Sectors

Highlights Portfolio Strategy Synchronized global growth, a soft U.S. dollar, our resurgent Boom/Bust Indicator and avoidance of a Chinese economic hard landing, are all signaling that it still pays to overweight cyclicals at the expense of defensives. Economically hyper-sensitive transports also benefit from synchronous global growth and capex. We expect a rerating phase in the coming months. Within transports, we reiterate our overweight stance in the key railroads sub-index as enticing macro tailwinds along with firming operating metrics underscore that profits will exit deflation in calendar 2018. Recent Changes There are no portfolio changes this week. Table 1 Staying Focused On The Dominant Macro Themes Staying Focused On The Dominant Macro Themes Feature The S&P 500 continued to consolidate last week, still digesting the early February tremor. Policy uncertainty is slowly returning and sustained Administration reshufflings are becoming slightly unnerving (bottom panel, Chart 1). Nevertheless, the dual themes of synchronized global growth and budding evidence of coordinated tightening in global monetary policy, i.e. rising interest rate backdrop, continue to dominate and remain intact. Importantly in the U.S., the latest non-farm payrolls (NFP) report was a goldilocks one. Month-over-month NFPs surpassed the 300K hurdle for the first time since late-2014, on an as-reported-basis, while wage inflation settled back down. The middle panel of Chart 2 shows that both in the 1980s and 1990s expansions, NFPs were growing briskly, easily clearing the 300K mark. The 2000s was the "jobless recovery" expansion and likely the exception to the rule. In all three business cycle expansions wage growth touched the 4%/annum rate before the recession hit. The yield curve slope also supports this empirical evidence, forecasting that wage inflation will likely attain 4%/annum before this cycle ends (wages shown inverted, Chart 3). Chart 1Watch Policy Uncertainty Watch Policy Uncertainty Watch Policy Uncertainty Chart 2Goldilocks NFP Report... Goldilocks NFP Report... Goldilocks NFP Report... Chart 3...But Wage Growth Pickup Looms ...But Wage Growth Pickup Looms ...But Wage Growth Pickup Looms One key element in the current cycle is that the government is easing fiscal policy to the point where both NFPs and wages will likely surge in the coming months as the fiscal thrust gains steam, likely extending the business cycle. This is an inherently inflationary environment, especially when the economy is at full employment and the Fed in slow and steady tightening mode. Last autumn, we showed that the SPX performs well in times of easy fiscal and tight money iterations, rising on average 16.7% with these episodes, lasting on average 16 months (Table 2).1 The latest flagship BCA monthly publication forecasts that the current fiscal impulse will last at least until year-end 2019, contributing positively to real GDP growth. Thus, if history at least rhymes, SPX returns will be positive and likely significant for the next couple of years (Chart 4). With regard to the composition of the equity market's return, we reiterate our view - backed by empirical evidence - that EPS will do the heavy lifting whereas the forward P/E multiple will continue to drift sideways to lower.2 Not only will rising fiscal deficits cause the Fed to remain vigilant and continue to raise interest rates and weigh on the equity market multiple (Chart 5), but also heightened volatility will likely suppress the forward P/E multiple. Table 2SPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Staying Focused On The Dominant Macro Themes Staying Focused On The Dominant Macro Themes Chart 4Stimulative Fiscal Policy##br## Extends The Business Cycle... Stimulative Fiscal Policy Extends The Business Cycle... Stimulative Fiscal Policy Extends The Business Cycle... Chart 5...But Weighs On ##br##The Multiple ...But Weighs On The Multiple ...But Weighs On The Multiple This week we revisit our cyclical versus defensive portfolio bent and update the key transportation overweight view. Cyclicals Thrive When Global Growth Is Alive And Well... While retaliatory tariff wars are dominating the media headlines, global growth is still resilient. Our view remains that the odds of a generalized trade war engulfing the globe are low, and in that light we reiterate our cyclical over defensive portfolio positioning, in place since early October.3 Global growth is firing on all cylinders. Our Global Trade Indicator is probing levels last hit in 2008, underscoring that cyclicals will continue to have the upper hand versus defensives (Chart 6). Synonymous with global growth is the softness in the U.S. dollar. In fact, the two are in a self-feeding loop where synchronized global growth pushes the greenback lower, which in turn fuels further global output growth. Tack on the rising likelihood that the trade-weighted dollar has crested from a structural perspective, according to the 16-year peak-to-peak cycle4 (Chart 7) and the news is great for cyclicals versus defensives (Chart 8). Chart 6Global Trade Is Alright Global Trade Is Alright Global Trade Is Alright Chart 7Dollar The Great Reflator... Dollar The Great Reflator... Dollar The Great Reflator... Chart 8...Is A Boon For Cyclicals Vs. Defensives ...Is A Boon For Cyclicals Vs. Defensives ...Is A Boon For Cyclicals Vs. Defensives Related to the greenback's likely secular peak is the booming commodity complex, as the two are nearly perfectly inversely correlated. Commodity exposure is running very high in the deep cyclical sectors and thus any sustained commodity price inflation gains will continue to underpin the cyclicals/defensives share price ratio. BCA's Boom/Bust Indicator (BBI) corroborates this upbeat message for cyclicals versus defensives. The BBI is on the verge of hitting an all-time high and, while this could serve as a contrary signal, there are high odds of a breakout in the coming months if synchronized global growth stays intact as BCA expects, rekindling cyclicals/defensives share prices (Chart 9). Finally, if China avoids a hard landing, and barring an EM accident, the cyclicals/defensives ratio will remain upbeat. Chart 10 shows that China's LEI is recovering smartly from the late-2015/early-2016 manufacturing recession trough, and the roaring Chinese stock market - the ultimate leading indicator - confirms that the path of least resistance for the U.S. cyclicals/defensive share price ratio is higher still. Chart 9Boom/Bust indicator Is Flashing Green Boom/Bust indicator Is Flashing Green Boom/Bust indicator Is Flashing Green Chart 10China Is Also Stealthily Firming China Is Also Stealthily Firming China Is Also Stealthily Firming Bottom Line: Stick with a cyclical over defensive portfolio bent. ...As Do Transports, Thus... Transportation stocks have taken a breather recently on the back of escalating global trade war fears. But, we are looking through this soft-patch and reiterate our barbell portfolio approach: overweight the global growth-levered railroads and air freight & logistics stocks at the expense of airlines that are bogged down by rising capacity and deflating airfare prices (Chart 11). Leading indicators of transportation activity are all flashing green. Transportation relative share prices and manufacturing export expectations are joined at the hip, and the current message is to expect a reacceleration in the former (top panel, Chart 12). Similarly, capital expenditures, one of the key themes we are exploring this year, are as good as they can be according to the regional Fed surveys, and signal that transportation profits will rev up in the coming months (middle panel, Chart 12). The possibility of an infrastructure bill becoming law later this year or in 2019 would also represent a tailwind for transportation EPS. Not only is U.S. trade activity humming, but also global trade remains on a solid footing. The global manufacturing PMI is resilient and sustaining recent gains, suggesting that global export volumes will resume their ascent. This global manufacturing euphoria is welcome news for extremely economically sensitive transportation profits (Chart 13). All of this heralds an enticing transportation services end-demand outlook. In fact, industry pricing power is gaining steam of late and confirms that relative EPS will continue to expand (Chart 12). Under such a backdrop, a rerating phase looms in still depressed relative valuations (bottom panel, Chart 13). Chart 11Stick With Transports Exposure Stick With Transports Exposure Stick With Transports Exposure Chart 12Domestic... Domestic... Domestic... Chart 13...And Global Growth/Capex Beneficiary ...And Global Growth/Capex Beneficiary ...And Global Growth/Capex Beneficiary ...Stay On Board The Rails Railroad stocks have worked off the overbought conditions prevalent all of last year, and momentum is now back at zero. In addition, forward EPS have spiked, eliminating the valuation premium and now the rails are trading on par with the SPX on a forward P/E basis (Chart 14). The track is now clear and more gains are in store for relative share prices in the coming quarters. Despite trade war jitters, we are looking through the recent turbulence. If the synchronized global growth phase endures, as we expect, then rail profits will remain on track. In fact, BCA's measure of global industrial production (hard economic data) is confirming the euphoric message from the global manufacturing PMI (soft economic data) and suggests that rails profits will overwhelm (Chart 15). Our S&P rails profit model also corroborates this positive global trade message and forecasts that rail profit deflation will end in 2018 (bottom panel, Chart 15). Beyond these macro tailwinds, operating industry metrics also point to a profit resurgence this year. Importantly, our rails profit margin proxy (pricing power versus employment additions) has recently reaccelerated both because selling prices are expanding at a healthy clip and due to labor restraint (second panel, Chart 15). Demand for rail hauling remains upbeat and our rail diffusion indicator has surged to a level last seen in 2009, signaling that there is a broad based firming in rail carload shipments (second panel, Chart 16). Chart 14Unwound Both Overbought Conditions And Overvaluation Unwound Both Overbought Conditions And Overvaluation Unwound Both Overbought Conditions And Overvaluation Chart 15EPS On Track To Outperform EPS On Track To Outperform EPS On Track To Outperform Chart 16Intermodal Resilience Intermodal Resilience Intermodal Resilience The significant intermodal segment that comprises roughly half of all shipments is on the cusp of a breakout. The retail sales-to-inventories ratio is probing multi-year highs on the back of the increase in the consumer confidence impulse and both are harbingers of a reacceleration in intermodal shipments (Chart 16). Coal is another significant category that takes up just under a fifth of rail carload volumes and bears close attention. While natural gas prices have fallen near the lower part of the trading range in place since mid-2016 and momentum is back at neutral, any spike in nat gas prices will boost the allure of coal as a competing fuel for energy generation (middle panel, Chart 17). Keep in mind that coal usage is highly correlated with electricity demand and the industrial business cycle, and the current ISM manufacturing survey message is upbeat for coal demand. Tack on the whittling down in coal inventories at utilities and there is scope for a tick up in coal demand (third panel, Chart 18). Finally, the export relief valve has reopened for coal with the aid of the depreciating U.S. dollar, and momentum in net exports has soared to all-time highs, even surpassing the mid-1982 peak (bottom panel, Chart 18). Chart 17Key Coal Shipments Underpin Selling Prices Key Coal Shipments Underpin Selling Prices Key Coal Shipments Underpin Selling Prices Chart 18Upbeat Leading Indicators Of Coal Demand Upbeat Leading Indicators Of Coal Demand Upbeat Leading Indicators Of Coal Demand All of this suggests that coal shipments will make a comeback later in 2018, and continue to underpin industry pricing power, which in turn boost rail profit prospects (bottom panel, Chart 17). Bottom Line: Continue to overweight the broad S&P transportation index, and especially the heavyweight S&P railroads sub-index. