening pressure. The 10-year TIPS breakeven inflation rate is still 25-45 bps below a range that is consistent with inflation being anchored around the Fed's target. We recommend a curve steepening trade for now, specifically a position long the 5-year bullet and short a duration-matched 2/10 barbell, because upward pressure on inflation will make it difficult for the curve to flatten much further during the next few months. We will shift aggressively into flatteners once TIPS breakevens reach our target range. Further, the 2/5/10 butterfly spread is priced for 19 bps of 2/10 flattening during the next six months (Chart 7). In other words, the 2/10 slope needs to flatten by more than 19 bps for a long 5-year bullet position to underperform. We view this as unlikely. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 17 basis points in March, dragging year-to-date excess returns down to +67 bps. The 10-year TIPS breakeven inflation rate fell 7 bps on the month and currently sits at 2.05%. The 5-year/5-year forward TIPS breakeven inflation rate fell 2 bps on the month and currently sits at 2.18%. 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.7 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. If the recent trend in realized inflation continues, then this re-anchoring could occur relatively soon. February data show that the annualized 6-month rate of change in trimmed mean PCE rose to 2.03% (Chart 8), and while the 12-month rate of change held steady at 1.7%, it will start to move higher in March when the strong inflation prints from January and February 2017 are removed from the sample. Pipeline measures of inflation pressure also suggest that inflation will head higher, as evidenced by our Pipeline Inflation Indicator, and in particular, the Prices Paid component of the ISM Manufacturing index which just hit its highest level since 2011 (panel 4). ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 3 basis points in March, dragging year-to-date excess returns down to -19 bps. The index option-adjusted spread for Aaa-rated ABS widened 2 bps on the month and currently sits at 44 bps, 11 bps above its pre-crisis low. While in prior research we highlighted that consumer ABS offer attractive spreads relative to many other sectors, we also pointed out that collateral credit quality is starting to weaken.8 With respect to value, Aaa-rated Consumer ABS offer a 12-month breakeven spread of 21 bps, while Agency MBS offer a spread of 6 bps and Agency CMBS offer a spread of 9 bps.9 However, household debt service ratios and delinquency rates appear to have bottomed for the cycle (Chart 9). While the pace of consumer credit accumulation remains robust, it has also moderated in recent months alongside rising delinquencies and tightening lending standards. We maintain a neutral allocation to ABS for the time being due to attractive valuation, but expect to downgrade in the future as household credit quality deteriorates. 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 36 basis points in March, dragging year-to-date excess returns down to +11 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 9 bps on the month and currently sits at 72 bps, close to one standard deviation below its pre-crisis mean. While a spread of 72 bps is still attractive compared to similarly-rated alternatives, we remain concerned about the gap that has emerged between CMBS spreads and the rate of appreciation in commercial real estate (CRE) prices (Chart 10). While bank lending standards on CRE loans are still tightening, they are tightening less aggressively than in recent years (bottom panel). This could eventually remove a headwind from CRE prices, but for now we view a position in non-agency CMBS as overly risky. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 22 basis points in March, dragging year-to-date excess returns down to -14 bps. The index option-adjusted spread widened 6 bps on the month and currently sits at 47 bps. The Agency CMBS sector continues to offer an attractive spread pick-up relative to similar investment alternatives, and has historically exhibited low excess return volatility.10 Remain overweight. 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 2.96% (Chart 11). While the fair value reading from our 2-factor model remains elevated for now, we expect it to fall once March Global PMI data are released this week. Based on a combination of final PMI data and Flash estimates for countries that have yet to report final March figures, we estimate that the Global PMI will decline to 53.8 in March from 54.2 in February. When combined with the most recent reading for dollar bullish sentiment, this gives a fair value of 2.85% for the 10-year Treasury yield. We will provide an official update to the model in next week's report, after the data are finalized. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 1, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.74%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Jeremie Peloso, Research Assistant jeremiep@bcaresearch.com 1 The 12-month breakeven spread is the spread widening required during the next 12 months for the bond to break even with a position in an equivalent-duration Treasury security. 2 Please see U.S. Bond Strategy Weekly Report, "Brainard Gives The Green Light", dated March 13, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 4 Please see Bank Credit Analyst, "U.S. Twin Deficits: Is The Dollar Doomed?", dated March 29, 2018, available at bca.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Profiting From A Higher LIBOR", dated March 20, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com 9 The 12-month breakeven spread is the spread widening required during the next 12 months for the bond to break even with a position in an equivalent-duration Treasury security. 10 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 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)

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of March 30, 2018. There are no significant changes in the model's allocation this month. The small overweight in the U.S. is scaled back to neutral with the proceeds mostly going to the euro area. In terms of absolute bet, the model still favors the euro area (mainly Italy, Germany, Netherland and Spain) vs. Japan and the U.K. , as shown in Table 1. As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model outperformed its benchmark by 19 bps in March, largely driven by Level 2 model which outperformed by 58 bps. Since going live, the overall model outperformed MSCI World by 127 bps, due to the 421 bps of outperformance from the Level 2 model which allocates funds among 11 non-U.S. countries. The Level 1 model (which allocates funds between U.S. and the non-U.S.) is on par with the MSCI World benchmark. Table 1Model Allocation Vs. Benchmark Weights GAA Quant Model Updates GAA Quant Model Updates 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 (Level1) GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) Chart 4Overall Model Performance Overall Model Performance Overall Model Performance 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 March 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 last month's switch to a defensive positioning, the model generated alpha of 40 bps for the month of March. Increasing risk of a global trade war has damaged growth forecasts, and the model consequently continues to produce negative signals from its growth component. As cyclical sectors such as financials and technology continue to falter, momentum signals remain unfavorable. Energy is the only cyclical sector with an overweight on the back of favorable long-term valuations. 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. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Highlights BCA expects consumer spending to remain supportive of above-trend economic growth in the U.S. in the next few quarters. Our view is that the 2018 outlook for both the U.S. economy and corporate profits remains constructive, but evidence is gathering that worldwide growth is peaking. Today's elevated levels of corporate leverage could intensify the pullback in business spending in the next recession. Housing is a reliable leading indicator of economic activity. Spending on new construction will enhance growth in the coming year, allowing the economy to expand at a pace well above its long-term potential. Feature U.S. equity prices rallied last week, although the NASDAQ lagged the broader indices. Despite the gain in the final week of the month, the S&P 500 finished lower in March. The back to back monthly declines in February and March were the first since September and October 2016. The 10-year Treasury yield fell last week, and credit underperformed. Oil and gold prices sold-off, but the dollar rose. Worries about global growth and a widening trade war were the key drivers, as investors looked ahead to Q1 earnings reporting season, which will kick into high gear next week. BCA expects global growth to be solid this year, although there are signs that growth is peaking outside the U.S. Moreover, the U.S. economy appears to be generating positive momentum, aided by housing and capex. This is why we expect 2018 to record strong EPS growth in the U.S., which will provide the equity market with a strong tailwind. That said, elevated levels of corporate leverage and low interest coverage ratios are a concern. Stay long stocks over bonds. We expect consumer spending to remain supportive of above-trend economic growth in the U.S. in the next few quarters. Household balance sheets are the best that they have been since 2007. Net worth is soaring and the aggregate debt-to-income ratio is close to record lows last seen at the turn of this century. Moreover, conditions that crushed the consumer ahead of the 2007-2008 recession are not in place and will not be for some time. Chart 1 shows that at 41.4%, household purchases of essentials as a percentage of disposable income are near an all-time low and have dropped by almost 2 percentage points since 2012. In contrast, spending on necessities rose by a record 3% in the five years ending 2008, matching levels reached at the end of the 1980s that reflected rising interest rates, surging inflation and soaring oil prices. Wrenching consumer-driven economic downturns ensued after both episodes. We see gradual increases ahead for both oil prices and interest rates, but nothing that would trigger the collapse of consumer spending. Furthermore, BCA forecasts only a modest rise in inflation and an acceleration in wage growth; both will boost disposable income. Meanwhile, U.S. inflation is heading higher. The core PCE deflator accelerated to 1.6% y/y in February, up from a low of 1.3% y/y in mid-2017. The coming months should see a further acceleration in inflation, in part due to the very soft base effects from last year (Chart 2). That said, one worrying point is that our diffusion index for the PCE deflator remains well below zero. This means that the inflation pick-up is not broad-based, but due to outsized gains in a few components. Core PCE inflation is usually decelerating when our diffusion index is below zero. Chart 1Consumer Is Not Stressed##BR##Despite Higher Energy Costs Consumer Is Not Stressed Despite Higher Energy Costs Consumer Is Not Stressed Despite Higher Energy Costs Chart 2BCA's Inflation Models Show Only##BR##Modest Acceleration Through Year-End BCA's Inflation Models Show Only Modest Acceleration Through Year-End BCA's Inflation Models Show Only Modest Acceleration Through Year-End Bottom Line: The Q1 weakness in consumer spending and GDP growth is unlikely to persist. A return to above-trend growth and inflation inching to the 2% target will keep the Fed on a path of gradual interest rates hikes. Animal Spirits Still Intact Our view is that the 2018 outlook for both the U.S. economy and corporate profits remain constructive, but evidence is gathering that worldwide growth is peaking. Investors may begin to question recent upward revisions to the growth outlook for this year and next. Globally, industrial production has softened and the manufacturing PMI has shifted lower in most of the advanced economies (Chart 3). Bad weather in North America and Europe in early 2018 may be partly to blame, but Korean exports - a leading indicator for the global business cycle - have also weakened. It is also disconcerting that some of BCA's measures of global activity related to capital spending are lower in recent months, including capital goods imports and industrial production of capital goods (Chart 4). Nonetheless, the G3 aggregate for capital goods orders remains in an uptrend, which suggests that it is too soon to call an end in the mini capital spending boom. Furthermore, our global leading indicators are not heralding any major economic slowdown (Chart 5). BCA's Global LEI continues to trend up and its diffusion index is above the 50 line. Chart 3A Downshift In##BR##Global Growth? A Downshift In Global Growth? A Downshift In Global Growth? Chart 4Some Measures Of##BR##Global Capex Have Softened Some Measures Of Global Capex Have Softened Some Measures Of Global Capex Have Softened Chart 5Global Leading Indicators Are Not##BR##Heralding A Major Economic Slowdown Global Leading Indicators Are Not Heralding A Major Economic Slowdown Global Leading Indicators Are Not Heralding A Major Economic Slowdown Turning to the U.S., the environment for continued robust capital spending is still in place. The Tax Cut and Jobs Act of 2017 will boost capex, although we note that business spending tends to climb faster in the 12 months before a corporate tax cut than in the year afterward.1 The caveat is that there have been only three corporate tax cuts in the past 50 years. Both BCA's real and nominal capex models, driven by surging capital goods orders along with elevated ISM data, roaring global exports and robust sentiment on business spending, indicate strong investment in plant and equipment in the next few quarters (Chart 6). CEO confidence reached an all-time high in 2018Q1. According to the latest Duke Fuqua School of Business/CFO Magazine Global Business Outlook (Chart 7, panel 1),"sixty-six percent of U.S. CFOs say corporate tax reform is helping their companies, with 36 percent saying the overall benefit is medium or large."2 Chart 6U.S. Capex Poised For Liftoff U.S. Capex Poised For Liftoff U.S. Capex Poised For Liftoff Chart 7CEO Confidence And Capex Plans Surging CEO Confidence And Capex Plans Surging CEO Confidence And Capex Plans Surging Surveys by the Conference Board and Business Roundtable show similar patterns (Chart 7, panel 1). Notably, the soundings on all three surveys climbed since Trump's election, but subsequently retreated as his pro-business agenda stalled during the summer. The dip in sentiment reflected the lack of legislative progress in Washington in the first 10 months of the Trump administration. The upbeat numbers in the regional Federal Reserve Banks' surveys of capital spending intentions further support escalating capex in the next few quarters. The average reading from the New York, Philadelphia and Richmond Feds' capex survey plans are at an all-time high in early 2018 (Chart 7, panel 2). Furthermore, the regional FRBs' capex spending plans diffusion indices are close to a cycle high, despite a modest pullback since last summer (Chart 7, panel 3). In addition, ABC's Construction Backlog indicator (CBI),3 a leading indicator that measures in months the amount of construction underway but not yet completed, hit a peak early this year, which suggests that 2018 is poised to be a strong year for nonresidential building activity (Chart 8). Moreover, architectural billings hit a new cycle high in Q4 2017(not shown). This signifies that investment in office, industrial and commercial space will accelerate in the coming year. However, there are some warning signs in the nonresidential construction portion of capital spending. Commercial real estate (CRE) prices have galloped to new heights (Chart 9, panel 1). Rent growth in all but the industrial buildings sub component of the U.S. CRE sector is starting to slow, suggesting that supply is slowly catching up with demand (Chart 9, panel 2) and that a slowdown in construction may ensue. Chart 8Nonresidential Construction##BR##Backlog At Eight Year High Nonresidential Construction Backlog At Eight Year High Nonresidential Construction Backlog At Eight Year High Chart 9Commercial Real Estate Prices Have##BR##Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Corporate Health Fundamentals Last week's National Accounts (NIPA) corporate profit report allows us to update BCA's Corporate Health Monitor (CHM) (Chart 10). The level of the CHM improved slightly between Q3 and Q4, but the overall reading remains in 'deteriorating health' territory. However, the CHM moved slowly back toward "improving health" in 2017. The improvement in Q4 was broad-based, as five of the six components improved. Liquidity decreased slightly between Q3 and Q4. Leverage declined and interest coverage improved. Our CHM has a tendency to improve during phases of increased fiscal thrust.4 In contrast, corporate leverage increases substantially in the 12 months following a corporate tax cut. As an economic expansion enters the late stages, investors focus on where leverage pressure points may lurk. The Bank Credit Analyst's March 2018 Special Report5 on U.S. corporate vulnerability to higher interest rates and a recession raised some eyebrows. In a sample of 770 companies, we