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?" dated October 9, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And 'Nothing Else Matters'," dated December 18, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 4 Please see BCA Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Overweight S&P defense shares have been enjoying a terrific streak over the past three years, solidly outperforming the S&P 500 in each of them. This is in no small part because of new orders, which have been steadily recovering (second panel) and surging demand eroding inventories (third panel), implying outsized cash generation. Adding to this excitement is President Trump's 2019 defense budget request of $686 billion, which would arrest seven years of real defense budget declines. It is thus unsurprising that threats of a global trade war have taken some of the energy out of the index, though we think recent declines are an overreaction for three reasons. First, the administration has shown a willingness to exclude allies (the principal international customer group for defense firms) from trade restrictions. Second, given high switching costs, a weaker U.S. dollar should be supportive of international orders regardless of the administration's stance. Third, as shown in the bottom panel, the fundamental performance driver of defense equities is domestic defense spending; as noted above, this is clearly biased higher from a secular perspective. Net, recent declines represent a buying opportunity; we reiterate our overweight recommendation. The ticker symbols for the stocks in the BCA Defense index are: LMT, GD, RTN, NOC, LLL Do Not Bet Against Defense Stocks In A Trade War Do Not Bet Against Defense Stocks In A Trade War

Highlights Several economic and financial market indicators point to a budding downtrend in Chinese capital spending and its industrial sector. The recent underperformance of global mining, chemicals and machinery/industrials corroborate that capital spending in China is starting to slump. Shipments-to-inventory ratios for Korea and Taiwan also point to a relapse in Asian manufacturing. This is occurring as our global growth sentiment proxy sits on par with previous peaks, and investor positioning in EM and commodities is overextended. Stay put on EM. Markets with currency pegs to the U.S. dollar, such as the Gulf states and Hong Kong, will face tightening local liquidity. Share prices in these markets have probably topped out. Feature On the surface, EM equities, currencies and local bond and credit markets are still trading well. However, there are several economic indicators and financial variables that herald negative surprises for global and Chinese growth. In particular: China's NBS manufacturing PMI new orders and backlogs of orders have relapsed in the past several months. Chart I-1 illustrates the annual change in new orders and backlogs of orders to adjust for seasonality. The measure leads industrial profits, and presently foreshadows a slowdown going forward. Furthermore, the average of NBS manufacturing PMI, new orders, and backlog orders also points to a potential relapse in industrial metals prices in general as well as mainland steel and iron ore prices (Chart I-2). The message from Charts I-1 and I-2 is that the recent weakness in iron ore and steel prices could mark the beginning of a downtrend in Chinese capital spending. While supply cuts could limit downside in steel prices, it would be surprising if demand weakness does not affect steel prices at all.1 Chart I-1China: Slowdown Has Further To Run China: Slowdown Has Further To Run China: Slowdown Has Further To Run Chart I-2Industrial Metals Prices Have Topped Out Industrial Metals Prices Have Topped Out Industrial Metals Prices Have Topped Out Although China's money and credit have been flagging potential economic weakness for a while, the recent manufacturing PMI data from the National Bureau of Statistics finally confirmed an impending deceleration in industrial activity and ensuing corporate profit disappointment. Our credit and fiscal spending impulses continue to point to negative growth surprises in capital spending. The latter is corroborated by the weakening Komatsu's Komtrax index, which measures the average hours of machine work per unit in China (Chart I-3). In both Korea and Taiwan, the overall manufacturing shipments-to-inventory ratios have dropped, heralding material weakness in both countries' export volumes (Chart I-4). Chart I-3Signs Of Weakness In Chinese Construction Signs Of Weakness In Chinese Construction Signs Of Weakness In Chinese Construction Chart I-4Asia Exports Are Slowing Asia Exports Are Slowing Asia Exports Are Slowing Notably, global cyclical equity sectors that are leveraged to China's capital spending such as materials, industrials and energy have all recently underperformed the global benchmark (Chart I-5). Some of their sub-sectors such as machinery, mining and chemicals have also begun to underperform (Chart I-6). Chart I-5Global Cyclicals Have ##br##Begun Underperforming... Global Cyclicals Have Begun Underperforming... Global Cyclicals Have Begun Underperforming... Chart I-6...Including Machinery ##br##And Chemical Stocks ...Including Machinery And Chemical Stocks ...Including Machinery And Chemical Stocks Among both global and U.S. traditional cyclicals, only the technology sector is outperforming the benchmark. However, we do not think tech should be treated as a cyclical sector, at least for now. In brief, the underperformance of global cyclical equity sectors and sub-sectors following last month's equity market correction corroborate that China's capital spending is beginning to slump. Notably, this is occurring as our global growth sentiment proxy rests on par with its previous apexes (Chart I-7). Previous tops in this proxy for global growth sentiment have historically coincided with tops in EM EPS net revisions, as shown in this chart. Chart I-7Global Growth Sentiment: As Good As It Gets Global Growth Sentiment: As Good As It Gets Global Growth Sentiment: As Good As It Gets All told, we may be finally entering a meaningful slowdown in China that will dampen commodities prices and EM corporate earnings. The latter are still very strong but EPS net revisions have rolled over and turned negative again (Chart I-8). Chart I-8EM EPS Net Revisions Have Plummeted EM EPS Net Revisions Have Plummeted EM EPS Net Revisions Have Plummeted EM share prices typically lead EPS by about nine months. In 2016, EM stocks bottomed in January-February, yet EPS did not begin to post gains until December 2016. Even if EM corporate profits are to contract in the fourth quarter of this year, EM share prices, being forward looking, will likely begin to wobble soon. Poor EM Equity Breadth There is also evidence of poor breadth in the EM equity universe, especially compared to the U.S. equity market. First, the rally in the EM equally-weighted index - where all individual stocks have equal weights - has substantially lagged the market cap-weighted index since mid 2017. This suggests that only a few large-cap companies have contributed a non-trivial share of capital gains. Second, the EM equal-weighted stock index's and EM small-caps' relative share prices versus their respective U.S. counterparts have fallen rather decisively in the past six weeks (Chart I-9, top and middle panels). While the relative performance of market cap-weighted indexes has not declined that much, it has still rolled over (Chart I-9, bottom panel). We compare EM equity performance with that of the U.S. because DM ex-U.S. share prices themselves have been rather sluggish. In fact, DM ex-U.S. share prices have barely rebounded since the February correction. Third, EM technology stocks have begun underperforming their global peers (Chart I-10). This is a departure from the dynamics that prevailed last year, when a substantial share of EM outperformance versus DM equities was attributed to EM tech outperformance versus their DM counterparts and tech's large weight in the EM benchmark. Chart I-9EM Versus U.S. Equities: Relative ##br##Performance Is Reversing EM Versus U.S. Equities: Relative Performance Is Reversing EM Versus U.S. Equities: Relative Performance Is Reversing Chart I-10EM Tech Has Started ##br##Underperforming DM Tech EM Tech Has Started Underperforming DM Tech EM Tech Has Started Underperforming DM Tech Finally, the relative advance-decline line between EM versus U.S. bourses has been deteriorating (Chart I-11). This reveals that EM equity breadth - the advance-decline line - is substantially worse relative to the U.S. Chart I-11EM Versus U.S.: Relative Equity Breadth Is Very Poor EM Versus U.S.: Relative Equity Breadth Is Very Poor EM Versus U.S.: Relative Equity Breadth Is Very Poor Bottom Line: Breadth of EM equity performance versus DM/U.S. has worsened considerably. This bodes ill for the sustainability of EM outperformance versus DM/U.S. We continue to recommend an underweight EM versus DM position within global equity portfolios. Three Pillars Of EM Stocks EM equity performance is by and large driven by three sectors: technology, banks (financials) and commodities. Table I-1 illustrates that technology, financials and commodities (energy and materials) account for 66% of the EM MSCI market cap and 75% of MSCI EM total (non-diluted) corporate earnings. Therefore, getting the outlook of these sectors right is crucial to the EM equity call. Table I-1EM Equity Sectors: Earnings & Market Cap Weights EM: Disguised Risks EM: Disguised Risks Technology Four companies - Alibaba, Tencent, Samsung and TSMC - account for 17% of EM and 58% of EM technology market cap, respectively. This sector can be segregated into hardware tech (Samsung and TSMC) and "new concept" stocks (Alibaba and Tencent). We do not doubt that new technologies will transform many industries, and there will be successful companies that profit enormously from this process. Nevertheless, from a top-down perspective, we can offer little insight on whether EM's "new concept" stocks such as Alibaba and Tencent are cheap or expensive, nor whether their business models are proficient. Further, these and other global internet/social media companies' revenues are not driven by business cycle dynamics, making top-down analysis less imperative in forecasting their performance. We can offer some insight for technology hardware companies such as Samsung and TSMC. Chart I-12 demonstrates that semiconductor shipment-to-inventory ratios have rolled over decisively in both Korea and Taiwan. In addition, semiconductor prices have softened of late (Chart I-13) Together, this raises a red flag for technology hardware stocks in Asia. Chart I-12Asia's Semiconductor Industry Asia's Semiconductor Industry Asia's Semiconductor Industry Chart I-13Semiconductor Prices: A Soft Spot? Semiconductor Prices: A Soft Spot? Semiconductor Prices: A Soft Spot? Finally, Chart I-14 compares the current run-up in U.S. FANG stocks (Facebook, Amazon, Netflix and Google) with the Nasdaq mania in the 1990s. An equal-weighted average stock price index of FANG has risen by 10-fold in the past four and a half years. Chart I-14U.S. FANG Stocks Now ##br##And 1990s Nasdaq Mania U.S. FANG Stocks Now And 1990s Nasdaq Mania U.S. FANG Stocks Now And 1990s Nasdaq Mania A similar 10-fold increase was also registered by the Nasdaq top 100 stocks in the 1990s over eight years (Chart I-14). While this is certainly not a scientific approach, the comparison helps put the rally in "hot" technology stocks into proper historical perspective. The main take away here is that even by bubble standards, the recent acceleration in "new concept" stocks has been too fast. That said, it is impossible to forecast how long any mania will persist. This has been and remains a major risk to our investment strategy of being negative on EM stocks. In sum, there is little visibility in EM "new concept" tech stocks. Yet Asia's manufacturing cycle is rolling over, entailing downside risks to tech hardware businesses. Putting all this together, we conclude that it is unlikely that EM tech stocks will be able to drive the EM rally and outperformance in 2018 as they did in 2017. Banks We discussed the outlook for EM bank stocks in our February 14 report,2 and will not delve into additional details here. In brief, several countries' banks have boosted their 2017 profits by reducing their NPL provisions. This has artificially boosted profits and spurred investors to bid up bank equity prices. We believe banks in a number of EM countries are meaningfully under-provisioned and will have to augment their NPL provisions. The latter will hurt their profits and constitutes a major risk for EM bank share prices. Energy And Materials The outlook for absolute performance of these sectors is contingent on commodities prices. Industrial metals prices are at risk of slower capex in China. The mainland accounts for 50% of global demand for all industrial metals. Oil prices are at risk from traders' record-high net long positions in oil futures, according to CFTC data (Chart I-15, top panel). Traders' net long positions in copper are also elevated, according to the data from the same source (Chart I-15, bottom panel). Hence, it may require only some U.S. dollar strength and negative news out of China for these commodities prices to relapse. Chart I-15Traders' Net Long Positions In ##br##Oil And Copper Are Very Elevated Traders' Net Long Positions In Oil And Copper Are Very Elevated Traders' Net Long Positions In Oil And Copper Are Very Elevated How do we incorporate the improved balance sheets of materials and energy companies into our analysis? If and as commodities prices slide, share prices of commodities producers will deflate in absolute terms. However, this does not necessarily mean they will underperform the overall equity benchmark. Relative performance dynamics also depend on the performance of other sectors. Commodities companies could outperform the overall equity benchmark amid deflating commodities prices if other equity sectors drop more. In brief, the improved balance sheets of commodities producers may be reflected in terms of their relative resilience amid falling commodities prices but will still not preclude their share prices from declining in absolute terms. Bottom Line: If EM bank stocks and commodities prices relapse as we expect, the overall EM equity index will likely experience a meaningful selloff and underperform the DM/U.S. benchmarks. Exchange Rate Pegs Versus U.S. Dollar With the U.S. dollar depreciating in the past 12 months, pressure on exchange rate regimes that peg their currencies to the dollar has subsided. These include but are not limited to Hong Kong, Saudi Arabia and the United Arab Emirates (UAE). As a result, these countries' interest rate differentials versus the U.S. have plunged (Chart I-16). In short, domestic interest rates in these markets have risen much less than U.S. short rates. This has kept domestic liquidity conditions easier than they otherwise would have been. However, maneuvering room for these central banks is narrowing. In Hong Kong, the exchange rate is approaching the lower bound of its narrow band (Chart I-17). As it touches 7.85, the Hong Kong Monetary Authority (HKMA) will have no choice but to tighten liquidity and push up interest rates. Chart I-16Markets With U.S. Dollar Peg: ##br##Policymakers' Maneuvering Window Is Closing Markets With U.S. Dollar Peg: Policymakers' Maneuvering Window Is Closing Markets With U.S. Dollar Peg: Policymakers' Maneuvering Window Is Closing Chart I-17Hong Kong: Interest ##br##Rates Are Heading Higher Hong Kong: Interest Rates Are Heading Higher Hong Kong: Interest Rates Are Heading Higher In Saudi Arabia and the UAE, the monetary authorities have used the calm in their foreign exchange markets over the past year to not match the rise in U.S. short rates (Chart I-18A and Chart I-18B). However, with their interest rate differentials over U.S. now at zero, these central banks will have no choice but to follow U.S. rates to preserve their currency pegs.3 Chart I-18ASaudi Arabian Interest Rates Will Rise The UAE Interest Rates Will Rise The UAE Interest Rates Will Rise Chart I-18BThe UAE Interest Rates Will Rise Saudi Arabian Interest Rates Will Rise Saudi Arabian Interest Rates Will Rise If U.S. interest rates were to move above local rates in Saudi Arabia and the UAE, those countries' currencies will come under considerable depreciation pressure because capital will move from local currencies into U.S. dollars. Hence, if U.S. short rates move higher, which is very likely, local rates in these and other Gulf countries will have to rise if their exchange rate pegs are to be preserved. Neither the Hong Kong dollar nor Gulf currencies are at risk of devaluation. The monetary authorities there have enough foreign currency reserves to defend their respective pegs. Nevertheless, the outcome will be domestic liquidity tightening in the Gulf's and Hong Kong's banking system. In addition, potentially lower oil prices will weigh on Gulf bourses and China's slowdown will hurt growth and equity sentiment in Hong Kong. All in all, equity markets in Gulf countries and Hong Kong have probably seen their best in terms of absolute performance. Potential negative external shocks and higher interest rates due to Fed tightening have darkened the outlook for these bourses. Bottom Line: Local liquidity in Gulf markets and Hong Kong is set to tighten. Share prices in these markets have probably topped out. However, given these equity markets have massively underperformed the EM equity benchmark, they are unlikely to underperform when the overall EM index falls. Hence, we do not recommend underweighting these bourses within an EM equity portfolio. For asset allocators, a neutral or overweight allocation to these bourses is warranted. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "China's "De-Capacity" Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017; the link is available on page 16. 2 Please see Emerging Markets Strategy Special Report "EM Bank Stocks Hold The Key," dated February 14, 2018; the link is available on page 16. 3 Please see BCA's Frontier Markets Strategy Special Report "United Arab Emirates: Domestic Tailwinds, External Headwinds," dated March 12, 2018. The link is available on fms.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The global economic mini-cycle is set to weaken while the euro is set to grind higher. Upgrade Telecoms to overweight. Also overweight Healthcare and Airlines. Underweight Banks, Basic Materials and Energy. Overweight France, Ireland, U.K., Switzerland and Denmark. Underweight Italy, Spain, Sweden and Norway. The Eurostoxx50 will struggle to outperform the S&P500. Feature We are strong believers in Investment Reductionism, a philosophy synthesized from the Pareto Principle and Occam's Razor.1 Investment reductionism offers a liberating thesis - the incessant barrage of investment research, newsfeeds and ten thousand word commentaries is largely superfluous to the investment process. What seems like a complexity of investment choice usually reduces to getting a few over-arching decisions right. Chart of the WeekIn Quadrant 4, Overweight Domestic Defensives And Underweight International Cyclicals The Four Quadrants Of Cyclical Investing The Four Quadrants Of Cyclical Investing For equity sector and country allocation, two over-arching decisions dominate: Whether the global economic mini-cycle is set to strengthen or weaken (Chart I-2). Whether the domestic currency is set to strengthen or weaken. Chart I-2The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The four permutations of these two decisions create the four quadrants of cyclical investing (Chart of the Week). Right now, European investors find themselves in quadrant four: the global economic mini-cycle is set to weaken while the euro is set to grind higher. This favours an overweight stance to defensives, especially domestic-focused defensives. Therefore today, we are upgrading Telecoms to overweight. We also recommend an underweight stance to the most cyclical sectors, especially international-focused cyclicals such as Basic Materials and Energy. Country allocation then just drops out of this sector allocation. The Global Economic Mini-Cycle Is Set To Weaken We can predict the changes of the seasons and the tides of the sea with utmost precision. How? Not because we have an ingenious leading indicator for the seasons and tides, but because we recognise that these phenomena follow perfectly regular cycles. Regular cycles create predictability. Significantly, global bank credit flows also exhibit remarkably regular cycles with half-cycle lengths averaging around eight months. Recognizing these mini-cycles is immensely powerful because, just as for the seasons and the tides, it creates predictability. Furthermore, if most investors are unaware of these cycles, the next turn will not be discounted in today's price - providing a compelling investment opportunity for those who do recognise the predictability. The empirical evidence for credit mini-cycles is irrefutable. The theoretical foundation is also rock solid, based on an economic model called the Cobweb Theory.2 This states that in any market where supply lags demand, both the quantity supplied and the price must oscillate. Given that credit supply clearly lags credit demand, the quantity of credit supplied and its price (the bond yield) must experience mini-cycles (Chart I-3). And as the quantity of credit supplied is a marginal driver of economic activity, economic