estimated how much interest coverage for an average company would decline under two scenarios: (1) interest rates rise by 100 basis points across the curve; and (2) interest rates rise by 100 basis points and there is a recession in which corporate profits tumble by 25% peak to trough. Given the number of client inquiries, we re-examined our results. We questioned whether our sample of high-yield companies distorted the overall results because it included many small firms and outliers. We are more comfortable with the results using only investment-grade firms, shown in Chart 11. The 'x' marks the interest rate shock and the 'o' marks the combined shock. Chart 10Corporate Health Improved In 2017 Corporate Health Improved In 2017 Corporate Health Improved In 2017 Chart 11Interest Coverage Is Deteriorating Interest Coverage Is Deteriorating Interest Coverage Is Deteriorating Nonetheless, the main qualitative message is unchanged. The starting point for interest coverage is low, considering that interest rates are near the lowest levels on record and profits are extremely high relative to GDP. This is the result of an extended period of corporate releveraging on the back of low borrowing rates. Chart 12 shows that the interest coverage ratio has declined even as profit margins remained elevated. Normally the two move together through the cycle. The implication is that the next recession will see the interest coverage ratio fare worse than in previous recessions. Rating agencies use many other financial ratios and statistics, but our results suggest that downgrades will proliferate when the agencies realize that the economy begins to turn south. Moreover, banks may tighten their C&I lending standards earlier and more aggressively because they also will be attuned to the first hint of economic trouble given the degree of corporate leverage in their portfolios. Recovery rates may be particularly low in the next recession because the equity cushion has been squeezed via buybacks, which will intensify widening pressures in corporate spreads. Tighter lending standards would generate more corporate defaults, even wider spreads and a more pronounced tightening in financial conditions. Therefore, corporate leverage could intensify the pullback in business spending in the next recession. The good news is that we do not see any other major macroeconomic imbalances, such as areas of overspending that could turn a mild recession into a nasty one. The market and rating agencies will ignore the leverage issue as long as growth remains solid. Indeed, ratings migration has improved markedly following energy-related downgrades in 2014 and 2015. An improving rating migration ratio is usually associated with corporate bond outperformance relative to Treasurys (Chart 13). For now, we remain overweight U.S. investment-grade and high-yield bonds within fixed-income portfolios. Chart 12Margins And Interest Coverage##BR##For Investment Grade Firms Margins And Interest Coverage For Investment Grade Firms Margins And Interest Coverage For Investment Grade Firms Chart 13Improving Ratings Migration##BR##Supports Our Credit Overweight Improving Ratings Migration Supports Our Credit Overweight Improving Ratings Migration Supports Our Credit Overweight Bottom Line: We are keeping an eye on our Corporate Health Monitor, bank lending standards, the yield curve and our profit margin proxy to time our exit from both corporate bonds and equities.6 We are also watching for a rise in the 10-year TIPS breakeven rate above 2.3% as a signal that the FOMC will get more aggressive in leaning against above-trend growth and a falling unemployment rate. The tightening labor market will continue to support the housing market, despite higher mortgage rates. Risks To Housing Are Limited Residential investment will add to growth in 2018. Inventories of new and existing homes are close to all-time lows (Chart 14). Housing affordability remains well above average and will remain supportive of housing investment even if rates climb by 100 bps (Chart 15). Recent soundings from the Fed's Senior Loan Officers survey shows that mortgage demand has ebbed in recent quarters (Chart 16). The housing sector has also benefited from a recovery in household formation in the past few years alongside the labor market and disposable income. Chart 14Housing Fundamentals##BR##Are Stout Housing Fundamentals Are Stout Housing Fundamentals Are Stout Chart 15Housing Affordability Under##BR##Various Rate Assumptions Housing Affordability Under Various Rate Assumptions Housing Affordability Under Various Rate Assumptions Chart 16Supply And Demand##BR##For Mortgages Supply And Demand For Mortgages Supply And Demand For Mortgages On that note, it is encouraging that the 10-year slide in the homeownership rate appears to have run its course (Chart 14, panel 3). Furthermore, U.S. real residential home prices are still below their 2006 peak. In addition, at under 3.9%, residential investment as a share of GDP remains well below the 12-year high of 6.6% achieved in 2005 (Chart 17, panel 1). It is difficult to see how residential investment can decline meaningfully when household formation is on the rise and home inventories are already low. Homebuilders appear to agree with this sentiment and report confidence levels near all-time peaks (Chart 17, panel 2). Employment in construction and related fields also suggests that the housing market remains on solid footing. (Chart 18, panel 1 and 2). Panel 3 shows that nearly 80% of states have escalating construction employment. This metric tends to lead construction jobs by a few months. Moreover, construction jobs tend to be at least coincident with housing construction. Segments of construction (residential and specialty employment) lead residential investment in some cases. Chart 17Real Home Prices Not Yet##BR##Back To Prior Peak Real Home Prices Not Yet Back To Prior Peak Real Home Prices Not Yet Back To Prior Peak Chart 18Housing Related##BR##Employment Trends Housing Related Employment Trends Housing Related Employment Trends Furthermore, the disconnect between the NAHB Housing Market Index and housing's contribution to economic growth (Chart 18, panel 4) also suggests housing is poised to lift off. Housing investment is the best leading indicator for real GDP growth among all sectors (Chart 14, panel 4). Construction of new homes and apartments, along with additions and alterations to existing stock, peaks as a share of GDP an average of seven quarters before the end of an expansion. Consumer spending on durable, nondurable and services reach a high, five quarters before GDP hits a zenith, while business capital spending tops out six quarters ahead of the economy. There are risks for housing despite the upbeat fundamentals. Banks have been tightening their lending standards in recent quarters, although they are still loose relative to previous cycles, and an overtightening may impede the real estate market (Chart 16). It is possible that the GOP's tax plan to significantly change the treatment of state and local real estate taxes and mortgage interest could also negatively affect housing demand, particularly in the luxury market. Additionally, rising foreign demand in certain U.S. markets may lead to mini-bubbles in coastal areas. The latest reading on the Case-Shiller home price index showed nominal housing prices climbing at the fastest rate in three years, although as noted above, inflation-adjusted house prices remain below prior peaks. A prolonged period of house price increases above income gains would challenge our sanguine view of housing affordability. However, the Fed and the banking system are hyper-vigilant about excesses in the housing market, therefore, it is unlikely that another housing bubble will be tolerated. Bottom Line: Housing is a reliable leading indicator of economic activity. Spending on new construction will enhance growth in the coming year, allowing the economy to expand at a pace well above its long-term potential. Faster GDP growth will be accompanied by higher inflation and a more active Fed, especially relative to current market expectations. BCA expects global growth to be solid this year although there are signs that growth is peaking outside the U.S. Moreover, the U.S. economy appears to be generating positive momentum even before the effects of tax cuts fully kick in. This is why we expect 2018 to record strong EPS growth in the U.S., which will provide the equity market with a strong tailwind. Stay long stocks over bonds. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA U.S. Investment Strategy Weekly Report "Opportunity," dated December 11, 2017, available at usis.bca.research.com. 2 http://www.cfosurvey.org/2018q1/press-release.html 3 https://www.abc.org/News-Media/Construction-Economics/Construction-Backlog-Indicator/entryid/13680/abc-s-construction-backlog-indicator-hits-a-new-high-2018-poised-to-be-a-very-strong-year-for-construction-spending 4 Please see BCA U.S. Investment Strategy Weekly Report "Opportunity," dated December 11, 2017, available at usis.bca.research.com. 5 Please see The Bank Credit Analyst Monthly Report, dated February 22, 2018, available at bca.bcaresearch.com. 6 Please see The Bank Credit Analyst Monthly Report, dated February 22, 2018, available at bca.bcaresearch.com.