activity will also experience the same regular oscillations. Today, the global 6-month credit impulse is turning from mini-upswing to mini-downswing, with all three subcomponents - the euro area, the U.S. and China - now in decline (Chart I-4). This is exactly in line with prediction. Mini half-cycles average eight months, and the latest mini-upswing started eight months ago. Chart I-3The Global Economic Mini-Cycle##br## Is Set To Weaken The Global Economic Mini-Cycle Is Set To Weaken The Global Economic Mini-Cycle Is Set To Weaken Chart I-4All Three Subcomponents Of The Global 6-Month ##br##Credit Impulse Are Now Declining All Three Subcomponents Of The Global 6-Month Credit Impulse Are Now Declining All Three Subcomponents Of The Global 6-Month Credit Impulse Are Now Declining More importantly, as we enter a mini-downswing, we can also predict that global growth is likely to experience at least a modest deceleration through the coming two to three quarters. The Euro Is Set To Grind Higher, Except Versus The Yen Chart I-5Lost In Translation Lost In Translation Lost In Translation Nowadays, mainstream stock markets tend to be eclectic collections of multinational companies which happen to be quoted on bourses in Frankfurt, Paris, New York, and so on. For example, BASF is not really a German chemical company, it is a global chemical company headquartered in Germany. For operational hedging, multinational companies like BASF will intentionally diversify their sales and profits across multiple major currencies, say euros and dollars. But of course, the primary stock market quotation will be in the currency of its home bourse, euros. Therefore, when the euro strengthens, the company's multi-currency profits, translated back into a stronger euro, will necessarily weaken (Chart I-5). Clearly, more domestic-focused companies like telecoms will not experience such a strong currency-translation headwind. We expect the main euro crosses to continue strengthening over the next 8 months, with the exception being the cross versus the Japanese yen. Our central thesis is that the payoff profile for a foreign exchange rate just tracks the bond yield spread. This means that when a central bank has already taken bond yields close to their lower bound, its currency possesses a highly attractive asymmetry called positive skew. In essence, as the ECB is at the realistic limit of ultra-loose policy, long-term expectations for the ECB policy rate possess an asymmetry: they cannot go significantly lower, but they could go significantly higher. Exactly the same applies to long-term expectations for the BoJ policy rate. In contrast, long-term expectations for the Fed policy rate possess full symmetry: they could go either way, lower or higher. This stark asymmetry of central bank 'degrees of freedom' favours the euro and the yen over the dollar. Which Sectors And Countries To Own And Which To Avoid? Pulling together the preceding two sections, the global economic mini-cycle is set to weaken while the euro is set to grind higher. This puts Europe in quadrant four of our four quadrant framework for cyclical investing. Unsurprisingly, the relative performance of the most cyclical sectors - Banks, Basic Materials and Energy - very closely tracks the regular mini-cycles in the global 6-month credit impulse. In a mini-downswing these cyclical sectors always underperform (Chart I-6, Chart I-7 and Chart I-8). Accordingly, underweight these three sectors on a two to three quarter horizon. Chart I-6In A Mini-Downswing, ##br##Banks Always Underperform In A Mini-Downswing, Banks Always Underperform In A Mini-Downswing, Banks Always Underperform Chart I-7In A Mini-Downswing,##br## Basic Materials Always Underperform In A Mini-Downswing, Basic Materials Always Underperform In A Mini-Downswing, Basic Materials Always Underperform Chart I-8In A Mini-Downswing,##br## Energy Always Underperforms In A Mini-Downswing, Energy Always Underperform In A Mini-Downswing, Energy Always Underperform Conversely, overweight the relatively defensive Healthcare sector. Also overweight the Airlines sector. Airlines' performance is a mirror-image of the oil price cycle, given that aviation fuel comprises the sector's main variable cost. Furthermore, as aviation fuel is priced in dollars, it also insulates European Airlines against a strengthening euro. Today, we are also upgrading the Telecoms sector to overweight given its relative non-cyclicality (Chart I-9), its domestic-focus, and the excessively negative groupthink towards it (Chart I-10). Chart I-9In A Mini-Downswing, ##br##Telecoms Always Outperform In A Mini-Downswing, Telecoms Always Outperform In A Mini-Downswing, Telecoms Always Outperform Chart I-10Telecoms Are Due ##br##A Trend Reversal Telecoms Are Due A Trend Reversal Telecoms Are Due A Trend Reversal In summary: Overweight: Healthcare, Telecoms, and Airlines Underweight: Banks, Basic Materials and Energy Then to arrive at a country allocation, just combine the cyclical view on the major sectors with the country sector skews in Box 1. The result is the following unchanged European equity market allocation. Overweight: France, Ireland, U.K., Switzerland and Denmark Neutral: Germany and Netherlands Underweight: Italy, Spain, Sweden and Norway Lastly, what is the prognosis for the Eurostoxx50 relative to the S&P500? Essentially, this reduces to a battle between the multinational cyclicals - especially banks - that dominate euro area bourses and the multinational technology giants that dominate the U.S. stock market. With the global economic mini-cycle set to weaken and the euro set to grind higher, the Eurostoxx50 will struggle to outperform the S&P500. Box 1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 The Pareto Principle, often known as the 80-20 rule, says that 80% of effects come from just 20% of causes. Occam's Razor says that when there are many competing explanations for the same effect, the simplest explanation is usually the best. 2 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11, 2018 and available at eis.bcaresearch.com. Fractal Trading Model* This week's recommended trade is to short the Helsinki OMX versus the Eurostoxx600. Apply a profit target of 3% with a symmetrical stop-loss. In other trades, we are pleased to report that short Japanese Energy versus the market achieved its 8% profit target at which it was closed. This leaves four open positions. 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 11 Helsinki OMX Vs. Eurostoxx 600 Helsinki OMX Vs. Eurostoxx 600 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. * 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 Fractal Trading Model 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##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Underweight Declining share of the consumer's wallet has been the narrative for media stocks for several years (top panel). Millennials, currently the largest U.S. age cohort, have been "cord cutting" and preferring competitive "on demand" services, largely explaining the near collapse in media spending. As a result, industry pricing power is under attack with relative sales and profit expectations steadily sinking (second and third panels). These bleak spending patterns are not isolated in the S&P movies and entertainment index, they have also infiltrated the S&P cable & satellite media sub-index. Even extremely resilient cable TV pricing power is losing its luster on the back of shrinking industry demand, as cable price hikes can no longer keep up with overall inflation (bottom panel). Given the high capital intensity of these firms, tightening margins will eventually translate into cash flow compression. Bottom Line: Downgrade the S&P movies & entertainment and S&P cable and satellite indexes to underweight and see this week's Weekly Report for more details. The ticker symbols for the stocks in the S&P movies & entertainment and S&P cable and satellite indexes, are BLBG: S5MOVI - DIS, TWX, FOXA, FOX, VIAB and BLBG: S5CBST - CMCSA, CHTR, DISH, respectively. Exit Stage Right Exit Stage Right

Highlights Chinese domestic stocks have materially lagged their investable peers over the past three years, due to the legacy effects of an enormous, policy-driven bubble in 2014-2015. While A-shares have worked off some of this speculative bubble and multiples are no longer extreme, the outlook for earnings is uninspiring and the valuation discount offered by domestic stocks is modest, at best. Investors should maintain a neutral stance towards Chinese A-shares over the coming 6-12 months, but should remain alert to any improvements in China's housing market and especially any easing monetary policy, as they may signal a potential upgrade catalyst. Finally, we note that the negative perception of Chinese domestic stocks by many global investors does not appear to be justified by the data. A-shares have a place within a regional equity portfolio, and should not be ignored when the right cyclical conditions present themselves. Feature Since last October we have written extensively about the character and magnitude of the economic slowdown in China, and what it means for both Chinese import growth as well as earnings growth for the MSCI China Index (our investable benchmark). Chart 1Disappointing Relative Performance ##br##From A-Shares Disappointing Relative Performance From A-Shares Disappointing Relative Performance From A-Shares We have focused our investment strategy discussions on investable stocks because domestic A-shares have underperformed our investable benchmark by a significant margin over the past three years (Chart 1). In this week's report we take a closer look at the reasons for this underperformance, and review the outlook for A-shares over the coming 6-12 months. We conclude that the case for A-shares is currently uninspiring over the cyclical investment horizon, warranting a neutral stance for now. However, we also note that the negative perception of China's domestic stocks among some global investors, that it is a "casino" market untethered from fundamentals, is not supported by the data. This underscores that A-shares deserve a place within a regional equity portfolio, and should be favored when cyclical conditions warrant it. 2014-2015: A Policy-Driven Bubble In Domestic Stocks The drivers of A-share underperformance over the past few years can be traced back to events that occurred in 2014/2015, when A-shares rose 160% over the course of 12 months (Chart 2). Following several years of poor performance in the domestic stock market, Chinese policymakers began a push in 2014 to encourage retail investors to buy A-shares. This policy was part of a plan to help reduce what the government saw as a massive flow of savings towards investments that were excessively speculative in nature (such as wealth management products and China's property market), as well as to support a market that authorities hoped would become a more prominent target of international investors. This push involved lowering transaction and account opening fees, lowering margin debt restrictions, and using state media to wage a campaign to encourage equity ownership.1 Chart 3 highlights that the authorities' efforts initially worked at boosting stock prices, by showing the strong relationship between the MSCI China A Onshore index and margin debt linked to the Shanghai and Shenzhen stock exchanges. But this experiment ultimately ended badly, and domestic stock prices and margin debt began to crash in the summer of 2015. In total, the MSCI China A Onshore index fell roughly 50% from June 2015 to January 2016, nearly rivaling the total decline experienced by the S&P 500 during the 2007-2009 global financial crisis. Chart 22014/2015 Was A Policy-Driven Bubble ##br##In Domestic Stocks 2014/2015 Was A Policy-Driven Bubble In Domestic Stocks 2014/2015 Was A Policy-Driven Bubble In Domestic Stocks Chart 3Easing Margin Debt Restrictions ##br##Had An Enormous Impact Easing Margin Debt Restrictions Had An Enormous Impact Easing Margin Debt Restrictions Had An Enormous Impact While domestic stocks have risen by an impressive 30% (12.5% annualized) since they troughed in early-2016, they have underperformed their investable peers (both overall and excluding technology) over the same period. This disappointing relative performance has caused many global investors to question whether they should bother investing in A-shares, and under what conditions, if any, should they favor domestic stocks over investable equities. A-Share Value No Longer Extreme... The narrative of a policy-driven bubble in 2014-2015 suggests that extreme overvaluation is the root cause of the recent underperformance of domestic Chinese equities. Chart 4 shows that this is indeed the case, by presenting the 12-month forward P/E ratio for MSCI China (our investable benchmark), MSCI China A Onshore, and All Country World. Chinese equities, both investable and domestic, were deeply discounted relative to global stocks in late-2014, reflecting the multi-year Chinese economic slowdown that began in mid-2010. But the government's campaign to encourage domestic stock ownership caused the A-share multiple to more than double in 12 months, and to exceed that of global stocks. Chart 4The Underperformance Of A-Shares, As Told By Multiples The Underperformance Of A-Shares, As Told By Multiples The Underperformance Of A-Shares, As Told By Multiples The multiple of investable equities also rose due to the campaign, but by a much smaller magnitude. It began to fall in mid-2015 alongside the domestic stock multiple but bottomed before the end of the year in response to signs that China's economy was about to enter the upswing of a mini economic cycle. The following 2 years saw investable equities re-rate significantly as China's economy recovered, whereas the still-elevated domestic market multiple simply trended sideways. But the bottom line for investors is that A-shares have worked off a good portion amount of the overvaluation that was caused by the policy-driven bubble of 2014-2015, meaning that their risk-reward profile has materially improved. ...But The Outlook For Domestic Stocks Is Uninspiring Given that domestic equities have largely closed their valuation gap relative to investable stocks, shouldn't investors be overweight the former? In our view, there are several factors currently arguing against an overweight stance towards A-shares: While we acknowledge the improvement in relative valuation, multiples at a level similar to the overall investable market are not cheap enough to make domestic stocks look highly attractive, given that the latter are no longer cheap themselves versus the global benchmark. We noted in our February 15 Weekly Report that investable technology stocks have been responsible for pushing our relative composite valuation indicator for China into overvalued territory over the past year,2 and we recommended in that report that investors continue to maintain their Chinese equity exposure on an ex-tech basis (which are considerably cheaper in relative terms). Given the fact that China's economy is slowing, and given that the corporate sector has substantially increased its leverage over the past decade, we believe that Chinese equities should be priced at some discount relative to global stocks. Chart 5 suggests that this discount is modest, at best. Chart 5 shows that domestic stocks are modestly cheap versus the global benchmark according to earnings and book value, but are expensive according to cash flow and dividends. While gaps of these kinds have existed in the past, the fact that cash-based measures have been lagging more accrual-based measures since 2013 raises the odds of a problem with earnings quality in the domestic market. This is a topic that we hope to revisit in the coming months, but for now it reinforces the view that the valuation discount applied to A-shares (versus global) is likely insufficient. Chart 6 presents a forecast for A-share earnings per share growth in U.S. dollars, based on its relationship with the Li Keqiang index. The chart shows that while a significant earnings contraction is not in the cards, the growth rate may fall to zero over the coming 6-12 months. This, in conjunction with only a minor valuation discount relative to global stocks, paints an uninspiring cyclical outlook for A-shares over the coming year. Chart 5The Current Valuation Discount Applied To A-Shares Is Modest, At Best The Current Valuation Discount Applied To A-Shares Is Modest, At Best The Current Valuation Discount Applied To A-Shares Is Modest, At Best Dispelling The Myth Of The "Casino" Market While we find the cyclical outlook for A-shares to be lackluster, the fact that valuation has improved significantly since mid-2015 is an important development from the perspective of regional equity allocation. From our perspective, A-shares should be on the radar screen of global investors as a potential market to favor if the opportunity presents itself, even if the cyclical conditions do not currently warrant an overweight stance. Besides the issue of regulated investability, one reason why global investors tend to overlook domestic Chinese stocks is the perception that A-shares are largely a "casino" market. Admittedly, the decision by policymakers in 2014 to effectively engineer a bubble in domestic stocks did not help to dispel this perspective. However, a closer examination of this question highlights that domestic Chinese equities are, while relatively volatile, hardly untethered from fundamentals at the broad index level. First, Chart 6 below highlighted that there is a close correlation between the Li Keqiang index and the growth rate of A-share trailing earnings. Earnings quality issues aside (the risk of which can be managed by assigning a valuation discount), this certainly does not suggest that A-share returns are more likely to be random than other stock markets. Second, as we noted in a September Special Report,3 the gap in the volatility of A-shares relative to other markets is slowly declining (Chart 7). More recently, the decline in A-share volatility appears to be due to the involvement of China's "national team", i.e. purchases by state-owned financial institutions that are designed to reduce the oscillation of daily price changes, and that began in the wake of the 2015 selloff with the goal of stabilizing the stock market. In the developed world, this type of government interference in financial markets is viewed with deep suspicion and is often referred to in the financial media as being necessary for the government to "prop up" its stock market to avoid an inevitable decline. Chart 6An Uninspiring Domestic Equity Earnings Outlook An Uninspiring Domestic Equity Earnings Outlook An Uninspiring Domestic Equity Earnings Outlook Chart 7A-Shares Are Relatively Volatile, But The Gap Is Narrowing A-Shares Are Relatively Volatile, But The Gap Is Narrowing A-Shares Are Relatively Volatile, But The Gap Is Narrowing But Chart 6 highlights how this is misleading: the recovery in A-share earnings that has occurred since 2015 is clearly legitimate given the mini-cycle upswing, meaning that China's "national team" has, at worst, prevented a sharp decline in an elevated multiple over the past two years. It is difficult to see this as anything but a genuine attempt at managing the workout process of a market that underwent a major shock, quite similar in concept to what the Federal Reserve did in the U.S. during the first few years of the subpar economic recovery. From our perspective, as long as this buying remains counter-cyclical and does not somehow interfere with the link between the economy and underlying earnings growth, this should argue in favor a global investor allocation to A-shares (via a lower equity risk premium), not against it. Third, a "casino" market that truly ignores fundamentals and is based heavily on herd-following behavior should rank as highly inefficient from the perspective of the Efficient Markets Hypothesis (EMH). We test whether the A-share market falls into this category by looking for two telltale signs of an inefficient market: whether past returns carry significant information about future returns, and whether simple technical trading rules can lead to outsized profits. Tables 1 and 2 present our findings: in Table 1, we show the F-statistic and R-squared of a second-order autoregression for several regional markets (higher numbers = less efficient), and in Table 2 we show the "win rate" of a trend following rule that buys stocks in the following month if the closing index price at the end of the prior month is above its 9-month moving average (higher win rate = less efficient). Table 1China's Domestic Market Is Less Inefficient Than It Used To Be A-Shares: Stay Neutral, For Now A-Shares: Stay Neutral, For Now Table 2Simple Technical Rules Don't Earn Outsized Profits In The A-Share Market A-Shares: Stay Neutral, For Now A-Shares: Stay Neutral, For Now The tables show that while there is some evidence to suggest that the A-share market has been relatively inefficient on average compared with other stock markets since the beginning of the last decade, this gap has been significantly reduced over the past few years. To us, this is a compelling sign that A-shares deserve a place within a global equity portfolio and should be favored when cyclical conditions warrant it. Investment Conclusions The ongoing economic slowdown in China means that the earnings outlook for domestic Chinese equities is uninspiring. When coupled with a modest (at best) valuation discount relative to global stocks, this suggests that global investors should have a neutral allocation to A-shares over the coming 6-12 months. However, the observable link between China's economy and domestic equity earnings growth means that investors should be looking to increase their allocation to A-shares on any signs of a pickup in Chinese economic activity. In particular, Chart 8 highlights that domestic stocks appear more likely to lead corporate bond spreads and housing market indicators than investable stocks are, suggesting that any significant easing in monetary policy or a continued improvement in the housing market could act as a potential catalyst to upgrade A-shares even within the context of a benign growth slowdown in China's industrial sector. Chart 8A-Shares Better Lead The Housing Market##br## And Domestic Corporate Bond Spreads A-Shares Better Lead The Housing Market And Domestic Corporate Bond Spreads A-Shares Better Lead The Housing Market And Domestic Corporate Bond Spreads As a final point, even if A-shares were to become a more attractive investment at some point in the future, investability remains somewhat of a challenge for some investors. Over the years, BCA's China Investment Strategy service has published and periodically updated our Research Note, "China Shop," as a practical guide for investors looking for exposure to Chinese assets. Our most recent edition, published last August, has a simple list of ETFs that investors can use to gain exposure to the domestic market when the right conditions present themselves.4 But for investors who wish to rank these ETFs based on a proprietary BCA methodology, or who want to easily compare key metrics such as liquidity, legal structure, constituents, sector exposure, performance, etc, BCA's Global ETF Strategy service has a new tool that will greatly assist the process. Effective mid-February, our Global ETF Strategy team launched a new completely redesigned interactive website, along with a Special Report that reviewed how investors can make the most of the matching engine at the heart of the platform (as well as how to best profit from the entire Global ETF Strategy service).5 Given the issues surrounding investability in China's domestic equity market, we highly recommend that any clients who are potentially interested in allocating to A-shares read the report, and take note of this unique, time-saving service. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 "China's State Media Join Brokerages Saying Buy Equities", Bloomberg News, September 4, 2014. 2 Please see China Investment Strategy Weekly Report, "After The Selloff: A View From China", dated February 15, 2018, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "A Stock Market With Chinese Characteristics", dated September 21, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Research Note, "China Shop: Calling Foreign Investors", dated August 10, 2017, available at cis.bcaresearch.com. 5 Please see Global ETF Special Report, "A User's Guide To Global ETF Strategy", dated February 14, 2018, available at etf.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Underweight In mid-January we put the S&P consumer discretionary sector on downgrade alert as our EPS model had rolled over. Combined with BCA's high interest rate theme for 2018, it is time to execute the alert and cut the S&P consumer discretionary sector to a below benchmark allocation. Fed tightening, from both higher rates and a balance sheet unwind, is negative for these extremely interest rate-sensitive equities. 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 (both series shown inverted, second and third panels). Our Consumer Drag Indicator (bottom panel) captures this, as well as other factors, and sends a clear message that relative share price momentum will dwindle in the coming months. As such, we recommend a below benchmark allocation in the S&P consumer discretionary index; please see yesterday's Weekly Report for more details. Trim Consumer Discretionary To Underweight Trim Consumer Discretionary To Underweight

Highlights Portfolio Strategy Quantitative tightening, a rising fed funds rate and higher prices at the pump are all bearish consumer discretionary stocks. Downgrade exposure to underweight. We are executing this interest rate-sensitive sector downgrade by reducing the S&P movies & entertainment and S&P cable & satellite sub-indexes to underweight. A downbeat industry spending backdrop and fading pricing power paint a gloomy EPS picture. Recent Changes S&P Consumer Discretionary - Downgrade to underweight today. S&P Movies & Entertainment - Trim to underweight today. S&P Cable & Satellite - Downgrade to underweight today. Table 1 Reflective Or Restrictive? Reflective Or Restrictive? Feature Equities are still in the recovery ward and the consolidation/absorption phase in place since the February 5th crack has yet to fully run its course. According to our "buy the dip" cycle-on-cycle analysis, a retest of the recent lows typically occurs in the first month following the initial shock, suggesting that the market is already out of the woods (Chart 1A). However, the return of vol may keep a lid on the SPX for a while longer (Chart 1B). Our strategy in place since February 8th is to buy this dip as we do not foresee an end to the business cycle in 2018.1 Chart 1ABuy This Dip Worked Out Nicely... Buy This Dip Worked Out Nicely... Buy This Dip Worked Out Nicely... Chart 1BBut The Return Of Vol May Spoil The Party But The Return Of Vol May Spoil The Party But The Return Of Vol May Spoil The Party Recent tariff news has dominated the media, however, our sense is that a full blown retaliatory trade war is a low probability outcome. Keep in mind, that the average U.S. tariff rates have drifted lower during the past three decades and, according to the World Bank, are now 1.6%, one of the lowest in the world2 (third panel, Chart 2). And as for concerns that the rhetoric surrounding trade will lead to a surge in the U.S. dollar, we note that the last two times there was a trade spat of sorts the U.S. dollar actually depreciated, both in the early-2000s and in the early-to-mid 1990s (Chart 2). Tack on the recent euphoria surrounding manufacturing exports - which just hit a 30-year high - and it is likely that deep cyclical EPS would overshoot were a trade war to ensue (bottom panel, Chart 2). Such a weak U.S. dollar policy is also a boon for overall SPX profits, if history at least rhymes (Chart 3). Chart 2Tariffs Don't Matter Tariffs Don't Matter Tariffs Don't Matter Chart 3SPX EPS Would Get a Boost From A Tariff War SPX EPS Would Get a Boost From A Tariff War SPX EPS Would Get a Boost From A Tariff War Importantly, synchronized global growth and the selloff in the bond markets remain the dominant macro themes. Last week we showed that since the GFC, empirical evidence suggests that the U.S. economy can withstand a tightening of roughly 125bps in a short time span (please see Chart 3B from the March 5th Special Report). This week we add two components to our interest rate analysis and increase the dataset range back to the 1960s. We compare cyclical momentum in the SPX with the annual change in the 10-year Treasury yield, and also document the shifting correlation between these two asset classes. We then filter for a minimum year-over-year (yoy) 100bps tightening in the 10-year Treasury yield and a clear indication of a negative correlation between the two variables, i.e. a deceleration or straight up contraction in the SPX annual percent change. In other words, we are searching for tightness in monetary conditions that cause equity market consternation, excluding recessions. Table 2 summarizes our results. While cyclical stock momentum and changes in the 10-year Treasury yield have been a near carbon copy since the late-1990s (Chart 4), according to our analysis there have been five iterations when rising bond yields proved restrictive for equities: once in each of the 1960s, 1970s and 1990s and twice in the 1980s. Table 2SPX Returns In Times Of ##br##Restrictive 10-Year UST Selloffs Reflective Or Restrictive? Reflective Or Restrictive? Chart 4The Great ##br##Moderation Years The Great Moderation Years The Great Moderation Years In the mid-1960s, the U.S. deployed troops in Vietnam and the Fed also tightened monetary policy by enough to invert the yield curve (Chart 5). During the mid-1970s episode, fresh off the first oil shock-induced recession, the Fed started tightening monetary policy in 1977 in order to contain inflation and never looked back. Eventually, the Fed inverted the yield curve in late-1978 before the second oil shock hit that morphed into the early-1980s recession (Chart 6). Chart 5100bps Tightening... 100bps Tightening... 100bps Tightening... Chart 6...Can Hurt Equities... ...Can Hurt Equities... ...Can Hurt Equities... In the 1980s, following the double dip recession, Fed Chairman Paul Volcker started lifting interest rates as the economy was recovering, and similarly in 1987 the Fed was aggressively tightening monetary policy up until the "Black Monday" crash (Chart 7). Finally, in 1994 the Fed doubled interest rates in a span of nine months and in December of that year Mexico had to devalue the peso and the "Tequila effect" gripped Asia and Latin America. Such abrupt tightening caused a mild indigestion in the stock market (Chart 8). Chart 7...When The Stock-To-Bond Yield Correlation... ...When The Stock-To-Bond Yield Correlation... ...When The Stock-To-Bond Yield Correlation... Chart 8...Turns Negative ...Turns Negative ...Turns Negative On average, the SPX drawdown from peak-to-trough during these five iterations was 19% and lasted 6.5 months. Currently, in order for interest rates to turn from reflective of growth to restrictive and cause a sizable pullback in the SPX, we calculate that the 10-year Treasury yield would have to rise above 3.05% by September 2018. Simultaneously, the correlation between stocks and bond yields would have to sink into negative territory. Nevertheless, given the steepness of the recent selloff in bonds, in order for the yoy 100bps rule of thumb to remain in place, post September the 10-year Treasury yield should continue to gallop higher and end the year near 3.5%, and further rise to 3.94% in early 2019. While this is possible, we assign low odds to such an outcome. As a reminder, BCA's higher interest rate view calls for a selloff in the 10-year Treasury bond near 3.25% by year-end 2018, a level that both the economy and the SPX will likely be able to shake off (Chart 4). This week we act on our mid-January alert and downgrade an interest rate-sensitive sector to underweight. Trim Consumer Discretionary To Underweight In mid-January we put the S&P consumer discretionary sector on downgrade alert heeding the anemic signal from our EPS growth model and also owing to BCA's high interest rate theme for 2018. We are now acting on the alert and cutting exposure and moving the S&P consumer discretionary sector to a below benchmark allocation. At this stage of the cycle, when the Fed is on track to continue to steadily lift interest rates in the coming two years as the economy heats up, investors should lighten up on consumer discretionary stocks (Chart 9). In addition, this cycle the Fed is orchestrating dual tightening as it is simultaneously unwinding the size of its balance sheet. Quantitative tightening is also bearish discretionary stocks (Chart 10). Chart 9Mind The Fed Funds Rate Mind The Fed Funds Rate Mind The Fed Funds Rate Chart 10Quantitative Tightening Also Bites Quantitative Tightening Also Bites Quantitative Tightening Also Bites This rising short-term interest rate backdrop is not conducive to owning extremely interest rate-sensitive equities. 