Highlights With North Korean diplomacy on track, Taiwan is the country most exposed to U.S.-China trade and strategic tensions. The Taiwanese public supports the status quo; however, a majority sees itself as exclusively Taiwanese, and the desire for independence may grow over time. Domestic political changes in mainland China and in the United States are also conducive to greater geopolitical tensions affecting Taiwan. Beijing will likely refrain from excessive pressure in the lead-up to Taiwan's November local elections ... but an independence-leaning outcome could change that. Stay overweight Taiwan within Emerging Market portfolios, but be prepared to downgrade if latent geopolitical risks begin to materialize. Feature The decision by the United States to toughen its enforcement of trade rules with China marks a shift that will have lasting ramifications.1 The U.S. is concerned not only about the trade imbalance but also the national security risk posed by China's economic might and increasing technological prowess. Hence President Donald Trump has imposed trade measures on China despite Chinese President Xi Jinping's cooperation on North Korea. Xi has enforced sanctions on the North and thus forced Kim Jong Un to the negotiating table, even getting him to consider denuclearization (Chart 1). Global financial markets may "climb the wall of worry" about the latest tariffs because the Trump administration has moderated its rhetoric in practice, notably by choosing to prosecute China in the World Trade Organization. However, the protectionist shift in U.S. policy is a lasting one. American power is declining relative to China, and the two countries no longer share the same economic interdependency that acted as a deterrent to conflict in the past (Chart 2).2 Chart 1China Gives Kim To Trump China Gives Kim To Trump China Gives Kim To Trump Chart 2Structural Increase In U.S.-China Tensions Structural Increase In U.S.-China Tensions Structural Increase In U.S.-China Tensions Taiwan is the country that is most exposed to both trade and strategic tensions between the U.S. and China (Chart 3). Indeed, BCA's Geopolitical Strategy has held since January 2016 that Taiwan is a potential geopolitical black swan.3 Does this warrant shifting to an underweight stance in EM portfolios? Not yet. But it is a left tail risk that investors should have on their radar. Taiwan Is Filled With Dry Powder There are three reasons to suspect that Taiwan geopolitical risk is understated. First, Chinese President Xi Jinping has consolidated power and made himself into Chairman Mao Zedong's peer in the Communist Party's ideological hierarchy. He is in power indefinitely. Xi has also followed his predecessor Jiang Zemin, in the 1990s, in taking a tough approach to security and defense. Implicitly he wants to make sure that unification occurs by 2049, but some argue that he wants to achieve it within his lifetime, namely by 2035. The Taiwanese public is resolutely opposed to any timetable. The fundamental risk is that economic slowdown could disappoint the aspirations of a big and ambitious middle class, which could force Xi to pursue nationalism and foreign aggression as a way to maintain domestic control (Chart 4). Beijing is still unlikely to attack Taiwan other than as a last resort, due to the American alliance system protecting it: this remains a hard constraint for now. But aggressive economic sanctions and military posturing with the intention to coerce Taiwan are much more likely than investors realize today. Chart 3Taiwan's Economy As Well As Security On The Line Taiwan's Economy As Well As Security On The Line Taiwan's Economy As Well As Security On The Line Chart 4China's Stability Vulnerable To Growth Slowdown China's Stability Vulnerable To Growth Slowdown China's Stability Vulnerable To Growth Slowdown Second, Taiwan's independence-leaning Democratic Progressive Party (DPP) has gained control of every level of government on the island - the presidency, the legislature, the municipalities - since the large-scale, anti-mainland "Sunflower" protests of 2014. President Tsai Ing-wen, who replaced the outspokenly pro-China President Ma Ying-jeou, is vocally uncomfortable with the status quo. She has refused to positively affirm the "1992 Consensus," which holds that there is only "One China" but two interpretations. Beijing sees this idea as the basis of smooth cross-strait relations. Tsai has not in practice tried to break the status quo, but she is clearly interested in enhancing Taiwan's autonomy. Moreover, a youthful "Third Force" has emerged in Taiwanese politics, with the backing of former presidents Lee Teng-hui and Chen Shui-bian, arguing for independence and the right to hold popular referendums on the question of sovereignty. Any success of this movement will provoke a massive response from China. Third, U.S. President Trump has suggested in several poignant ways that his tougher approach to China will entail a more robust American guarantee of Taiwan's security. While he has promised Xi to uphold the "One China policy," he is actively upgrading diplomatic and possibly naval relations with Taiwan and considering more substantial arms sales to Taiwan.4 His negotiation style suggests that he is not afraid to touch this "third rail" in Sino-American relations. Moreover, in the wake of the 1995-96 Third Taiwan Strait Crisis, and again in the wake of the Global Financial Crisis, a hugely important shift in Taiwanese national identity accelerated. Today the public mostly identifies solely as Taiwanese, as opposed to both Taiwanese and Chinese (Chart 5). This trend has abated somewhat since the DPP rose to full control in 2014-16, but a 55% majority still sees itself as exclusively Taiwanese. Among the youth, that number is 70%. This dynamic raises the possibility that a political independence movement could one day emerge. Beijing, at any rate, is watching with great concern. Of course, this shift in national identity does not imply that Taiwanese want to declare independence for the state of Taiwan anytime soon. Only about 22% want the country to move toward formal independence, and only 5% want to declare independence today. Whereas 69% are comfortable maintaining the status quo for a long time (Chart 6). The Taiwanese want to preserve their de facto independence and continue to prosper. But support for independence has grown faster than support for the status quo since the 1994 consensus. The status quo barely, if at all, holds majority support if one removes from its ranks those who eventually want to see the country declare independence. And younger cohorts have larger majorities than older cohorts in favor of independence. Chart 5Majority Of Taiwanese Are Exclusively Taiwanese ... Taiwan Is A Potential Black Swan Taiwan Is A Potential Black Swan Chart 6... Yet Majority Support Status Quo For Now Taiwan Is A Potential Black Swan Taiwan Is A Potential Black Swan The point is that there is a lot of "dry powder" in Taiwanese public opinion that could be ignited against China in the event of a change of circumstances, i.e. another military crisis or economic shock. Essentially, China is worried that someday this national identity could be weaponized. Chart 7China Gains Leverage Over Time China Gains Leverage Over Time China Gains Leverage Over Time How will China respond to the situation? So far it has not overreacted. Xi Jinping has launched more intimidating military drills and has hardened his rhetoric - including in key reports at the 2017 party congress and this year's National People's Congress. His administration has also pursued policies to emphasize its dominance, such as setting up new air traffic routes over the strait that Taiwan claims violate its rights.5 Nevertheless, the cross-strait status quo has not yet changed in any fundamental way that would suggest relations are about to explode. And this is fitting because the status quo is beneficial to the mainland, having created a vast imbalance of economic influence over Taiwan (Chart 7). This imbalance gives China the ability to use economic coercion to dissuade Taiwan's leaders from trying anything too daring. This year, in particular, there is reason to think that Xi Jinping may want to limit any provocations. Taiwan will hold local elections on November 24, an opportunity for the pro-China Kuomintang (KMT) to at least begin to claw back the political stature it has lost (Chart 8). A good showing in 2018 is essential for the KMT if it is to rebuild momentum for the 2020 general election. Tsai's and the DPP's approval ratings have fallen precipitously since her inauguration (Chart 9). Xi may deem that saber-rattling would be counterproductive by giving Tsai and the DPP a foil, when in fact the tide is already working against them. If the KMT's performance is abysmal in the November elections, then Beijing faces a problem. Its strategy of gaining influence over Taiwan through economic integration has not prevented the emergence of an exclusively Taiwanese identity. So far Beijing has not given up on this strategy but that might become a concern if the Xi administration treads softly this year and yet the DPP broadens its control of local offices. Worse still for Beijing would be sweeping gains for outspoken, pro-independence candidates, since China cannot expel them from the legislature as easily as it did their peers in Hong Kong. Chart 8Kuomintang Needs A Win In 2018 Taiwan Is A Potential Black Swan Taiwan Is A Potential Black Swan Chart 9DPP Only Leads KMT By A Little Now Taiwan Is A Potential Black Swan Taiwan Is A Potential Black Swan Bottom Line: Political changes in China, Taiwan, and the United States are conducive to souring relations across the strait. Moreover, Taiwanese national identity is dry powder that Beijing fears could be exploited by independence-leaning politicians - potentially with American backing from an aggressive President Trump. This three-way dynamic means that Taiwanese geopolitical risk is understated, despite the fact that these powers are all familiar with the dynamics and Beijing may not want to overly provoke voters ahead of local elections, knowing that heavy-handedness in 1995-96 encouraged Taiwanese uniqueness. Macro Backdrop And Trade Tensions Undermine DPP The problem for President Tsai and the ruling DPP, as local elections approach, is that the Taiwanese economy faces headwinds as Chinese and Asian trade slows down and as the Trump administration converts its protectionist rhetoric into action. Since last year, China has tightened financial conditions and regulation and has cracked down on corruption in the financial sector. The result is a slump in broad money supply that is now pointing to a drop in EM and Taiwanese exports (Chart 10). Indeed, a cyclical slowdown is emerging in Taiwan: The short-term loans impulse is weakening which suggests that Taiwanese export growth will slow further (Chart 11, top panel). The basis for this relationship is that short-term loans are used by Taiwanese businesses to fund their working capital needs as well as purchase inputs to fill their export orders. Further, broad money is also weak (Chart 11, bottom panel). Chart 10China Slowdown Spells Trouble For Taiwan bca.gps_sr_2018_03_30_c10 bca.gps_sr_2018_03_30_c10 Chart 11Taiwanese Money/Credit Growth Slowing Taiwanese Money/Credit Growth Slowing Taiwanese Money/Credit Growth Slowing The manufacturing sector is slowing, with the shipments-to-inventories ratio weak and manufacturing PMI dipping sharply (Chart 12). Worryingly, the new orders, export orders, and electronic-sector employment components of the manufacturing PMI are approaching a precarious level. Various prices of semiconductors are also starting to show signs of weakness globally which does not bode well for a market that relies heavily on this trade. The semiconductor shipment-to-inventory ratio has rolled over (Chart 13). Taiwanese exports to ASEAN are also slowing, which signifies that final demand for semiconductors is softening, as ASEAN economies lie at the final stage of the semiconductor supply chain process. Chart 12Manufacturing Indicators Rolling Over Manufacturing Indicators Rolling Over Manufacturing Indicators Rolling Over Chart 13Softness In Key Semiconductor Exports Softness In Key Semiconductor Exports Softness In Key Semiconductor Exports Further, global trade tensions have the potential to harm global growth and especially heavily trade-exposed economies like Taiwan. Taiwan is not guaranteed to benefit from the U.S.'s more aggressive posture toward China. Theoretically, if the U.S. imposes tariffs on goods from China that can be substituted by Taiwan, then Taiwan will benefit. But in practice, the U.S. is using tariffs as a threat to force China to open its market more to U.S. exports. One way that Beijing may respond is by purchasing American goods instead of goods that come from American allies like Taiwan. Beijing has already attempted this strategy by offering to increase imports of American semiconductors at the expense of Taiwan and South Korea. At the moment there are no details on how much of an increase China is proposing. In Table 1 we show several scenarios to assess the damage that could be inflicted on Taiwan if China substituted away from it. The impact on Taiwan's exports is not negligible. For instance, under the benign scenario, if U.S.'s share of semiconductor exports to China rise from 4%6 to 10%, then Taiwan's share of semiconductor exports to China would drop from 15% to 12%. That would amount to a $4 billion loss for Taiwan, approximately, which represents 1.4% share of its total exports and 4% of its overall semiconductor exports. This analysis assumes that the trade losses resulting from China's shift to its semiconductor import mix would harm Taiwan somewhat more than Korea. The latter holds a competitive advantage on Taiwan as Korea designs and manufactures unique semiconductors that are not as easily substitutable. At any rate, the damage to Taiwan's geopolitical and trade outlook would be more concerning than the loss of revenue. Table 1China's Trade Concessions To U.S. Could Impose Costs On U.S. Allies Taiwan Is A Potential Black Swan Taiwan Is A Potential Black Swan It is unlikely that the Trump administration is willing to accept such a deal, which is flagrantly designed to appease the U.S. at the expense of its allies. But the exercise illustrates a broader dynamic in which U.S. negotiations with China threaten to disrupt trade relationships and supply chains that have benefited Taiwan in recent decades. The result will be greater uncertainty and a higher potential for negative shocks. Chart 14China Punishes Taiwan For 2016 Election China Punishes Taiwan For 2016 Election China Punishes Taiwan For 2016 Election Moreover, the Trump administration has not entirely exempted allies from trade pressure. For instance, Taiwan has appreciated the dollar a bit in response to the threat of punishment for currency manipulation from the U.S. Washington has also just secured assurances from South Korea that it will not competitively depreciate the won. If agreements like these stand, and yet China makes less robust or less permanent agreements regarding its own currency, South Korea and Taiwan could suffer marginal losses of competitiveness. Taiwan is also exposed to coercive economic measures from China. Since Tsai's election, Beijing has made a notable effort to reduce tourist travel to Taiwan, which is reflected in tourism and flight data (Chart 14). Given the context of political tensions, the risk of discrete sanctions will persist and could flare up at any time if an incident occurs that aggravates the distrust between the two governments. How will investors know if Taiwanese geopolitical risk is about to spike upwards? At the moment, geopolitical risk is subdued, according to a proxy based on USD/JPY and USD/KRW exchange rates and relative Taiwanese/American inflation (Chart 15). This indicator tracks well with previous cross-strait crises. It even jumped upon the heightened tensions around the 2016 election of Tsai, and her controversial phone call with Donald Trump after his election. At the moment it suggests that cross-strait tensions have subsided significantly, despite the cutoff in formal diplomatic communication. However, the low point of the measure, and the underlying political factors outlined in the previous section, suggest that it should rise going forward. Chart 15Taiwanese Geopolitical Risk Likely To Rise From Here Taiwanese Geopolitical Risk Likely To Rise From Here Taiwanese Geopolitical Risk Likely To Rise From Here In the short run, it will be important to watch the Trump administration's handling of diplomatic visits and arms sales to Taiwan. Trump's signing of the Taiwan Travel Act has elevated diplomatic exchanges in a way that is mostly symbolic but could still spark an episode of heightened tension with China that would result in economic sanctions. An unprecedented naval port call could turn into an incident. At the same time, the U.S. guarantees Taiwan's security and in token of that guarantee periodically provides Taiwan with weapons packages. Beijing, for its part, always protests these sales, more or less vigorously depending on the military capabilities in question. The currently slated one is not too big but there is a rumor that it will include F-35 stealth fighter jets; other surprises could occur. Traditionally, the biggest spikes in sales have fallen under Democratic, not Republican, administrations. However, Trump may change that. There is a consensus in Washington that policy toward China should get tougher. The Taiwan Travel Act, upgrading diplomatic ties, passed with unanimous consent in both the House and Senate. Taiwanese governments have a record of increasing military spending when Republican presidents sit in Washington. And the first DPP government, under Chen Shui-bian from 2000-08, marked a clear upturn in Taiwanese military spending growth (Chart 16). If the Trump administration decides to sell Taiwan weapon systems that make a qualitative difference in the military balance, it will raise tensions with Beijing and likely prompt economic sanctions against Taiwan. Chart 16Arms Sales Could Reemerge As An Irritant Arms Sales Could Reemerge As An Irritant Arms Sales Could Reemerge As An Irritant In the long run, there are three key negotiations taking place in the region that could increase Taiwanese geopolitical risk: U.S.-China trade negotiations: Taiwan has benefited from China's engagement with the U.S., and with the West more broadly, and stands to suffer if they disengage. That would herald rising strategic tensions that would put Taiwan's trade and security in jeopardy. Geopolitical risk would go up. North Korean diplomacy: Kim Jong Un has met with Xi Jinping and formally agreed to hold bilateral summits with Presidents Trump and Moon Jae-in of South Korea. He has also indicated that denuclearization is on the table. If the different parties enter onto a path towards a peace treaty and denuclearization, then Taiwan might worry that the U.S. will eventually remove troops from the peninsula - far-fetched but not out of the question. Taiwan would fear abandonment and could attempt to entangle the U.S. For its part, China could believe that cooperation on North Korea requires the U.S. to give China greater sway over Taiwan. Geopolitical risk would go up. The South China Sea: These sea lanes are vital to Taiwan as well as China, South Korea, and Japan. If the U.S. washes its hands of the matter, ceding China a maritime sphere of influence, Taiwan will face both greater supply risk and greater anxiety about American commitment to its security. Beijing might be emboldened to pressure Taiwan, or Taiwan might act out to try to secure American support. Geopolitical risk would go up. Bottom Line: Taiwan's economy is entering a cyclical slowdown on the back of China's slowdown and rollover in the semiconductor industry. At the same time, trade tensions emanating from the U.S.-China negotiations and political tensions emanating from the other side of the strait suggest that Taiwan's geopolitical risk premium will rise. Over the short term, Taiwan's local elections, the referendum movement, or U.S. diplomacy or arms sales could provide a catalyst for a cross-strait crisis. Over the long term, significant changes in U.S.-China relations, North Korea, or the South China Sea could put Taiwan in a more precarious position. Investment Conclusions While the absolute outlook for Taiwanese stock prices is negative, the potential downside in share prices in U.S. dollar terms is lower than for the EM benchmark. BCA's Emerging Markets Strategy recommends that EM-dedicated investors remain overweight Taiwanese risk assets relative to the EM benchmark. First, the epicenter of China's slowdown is capital spending in general and construction in particular. Various Chinese industrial activity indicators have already begun decelerating. This is negative for industrial commodity prices and countries that produce them. Taiwan is less exposed to China's construction slump than many other EM economies. Second, China's spending on technology will not slow much. As a part of its ongoing reforms, Beijing will encourage more investment in technology as well as upgrading industries across the value-added curve. Hence, China's tech spending will outperform its expenditure on construction and infrastructure. Taiwan is poised to benefit from this relative shift in China's growth priorities. Third, there are no fresh credit excesses in Taiwan like in some other EMs. Taiwan's banking system worked out bad assets extensively following the credit excesses of the 1980s-90s. Hence it is less vulnerable than its peers in the developing world. Finally, Taiwan has an enormous current account surplus of 14% of GDP and, contrary to many other EMs, foreign investors hold few Taiwanese local bonds. When outflows from EM occur, the Taiwanese currency will fall under less pressure and its financial system under much less stress. This will allow Taiwanese stocks to act as a low-beta defensive play. Crucially, despite some appreciation to appease Trump, the Taiwanese dollar is among the cheapest currencies in EM (Chart 17). Chart 17Cheap Taiwanese Dollar Removes Risk Cheap Taiwanese Dollar Removes Risk Cheap Taiwanese Dollar Removes Risk As for heightened geopolitical risk, BCA's Geopolitical Strategy would note that while we view Taiwan as a potential "black swan," nevertheless tail risks are not the proper basis for an investment strategy. We will continue to monitor the situation so that we can alert clients when a major, market-relevant deterioration in cross-strait relations appears imminent, based largely on the factors highlighted above. If the DPP remains dominant after the local elections later this year, or if "Third Forces" make notable gains, we would suspect that the Xi administration will shift to using more sticks than carrots. This could include economic sanctions and military saber-rattling. The question then will be whether Beijing (or Washington or Taipei) attempts a material change to the status quo. Ultimately - from a bird's eye point of view - a war is more likely in the wake of Xi Jinping's elimination of term limits, consolidation of power, and the secular slowdown in China's economy and rise of Chinese nationalism. But we see no reason to fear such a catastrophic outcome in the near term. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, and "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 4 Trump began, as president-elect, by holding an unprecedented telephone call with the Taiwanese president. His administration has since requested a new $1.4 billion arms package, opened legal space for port calls (including potentially naval port calls) in the 2018 Defense Authorization Act, and for higher-level diplomatic meetings via the Taiwan Travel Act, which became public law on March 16, 2018. 5 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. Military drills have involved symbolic shows, like sailing China's only operational aircraft carrier along the mid-line of the Taiwan Strait, as well as more poignant maneuvers, like drilling north and south of Taiwan simultaneously. As for rhetoric, Xi omitted from his 2017 party congress speech any reference to hopes that the Taiwanese "people" would bring about unification; in his speech after the March National People's Congress, he warned of the "punishment of history" for those who would promote secession. 6 Shown as the average of 2015 and 2017.

Highlights There is growing evidence that China's industrial sector is slowing, as are Asian trade flows. EM stocks have seen their tops. Even though current trade tensions between the U.S. and China could well dissipate, we are at the beginning of a long-term geopolitical standoff between these two superpowers. We are reinstating our long MXN / short BRL and ZAR trade. We are also upgrading Mexican sovereign credit and local bonds to overweight within their respective EM benchmarks. This week we review our recommended country allocation for the EM sovereign credit space. Feature The combination of budding signs of deceleration in both China and global trade, the trade confrontation between the U.S. and China as well as elevated equity valuations, leaves EM stocks extremely vulnerable. Odds are that EM share prices have made a major top. A few financial indicators point to a top in EM risk assets and commodities, while several leading economic indicators herald a global trade slowdown. Taken together we are reiterating our bearish stance on EM risk assets. Market- And Liquidity- Based Indicators Financial market indicators are signalling a major top in EM risk assets and commodities prices: The relative total return (carry included) of four equally weighted EM (ZAR, RUB, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc - has rolled over at its previous highs, and is about to break below its 200-day moving average (Chart I-1). This technical profile points to rising odds of a major down-leg in this carry adjusted ratio of seven 'risk-on' versus two 'safe-haven' currencies, herein referred to as the risk-on / safe-haven currency ratio. Importantly, Chart I-2 demonstrates that this risk-on / safe-haven currency ratio has historically been coincident with EM share prices. A breakdown in this ratio would herald a major downtrend in EM equities. This is consistent with our qualitative assessment that EM equities have seen the peak in this rally. Chart I-1A Major Top In Risk-On Versus ##br##Safe-Haven Currency Ratio bca.ems_wr_2018_03_29_s1_c1 bca.ems_wr_2018_03_29_s1_c1 Chart I-2Risk-On Versus Safe-Haven Currency Ratio##br## And EM Share Prices: Twins? bca.ems_wr_2018_03_29_s1_c2 bca.ems_wr_2018_03_29_s1_c2 The annual rate of change in the risk-on / safe-haven currencies ratio leads global export volumes by several months. It currently indicates that global trade has already peaked, and a meaningful slowdown is in the cards (Chart I-3). As we documented in March 15 report,1 global cyclical sectors - mining, machinery and chemicals - have been underperforming since January. Industrial metals prices, including copper, are gapping down, as are steel and iron ore prices in China (Chart I-4). Chart I-3Global Trade Is Set To Slow bca.ems_wr_2018_03_29_s1_c3 bca.ems_wr_2018_03_29_s1_c3 Chart I-4A Breakdown In Metals Prices Is In The Making A Breakdown In Metals Prices Is In The Making A Breakdown In Metals Prices Is In The Making Our aggregate credit and fiscal spending impulse for China projects considerable downside risks for industrial metals prices (Chart I-5). In this context, a question arises: Why is oil doing well so far? Chart I-6 illustrates that industrial metals prices typically lead oil at peaks. Oil prices have historically been a lagging variable of global business cycles. Chart I-5China's Slowdown Is Far From Over China's Slowdown Is Far From Over China's Slowdown Is Far From Over Chart I-6Industrial Metals Lead Oil Prices At Tops Industrial Metals Lead Oil Prices At Tops Industrial Metals Lead Oil Prices At Tops Furthermore, our two measures of U.S. dollar liquidity have rolled over. These two measures have a high correlation with EM share prices and are inversely correlated with the trade-weighted U.S. dollar (Chart I-7A and Chart I-7B). The dollar is shown inverted on Chart I-7B. The rollover in these measures of U.S. dollar liquidity is due to shrinking U.S. banks' excess reserves at the Federal Reserve. The Fed's ongoing balance sheet reduction and the Treasury's replenishment of its account at the Fed will continue to shrink banks' excess reserves, and thereby weigh on these measures of U.S. dollar liquidity. In short, downside risks to EM stocks and upside risks to the U.S. dollar have increased. Last but not least, China's yield curve has recently ticked down again and is about to invert, signaling weaker growth ahead (Chart I-8). Chart I-7AU.S. Dollar Liquidity And EM Stocks... U.S. Dollar Liquidity And EM Stocks... U.S. Dollar Liquidity And EM Stocks... Chart I-7B...And Trade-Weighted Dollar (Inverted) ...And Trade-Weighted Dollar (Inverted) ...And Trade-Weighted Dollar (Inverted) Chart I-8China's Yield Curve Is About To Invert China's Yield Curve Is About To Invert China's Yield Curve Is About To Invert Hard Data In addition, certain economic data have also decisively rolled over, in particular: Taiwanese shipments to China lead global trade volumes by several months, and they now portend a meaningful slowdown in global export volumes (Chart I-9). The basis for this relationship is that Taiwan sends a lot of intermediate products to mainland China. These inputs are in turn assembled by China and then shipped worldwide. Therefore, diminishing trade flow from Taiwan to China is a sign of a slowdown in world trade. The three-month moving average of Korea's 20-day exports growth rate, which includes the March data point, reveals that considerable softness in global trade is underway (Chart I-10). Chart I-9Another Sign Of Peak In Global Trade Another Sign Of Peak In Global Trade Another Sign Of Peak In Global Trade Chart I-10Korean Export Growth Is Already Weak Korean Export Growth Is Already Weak Korean Export Growth Is Already Weak China's shipping freight index - the freight rates for containers out of China - is softening, and its annual rate of change points to weaker Asian exports (Chart I-11). The annual growth rate of vehicle sales in China has dropped to zero, with both passenger cars and commercial vehicles registering no growth in the past three months from a year ago (Chart I-12). Chart I-11Container Freight Rates In Asia Are Softening Container Freight Rates In Asia Are Softening Container Freight Rates In Asia Are Softening Chart I-12China's Auto Sales: Post-Stimulus Hangover China's Auto Sales: Post-Stimulus Hangover China's Auto Sales: Post-Stimulus Hangover Finally, measures of industrial activity in China such as total freight volumes and electricity output growth continue to downshift (Chart I-13). Next week we are planning to publish a Special Report on China's property market. Our initial research shows that structural imbalances remain acute in the nation's real estate market, and a downturn commensurable if not worse than those that occurred in 2011 and 2014-'15 is very likely. Will the Fed and the People's Bank of China (PBoC) reverse their stance quickly to stabilize growth or preclude a downdraft in global risk assets? In the U.S., the primary trend in core inflation is up. Chart I-14 demonstrates that measures of core inflation have recently risen. This, along with the tight labor market, potential upside surprises in U.S. wages and a still-large fiscal stimulus entails that the bar for the Fed to turn dovish will be somewhat higher this year. It may take a large drawdown in the S&P 500 and a meaningful appreciation in the dollar for the Fed to come to the rescue of risk assets. Chart I-13Chinese Industrial Sector Is Decelerating Chinese Industrial Sector Is Decelerating Chinese Industrial Sector Is Decelerating Chart I-14U.S. Core Inflation Has Bottomed U.S. Core Inflation Has Bottomed U.S. Core Inflation Has Bottomed The Chinese authorities on the other hand, had already been facing enormous challenges in balancing the needs for structural reforms and achieving robust growth before the eruption of the trade confrontation with the U.S. As such, the balancing task is becoming overwhelming. Even if the Chinese authorities stop tightening liquidity now, the cumulated impact of earlier liquidity and regulatory tightening will continue to work its way into the economy, thereby slowing growth. Bottom Line: There is growing evidence that China's industrial sector is slowing, as are Asian trade flows. This is bearish for commodities and EM risk assets. Geopolitics: Icing On The Cake The recent U.S. trade spat with China has arrived at a time when global trade and China's industrial cycle have already begun to downshift, as discussed above. At the same time, investor sentiment on global risk assets remains very complacent, and equity and credit markets are pricey. As such, the U.S.-China trade confrontation has become the icing on the cake. U.S. equity valuations are elevated - the median stock's P/E ratio is at an all-time high (Chart I-15). While EM share prices are not at record expensive levels, valuations are on the pricey side. The top panel of Chart I-16 shows the equal-weighted average of trailing and forward P/E, price-to-book, price-to-cash earnings and price-to-dividend ratios for the median EM sub-sector. This valuation indicator is about one standard deviation above its historical mean. Chart I-15U.S. Equities: Median P/E ##br##Is At Record High U.S. Equities: Median P/E Is At Record High U.S. Equities: Median P/E Is At Record High Chart I-16EM Stocks Are Expensive##br## In Absolute Term bca.ems_wr_2018_03_29_s1_c16 bca.ems_wr_2018_03_29_s1_c16 The bottom panel of Chart I-16 illustrates the same valuation ratio relative to DM. Contrary to prevailing consensus, EM equities are not cheap relative their DM peers. Using median multiples of sub-sectors helps remove outliers. We discussed EM stock valuations in greater detail in our January 24 and March 1 special reports; the links to these reports are available on page 17. As to the duration and depth of the U.S.-China trade confrontation, we have the following remarks: If the U.S.'s plan to impose import tariffs on Chinese goods is primarily about domestic politics ahead of the mid-term elections later this year, as well as to obtain some trade concessions from China, then the current standoff will be resolved in a matter of months. If the true intention of the U.S. is to contain China's geopolitical rise to preserve its global hegemony, this episode of import tariffs will likely mark the beginning of a much longer and drawn-out geopolitical confrontation. In such a case, the U.S.-China relationship will likely witness a roller-coaster pattern with periods of ameliorations followed by periods of escalation and confrontation. Critically, mutual distrust will set in - if not already the case - which will hamper cooperation on various issues. As trade tensions ebb and flow in the months ahead, the reality is that America is worried about losing its geopolitical hegemony to the Middle Kingdom. Our colleagues at BCA's Geopolitical Strategy service have been noting for several years that a U.S.-China confrontation is unavoidable.2 Bottom Line: Even though the current trade tensions between the U.S. and China could well dissipate, we are at the beginning of a long-term geopolitical standoff between these two superpowers. Re-Instating Long MXN / Short BRL and ZAR Trade Chart I-17MXN's Carry Is Above Those Of BRL And ZAR MXN's Carry Is Above Those Of BRL And ZAR MXN's Carry Is Above Those Of BRL And ZAR Odds are that the Mexican peso will begin outperforming the Brazilian real and the South African rand. The main reason why we closed these trades in October was due to NAFTA renegotiation risks. Presently, with the U.S.-Sino trade confrontation escalating, the odds of NAFTA abrogation are declining. In fact, the U.S. may attempt to strike a deal with its allies, including its NAFTA partners, to focus more directly on China. Consequently, a menace hanging over the peso from the Sword of Damocles, i.e., NAFTA retraction, will continue to diminish. Consistently, the risk premium priced into Mexican risk assets will wane, helping Mexican markets outperform their EM peers. Interestingly, for the first time in many years, the Mexican peso's carry is above those of the Brazilian real and the South African rand (Chart I-17). Therefore, going long MXN versus ZAR and BRL are carry positive trades. Importantly, the Mexican peso is cheap. Chart I-18A illustrates the peso is cheap in absolute terms, according to the real effective exchange rate (REER) based on unit labor costs. Chart I-18B shows the peso's relative REER against those of the rand and real. These measures are constructed using consumer and producer prices-based REERs. The peso is cheaper than the South African and Brazilian currencies. Not only is Mexico's currency cheap versus other EM currencies, but Mexican domestic bonds and sovereign spreads also offer great value relative to their EM benchmarks (Chart I-19).Finally, the Mexican equity market has massively underperformed the EM benchmark and is beginning to look attractive on a relative basis. Chart I-18AMXN Is Cheap In Trade-Weighted Terms... MXN Is Cheap In Trade-Weighted Terms... MXN Is Cheap In Trade-Weighted Terms... Chart I-18B...And Relative BRL And ZAR ...And Relative BRL And ZAR ...And Relative BRL And ZAR Chart I-19Mexican Local Currency And Dollar Bonds Offer Value Mexican Local Currency And Dollar Bonds Offer Value Mexican Local Currency And Dollar Bonds Offer Value If and as dedicated EM portfolios rotate into Mexican domestic bonds and equities, this will bid up the peso. Brazil and South Africa are leveraged to China and metals, while Mexico is exposed to the U.S. and oil. Our main theme remains that U.S. growth will do much better than that of China. While a potential drop in oil prices is a risk to the peso, Mexican goods shipments to the U.S. will remain strong, benefiting the nation's balance of payments. Macro policy in Mexico has been super-orthodox: the central bank has hiked interest rates significantly, and the government has tightened fiscal policy (Chart I-20, top panel). This has hurt growth but is positive for the trade balance and the currency (Chart I-20). Mexico will elect a new president in July, and odds of victory by leftist candidate Lopez Obrador are considerable. However, we do not expect a massive U-turn in macro policies after the elections. Importantly, the starting point of Mexico's macro settings is very healthy. In Brazil, government debt dynamics remain unsustainable, yet its financial markets have been extremely complacent. Brazil needs much higher nominal GDP growth and much lower interest rates to stabilize its public debt dynamics. As we have repeatedly argued, a major currency depreciation is needed to boost nominal GDP and government revenues. Besides, Brazil is set to hold general elections in October, and there is no visibility yet on the type of government that will enter office. In South Africa, financial markets have cheered the election of President Cyril Ramaphosa, but the outlook for structural reforms is still very uncertain. The recent decision to consider a constitutional change in Parliament that would allow the confiscation of land from white landlords may be an indication that investors have become overly optimistic on the outlook for structural reforms. In short, the median voter in both Brazil and South Africa favors leftist and populist policies. This entails that the odds of supply side reforms without meaningful riots in financial markets are not great. Finally, the relative performance of the MXN against the BRL and ZAR, including carry, seems to be attempting to make a bottom (Chart I-21). Chart I-20Mexico: Improved Macro Fundamentals Mexico: Improved Macro Fundamentals Mexico: Improved Macro Fundamentals Chart I-21A Major Bottom In MXN's Cross? A Major Bottom In MXN's Cross? A Major Bottom In MXN's Cross? Bottom Line: Go long MXN versus an equally weighted basket of BRL and ZAR. Consistently, we also recommend overweighting Mexican local currency bonds and sovereign credit relative to their respective EM benchmarks. We will review the outlook for Mexican stocks in the coming weeks. EM Sovereign Credit Space: Country Allocation Asset allocators should compare EM sovereign and corporate credit with U.S. and European corporate bonds rather than EM local bonds or equities. The basis is that EM sovereign U.S. dollar bonds are a credit market, and vastly differ from local bonds and equities in terms of volatility, risk-reward trade-off and many other parameters. In short, EM credit markets should be compared to DM credit markets and EM equities to DM equities. EM local currency bonds are a separate, unique asset class.3 We continue to recommend underweighting EM sovereign and corporate credit versus U.S. and European corporate bonds. Within the EM sovereign space, our overweights are: Mexico, Argentina, Russia, Hungary, Poland, the Philippines, Chile and Peru. Neutral: Colombia, Indonesia, Egypt and Nigeria. Our underweights are: Brazil, Venezuela, Malaysia, Turkey and South Africa. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EM: Disguised Risks", dated March 15, 2018; the link is available on page 17. 2 Please see Geopolitical Strategy Weekly Report "We Are All Geopolitical Strategies Now", dated March 28, 2018, available at gps.bcaresearch.com. 3 You may request May 7, 2013 Emerging Markets Strategy Weekly Report discussing our perspectives on how asset allocation for EM financial markets should be done. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Neutral In our recent initiation of coverage on the S&P industrial conglomerates sector,1 our neutral investment thesis was that the globally synchronous capital goods upcycle should mostly keep sales and profits buoyant in this industrials subsector. However, we expected this to be offset by weakness in GE (the index giant) and their core aerospace, health care and utilities industries. To date, that thesis has been correct as the industrial conglomerates excluding GE have soared (top panel) while GE's share of S&P industrials has collapsed from nearly 50% in 2000 to approximately 5% now (second panel). Recent speculation that Berkshire Hathaway may be interested in investing in the company has provided a lift to GE's struggling share price. Such an investment would likely hasten divestitures in the company and would represent a strong positive in our view. Given that GE still represents 30% of the industrial conglomerates sector (bottom panel), a more positive outlook on GE would extend to the index as a whole; stay tuned. The ticker symbols for the stocks in this index are: BLBG: S5INDCX - GE, MMM, HON, ROP. Will The Oracle Of Omaha Save GE? Will The Oracle Of Omaha Save GE? 1 Please see BCA U.S. Equity Strategy Special Report, "Industrial Conglomerates: Rebooting" dated October 30, 2017, available at uses.bcaresearch.com.