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 (both series shown inverted, Chart 11). The U.S. consumer has been firing on all cylinders with PCE growing 4% in real terms last quarter and contributing positively to overall real output growth (Chart 12). Chart 11Household Financing ##br##Costs Have Troughed Household Financing Costs Have Troughed Household Financing Costs Have Troughed Chart 124% Real PCE Growth Is##br## Unsustainable Absent Wage Inflation 4% Real PCE Growth Is Unsustainable Absent Wage Inflation 4% Real PCE Growth Is Unsustainable Absent Wage Inflation However, such a breakneck pace is unsustainable without wage inflation follow through. Worrisomely, the personal savings rate has been depleted to the point where the consumer appears tapped out. Historically, consumer confidence and the savings rate have been perfectly inversely correlated (Chart 13). Sky high sentiment and almost zero savings suggest that the consumer has to resort to credit card debt in order to finance outlays in the absence of wage inflation. Revolving credit is soaring, but worryingly credit card delinquency and chargeoff rates at small commercial banks are at recession type levels, warning that this credit outlet may be drying up (Chart 14). Chart 13Depleted Savings Are Problematic Depleted Savings Are Problematic Depleted Savings Are Problematic Chart 14Early Signs Of Trouble? Early Signs Of Trouble? Early Signs Of Trouble? All of this is taking place at a time when bankers are still not willing extenders of consumer installment credit, according to the Fed's latest Senior Loan Officer Survey. The implication is that even a modest tick down in consumer confidence and simultaneous rebuilding of savings will likely, at the margin, dent consumer spending. Another macro headwind the consumer has to contend with is higher prices at the pump. BCA's constructive crude oil view suggests that increasing gasoline prices will continue to eat into consumer discretionary spending power. Taken together, these macro headwinds will dampen consumer discretionary outlays. Our Consumer Drag Indicator captures these forces and is signaling that relative share price momentum will dwindle in the coming months (Chart 15). Under such a backdrop, while consumer discretionary EPS can expand modestly, they will trail the broad market that is slated to grow profits close to 20% in calendar 2018. Relative performance will likely converge lower to falling relative profitability (top panel, Chart 16). We currently side with the sell-side community and expect a contraction in relative profit growth. Therefore, not only are we unwilling to pay an 18% premium valuation to own this interest rate-sensitive sector, but we would also sell into strength given our view of a derating phase taking root in the coming months (bottom panel, Chart 16). Our Cyclical Macro Indicator confirms this downbeat relative EPS growth outlook, and underscores that the path of least resistance is lower for consumer discretionary stocks (Chart 15). Chart 15Models Say Sell Models Say Sell Models Say Sell Chart 16Unsustainable Divergence Unsustainable Divergence Unsustainable Divergence Finally, a few words on AMZN.3 Cracks have already formed in relative share prices ex-AMZN (top panel, Chart 11). The AMZN juggernaut has masked the true consumer discretionary picture given its hefty market cap weight in the index (20%) that will only increase in late-summer following the already announced S&P index composition changes. Accordingly at that time, we will also make changes to our portfolio. While we maintain a neutral exposure to the S&P internet retail index, that AMZN dominates4 and that we recently initiated coverage on, the way we are executing the S&P consumer discretionary downgrade to underweight is by trimming the media index to a below benchmark allocation. Media: Exit Stage Right Since the late 1970s the media complex's fortunes have been joined at the hip with the U.S. dollar. When the greenback is roaring, investors pile into media shares and vice versa. While media outlets do have international sales exposure, it is small and significantly trails the overall market's foreign revenue exposure. Thus, the mostly domestic nature of media stocks explains the positive correlation with the U.S. dollar (Chart 17). This multi-decade relationship remains in place, and given the sizable losses in the trade-weighted U.S. dollar since the December 2016 peak, the relative share price ratio will remain under intense pressure. On the operating front, shifting consumer spending trends are weighing on relative performance. The top panel of Chart 18 shows that relative media outlays have been in a free fall. Millennials, currently the largest U.S. age cohort, have been "cord cutting" and preferring competitive "on demand" services, largely explaining the near collapse in media spending. Chart 17Joined At The Hip Joined At The Hip Joined At The Hip Chart 18Bearish Operating Metrics Bearish Operating Metrics Bearish Operating Metrics As a result, industry pricing power is under attack with relative sales and profit expectations steadily sinking (middle & bottom panels, Chart 18). Nevertheless, media barons have awakened to the threats engulfing this industry and are scrambling to fight back. The knee-jerk reaction in the movies & entertainment subindustry has been to seek intra-industry buyout candidates (Chart 19). Inter-industry M&A is also ongoing with the AT&T/Time Warner and Justice Department trial still pending, the tie-up between Disney and Fox and the competitive bids for Sky plc from Fox and Comcast. However, media consolidation is not a sustainable way forward for profit growth. Organic EPS growth remains anemic and the visible breakdown in the correlation between consumer confidence and relative share prices since early 2016 represents a yellow flag (top panel, Chart 20). Chart 19M&A Nearly Exhausted M&A Nearly Exhausted M&A Nearly Exhausted Chart 20Unnerving Breakdown In Correlations Unnerving Breakdown In Correlations Unnerving Breakdown In Correlations Similar to consumer confidence, the ISM non-manufacturing composite is also probing cycle highs, however, industry spending is now outright contracting and steeply diverging from the upbeat ISM services survey. Tack on rising gasoline prices and the news is grim for S&P movies & entertainment profitability (Chart 20). These bleak spending patterns are not isolated in the S&P movies and entertainment index, they have also infiltrated the S&P cable & satellite media sub-index. Chart 21 shows that relative consumer outlays on cable services have taken a plunge, warning that relative share prices will likely suffer the same fate in the coming quarters. Even extremely resilient cable TV pricing power is losing its luster on the back of shrinking industry demand, as cable price hikes can no longer keep up with overall inflation (bottom panel, Chart 21). The implication is that sales are at risk of further steep deceleration. Given that cable providers have to continually upgrade their networks in order to keep up with ever increasing bandwidth demand, tightening margins will eventually translate into cash flow compression (Chart 22). Chart 21Demand And Prices Are Deflating Demand And Prices Are Deflating Demand And Prices Are Deflating Chart 22Margin Trouble Margin Trouble Margin Trouble Bottom Line: Downgrade the S&P movies & entertainment and S&P cable and satellite indexes to underweight. This also pushes our exposure to the broad S&P consumer discretionary sector to the underweight column. The ticker symbols for the stocks in the S&P movies & entertainment and S&P cable and satellite indexes, are BLBG: S5MOVI - DIS, TWX, FOXA, FOX, VIAB and BLBG: S5CBST - CMCSA, CHTR, DISH, respectively. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Insight, "Buy The Dip," dated February 8, 2018, available at uses.bcaresearch.com. 2 https://data.worldbank.org/indicator/TM.TAX.MRCH.WM.AR.ZS?locations=US 3 Please see BCA U.S. Equity Strategy Special Report, "Internet Retail: Dialed Up," dated February 26, 2018, available at uses.bcaresearch.com. 4 Ibid. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Dear Client, Following up on last week's report, my colleagues Caroline Miller, Mathieu Savary, and I held a webcast on Wednesday to discuss the outlook for the dollar along with recent events. If you haven't already, I hope you find the time to listen in. Best regards, Peter Berezin, Chief Global Strategist Highlights Protectionism is popular with the American public in general, and Trump's base specifically. The sabre-rattling will persist, but an all-out trade war is unlikely. Trump is focused on the stock market, and equities would suffer mightily if a trade war broke out. The Pentagon has also warned of the dangers of across-the-board tariffs that penalize America's military allies. The rationale for protectionism made a lot more sense when there were masses of unemployed workers. That's not the case today. The equity bull market will eventually end, but chances are that this will happen due to an overheated U.S. economy and rising financial imbalances, not because of escalating trade protectionism. Investors should remain overweight global equities for now, but look to pare back exposure later this year. Feature Q: What prompted Trump's announcement? A: Last week began with President Trump proclaiming that he would seek re-election in 2020. Then came a slew of negative news, including the resignation of Hope Hicks, Trump's White House communications director, and the downgrading of Jared Kushner's security clearance. All this happened against the backdrop of the ever-widening Mueller probe. Trump needed to change the subject. Fast. However, it would be a mistake to think that the tariff announcement was simply a distractionary tactic. Turmoil in the White House might have been the immediate trigger, but events had been building towards this outcome for some time. The Trump administration had imposed tariffs on washing machines and solar panels in January. Hiking tariffs on steel and aluminum - two industries that had suffered heavy job losses over the past two decades - was a logical next step. In fact, the 25% tariff on steel and 10% tariff on aluminum were similar to the 24% and 7.7% tariff rates, respectively, that the Commerce Department proposed as one of three options on February 16th.1 Protectionism is popular with the American public. This is especially true for Trump's base (Chart 1). Indeed, it is safe to say that Trump's unorthodox views on trade are what handed him the Republican nomination and what allowed him to win key swing (and manufacturing) states such as Ohio, Michigan, and Pennsylvania. Trump made a promise to his voters. He is trying to keep it. Q: Wouldn't raising trade barriers hurt the U.S. economy, thereby harming the same workers Trump is trying to help? A: That's the line coming from the financial press and most of the political establishment, but it's not as clear cut as it may seem. An all-out trade war would undoubtedly hurt the U.S., but a minor skirmish probably would not. The U.S. does run a large trade deficit. Economists Katharine Abraham and Melissa Kearney recently estimated that increased competition from Chinese imports cost the U.S. economy 2.65 million jobs between 1999 and 2016, almost double the 1.4 million jobs lost to automation.2 This accords with other studies, such as the one by David Autor and his colleagues, which found that increased trade with China has led to large job losses in the U.S. manufacturing sector (Chart 2).3 Chart 1Trump Is Catering ##br##To His Protectionist Base Trump's Tariffs: A Q&A Trump's Tariffs: A Q&A Chart 2China's Ascent Has Reduced##br## U.S. Manufacturing Employment China's Ascent Has Reduced U.S. Manufacturing Employment China's Ascent Has Reduced U.S. Manufacturing Employment Granted, China does not even make it into the top ten list of countries that export steel to the United States. But that is somewhat beside the point. As with most commodities, there is a fairly well-integrated global market for steel. Due to its proximity to Asian markets, China exports most of its steel to the rest of the region (Chart 3). That does not stop Chinese overcapacity from dragging down prices around the world. Chart 3Most Of China's Steel Exports Don't Travel That Far Trump's Tariffs: A Q&A Trump's Tariffs: A Q&A Q: Wouldn't steel and aluminum tariffs simply raise prices for American consumers, thereby reducing real wages? A: That depends. If Trump's gambit reduces the U.S. trade deficit, this will increase domestic spending, putting more upward pressure on wages. As far as prices are concerned, the U.S. imported $39 billion of iron and steel in 2017, and an additional $18 billion of aluminum. That's only 2% of total imports and less than 0.3% of GDP. If import prices went up by the full amount of the tariff, this would add less than five basis points to inflation. And even that would be a one-off hit to the price level, rather than a permanent increase in the inflation rate. In practice, it is doubtful that prices would rise by the full amount of the tariff (if they did, what would be the purpose of retaliatory measures?). Most econometric studies suggest that producers will absorb about half of the tariff in the form of lower profit margins. To the extent that this reduces the pre-tariff price of imported goods, it would shift the terms of trade in America's favor. Chart 4Does Trade Retaliation Make Sense ##br## When Most Trade Is In Intermediate Goods? Trump's Tariffs: A Q&A Trump's Tariffs: A Q&A There is an old economic theory, first elucidated by Robert Torrens in the 19th century, which says that the optimal tariff is always positive for countries such as the U.S. that are price-makers rather than price-takers in international markets. Put more formally, Torrens showed that an increase in tariffs from very low levels was likely to raise government revenue and producer surplus by more than the loss in consumer surplus. So, in theory, the U.S. could actually benefit at the expense of the rest of the world by imposing higher tariffs.4 Q: This assumes that there is no trade retaliation. How realistic is that? A: That's the key. As noted above, a breakdown of the global trading system would hurt the U.S., but a trade spat could help it. Trump was trying to scare the opposition by tweeting "trade wars are good, and easy to win." In a game of chicken, it helps to convince your opponent that you are reckless and nuts. Trump's detractors would say he is both, so that works in his favor. Trump has another thing working for him. Most trade these days is in intermediate goods (Chart 4). It does not pay for Mexico to slap tariffs on imported U.S. intermediate goods when those very same goods are assembled into final goods in Mexico - creating jobs for Mexican workers in the process - and re-exported to the U.S. or the rest of the world. The same is true for China and many other countries. This does not preclude the imposition of targeted retaliatory tariffs. The EU has threatened to raise tariffs on Levi's jeans and Harley Davidson motorcycles (whose headquarters, not coincidently, is located in Paul Ryan's Wisconsin district). We would not be surprised if high-end foreign-owned golf courses were also subject to additional scrutiny! But if this is all that happens, markets won't care. The fact that the United States imports much more than it exports also gives Trump a lot of leverage. Take the case of China. Chinese imports of goods and services are 2.65% of U.S. GDP, but exports to China are only 0.96% of GDP. And nearly half of U.S. goods exports to China are agricultural products and raw materials (Chart 5). Taxing them would be difficult without raising Chinese consumer prices. Simply put, the U.S. stands to lose less from a trade war than most other countries. Chart 5China Stands To Lose More From A Trade War With The U.S. Trump's Tariffs: A Q&A Trump's Tariffs: A Q&A Q: Couldn't China and other countries punish the U.S. by dumping Treasurys? A: They could, but why would they? Such an action would only drive down the value of the dollar, giving U.S. exporters an even greater advantage. The smart, strategic response would be to intervene in currency markets with the aim of bidding up the dollar. Chart 6Slowing Global Growth Is Bullish##br## For The Dollar Slowing Global Growth Is Bullish For The Dollar Slowing Global Growth Is Bullish For The Dollar Q: So the dollar could strengthen as a result of rising protectionism? A: Yes, it could. This is a point that even Mario Draghi made at yesterday's ECB press conference. If higher tariffs lead to a smaller trade deficit, this will increase U.S. aggregate demand. The boost to demand would be amplified if more companies decide to relocate production back to the U.S. for fear of being shut out of the lucrative U.S. market. The U.S. economy is now operating close to full employment. Anything that adds to demand is likely to prompt the Fed to raise rates more aggressively than it otherwise would. That could lead to a stronger greenback. Considering that the U.S. is a fairly closed economy which runs a trade deficit, it would suffer less than other economies in the event of a trade war. A scenario where global growth slows because of rising trade tensions, while the composition of that growth shifts towards the U.S., would be bullish for the dollar (Chart 6). Q: What are the implications for stocks and bonds? A: Wall Street will dictate what happens to stocks, but Main Street will dictate what happens to bonds. The stock market hates protectionism, so it is no surprise that equities sold off last week. It is this fact that ultimately got Trump to soften his position. Trump is used to taking credit for a rising stock market. If stocks flounder, this could make him think twice about pushing for higher trade barriers. As far as bonds are concerned, they will react to whatever happens to growth and inflation. As noted above, a trade skirmish could actually boost growth and inflation. Given that the economy is near full capacity, the latter is likely to rise more than the former. This, too, could cause Trump to cool his heels. After all, if higher inflation pushes up bond yields, this will hurt highly-levered sectors such as, you guessed it, real estate. Q: In conclusion, where do you see things going from here? A: Trade frictions will continue. As my colleague Marko Papic highlighted in a report published earlier this week, NAFTA negotiations are likely to remain on the ropes for some time.5 The Trump administration is also investigating allegations of Chinese IP theft. The U.S. is a major exporter of intellectual property, but these exports would be much larger if U.S. companies were properly compensated for their ingenuity. Chinese imports of U.S. intellectual property were less than 0.1% of Chinese GDP in 2017, an implausibly small number (Chart 7). If China is found to have acted unfairly, this could lead the U.S. to impose across-the-board tariffs on Chinese goods and restrictions on inbound foreign direct investment. Nevertheless, as noted above, worries about a plunging stock market will constrain Trump from acting too aggressively. The rationale for protectionism made a lot more sense when there were masses of unemployed workers. Today, firms are struggling to find qualified staff (Chart 8). This suggest that Trump will stick to doing what he does best, which is taking credit for everything good that happens under the sun. Chart 7China Is Importing More IP From The U.S., ##br##But The "True" Number Is Probably Higher China Is Importing More IP From The U.S., But The "True" Number Is Probably Higher China Is Importing More IP From The U.S., But The "True" Number Is Probably Higher Chart 8Protectionism Makes Less Sense ##br##When The Labor Market Is Strong Protectionism Makes Less Sense When The Labor Market Is Strong Protectionism Makes Less Sense When The Labor Market Is Strong Ironically, the latest trade skirmish is occurring at a time when the Chinese government is taking concerted steps to reduce excess capacity in the steel sector, and the profits of U.S. steel producers are rebounding smartly (Chart 9). In fact, the latest Fed Beige Book released earlier this week highlighted that "steel producers reported raising selling prices because of a decline in market share for foreign steel ..."6 Chart 9Chinese Steel Exports Falling, U.S. Steel Profits Rising Chinese Steel Exports Falling, U.S. Steel Profits Rising Chinese Steel Exports Falling, U.S. Steel Profits Rising Meanwile, German automakers already produce nearly 900,000 vehicles in the U.S., 62% of which are exported. In fact, European automakers have a smaller share of the U.S. market than U.S. automakers have of the European one.7 A lot of what Trump wants he already has. The Pentagon has also warned that trade barriers imposed against Canada and other U.S. military allies could undermine America's standing abroad. This is an important point, considering that Trump invoked the rarely used Section 232 of the Trade Expansion Act of 1962, which gives the President broad control over trade policy in matters of national security, to justify raising tariffs. Trump tends to listen to his generals, if not his other advisors. He probably was not expecting their reaction. All this suggests that a major trade war is unlikely to occur. As we go to press, it appears that the White House will temporarily exclude Canada and Mexico from the list of countries subject to tariffs. We suspect that the EU, Australia, South Korea, and a number of other economies will get some relief as well. White House National Trade Council Director Peter Navarro has also said that some "exemptions" may be granted for specific categories of steel and aluminum products that are deemed necessary to U.S. businesses. That is a potentially very broad basket. The bottom line is that the equity bull market will end, but chances are that this will happen due to an overheated U.S. economy and rising financial imbalances met with restrictive monetary policy, not because of escalating trade protectionism. Investors should remain overweight global equities for now, but look to pare back exposure later this year. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see "Secretary Ross Releases Steel and Aluminum 232 Reports in Coordination with White House," U.S. Department of Commerce, February 16, 2018. 2 Katharine G. Abraham, and Kearney, Melissa S., "Explaining the Decline in the U.S. Employment-to-Population Ratio: A Review of the Evidence," NBER Working Paper No. 24333, (February 2018). 3 David H. Autor, Dorn, David and Hanson, Gordon H., "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Reviews of Economics, dated August 8, 2016, available at annualreviews.org. 4 A graphical illustration of this point is provided here. 5 Please see BCA Geopolitical Strategy, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018. 6 Please see "The Beige Book: Summary of Commentary on Current Economic Conditions By Federal Reserve District,"Federal Reserve, dated March 7, 2018. 7 Please see Erik F. Nielsen, "Chief Economist's Comment: Sunday Wrap," UniCredit Research, dated March 4, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades