Equities

Highlights Our indicators suggest that investors should be especially cautious in the next month or two. April's Beige Book supports our view that higher inflation will lead to at least three more Fed rate hikes this year. However, the nation's trade policy is a concern for businesses. BCA's Bankers' Beige Book is booming. The Q1 earnings reporting season is off to a strong start, with both EPS and revenue growth exceeding consensus expectations at the start of April. Feature U.S. equity prices may struggle in the next few months. BCA's base case is that global growth will stabilize at an above-trend pace. Fiscal policy is a tailwind and global monetary policy remains easy, although several central banks are removing some of the accommodation. Moreover, the Fed sees only moderate risks to financial stability at home and abroad, its latest Beige Book is upbeat amid concerns over trade and labor shortages, and the Q1 earnings season is off to a strong start. BCA's Bankers' Beige Book for Q1 is booming. Nonetheless, BCA's Global Investment Strategy's MacroQuant model1 suggests that equities will struggle in the short-term. In our Bank Credit Analyst publication, the Equity Scorecard (Chart 1) and its Bear Market Checklist (Table 1) are both flashing red.2 The U.S.-China trade spat will linger for several more months and trade protectionism remains a risk. BCA's Geopolitical Strategy service notes that the stock market will likely seesaw during the summer as confusion grows amidst the upcoming geopolitical event risk (Table 2).3 Markets could also dip on Iran-U.S. tensions, an escalation of the conflict in Syria and a Russia-West confrontation. Indeed, sanctions on Russia are already pushing some base metal prices higher. Moreover, oil prices are more susceptible to supply disruptions given the tightness of global oil markets (Chart 2). BCA views any spike in oil prices as a tax on U.S. consumers. Chart 1Equity Scorecard: Flashing Red Table 1Exit Checklist Table 2Protectionism: Upcoming Dates To Watch Chart 2Oil Markets Are Tight Bottom Line: The 12-month cyclical outlook is still reasonably positive for risk assets such as stocks. Nonetheless, the near-term is fraught with risk. Our indicators suggest that investors should be especially cautious in the next month or two. Focus On Financial Stability Chart 3FOMC Is Closely Monitoring##BR##Financial Stability BCA views financial stability as a third mandate4 for the Fed, along with low and stable inflation, and full employment. Financial stability was not discussed at the FOMC's March 20-21 meeting, despite the spike in financial market volatility in early February. At the prior meeting in January, Fed staff continued to characterize financial vulnerabilities of the U.S. financial system as moderate on balance, but they declined to provide an assessment of foreign financial stability (Chart 3). However, in November 2017, Fed staff highlighted specific vulnerabilities in various foreign economies, including weak banks, heavy indebtedness in the corporate and/or household sector, rising property prices, overhangs of sovereign debt and significant susceptibility to various political developments. The Fed does not provide a financial stability grade at every meeting. Fed staff described financial conditions as moderate in September and December 2013, and then again in April 2014. The next assessment was only in January 2016 but since then, it has upped its discussions. Fed staff provided an assessment of financial stability in 8 of its 16 subsequent meetings. FOMC participants debated the issue at all but 1 of its 8 meetings in 2017, and in 13 of the 16 since April 2016. Fed Chair Jay Powell has followed his predecessor's lead in highlighting financial stability. Former Chair Janet Yellen elevated the topic during her tenure, leading discussions or staff briefings in 26 of the 32 meetings she presided over. The February 2018 edition of the Fed's semiannual Monetary Policy Report (MPR),5 which was the first one in Powell's tenure, has a full section devoted to financial stability. The report characterized the vulnerabilities of the financial system as moderate. Every MPR since July 2013 has provided an update on financial stability. Powell addressed financial stability in a June 2017 speech when he was a Fed governor and also reviewed the concern at his Senate confirmation hearing in November 2017. Moreover, in March's post-FOMC news conference, Powell answered a question about market bubbles by detailing the FOMC's approach to financial stability, and reiterated that financial vulnerabilities were "moderate." The San Francisco Fed noted that a more restrictive monetary policy could pose risks to financial stability.6 A surprise tightening can pressure U.S. bank balance sheets via higher market leverage. Moreover, a higher fed funds rate often leads to an expansion of assets held by money market funds (MMFs) (Chart 4). It concluded that during the 2007-2009 crisis, funding problems for MMFs spread across to the financial system and infected the real economy. In October 2016, the SEC introduced reforms aimed at targeting instability in the MMF sector. Still, the FOMC will closely watch MMF flows as the tightening cycle continues. Chart 4Money Market Funds And The Fed Funds Rate Bottom Line: BCA expects the Fed to remain vigilant about financial stability, but this means that rates will increase only gradually despite below-target inflation. The central bank must find the optimal pace to encourage employment and stable prices while guarding against financial excesses developing if policy stays too loose for too long. Beige Book Highlights The Beige Book released last week ahead of the FOMC's May 1-2 meeting suggested that uncertainty surrounding U.S. trade policy was an important headwind in March and early April. The Fed's business and banking contacts mentioned either tariffs or trade policy 44 times in the Beige Book; there were only 3 mentions in the March edition. Moreover, uncertainty came up nine times in April (Chart 5, panel 5) and eight were related to trade policy. There were just two mentions of the word in the March Beige Book. BCA's view is that trade-related uncertainty will persist through at least mid-year.7 Chart 5Latest Beige Book Supports##BR##The Fed's View On Rates, Inflation and Economy BCA's quantitative approach8 to the Beige Book's qualitative data continues to point to underlying strength in the U.S. economy, a tighter labor market and higher inflation. Moreover, references to a stronger dollar have disappeared from the Beige Book. Chart 5, panel 1 shows that at 55% in April, BCA's Beige Book Monitor dipped to its lowest level since November 2017 when doubts over the tax bill weighed on business sentiment. The number of "weak" words in the Beige Book remained near four-year lows; the number of strong words returned to last summer's hurricane levels. The tax bill was noted five times in the latest Beige Book, down from 15 in March and 12 in January. The legislation was cast in a positive light in five of six mentions. Based on minimal references to a robust dollar in the past seven Beige Books, the greenback should not be an issue for corporate profits in Q1 2018. The handful of references sharply contrasts with 2015 and early 2016 when there were surges in Beige Book comments (Chart 5, panel 4). The last time that seven consecutive Beige Books had so few remarks about a strong dollar was in late 2014. BCA's stance is that the dollar will move modestly higher in 2018. The disagreement on inflation between the Beige Book and the Bureau of Labor Statistics widened in April's Beige Book (Chart 5, panel 3). The number of inflation words in the Beige Book rose to a nine-month peak in April, nearly matching the cycle high hit in July 2017. Core PCE also increased in early 2018. However, in the past year, inflation measured by the PCE deflator and CPI failed to match the escalation in inflation references. In the past, increased remarks about inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. April's Beige Book continued to highlight labor shortages, especially among skilled workers in key areas of the economy. Several contacts noted trouble finding moderately skilled workers in the manufacturing sector. Additionally, a lack of truck drivers, IT and software employees, and construction workers were often cited. Table 3 shows industries with labor shortages. In the year ended March 2018, the gain in average hourly earnings in most of the industries was faster than average. Moreover, in nearly all these categories, labor market conditions are currently the tightest since before the onset of the 2007-2009 recession. More details can be found in a recent Fed study on labor shortages in the manufacturing sector.9 BCA's Beige Book Commercial Real Estate (CRE) Monitor10 remains in a downtrend (Chart 6). The Fed has highlighted valuation concerns in CRE and BCA's Global Investment Strategy service recently stated that the sector is increasingly vulnerable.11 Table 3Labor "Shortages" Identified##BR##In The Beige Book Chart 6Beige Book Commercial##BR##Real Estate Monitor Bottom Line: April's Beige Book supports our view that higher inflation will lead to at least three more Fed rate hikes by the end of the year. Labor shortages may be spreading from highly skilled to moderately skilled workers. The nation's tax policy still gets high marks from the business community, but ongoing concerns over trade policy will restrain growth. Bankers' Beige Book Booming Chart 7Bankers' Beige Book BCA's Big 5 Bank Lending Beige Book12 for Q1 2018 highlights several positive trends in the financial sector. All five banks were uniformly upbeat about loan growth, although there was some unease about commercial real estate loans. Chart 7 shows key banking-related variables cited in the Bank Lending Beige Book. Appendix Table 1 shows the Big 5 Bank Lending Beige Book for Q1 2018. Several bank executives noted that Q1 was a seasonally weak time for loan growth. Comments on the credit quality of the banks' loan and credit card portfolios were equally positive. Bank managements highlighted how higher rates have improved their net interest margins in Q1 and noted that further Fed rate hikes would benefit operations. Moreover, our panel of bank CFOs and CEOs cited the positive impact of the 2017 Tax Cut and Jobs Act on their businesses via better loan growth, stronger capital market activity and more capital spending. Several noted that their corporate clients are also experiencing benefits from the tax bill. Bottom Line: The banking system is humming. Lenders are ready to extend credit to businesses and consumers to boost the economy despite higher rates. The tax bill continues to be a positive for banks and their corporate clients. BCA's U.S. Equity strategists recommend an overweight position in the S&P 500's financial sector, with a high conviction overweight on banks.13 Strong Start The Q1 reporting season is off to a strong start, with both EPS and revenue growth exceeding consensus expectations at the start of April. We previewed the S&P 500's Q1 2018 earnings earlier this month.14 Just under 15% of companies have reported results thus far, with 77% beating consensus EPS projections, which is well above the long-term average of 69%. Furthermore, 75% posted Q4 revenues over expectations, exceeding the long-term average of 56%. The surprise factor for Q1 stands at 5% for EPS and 2% for sales. Both readings are right at the average surprise recorded in the past five years. The surprise figures are even more impressive given that analysts bumped up their Q1 assessments in 10 of 11 sectors between the start of 2018 and the beginning of the Q1 reporting season. Analysts' estimates typically move lower as a quarter unfolds, which has the effect of lowering the bar for results. Table 4S&P 500: Q1 2018 Results* We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning in mid-2018. Nonetheless, initial results imply that Q1 will be another quarter of margin expansion. Average earnings growth (Q1 2018 versus Q1 2017) is stout at 19% with revenue growth at 8%. However, on a four-quarter basis, U.S. margins fell slightly in the fourth quarter. Still, they remain at a high level on the back of decent corporate pricing power. Strength in earnings and revenues is broadly based (Table 4). Earnings per share rose in Q1 2018 versus Q1 2017 in all 11 sectors. EPS results are particularly robust in energy (71%), financials (29%), materials (27%) and technology (24%). The energy, materials and technology sectors likewise all experienced substantial sales gains (14%, 12% and 14% respectively). Excluding energy, S&P 500 profits in Q1 2018 versus Q1 2017 are still vigorous at 18%. Our U.S. Equity Strategy service introduced profit models for the S&P 500's sectors in January.15 Optimistic managements have raised the bar significantly for 2018 results in the past few months (Chart 8). On October 1, 2017, before the GOP introduced the tax bill, the bottom-up estimate for the S&P 500's 2018 EPS growth stood at 11%. As of April 19, 2018, the estimate is 20%. Moreover, the upward revisions are widespread. Calendar year 2018 EPS growth rate estimates in 10 of 11 sectors are higher today than at the start of October 2017. Chart 8The Bar Is High For 2018 EPS; Focus Should Shift To 2019 Soon While the ebullience is due to the tax bill, solid global growth, a steeper yield curve and higher energy prices are also responsible. The tax bill lowered the corporate tax rate for 2018 and the repatriation holiday provides firms with excess cash. As noted in the previous section, U.S. trade policy is a concern in several industries. Table 5 reports the Q4 2017 profit and sales performance of globally - and domestically - oriented firms (Q1 data will be available later this quarter). At year-end, domestic firms' earnings and revenue surprise outpaced that of global industries. However, global firms saw more robust sales and EPS growth than companies with sales mainly from domestic sources. Analysts expect EPS growth to slow considerably in 2019 from the anticipated 2018 clip, which matches BCA's view (Chart 9). However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in early 2020. Table 52017 Q4 Earnings##BR##Breakdown Chart 9Strong S&P 500 EPS Growth Ahead,##BR##Will Start To Slow Soon Bottom Line: EPS growth is expected to peak at over 20% later this year (4-quarter moving total basis using S&P 500 data). Growth is expected to decelerate thereafter since we have factored in a modest margin squeeze as U.S. wage growth picks up (Chart 9). The incorporation of the fiscal stimulus lifted the U.S. EPS growth profile relative to our previous forecast. Nonetheless, BCA believes that the earnings backdrop will remain a tailwind for the equity market. The Tax Cut and Job Act raised expectations for 2018 in most sectors and so far, corporate managements have exceeded the lofty projections. However, it may be more difficult to maintain in the second half of 2018. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report "Is China Headed For A Minsky Moment?," dated April 13, 2018. Available at gis.bcaresearch.com. 2 Please see BCA Research's Bank Credit Analyst Monthly Report, dated February, 2018. Available at bca.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report "Expect Volatility... Of Volatility," dated April 11, 2018. Available at gps.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com. 5 https://www.federalreserve.gov/monetarypolicy/2018-02-mpr-summary.htm 6 https://www.frbsf.org/economic-research/publications/economic-letter/2018/february/monetary-policy-cycles-and-financial-stability/ 7 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," April 4, 2018. Available at gps.bcaresearch.com. 8 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Great Debate Continues," April 17, 2017. Available at usis.bcaresearch.com. 9 https://www.federalreserve.gov/econres/notes/feds-notes/evaluating-labor-shortages-in-manufacturing-20180309.htm 10 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Summer Stress Out", dated July 3, 2017. Available at usis.bcaresearch.com. 11 Please see BCA Research's Global Investment Strategy Weekly Report, "Three Tantalizing Trades - Four Months On", dated January 19, 2018. Available at gis.bcaresearch.com. 12 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Commitments," January 20, 2014. Available at usis.bcaresearch.com. 13 Please see BCA Research's U.S. Equity Strategy Weekly Report, "High Conviction Calls," dated November 27, 2017. Available at uses.bcaresearch.com. 14 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Policy Peril," dated April 9, 2018. Available at usis.bcaresearch.com. 15 Please see BCA Research's U.S. Equity Strategy Special Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models," January 16, 2018. Available at uses.bcaresearch.com. Appendix: Bankers Beige Book

Highlights Portfolio Strategy Expensive valuations leave no room to maneuver in the S&P real estate index that has to contend with a higher interest rate backdrop and deteriorating cash flow growth fundamentals. Trim to underweight. In contrast, capital markets stocks are firing on all cylinders and the return of animal spirits, the capex upcycle, booming M&A activity and a brighter operating backdrop auger well for this highly cyclical financials sub-index. Stay overweight. Recent Changes S&P Real Estate - Downgrade to underweight today. Table 1 Feature Equities rebounded in the past two weeks, as earnings took center stage and they delivered beyond expectations. Impressively, the blended Q1 EPS growth rate is running at 20% (versus 18.5% expected on April 1) with roughly 18% of the S&P 500 constituents reporting profit numbers. This earnings validation served as a catalyst for the SPX to briefly reclaim the key 50-day moving average and, most importantly, the Advance/Decline (A/D) line hit fresh all-time highs. Historically, the A/D line and the S&P 500 move hand-in-hand and there is a high chance that the SPX will follow suit in the coming quarters (top panel, Chart 1). Our upbeat cyclical 9-12 month equity market view remains intact, as the odds of a recession are close to nil. Despite fears of a generalized global trade war, global trade volumes have been resilient vaulting to multi-year highs on a short-term rate of change basis (middle panel, Chart 2). While a global growth soft patch cannot be ruled out, as long as manufacturing PMIs can stay above the 50 boom/bust line, synchronized global growth will remain the dominant macro theme. Chart 1New Highs Ahead? Chart 2What Slowdown? The IMF concurred in its April, 2018 World Economic Outlook: "The global economic upswing that began around mid-2016 has become broader and stronger. This new World Economic Outlook report projects that advanced economies as a group will continue to expand above their potential growth rates this year and next before decelerating, while growth in emerging market and developing economies will rise before leveling off." 1 The bond market is also not sending a distress signal as very sensitive junk bond spreads have nosedived of late (shown inverted, bottom panel, Chart 1). Under such a backdrop, EPS will continue to shine and underpin stocks (Chart 2). Nevertheless, steeply decelerating money supply growth is slightly disconcerting. This is not only a U.S. only phenomenon, but G7 money supply growth is also losing momentum. Chinese and overall emerging markets money growth numbers are also stuck in a rut (Chart 3). While this could be the precursor to a global growth slowdown, we would expect commodity prices to be the first to sniff it out (Chart 4). Clearly this is not the case as commodities spiked last week. Moreover, keep in mind that money growth tends to peak before recessions and what we are currently observing is likely a typical late cycle phenomenon. We will continue to closely monitor money growth around the globe, as this steep deceleration represents a risk to our sanguine equity market view. This week we are updating our corporate pricing power indicators. Chart 5 shows that our corporate sector pricing power proxy and our diffusion index are holding on to recent gains. On the labor front, the business sector's overall wage inflation and associated diffusion index from the latest BLS employment report ticked lower (fourth panel, Chart 5). Chart 3Money Growth Yellow Flag... Chart 4... But Commodities Are Resilient Chart 5No Margin Trouble Yet However, the spread between job switchers and stayers (courtesy of the Atlanta Fed Wage Growth Tracker) suggests that wage inflation should pick up steam in the coming months. While rising pay would eat into profit margins and thus dent profits ceteris paribus, this would be problematic only if businesses failed to lift selling prices in the coming months. We assign low odds to this outcome as domestic (and global) final demand is firm, suggesting that companies will manage to pass on rising input prices either down the supply channel, to the government and/or the consumer. Table 2Industry Group Pricing Power Table 2 summarizes the sectorial results. We calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Chart 6Cyclicals Have The Upper Hand Over 83% of the industries we cover are lifting selling prices, and 45% are doing so at a faster clip than overall inflation. This is a slight improvement compared with our late-January report The number of outright deflating sectors dropped by three to 10 since our last update. Encouragingly, only 7 industries are experiencing a downtrend in selling price inflation, on par with our most recent report. Impressively, deep cyclicals/commodity-related industries continue to dominate the top ranks, occupying the top 7 slots (top panel, Chart 6). Improving global trade dynamics and sustained softness in the greenback are behind the commodity complex's ability to increase prices. In contrast, tech, telecom, autos and airlines populate the bottom ranks of Table 2. In sum, firming corporate sector pricing power will continue to boost sales growth for the rest of the year. Tack on operating leverage kicking into higher gear at this stage of the cycle, especially for the high fixed cost deep cyclical businesses, and still modest wage inflation, and profit margins and EPS growth will remain upbeat. This week we downgrade a niche interest rate-sensitive sector and update our view on a very cyclical financials sub-sector. DowngREITing There are good odds that laggard REITs will suffer the same fate as telecom services and utilities stocks and plumb relative all-time lows, breaching the early 2000s nadir (Chart 7). A higher interest rate backdrop, a key BCA theme for 2018, along with deteriorating profit fundamentals compel us to downgrade the niche S&P real estate sector to an underweight stance. Real estate stocks are behaving like fixed income proxied equities, given that, by construction, REITs are high dividend yielding. Thus, a tightening monetary backdrop serves as a noose around their necks (top panel, Chart 8). Not only is the Fed slated to raise interest rates two or three more times this year, but FOMC median projections also assume an additional two to three hikes in 2019. At the margin, competing higher yielding risk free assets will eat into demand for REITs. On the operating front, a number of indicators we track are sending an outright bearish signal for the commercial real estate (CRE) sector. The occupancy rate has crested just shy of 90% or 160bps below the previous cycle's peak. Rising vacancies are emblematic of decreasing rents and thus CRE related cash flows (middle panel, Chart 8). Chart 7New Lows Looming Chart 8Rental Deflation Alert Importantly, CRE prices continue to defy gravity and are steeply deviating from our petered out occupancy rate composite (bottom panel, Chart 8). This supply/demand imbalance typically resolves itself via deflating prices. Industry overbuilding explains this disequilibrium, as ZIRP and loose credit standards encouraged a construction boom. Overall non-residential construction is probing all-time highs and multi-family housing starts are expanding close to 400K/annum, a level that has coincided with previous peaks in the CRE market (third & fourth panels, Chart 9). This industry oversupply should weigh heavily on rents especially given the slackening demand backdrop, according to the message from our REITs Demand Indicator (RDI). The softening RDI reading also bodes ill for CRE price inflation (bottom panel, Chart 10). The latest Fed Senior Loan Officer Survey (FSLOS) corroborates that demand for CRE loans is in a steady decline and bankers are not willing extenders of CRE credit, exerting a downward pull on CRE prices (middle panel, Chart 10). Chart 9Rents Are Under Attack Chart 10CRE Prices Skating On Thin Ice Historically, demand for CRE loans as per the FSLOS has been an excellent leading indicator of actual CRE loan growth, and the current message is grim (second panel, Chart 11). It would be unprecedented for another upleg to take root in the CRE market with the absence of credit growth to fuel such an overshoot phase. Worrisomely, there is no valuation cushion to absorb the plethora of possible CRE mishaps. Cap rates have troughed for the cycle and a rising interest rate backdrop warns that a de-rating in expensive valuations is looming (third panel, Chart 11). While CRE credit quality shows no signs of deterioration, at this stage of the cycle and given weak industry profit fundamentals we would caution against extrapolating such good times far into the future (bottom panel, Chart 11). Adding it all up, our S&P real estate profit growth model does an excellent job encapsulating all of these forces, and it is currently sending an unambiguous sell signal (Chart 12). Chart 11Happy Days Are Over Chart 12Model Says Sell Bottom Line: Downgrade the niche S&P real estate index to a below benchmark allocation. Capital Markets: Stay The Bull Course We upgraded capital markets stocks to an above benchmark allocation mid-May last year. Our thesis, recovering overall market top and bottom line growth would prolong the overshoot phase in equities at a time when monetary conditions would stay sufficiently loose, has panned out and this hyper sensitive early-cyclical index has added alpha to our portfolio raising the question: is it time to book profits or are there more gains in store? The short answer is that it is too soon to crystalize gains. This financials sub-index thrives when animal spirits are rising, CEOs embrace an expansionary mindset, and investor risk appetites are healthy. The opposite is also true. We first started exploring the underappreciated global capex upcycle theme in mid-October2 and by late-November it became one of our two core themes for 2018 (rising interest rate backdrop is the other).3 The second panel of Chart 13 shows that capex intentions move in tandem with relative EPS and are pointing toward a profit reacceleration in the coming months. Bankers are also willing extenders of credit, a necessary fuel for the capex upcycle phase, and demand for loans is upbeat as per our commercial loans & leases model. Historically, such a macro backdrop has been a sweet spot for capital markets stocks (Chart 13). Not only business, but investor confidence is also sky high. Junk bond spreads have once again plumbed multi-year lows and even investment grade bond spreads are tight (high-yield spread shown inverted, Chart 1). Corporate bond issuance remains resilient. The Equity Risk Premium has also narrowed by 200bps since the end of the manufacturing recession (shown inverted, top panel, Chart 14), reducing the cost of equity capital. This is fertile ground both for IPOs and secondary stock offerings. Chart 13Solid Foundation Chart 14Enticing Operating Backdrop Meanwhile, the return of volatility has caused revenue generating equity trading desks to breathe a huge sigh of relief, as we had posited in early March,4 and this earnings season made abundantly clear. Trading volumes have soared and margin debt continues to climb both in absolute terms and relative to GDP (Chart 14). If volatility stays elevated as the year progresses, as we expect, then more gains are likely for investment bank trading desks. The upshot is that the capital markets' EPS upswing is in the early innings. Another key earnings driver, M&A activity, is booming around the globe. Still sloshing global liquidity with near generationally low interest rates is fueling an M&A spree. In the U.S. alone, M&A has hit a fresh cycle high and is running near $3.1Tn/annum. Even relative to output, M&A has returned to the previous cycle's peak (bottom panel, Chart 14), and is music to the ears of investment bankers. The implication is that a capital markets ROE expansion phase looms (bottom panel, Chart 15). On the operating front, capital markets employment is hyper-cyclical. Investment banks are quick to slash labor costs during a downturn and equally swift to expand headcount in anticipation of good times. Currently, industry payrolls are rising steadily and outpacing overall non-farm payroll growth, and represent a positive backdrop (Chart 16). Chart 15M&A Fever Is Positive... Chart 16...And So Is Rising Headcount Sell-side analysts have taken notice and EPS pessimism has violently swung into extreme optimism in the past 18 months. Granted, President Trump's election and tax reform euphoria are part of the slingshot recovery in EPS expectations. However, firming industry-specific EPS growth prospects are also driving analysts' upward revisions (bottom panel, Chart 16). Bottom Line: We recommend an above benchmark allocation in the still compellingly valued S&P investment banks & brokers index. The ticker symbols for the stocks in this index are: BLBG: S5INBK - ETFC, GS, MS, RJF, SCHW. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 http://www.imf.org/en/Publications/WEO/Issues/2018/03/20/world-economic-outlook-april-2018 2 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. 3 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Special Report, "Top 10 Reasons We still Like Banks," dated March 5, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Stay neutral small over large caps (downgrade alert)

Highlights The global economy is slowing. However, growth should stabilize at an above-trend pace over the next few months, as fiscal policy turns more stimulative and interest rates remain in accommodative territory. President Trump's macroeconomic policies are completely at odds with his trade agenda. Fortunately, Trump appears willing to cut a deal on trade, even if it is on terms that are not nearly as favorable to the U.S. as he might have touted. The recently renegotiated South Korea-U.S. Free Trade Agreement is a case in point. We remain cyclically overweight global equities, but acknowledge that valuations are stretched and the near-term market environment could remain challenging until leading economic indicators improve. Feature Global Equities: Near-Term Outlook Is Still Hazy We published a note on February 2nd entitled "Take Out Some Insurance" warning investors that the stock market had become highly vulnerable to a correction.1 The VIX spike began the next day. Although volatility has fallen and equities have rebounded so far in April, we are reluctant to sound the all-clear. The near-term signal from the beta version of our MacroQuant model has improved a bit but remains in bearish territory, as it has for over two months now (Chart 1). Chart 1MacroQuant Model Suggests Caution Is Warranted The model is highly sensitive to changes in growth. Starting early this year, it began to detect a weakening in a variety of leading economic indicators in the U.S. and, to an even greater degree, abroad. Most notably, global PMIs and the German IFO have dipped, Korean and Taiwanese exports have decelerated, Japanese machinery orders have fallen, and the Baltic Dry Index has swooned by 36% from its December high (Chart 2). The model also noted an increase in inflationary pressures, suggesting that monetary policy would likely end up moving in a less accommodative direction. The emergence of stagflationary concerns came at a time when bullish stock market sentiment stood at very elevated levels (Chart 3). Our empirical work has shown that equities perform worst when sentiment is deteriorating from bullish levels and perform best when sentiment is improving from bearish levels (Chart 4). Chart 2Growth Has Peaked Chart 3Stock Market Sentiment Was Very ##br##Bullish Earlier This Year Chart 4Swings In Sentiment And ##br##Stock Market Returns Waiting For The Economic Data To Stabilize The good news is that the drop in equity prices has caused sentiment to return to more normal levels. The bad news is that the activity data has continued to disappoint at the margin, as evidenced by the weakness in economic surprise indices and various "nowcasts" of real-time growth (Chart 5). Ultimately, we expect global growth to stabilize at an above-trend pace over the coming months, which should allow equities to grind higher. Monetary policy is still quite accommodative. The yield on the JP Morgan Global Bond Index has averaged 1.88% since the end of the Great Recession (Chart 6). We do not know where the "neutral" level of bond yields has been over this period. However, we do know that unemployment in the major economies has been falling, which suggests that monetary policy has been in expansionary territory. Despite the move away from quantitative easing by many central banks, the yield on the JP Morgan Global Bond Index is only 1.53% today. This implies a fortiori that bond yields today are well below restrictive levels. The conclusion is further strengthened if one assumes, as seems highly plausible, that the neutral bond yield has risen over the past few years, as deleveraging headwinds have abated and fiscal policy has turned more stimulative (Chart 7). Chart 5Unexpected Slowdown In Growth Chart 6Interest Rates Are Off Their Bottom, ##br##But Are Not Restrictive Chart 7Fiscal Policy Will Be Stimulative ##br##This Year And Next The Protectionism Bugbear Global growth has not been the only thing on investors' minds. The specter of a trade war has also loomed large. It is true that the standard early-19th century Ricardian model that first-year economics students learn predicts very small welfare losses from increased protectionism.2 The model, however, makes highly antiquated assumptions about how trade works. Trade today bears little resemblance to the world in which David Ricardo lived - the one where England exchanged cloth for Portuguese wine (the example Ricardo used to illustrate his famous principle of comparative advantage). Chart 8Trade In Intermediate Goods Dominates To an increasingly large extent, countries do not really trade with one another anymore. One can even go as far as to say that different companies do not really trade with each other in the way they once did. A growing share of international trade is between affiliates of the same companies. Trade these days is dominated by intermediate goods (Chart 8). The exchange of goods and services takes place within the context of a massive global supply chain, where such phrases as "outsourcing," "vertical integration" and "just-in-time inventory management" have entered the popular vernacular. This arrangement has many advantages, but it also harbors numerous fragilities. A small fire at a factory in Japan that manufactured 60 percent of the epoxy resin used in chip casings led to a major spike in RAM prices in 1993. Flooding in Thailand in 2011 wreaked havoc on the global auto industry.3 The global supply chain is highly vulnerable to even small shocks. Now imagine an across-the-board trade war. Equities represent a claim on the existing capital stock, not the capital stock that might emerge after a trade war has been fought. A trade war would result in a lot of stranded capital. It is not surprising that investors are worried. Trump's Dubious Trade Doctrine The psychology of a trade war today is not that dissimilar to that of an actual war among the great powers. It would be immensely damaging if it were to happen, but because everyone knows it would be so damaging, it is less likely to occur. How then should one interpret President Trump's tweet that "Trade wars are good, and easy to win?" One possibility is that he is bluffing. The U.S. exported only $131 billion in goods to China last year, which is less than the $150 billion in Chinese imports that Trump has already targeted for tariffs. China simply cannot win a tit-for-tat trade war with the United States. Unfortunately, there is also a less charitable interpretation, as revealed by the second part of Trump's tweet, where he said, "When we are down $100 billion with a certain country and they get cute, don't trade anymore - we win big. It's easy!" Trump seems to equate countries with companies: Exports are revenues and imports are costs. If a country is exporting less than it is importing, it must be losing money. This is deeply flawed reasoning. I run a trade deficit with the place where I eat lunch, but I don't go around complaining that they are ripping me off. One would think that Trump - whose businesses routinely spent more than they earned, accumulating debt in the process - would understand this. But apparently not. As we discussed two weeks ago, the U.S. runs a trade deficit mainly because its deep and open financial markets, along with a relatively high neutral rate of interest, make it an attractive destination for foreign capital.4 If a country runs a capital account surplus with the rest of the world - meaning that it sells more assets to foreigners than it buys from foreigners - it will necessarily run a current account deficit. Trump's Macro Policy Colliding With His Trade Policy In this respect, President Trump's macroeconomic policies are completely at odds with his trade agenda. By definition, the current account balance is the difference between what a country saves and what it invests. The U.S. fiscal position is set to deteriorate over the coming years, even if the unemployment rate continues to fall - an unprecedented occurrence (Chart 9). A bigger budget deficit will drain national savings. Chart 9The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Meanwhile, an overheated economy will cause capital spending to rise as firms run out of low-cost workers. If Trump succeeds in boosting infrastructure spending, aggregate U.S. investment will rise even more. The current account deficit is highly likely to widen in this environment. A Temporary Reprieve? Chart 10Trump's Protectionist Agenda Is A ##br##Popular One Among Republican Voters The prospect of a wider trade deficit means that Trump's protectionist wrath will not go quietly into the night. It may, however, go into remission for a little while. Trump's approval rating has managed to rise over the past few months because his protectionist agenda is popular with a large segment of the population (Chart 10). However, if the problems on Wall Street begin to show up on Main Street - as is likely to happen if stocks resume their decline - Trump will change his tune. This is especially true if a trade war threatens to hurt U.S. agricultural interests. Rural areas have been a key source of support for Trump's populist rhetoric. Trump has shown a willingness to cut a deal on trade even if the negotiated outcome falls well short of his bluster. Consider the agreement between the U.S. and Korea in late March to amend their existing trade pact. Trump had called the South Korea-U.S. Free Trade Agreement an "unacceptable, horrible deal" and a "job killer." After the agreement was renegotiated, the President described it as a "wonderful deal with a wonderful ally." What did Trump get that was so wonderful? The Koreans agreed to double the ceiling on the number of U.S. automobiles that can be exported to Korea without having to meet the country's tough environmental standards to 50,000. The problem is that the U.S. only shipped 11,000 autos to Korea last year, so the original quota was nowhere close to binding. The Koreans also agreed to reduce steel exports to the U.S. to about 70% of the average level of the past three years in exchange for a permanent exemption from Trump's 25% steel tariff. That may sound like a major concession, but keep in mind that only 12% of Korea's steel exports go to the United States. Korea also re-exports steel from other countries. These re-exports can be curtailed without causing major damage to Korea's steel industry. The shares of Korea's largest publicly-listed steel companies jumped by 1.7% on the first trading day after news of the deal broke, eclipsing the 0.8% rise in the KOSPI index. Investment Conclusions The global economy is going through a soft patch and this could weigh on stocks in the near term. However, if trade frictions fade into the background and global growth stabilizes over the coming months, as we expect will be the case, global equities should rally to fresh cycle highs. Granted, we are in the late stages of the business-cycle expansion. U.S. interest rates are likely to move into restrictive territory in the second half of 2019. Given the usual lags between changes in monetary policy and the real economy, this would place the next recession in 2020. By then, barring any fresh stimulus, the U.S. fiscal impulse will have dropped below zero. It is the change in the fiscal impulse that matters for growth. If growth has already slowed to a trend-like pace by late 2019 due to a shortage of workers, the economy could easily stall out in 2020. Given the still-dominant role played by U.S. financial markets, a recession in the U.S. would quickly be transmitted to the rest of the world. Stocks will peak before the next recession starts, but if history is any guide, this will only happen six months or so before the economic downturn begins (Table 1). This suggests that the equity bull market still has another 12-to-18 months of life left. The extent to which investors may wish to participate in any blow-off rally this year is a matter of personal preference. As was the case in the late 1990s, long-term expected returns have fallen to fairly low levels. A comparison between the Shiller P/E ratio and subsequent 10-year returns over the past century suggests that the S&P 500 will deliver a total nominal annualized return of only 4% during the next decade (Chart 11). A composite valuation measure incorporating both the trailing and forward P/E ratio, price-to-book, price-to-cash flow, price-to-sales, market cap-to-GDP, dividend yield, and Tobin's Q shows only modestly higher expected returns for stock markets outside the U.S. (Appendix A). Table 1Cyclically, It Is Too Soon To Get Out... Chart 11...But Long-Term Investors, Take Note As such, while we recommend overweighting global equities over a 12-month horizon, we would not fault long-term investors for taking some money off the table now. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Take Out Some Insurance," dated February 2, 2018. 2 Roughly speaking, the Ricardian model predicts that the welfare loss from protectionism will be one-half times the average percentage-point increase in tariffs times the change in the import-to-GDP ratio. Imports are about 15% of U.S. GDP. Consider a 10 percent across-the-board increase in tariffs. Assuming a price elasticity of import demand of 4, this would reduce trade by 1-0.96^10=0.33 (i.e., 33%), which would take the import-to-GDP ratio down from 15% to 10%. As such, the welfare loss would be 0.5*0.1*(15%-10%)=0.25%, or just one quarter of one percent of GDP. 3 James Coates, "Real Chip Shortage Or Just A Panic, Crunch Is Likely To Boost Pc Prices," Chicago Tribune, dated August 6, 1993. "Thailand Floods Disrupt Production And Supply Chains," BBC.com, dated October 13, 2011; Ploy Ten Kate, and Chang-Ran Kim, "Thai Floods batter Global Electronics, Auto Supply Chains," Reuters.com, dated October 28, 2011. 4 Please see Global Investment Strategy Weekly Report, "U.S.-China Trade Spat: Is R-Star To Blame?" dated April 6, 2018. APPENDIX A Chart 1Long-Term Real Return Prospects Are Slightly Better Outside The U.S. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Our analysis is often focused on China, commodities prices and Asia's business cycle. The key points of these discussions are applicable to the majority of EM countries and their financial markets. Yet, there are some countries that are not exposed to China, commodities or global trade. India and Turkey are two prominent examples from the EM space that fall into this category. This week we re-visit our analysis on these economies and their financial markets. Feature India: Inflation Holds The Key Indian government bonds sold off sharply over the past eight months, with the yield gap widening significantly relative to EM local currency bonds (Chart I-1, top panel). During this time, the country's stock market has been underperforming the EM benchmark notably (Chart I-1, bottom panel). Rising Indian inflation was a main culprit behind the selloff. However, the most recent print for headline CPI was down (Chart I-2). Diminished inflation worries have recently led to a modest drop in bond yields. Chart I-1India Relative To EM: Bonds And Stocks Chart I-2Indian Inflation Has Accelerated The key question for investors is if inflation will rise or stay tame. This, by extension, will determine whether Indian stocks will outperform their EM counterparts. Risks: Inflation, Fiscal Balance And Bond Yields Odds point to upside inflation surprises ahead, and a potential rise in bond yields: The supply side of the economy has been stagnant. Chart I-3 illustrates that Indian consumption has been outpacing investments since 2012, creating a significant accumulated gap. Capex is now picking up (Chart I-4, top panel) but the fact that past investment was low means that the output gap could become positive sooner than later. Chart I-3Consumption Is Outpacing Investments Chart I-4Timid Pick Up In Capex Crucially, in order for the capex rebound to be robust and sufficient to expand the economy's productive capacity, Indian commercial banks need to finance corporate investments aggressively. The bottom panel of Chart I-4 shows that this is not yet the case. On the fiscal front, the Indian central government released a mildly expansionary 2018-2019 budget, and is pushing for fiscal consolidation beyond 2019. Importantly, this was the last budget announcement of the ruling National Democratic Alliance (NDA) coalition before the 2019 general elections. It therefore entails a 10% increase in government expenditures. Growing government expenditures are often inflationary in India; hence a 10% rise in government spending could boost inflation modestly (Chart I-5). Additionally, there are also non-trivial risks that the Bharatiya Janata Party (BJP) government might end up spending beyond the official budget announcement in order to appease voters in the run-up to the 2019 general elections. The risks of overspending extend to state governments as well. The latter plan to raise their employees' housing rental allowances (HRA). Depending on the magnitude and timing of these increases, inflation could accelerate significantly and have spillover effects. Turning to bond yields, excess demand for credit by borrowers against a restricted supply of financing by banks is also creating a ripe environment for higher bond yields: The combined Indian central and state fiscal deficit is very wide, signaling strong demand for credit by the government (Chart I-6, top panel). Yet broad money creation by banks has generally been weak (Chart I-6, bottom panel). Chart I-5Indian Government ##br##Expenditure Is Inflationary Chart I-6Large General Fiscal Deficit ##br##Amid Slow Money Creation Chart I-7 illustrates that the combined central and state government fiscal deficit plus the annual change in the total broad stock of money is negative. This signals that new money creation might be insufficient. Commercial banks' holdings of government bonds is also falling (Chart I-8, top panel). Indian banks are at the margin beginning to turn their focus to private sector lending (Chart I-8, bottom panel). Chart I-7Insufficient New Funding ##br##For The Economy Chart I-8Indian Commercial Banks Are Shifting ##br##Focus To The Private Sector This is expected as commercial banks' holdings of government bonds have reached 29% of total deposits, which is significantly above the minimum required Statutory Liquidity Ratio (SLR) of 19.5%. Given the ongoing improvement in private sector growth and hence demand for credit, Indian banks are now more inclined to augment their loan portfolios. Non-bank financial corporations such as insurance companies could offset banks' lower demand for government securities, but the former are not as large players as banks to make a meaningful impact. They own only 24% of government bonds compared to the banks' 42% ownership. Mutual funds and other non-bank finance corporations' ownership of government bonds is even smaller than that of insurance companies. Chart I-9India's Cyclical Profile Bottom Line: Upside risks to government spending, the budget balance and inflation will likely keep upward pressure on domestic bond yields. That amid high equity valuations might lead to lower share prices in absolute terms. India Can Still Outperform The EM Benchmark While Indian government bonds could sell off and stocks could fall in absolute terms, India is in a better position relative to its EM counterparts. Our view remains that we will see a material slowdown in Chinese growth this year - which is negative for commodities prices and EM economies. This scenario will be beneficial for India at the margin relative to other EM bourses. Importantly, Indian economic activity is gaining upward momentum: Overall loan growth has picked up meaningfully, and consumer loan growth in particular is accelerating at a double-digit pace (Chart I-9, top panel). Motorcycle sales have resumed their upward trend (Chart I-9, panel 2). Commercial vehicle sales are now accelerating robustly (Chart I-9, panel 2) and manufacturing production has picked up noticeably (Chart I-9, panel 3). Bottom Line: We recommend investors keep an overweight position in Indian equities versus the EM benchmark. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Turkish Markets Are In Freefall The lira has been in freefall and local bond yields have spiked (Chart II-1) following the Turkish government's announcement that it wants to stimulate growth even further by implementing a new investment incentive package worth $34 billion, or 5% of GDP. Our view is that the recent lira depreciation as well as the selloff in stocks and bonds have further room to go. Stay short/underweight Turkish risk assets. The Turkish economy is clearly overheating and inflation has broken out into double digit territory (Chart II-2). This comes as no surprise, given high and accelerating wage growth together with stagnant productivity gains (Chart II-3, top panel). Unit labor costs are surging in both manufacturing and services sectors (Chart II-3, bottom panel). Demand is booming, as such firms will likely succeed in hiking selling prices further, reinforcing the wage-inflation spiral. Chart II-1Turkey: Currency Is Falling And ##br##Bond Yields Are Rising Chart II-2Turkey: Genuine Inflation Breakout Chart II-3Turkey: Wage Growth Is Too High Most alarmingly, Turkish policymakers are doing the opposite of what is currently needed - instead of tightening, they have been easing policy: On the fiscal side, government expenditures excluding interest payments have accelerated significantly (Chart II-4). On the monetary policy side, Turkey's banking system has been relying on enormous amounts of liquidity provisions by the central bank (Chart II-5, top panel) to sustain its ongoing credit boom and hence economic growth. Chart II-4Turkey: Fiscal Policy Is Easing Chart II-5Turkey: Monetary Policy Is Too Accommodative On the whole, the central bank's net liquidity injections into the banking system continue to increase rapidly. The nature of the central bank's reserves provisions to commercial banks has shifted away from open market operations and more towards direct lending to banks (Chart II-5, bottom panel). Yet, the essence remains the same: to provide liquidity to banks so that the latter can continue expanding their balance sheets. Adding all the liquidity facilities - the intraday, overnight and late window facilities - the Central Bank of Turkey's (CBT) outstanding funding to banks is TRY 90 billion, or 3% of GDP, abnormally elevated on a historical basis. All this entails that monetary policy is too loose. Consistently, even though local currency bank loan growth has moderated, it still stands at 18% (Chart II-6). With the newly announced government stimulus plan, bank loan growth will likely accelerate from an already high level. As debt levels rise, so are debt servicing costs (Chart II-7). Notably, debt (both domestic/local currency and external debt) servicing costs will continue to escalate as the currency plunges. The reason is that Turkish private sector external debt stands at 40% of GDP, with 13% of GDP being short-term, the highest among EM countries. Currency depreciation will make external debt more expensive to service. Chart II-6Turkey: Rampant Credit Growth Chart II-7Higher Debt Servicing Costs Lastly, the Turkish authorities are expanding the Credit Guarantee Fund, what we would call the "free money" program. The aim of this fund is to incentivize banks to lend more, making the government essentially assume credit risk on loans extended to small and medium enterprises. Under this scheme, the government is effectively giving a green light to flood the economy with more money/credit. This will only heighten inflationary pressures and lead to much more currency devaluation. So far, the scheme has been responsible for the creation of TRY 250 billion, or 8% of GDP worth of new credit. The new tranche of this program announced in January of this year entails another TRY 55 billion. While smaller than the previous tranche, it is still significant at 1.8% of GDP. Fiscal and monetary policies are overly simulative and the country's twin deficits - both fiscal and current account - are widening (Chart II-8). The current account deficit now exceeds 6% of GDP. With foreign holdings of equities and government bonds already at historic highs (Chart II-9), it is questionable whether Turkey has the capacity to attract more capital inflows to finance a widening current account deficit on a sustainable basis. Chart II-8Turkey: Large Twin Deficits Chart II-9Turkey: Foreign Holdings Of ##br##Stocks And Bonds Are Large Remarkably, despite extremely strong exports due to robust growth in the euro area, the current account deficit in Turkey has been unable to narrow at all. This confirms the excessive domestic demand boom. Chart II-10The Turkish Lira Is Not Cheap Even after undergoing large nominal depreciation, Chart II-10 demonstrates that the Turkish lira is still not cheap, according to unit labor cost-based real effective exchange rate, which in our opinion is the best valuation measure for currencies. With wage and general inflation in the double digits and escalating, it will take much more nominal deprecation for the lira to become cheap. At this point, the Turkish authorities are clearly over-stimulating growth while disregarding inflation. The current policy stance will all but ensure that the lira depreciates much further. Excessive money creation is extremely bearish for the local currency. To put the amount of outstanding money into perspective and gauge exchange rate risk, one can compute the ratio of foreign exchange reserves to broad money (local currency money supply). Chart II-11 illustrates that the current net level of foreign exchange reserves (excluding banks' foreign currency deposits at the central bank) including gold currently stands at US$30 billion, which is equivalent to a mere 11% of broad local currency money M3. The ratio for other EM countries is considerably higher (Chart II-12). Chart II-11Turkey: Central Bank FX ##br##Reserves Level Is Inadequate Chart II-12Foreign Exchange Reserves Adequacy In EM Given the inflationary backdrop and the risk of further currency depreciation, interest rates will have to rise. With time this will inevitably trigger another upward non-performing loan (NPL) cycle. Banks are very under-provisioned for non-performing loans (NPLs). Even worse, banks have been reducing the ratio of NPL provisions to total loans in order to book strong profits. NPLs and NPL provisions are set to rise substantially, and banks' equity will be considerably eroded as a result. Lastly, as Chart II-13 demonstrates, rising interest rates are bearish for bank share prices. Investment Implications The government is doubling down on pro-growth policies and is disregarding inflation. Hence, inflation will spiral out of control and the central bank will fall even more behind the curve. This is extremely bearish for the lira. We are reiterating our short position on the lira. We remain short the lira versus the U.S. dollar, but the lira will likely also continue to plummet versus the euro as well. As such, we are also reiterating our underweight/short stance on Turkish stocks in general, and banks in particular (Chart II-14). Chart II-13Turkey: Higher Interest Rates ##br##Will Hurt Bank Stocks Chart II-14Stay Short/Underweight Turkish Stocks A weaker lira will undermine returns for foreign investors on Turkish domestic bonds and assures widening sovereign and corporate credit spreads. Dedicated EM fixed income and credit portfolios should continue to underweight Turkey within their respective EM universes. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Midterm election is yet another geopolitical headwind to the markets this summer; A "lame duck" Trump could seek relevance abroad, with aggressive foreign and trade policy; Investors would be right to fret about a hard turn to the left by the Democratic Party; Democrats have 60% probability of taking the House and 45% probability of taking the Senate; On a cyclical horizon, midterm election will not undermine pro-business policies of the Trump administration, but may signal a paradigm shift over a more structural time horizon. Feature Geopolitical winds have turned from tailwinds to headwinds. This is as we expected last April, when we correctly forecast that geopolitical risks were overstated in 2017 but understated for 2018.1 This January we focused on several key risks for 2018: trade protectionism, Iran-U.S. geopolitical tensions, and a potential black swan risk in Taiwan.2 In our 2018 Strategic Outlook, we also pointed out that if Donald Trump becomes an early "lame duck" president, he will seek relevance abroad.3 It is therefore time to turn to the question of the upcoming midterm election, set to take place on November 6. For most of our clients, the midterm election is another volatile political event to add to an already long list (Table 1). True, the midterm election could produce a gridlocked Congress - which we recently showed quantitatively is marginally negative for the markets - and a potential push to impeach President Trump.4 However, this is not the worst of it. As November approaches, through a tumultuous summer full of headline risks, President Trump may double-down on his doctrine of "maximum pressure" - which objectively succeeded in the case of North Korea. This could produce more aggressive rhetoric and policy in the ongoing trade skirmish with China, further sanctions against Iran, and tensions with Russia. Table 1Protectionism: Upcoming Dates To Watch President Trump would not be the first U.S. president to seek relevance abroad, although he may be the earliest, and potentially the lamest, lame duck president in recent U.S. history.5 As such, the real risk is not the Democrats taking over the House, but rather how the Trump administration reacts to a sudden loss of legislative initiative. While a Democratic House would dramatically increase domestic political constraints on President Trump, there are few constitutional constraints on U.S. presidents when it comes to foreign policy. As such, the midterm election is market relevant, but not because Democratic Party control will be able to impact domestic policy. Investors should remember why markets cheered President Trump in the first place: Chart 1Trump: A Boon For Main Street And Wall Street Chart 2Easy Fiscal + Tight Money = Buy SPX Deregulation: Business confidence soared even before Donald Trump was inaugurated as president, especially among small businesses, while regulatory worries melted away (Chart 1).6 The executive branch controls the regulatory process, which means that the Democratic takeover of the House of Representatives, or even the Senate, will have little impact. Tax cuts: Fears that the Democrats will be able to reverse the tax cuts are overstated. Without a veto-proof majority in both chambers of Congress - two-thirds of the seats - the Democrats cannot regain legislative initiative or reverse President Trump's accomplishments. Table 2ADXY Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Table 2BSPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Fiscal policy: Markets are currently pricing in a rare mix of tightening monetary policy and stimulative fiscal policy, a bullish combination (Chart 2) that tends to boost both equities and the dollar (Table 2). While there is no need for fiscal profligacy at the current point in the cycle (Chart 3), we would think that investors would recoil at any sign of fiscal conservativism. But looking for austerity within the current Democratic Party - whose official party platform calls for universal health coverage, for example - is a mistake. Chart 3An Odd Time For Fiscal Profligacy As such, the Democratic Party's control of the House - or even the Senate, given that a filibuster-proof majority is out of reach in 2018 - is unlikely to reverse the policy and regulatory backdrop that has been so beneficial for equities over the past 18 months. Instead, the risks are twofold. First, that President Trump reacts to the coming electoral bloodbath well ahead of November with aggressive foreign and trade policy that plays to his base. Second, that markets begin pricing in impeachment risk. Although we do not think that impeachment would have a major or direct impact on earnings and the real economy, it could add to volatility and could imply higher odds of a Democratic win in 2020 (think Gerald Ford). This would present a scenario in which the Democrats would be more likely to reverse Trump's policies in 2020, thus increasing uncertainty. As such impeachment could start being priced in well ahead of the November election. We would therefore expect midterm-related volatility to rise before the election. The election itself could likely be a time to buy risk assets, provided that fundamentals, the macro backdrop, and geopolitical risks all combine into a bullish signal, as long as President Trump makes an effort to move to the middle and work with either a split Congress, or even a potentially Democratic-led legislature. These are all sources of uncertainty and therefore provide plenty of reasons for the markets to fret ahead of the election. Who Will Win The Midterm Election? It is too early to have a high conviction view on the midterm election, which is still over six months away. Betting markets give Democrats roughly 70% probability of winning the House and just 40% of winning the Senate (Chart 4). We roughly agree with those odds, but would give the Democrats a lower chance of winning the House and a slightly higher chance of winning the Senate. There are broadly five reasons why the Democratic Party has a very good chance of winning the House of Representatives in November: Chart 4GOP Odds Have Fallen, But Stabilized Chart 5GOP Trails In Polls, But Still Close Polling: The generic congressional ballot (Chart 5) has the Democrats up 6.7% on the Republicans. The generic ballot has a decent predictive track record. Basically, the party that is up tends to perform well in the election. Meanwhile, Trump's approval rating, despite its recent recovery in support, remains at the lower end of presidential approval ratings ahead of midterm elections, predicting a 35-seat loss for Republicans in the House (Chart 6). On the whole, the Democrats' polling advantage is modest-to-strong. True, it could unravel over the summer. But at current levels, it is still a respectable advantage. Chart 6Republican Presidents And Midterm Results Retirements: Republicans in the House and the Senate are retiring at an alarming pace, one never seen in the modern political context (Chart 7). We cannot overstate how important this is, especially given that there has been a 20% swing against non-incumbent Republicans in deeply conservative districts that have held special elections thus far (Table 3). Most worrying for the GOP is that, of the 42 Republicans who have announced retirement, 18 sit in seats that are not "solidly" held by the GOP.7 These are seats that only elected the Republican candidate by an average of at most 5% more than the overall Republican vote in the 2012 and 2016 election. Chart 7GOP Retirements Are Unprecedented Table 32017 Special Elections Are Ominous For The GOP History: Of the 18 midterm elections since World War II, the sitting president's party only retained congressional control four times (Chart 8). The only president to win congressional control during the midterm election was Bush Jr., an election that was held a year after the September 11 terrorist attack (i.e., an exception). Americans like checks and balances and abhor hubris. Redistricting: Gerrymandering - politically motivated redrawing of district electoral maps - has mainly favored Republicans over the past decade.8 It has also significantly reduced the number of competitive districts available to electoral swings (Chart 9). Recently, however, the Pennsylvania state Supreme Court invoked the state constitution and struck down the congressional map that favored the GOP. The Supreme Court of the U.S. then refused an emergency request from Pennsylvania Republicans to block the new, non-partisan map drawn by the state court. This decision followed several decisions in 2016-17 that saw congressional maps in North Carolina, Virginia, Texas, Wisconsin, and Alabama either thrown out or questioned. The changes will help the Democrats at the margin, potentially making the difference between a majority and a minority position in the House. Chart 8Trump Is ##br##Fighting History Chart 9Gerrymandering Reduces##br## Competitive House Seats Momentum: Shouldn't a strong economy and sub-4% unemployment rate help the Republicans in November? The simple answer is not much. Just as a strong economy and a 4.7% unemployment rate did not help the incumbent party and its candidate Secretary Hillary Clinton fend off the inexperienced challenger, Donald Trump, in 2016. Simply put, economics is relative and partisan. While Republican voters suddenly became very happy about the economy after Trump's election - having been miserable merely days before- it is now the Democrats who believe that the economy is in a downward spiral (Chart 10). It is therefore difficult to see how the current economic performance makes enough of a difference to swing voters away from the trends we describe above. Further supporting this view is the fact that economic issues, broadly defined, are declining in terms of relevance in the upcoming election (Chart 11).9 Chart 10Politics Trumps Data! Chart 11It's Not Necessarily The Economy The trend is clear: Republicans are in trouble when it comes to the House of Representatives (Chart 12). Democrats need to win only 25 seats in November and there are now 29 Republicans representing seats that The Cook Political Report, the expert political analysis shop when it comes to predicting individual House races, classifies as "toss-up or worse." Our call, at this point, is that the Democrats have a 60% probability of winning the House of Representatives. We hesitate to set our odds at the higher end, near where the betting markets are pricing it, as there is still a long time until the election. In addition, the Democrats' lead in the generic congressional ballot has halved from 13% since December. What about the Senate? We modeled the individual Senate races by combining the state and national economic and political variables with the latest available opinion polling.10 We only focused on the races that we believe are currently competitive and we may change the mix as new information becomes available. Our model is a work in progress and we will update our clients as it develops. The results of our "beta" model, expressed as a margin of victory by the GOP candidate (GOP total vote minus Democrat total vote), show that the Democrats have a surprisingly decent chance of picking up the Senate (Chart 13).11 This is astonishing given that the Democrats are defending nine seats in "red states," whereas Republicans are only defending one seat in a "blue state" (Nevada). Basically, our model predicts that Republicans would lose Nevada and Tennessee. Meanwhile, of the five Senate races that are ranked as "toss ups" and that are currently held by Democrats, our model predicts that Republicans will only win Indiana. Given that current polling is highly unreliable, we would take all predictions of our model with a healthy dose of skepticism. Nonetheless, the results are surprisingly bullish for the Democrats. Chart 12The Number Of "At-Risk" GOP Seats Has Doubled Chart 13BCA Senate Model Says: Election Is Too Close To Call Our call, at this point, is that the Democrats have a 45% probability of winning the Senate; essentially the election is too close to call. This is higher than where the betting markets are pricing the election and an astonishing turnaround from 12 months ago, when most forecasts ignored Democrat chances in the Senate given how unfavorable the math was for their odds of winning. What does it all mean for the markets? Chart 14Midterm Elections Are A Boon For The S&P 500... Chart 15...But Really, It's All About The Fed Generally speaking, the market has performed very well following midterm elections during a Republican presidency (Chart 14). At closer inspection, however, it appears that this may have been because monetary policy has almost always been easy during these periods (Chart 15). As fate would have it, Republican presidents have been generally blessed with easy monetary policy. As such, we do not think that investors should take anything from this data. Table 4Democratic Primaries To Watch Rather than rely on uncertain empirical results, we would simply point out that the run-up to the midterm election, this coming summer, looks packed with geopolitical risks and uncertainty. President Trump is facing a potential defeat in Congress and will want to ensure that his base turns out for the election. This could mean doubling down on those parts of his policy agenda where the constitutional constraints are the weakest: foreign and trade policy. This is a recipe for more volatility. The midterm election is therefore a catalyst, if not the source, of near-term volatility. Furthermore, investors should carefully observe the results of key Democratic primary races (Table 4). Any sign that the Democratic Party is fielding left-wing candidates, as opposed to centrists, would have two implications. On one hand, it would lower our odds of the Democrats winning the House and definitely the Senate. On the other hand, it would increase the odds that the U.S. will have a political paradigm shift over the next electoral cycle. If the Democrats swing hard to the left and win the midterm election, the implications for investors would be hard to overstate. As a point of reference, investors should remember that Republicans swung hard to the right in 2010-14, presaging the rise of Trump. Yet these Republican victories took place in the face of long-term demographic and social headwinds, whereas comparable Democratic victories today would take place in the face of long-term demographic and social tailwinds. American policy can shift harder to the left over the coming decade than it did to the right over the past eight years.12 As Charts 16 and 17 show, the U.S. is at "peak inequality." As the example of France illustrates, income inequality does not necessarily go up. In the early 1960s, France had a larger share of the national income apportioned to the wealthy than the U.S. does today. Since then, it has fallen. In other words, societal decisions on wealth redistribution vary over time. The concern for investors would be if any Democratic party move to the far left is rewarded at the polls in November. If this were to happen, it would be appropriate to begin pricing in a significant decline in the share of national income that goes to corporate profits, if not yet a decline in social unrest. As Chart 17 illustrates, a significant decline in wealth concentration in France occurred right around the late 1960s. The May 1968 revolution was one of the most paradigm-shifting moments in France's post-World War II history. If the markets begin pricing in anything close to this degree of change in the U.S., the S&P 500 could enter a bear market. Chart 16GOP Tax Cuts: Same Old Story Chart 17Beware May 1968 Bottom Line: Our odds of the Democrats winning the House are 60%, below market expectations. Our odds of the Democrats winning the Senate are 45%, above market expectations. While we do not think that Democratic control of Congress, or just the House, will be negative for earnings on a cyclical time horizon, we do understand why investors would price in higher volatility. First, President Trump may respond to a loss of congressional control by seeking relevance abroad through hawkish foreign and trade policy. Second, investors may sense a paradigm shift occurring in the U.S. if left-wing Democrats start winning primary races and then go on to win the House. Is Impeachment A Risk? In a report titled Break Glass In Case Of Impeachment, we argued that investors should fade impeachment-related volatility.13 Equity markets are driven by earnings. As such, there has to be a direct relationship between political volatility and company earnings. Impeachment has rarely produced such a link. Chart 18 looks at market performance during the Teapot Dome Scandal (April 1922 to October 1927), Watergate (February 1973 to August 1974), and President Clinton's Lewinsky Affair (January 1998 to February 1999). Of the three, the Teapot Dome scandal did not result in impeachment proceedings, but only because President Harding died in office in 1923 - and neither his death nor the unfolding scandal prevented the stock market from "roaring" through the mid-1920s.14 Chart 18AVolatility Amid Three U.S. Scandals Chart 18BEquities Amid Three U.S. Scandals The market reaction to the Lewinsky Affair was also highly muted. Like the Teapot Dome incident, it occurred amidst one of the greatest bull markets in U.S. history. Of course, U.S. equities did fall 19% mid-way through the Clinton impeachment process, but this was more due to global risk factors than domestic politics. Watergate appears to have affected both equity markets and volatility. The S&P 500 fell 39% from February 7, 1973 - when the Senate established a select committee to investigate Watergate - until Nixon's resignation on August 9, 1974. That said, the scandal alone did not cause the correction; rather, it was a combination of factors, including the second devaluation of the dollar, rapid increases in price inflation, and a massive insurance fraud scandal. Writing in the summer of 1973, BCA remarked that while a speculative, "Watergate-inspired," attack on the dollar further contributed to some short-term capital outflow, but that the macro-fundamentals of the economy would ultimately persevere. Would today play out more like Teapot and Clinton, or Nixon? It will depend on the fundamentals. In the 1920s and the 1990s, fundamentals were solid and thus politics could not dent the ongoing bull market. In the early 1970s, macro fundamentals were terrible and thus politics accentuated the decline in the bear market. One thing that impeachment would not change, however, is policy. The U.S. is not Brazil. Impeachment will not lead to a 180 degree change in policy outcomes. Vice President Mike Pence is a Republican and is as pro-business as Trump. Given that the aggressive trade policy towards China has both public and establishment support, we would not expect any relief on the protectionism front. However, there would be a lot less tweeting, insults, and erratic foreign policy rhetoric aimed at both allies and rivals. The "maximum pressure" doctrine would likely be replaced by a more traditional policy of carrots and sticks. Most notably, we think this would minimize the risk of a proxy war with Iran in the Middle East. How likely is impeachment once Democrats take over the House? It depends. If President Trump fires Department of Justice Special Counsel Robert Mueller, the Democrats in the House of Representatives may get enough votes to impeach President Trump even without a House takeover! The question is whether impeachment would matter. As we outlined in our special report, impeachment is a political, not a legal, process. As such, the House of Representatives has a low bar for impeachment. It can essentially impeach the U.S. president for anything, including a debatable claim that he obstructed justice. The real question is whether the Senate would convict. To do so, the Senate must hold a trial and vote on whether to remove the president from office by a two-thirds majority (67 votes). Even if Democrats win the Senate, they would need over 15 Republican Senators to join them in removing a sitting U.S. president from office, which has never been done in American history. This could happen, but it would require the American public, particularly Republicans, to lose faith in President Trump. In particular, we have been advising clients to focus on Republican voters' support for Trump. If it dips well below 70%, we suspect that Senators could start switching sides. We are currently nowhere near these levels (Chart 19). What could change these levels of support? The Mueller special investigation is a big risk to President Trump even if one thinks that the charge of collusion with Russia is unfounded. President Bill Clinton was similarly investigated by an independent special investigator, Kenneth Starr. Starr initially focused on the suicide of deputy White House counsel Vince Foster and the Whitewater real estate investments by Bill Clinton. But the trail led elsewhere. Ultimately, the "Starr Report" alleged that Clinton lied under oath regarding his extramarital affair with Monica Lewinsky, an issue completely unrelated to the original investigation. In other words, once independent investigators start digging, there is no telling what skeletons they will exhume. We do not intend to "prosecute" claims against President Trump in this or any future report. But we can also envision a scenario where the Mueller investigation reveals enough evidence of malfeasance to shake GOP voter confidence in President Trump, leading to a potential scenario where he is removed from power. Would the market care at this point? We think the answer is yes. While removal of a U.S. president has no impact on earnings, it could have an impact on social stability. Political polarization is at its highest levels in the U.S. (Chart 20), and roughly 40% of both Democrats and Republicans believe that their political competitors pose a "threat to the nation's well-being" (Chart 21). Chart 19Impeachment: Not A Risk (Yet) Chart 20Polarization, As Inequality, Remains At Record Highs Chart 21"A Threat To The Nation's Well-Being?" Really?! We would fade any risk of a widespread, Red State rebellion. Since a change in Republican opinion is required for Senators to convict Trump, most of Trump's supporters will have already lost faith in him by the time he is removed from office. As we outlined in our Strategic Outlook, we doubt that many Trump voters would risk social unrest to defend their champion.15 Many conservative voters simply wanted change and were willing to give an outsider a chance (much as their liberal counterparts did in 2008!). But convincing the markets may take time, and any sign of even minimal right-wing terrorism could create volatility and drawdowns. Bottom Line: Impeachment remains a headline risk to the markets. We continue to believe that impeachment will merely accentuate the impact of fundamentals on risk assets. However, fundamentals themselves are starting to look vulnerable, at least on a tactical horizon. As such, we are entering a six-month period where geopolitical, trade, and domestic political risks could pose headwinds to U.S. risk assets. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Ekaterina Shtrevensky, Research Assistant ekaterinas@bcaresearch.com David Boucher, Associate Vice President Quantitative Strategist davidb@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017; "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 5 President Clinton launched the largest NATO military operation at the time against Yugoslavia amidst impeachment proceedings against him while President George H. W. Bush ordered U.S. troops into Somalia a month after losing the 1992 election. Ironically, President George H. W. Bush intervened in Somalia in order to lock in the supposedly isolationist Bill Clinton, who had defeated him three weeks earlier, into an internationalist foreign policy. Less dramatic, but still notable examples, are President George W. Bush ordering the "surge" of troops into Iraq in 2007 after losing both houses of Congress in 2006, and President Barack Obama negotiating the Iranian nuclear deal after losing the Senate (and hence the entire Congress) to the Republicans in 2014. 6 Please see BCA Geopolitical Strategy Weekly Report, "Tax Cuts Are Here... So Much For Populism!" dated November 8, 2017, available at gps.bcaresearch.com. 7 We use The Cook Political Report methodology for reporting the characteristic of House seats. Seats are split into "toss-up or worse," "likely/lean," and "solid" based on their Partisan Voter Index (PVI) score. The Cook PVI measures how each district performs at the presidential level compared to the nation as a whole. A district with a D+2 PVI voted an average of two points more Democratic than the nation did as a whole in the last two presidential elections (2012 and 2016 for current PVI rating). The Cook Political Report defines a "swing seat" as one that falls between D+5 and R+5. A "solid Republican" seat would therefore be any seat with a PVI of R+5 or higher. A "solid Democrat" seat would therefore be any seat with a PVI of D+5 or greater. 8 This is not to say that Democrats have not redistricted for partisan reasons. California was famously redistricted in the 1980s. Most recently, former Maryland Governor Martin O'Malley admitted, during a court deposition, that he redrew the state's district borders specifically to increase the Democratic congressional majority in the state. Please see Amber Phillips, "Maryland's redistricting case reminds us: Both parties gerrymander. A lot." The Washington Post, dated March 28, 2018, available at washingtonpost.com. 9 Please see BCA U.S. Investment Strategy Weekly Report, "As Good As It Gets?" dated January 29, 2018, available at usis.bcaresearch.com. 10 The state variables include the annual percent change in personal income, the annual change in the Philadelphia Fed Coincidence index, and incumbency. The national variables include presidential approval ratings, a variable indicating whether the last presidential election was close, and the annual percent change in real GDP, CPI, industrial production, and the DXY. We add to this mix of national and state data the latest opinion polling by state race and the generic congressional ballot. 11 The U.S. Vice President, Republican Mike Pence, would cast the deciding vote in case of a 50-50 tie and therefore the Democrats require a pickup of two seats. 12 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 14 "Teapot Dome" was for decades the largest corruption scandal in U.S. history. It involved President Warren G. Harding, his Secretary of the Interior, other officials, and a number of oil companies that were given extremely favorable leases to drill oil in federal land in Wyoming. Investigations and prosecutions lasted through 1927. 15 Please see BCA Geopolitical Strategy Strategic Outlook, "BCA Geopolitical Strategy 2017 Report Card," dated December 13, 2017, available at gps.bcaresearch.com.

Highlights An additional heavy salvo of U.S. import tariffs, were they to occur, would cause a material deceleration in Chinese economic growth (ceteris paribus). Trade negotiations are likely to produce a relatively benign outcome, but Chinese stocks and related financial assets may suffer meaningfully if not. Chinese policymakers have several policy options at their disposal to ease the impact of a major export sector shock, but many drawbacks make the choice a difficult one. For now, manufacturing sector-specific stimulus is the most likely policy response. A broad reading of key leading indicators for China's business cycle suggest that the industrial sector continues to slow. Recent bright spots in the data appear to be linked to unsustainably strong export demand, which is likely to wane in the months ahead. Stay overweight Chinese ex-tech stocks versus their global peers despite the looming trade threat, but with a short leash. Feature Trade frictions between China and the U.S. continue to dominate the headlines of the financial press. The most significant potential escalation in the conflict came two weeks ago, when President Trump instructed the U.S. Trade Representative to consider an additional $100 billion in tariffs on imports from China (on top of the initially proposed $50 billion). For investors, the possibility of a full-blown trade war between China and the U.S. and its implications for financial markets remains the "question that won't go away". Given that negotiations between trade representatives of both countries are highly active, the President's public suggestion that an additional heavy salvo of tariffs may be levied appears to be a clear case of economic saber-rattling. Still, investors cannot neglect the odds that such a scenario does indeed materialize, and in this week's report we revisit some of our previous work on the impact of proposed U.S. tariffs on Chinese economic growth. We also outline the (difficult) policy options available to Chinese policymakers, update investors on the state of China's business cycle, and reiterate our recommended investment strategy of staying overweight Chinese ex-tech stocks (with a short leash). The Impact Of Proposed Tariffs On Growth, Part II Chart 1150$ Billion In Import Tariffs Would Seriously ##br##Harm Chinese Export Growth We presented our framework for modeling the impact of U.S. import tariffs on overall Chinese export growth in our March 28 Weekly Report.1 Our approach suggested that the original $50 billion in proposed tariffs would cause China's total export growth to decelerate about 2%, which would work to counteract the acceleration in underlying export growth that we would normally expect over the coming months given the pace of the global demand. Chart 1 updates this framework assuming a total of $150 billion in tariffs. While overall nominal export growth would not contract outright as a result of the tariff imposition, it would decelerate materially from our estimate of its underlying rate (currently 10%). There are good odds that Trump's suggestion of an additional $100 billion in tariffs against China was merely a negotiating tactic, and it is clear that China has a strong incentive to agree to a trade deal with the U.S. that will prevent the scenario depicted in Chart 1 from taking place. But were it to, it would represent a significant threat to China's cyclical economic momentum, in a manner that would surpass the direct contribution to Chinese growth from the external sector. Charts 2 and 3 explain why. Chart 2 first presents an annual time series of the net export (NX) contribution to Chinese real GDP growth, relative to final consumption expenditure and gross capital formation. Investors might initially react to this chart by concluding that a significant deceleration in export growth would have a minimal impact on the Chinese economy, since the net contribution to growth from the external sector has typically been small relative to the other expenditure categories. Chart 2Net Exports Are Not A Huge##br## Direct Contributor To Growth... Chart 3...But The Export Sector Is Highly ##br## Investment-Intensive However, this perspective misses two important elements of the Chinese economy that are crucial to understand: China's import demand is strongly tied to the export channel, given that roughly half of Chinese imports are commodity-oriented. This means that Chinese import growth would also suffer from a sudden hit to U.S. exports, which would reverberate the shock to China's trading partners (and back again to China). In short, the imposition of major U.S. tariffs on imports from China would cause a negative feedback loop for China and its key trading partners. Abstracting from the global financial crisis, Chart 3 highlights that there is a strongly positive relationship between the annual change in contribution to growth from China's net exports and subsequent investment. This underscores that an important portion of China's gross capital formation, which is a significant contributor to the Chinese economy, is driven by the export sector. Based on the relationship shown in Chart 3, and the historical relationship between nominal exports and the real contribution from net exports, the scenario depicted in Chart 1 could cause the contribution to growth from Chinese investment to fall 0.5-0.6 percentage points, which could push real GDP growth to or below 6% if consumption remained constant. While we have not focused on real GDP growth as an accurate measure of Chinese economic activity, a deceleration of that magnitude would be on par with what occurred in 2011-2012, when Chinese stocks and related financial assets fared quite poorly. Bottom Line: An additional heavy salvo of U.S. import tariffs, were they to occur, would cause a material deceleration in Chinese economic growth. Trade negotiations are likely to produce a relatively benign outcome, but Chinese stocks and related financial assets may suffer meaningfully if not. China's Policy Options Our analysis above did not incorporate a stimulative response from Chinese policymakers, which we would certainly expect if China experienced a large shock to its export sector. Table 1 presents a brief list of policy actions that the Chinese government could employ in response; some are narrowly focused on the export channel, and some would impact the economy more broadly. Table 1No Easy Cure-Alls To Ease The Impact Of Tariffs Our assumption is that policymakers will initially choose more focused policies and will refrain from broad-based stimulus unless the impact of the export sector shock is expected to much more significant than is currently the case. This is particularly true given that Table 1 highlights the difficulty facing Chinese policymakers, in that there are significant drawbacks associated with any of the policies described. Given that the proposed import tariffs will primarily affect firms manufacturing goods for export to the U.S., the most focused policies would be to provide some offsetting form of stimulus to the manufacturing sector and to depreciate the RMB versus the U.S. dollar. In our view, manufacturing sector-specific stimulus is the most likely to occur of any policies described in Table 1: the drawbacks are primarily structural in nature, and China has already announced a slight reduction in the tax rate for manufacturing industries as part of a series of changes to the VAT regime. We expect to see more announcements in this vein over the coming months. Materially depreciating the RMB vs the U.S. dollar, however, is quite unlikely to occur as a stimulative response, as it would very likely inflame trade tension with the U.S. Chinese authorities may use threats of backtracking on the non-trivial appreciation in CNYUSD over the past year during talks with the U.S., but we doubt that authorities would actually go ahead with this barring a complete breakdown in negotiations. Depreciating versus the euro is similarly problematic. Chart 4 highlights that the RMB has barely risen at all versus the euro over the past year, implying that a meaningful depreciation would likely anger euro area policymakers, especially given that the trade-weighted euro has already risen nearly 10% over the past year. Instead, Chart 5 highlights the most likely route if China chooses to use the RMB as a relief valve: a depreciation against Japan, Korea, Vietnam, and India. China's combined export weight to these countries is meaningful, and the chart shows that there is depreciation potential: a weighted RMB index versus these currencies has risen about 8% in the past 12 months. Chart 4The RMB Has Not Appreciated ##br##Against The Euro Chart 5Room To Depreciate Against A ##br##Basket Of Asian Currencies We will revisit the remaining policies listed in Table 1 if the U.S. does indeed follow through with a second round of significant tariffs against Chinese imports, or if the economic effect of the first round proves to be more significant than we expect. From a bigger picture perspective, the potential for broader stimulus from Chinese authorities (in response to a more impactful shock) raises the interesting possibility of another economic mini cycle in China. While the need to stimulate broadly, were it to occur, would clearly imply that the economy would first be weakening, investors should remember that China's economy ultimately accelerated meaningfully in response to the last episode of material fiscal & monetary easing. We presented our framework for tracking the end of China's current mini-cycle in our October 12 Weekly Report,2 and argued that a benign, controlled deceleration was the most likely outcome (Chart 6). In our view the economic data has validated this call over the past six months, and we do not see any reason yet to deviate from it (see next section below). But a severe export shock followed by a burst of economic stimulus would clearly alter our expectations for China's business cycle dynamics, and would also create some exciting investment opportunities for investors (both on the downside and the upside). While the odds of this scenario are not currently probable, we raise the possibility because of the significance that another cycle would have for global investor sentiment and the returns from Chinese financial assets. Chart 6A Stylized View Of China's Recent "Mini-Cycle" Bottom Line: Chinese policymakers have several policy options at their disposal to ease the impact of a major export sector shock, but many drawbacks make the choice a difficult one. For now, manufacturing sector-specific stimulus is the most likely policy response. Abstracting From Trade, China Continues To Slow As noted above, we have been flagging a deceleration in China's industrial sector since early-October. Table 2 is an updated version of a table that we presented in our March 7 Weekly Report,3 which shows recent data points for several series that we have identified as having leading properties for the Chinese business cycle, as well as the most recent month-over-month change, an indication of whether the series is currently above its 12-month moving average, and how long this has been the case. While we do not yet have all of the March components of our BCA Li Keqiang leading indicator, the four that are available all declined in March from February, suggesting that the ongoing economic slowdown continues. Table 2Key Chinese Data Do Not Signal A Broad Acceleration The table does highlight, however, two relatively positive developments: the Bloomberg Li Keqiang index was materially higher on average in January and February than it was in the two months prior, and now both the official and Caixin manufacturing PMIs are above their 12-month moving average, with the latter having been so for 4 months in a row. An average of the two measures, along with its 12-month moving average, in shown in Chart 7. Are these budding signs of a durable upturn in China's industrial sector? We do not take a dogmatic approach to forecasting China's cyclical trajectory, and will be monitoring this possibility over the coming months. But in our current judgement, the answer is no. The January pop in Bloomberg Li Keqiang index reflects two separate factors: a jump in the annual growth of rail cargo volume in January (which subsequently unwound in February), as well as strong growth in electricity production on average in January and February (Chart 8). Normally this would be an encouraging sign for China's economy, but when connected with the countertrend move in the manufacturing PMIs and the sharp, unsustainable rise in February's export growth, a pattern begins to emerge. Chart 7A Modest Tick Up In China's ##br##Manufacturing PMIs Chart 8The Li Keqiang Index: ##br##A Brief, Countertrend Move While far from conclusive, it would appear that China experienced a very sudden burst of goods production for the purposes of export. Given that this is occurring in the context of considerable trade frictions and the eventual imposition of import tariffs, and against the backdrop of strong but steady (and possibly peaking) global demand, it is conceivable that China's exporters are attempting to front-load shipments for the year before these tariffs take effect. Although a February surge is visible in Chinese export growth to several countries (not just the U.S.), and undoubtedly some of the effect is due to the timing of the Chinese new year, it is possible that Chinese exporters are acting in anticipation of possible additional tariffs on other countries or global industries that China acts as a supplier to. We noted above that the imposition of the first round of U.S. tariffs will likely be enough to arrest any acceleration in overall Chinese export growth, with a second round likely to cause a downward change in trend. Thus, to us, it is difficult to see an export-driven catalyst for China's industrial sector continuing over the coming months. On the import side, the data has also been more positive than we would have expected, given the close link between import growth and the Li Keqiang index (Chart 9). Part of this deviation may be accounted for by unsustainable export growth, given the typically strong link between import and export growth in highly trade-oriented economies. Interestingly, Chart 10 highlights that the flat trend in import growth appears to be supported by an uptrend in manufactured products, whereas the trend of primary products imports is much more consistent with what our indicators would suggest. For now, we are sticking with the signal given by the latter, since it has historically been a more reliable predictor of whether overall future import growth will be growing at an above-trend pace. But as we stated above, our view of a benign slowdown in China is empirically-based, and we will continue to monitor the data for signs that the external sector of China's economy warrants a change in our slowdown view. Chart 9Import Growth Has Held Up##br## Better Than We Expected... Chart 10...But Commodity Imports Suggest##br## Broad Import Growth Will Weaken Bottom Line: A broad reading of key leading indicators for China's business cycle suggest that the industrial sector continues to slow. Recent bright spots in the data appear to be linked to unsustainably strong export demand, which is likely to wane in the months ahead. Investment Implications We noted in our March 28 Weekly Report that the shift in U.S. protectionism from rhetoric to action and the continued decline in our leading indicators makes a tenuous case for a continued overweight stance towards Chinese stocks.1 We recommended in that report that investors put Chinese ex-tech stocks on downgrade watch over the course of Q2. This recommendation stands, although it is notable that the relative performance of Chinese ex-tech shares (versus global) remains comfortably above its 200-day moving average (Chart 11). Chinese tech stocks, on the other hand, have sold off meaningfully over the past month (Chart 11 panel 2) due in part to the tech oriented nature of the U.S.' trade action. We advised investors to reduce their exposure to the tech sector in our February 15 Weekly Report,4 based on elevated earnings momentum and very rich valuation. Conversely, pricing also appears to be at the root of resilient ex-tech relative performance: Chart 12 shows that the 12-month forward earnings yield versus U.S. 10-year Treasurys is considerably higher for Chinese ex-tech companies than in developed or other emerging equity markets. This reinforces an argument that we have made in previous reports, which is that investors should have a high threshold for reducing exposure to China. Chart 11Chinese Ex-Tech Stocks ##br##Are Doing Fine, For Now... Chart 12...Supported By A Sizeable ##br##Risk Premium The key question is therefore whether the probable shock to Chinese export growth coupled with the ongoing slowdown in the industrial sector is significant enough to pre-emptively downgrade Chinese stocks. Our answer to this question remains "no", since investors still do not have the requisite visibility on the magnitude of the hit to exports and the likely policy response. Until this information emerges, we continue to recommend that investors stay overweight Chinese ex-tech stocks unless a technical breakdown emerges, and to watch for additional updates on this issue from BCA's China Investment Strategy service over the coming weeks and months. Bottom Line: Stay overweight Chinese ex-tech stocks versus their global peers despite the looming trade threat. Our downgrade watch remains in effect, and we are likely to advise a reduction in exposure in response to a technical breakdown. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Stocks: Trade Frictions Make For A Tenuous Overweight", dated March 28, 2018, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Tracking The End Of China's Mini-Cycle", dated October 12, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "China And The Risk Of Escalation", dated March 7, 2018, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "After The Selloff: A View From China", dated February 15, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Special Report

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

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

Highlights The ECB admits that its policy is considerably more accommodative than it would be absent the need to integrate the weaker euro area economies. But a strategy designed to integrate some is alienating others, both within the euro area and outside it. The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. It follows that the 10% undervaluation of the euro will eventually correct. And German consumer services will structurally outperform the consumer goods exporters. Feature Let's begin with some facts, which are difficult to dispute. Fact 1: The euro area is running a €400 billion trade surplus with the rest of the world, equivalent to 4% of euro area GDP. €300 billion of this surplus resides in Germany.1 Fact 2: The trade surplus is a direct result of the undervaluation of the euro (Chart of the Week). This we know, because the surplus has evolved as a perfect mirror image of the euro's undervaluation as calculated by the ECB itself. The central bank admits that the euro is undervalued by around 10%2 (Chart I-2). Chart of the WeekThe Euro Area's Huge Trade Surplus Is Due To The Undervalued Euro Chart I-2The Euro Is Undervalued By 10% Fact 3: The substantial undervaluation of the euro is the unavoidable result of the of the ECB's extreme experiment with bond buying and zero and negative interest rates. This we know, because the euro's undervaluation is a near perfect function of the yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts (Chart I-3 and Chart I-4). Chart I-3The Euro Is Undervalued Because Of The ##br##ECB's Ultra-Accommodative Policy Chart I-4The Euro Has Tracked Expected##br## Relative Monetary Policy Nevertheless, a reasonable riposte to facts 1-3 is that the ECB does not target the euro exchange rate. The ECB sets policy to achieve its price stability mandate, which it defines as an inflation rate of "below, but close to, 2%", the same definition as the Federal Reserve uses. Given that the ECB is further from its price stability mandate than the Fed is, the ECB has to set much more accommodative policy. And there the story might end. 2% Inflation In The Euro Area Is Different To 2% Inflation In The U.S. Except that the story has a twist. The price stability mandates of the ECB and Fed appear very similar, but they are not. The ECB mandate is much harder to achieve, because of two further facts. Fact 4: The definitions of consumer prices in the euro area and the U.S. are quite different. The euro area's Harmonized Index of Consumer Prices (HICP) excludes the consumption costs of owner-occupied housing, whereas the U.S. consumer price basket includes it at a very substantial 25% weight. The omission of owner-occupied housing costs - which consistently tend to rise faster than other prices - makes it much more difficult for overall inflation to reach 2%. Indeed, excluding shelter, core inflation in the U.S. today is running at 1.2%, the same rate as in the euro area (Chart I-5 and Chart I-6). Chart I-5Core Inflation Is Higher##br## In The United States... Chart I-6...But On A Like-For-Like Basis, Core Inflation##br## Is Not Higher In The United States Fact 5: The ECB has a single mandate of price stability, whereas the Fed has a dual mandate of price stability and maximizing employment. Some people even argue that the Fed has a triple mandate which includes financial stability. The point is that for Fed policy, price stability is only one of several considerations, creating flexibility; whereas for ECB policy, price stability is the only consideration, creating inflexibility. Nevertheless, a reasonable riposte to facts 4-5 is that we must just accept that the ECB and Fed operate within different frameworks. If the ECB's framework necessitates ultra-accommodative monetary policy today, then so be it. And there the story might end. Why Should Americans Pay For European Integration? Except that the story has another twist. The ECB framework wasn't always what it is today. Fact 6: On May 8 2003, the ECB changed its definition of price stability from "inflation below 2%" to "inflation below, but close to, 2%". Thereby, the addition of three small words transformed the flexibility of a 0-2% inflation range to the inflexibility of a 2% point target. Why did the ECB change its objective and make it so much more difficult? Here is the answer, straight from the horse's mouth: "The founding fathers of the ECB thought about the adjustment within the euro area, the rebalancing of the different members. To rebalance these disequilibria, since the countries do not have the exchange rate, they have to readjust their prices. This readjustment is much harder if you have zero inflation than if you have 2%" - Mario Draghi So there you have it - the ECB admits that it changed its objective to ease the integration burden on weaker euro area economies. The undisputed consequence is structurally easier monetary policy than would be the case without the integration burden. The ECB also admits that an unavoidable result is a structurally undervalued euro, meaning a substantial competitive advantage for the euro area versus its major trading partners, including the United States. To which President Trump might rightly ask: why should American competitiveness shoulder the burden for European integration? Trump's crosshairs may be trained on Germany, which is running the largest export surplus. But he should redirect his focus to the ECB. The majority of German export hyper-competitiveness is no fault of Germany, it is due to the structural undervaluation of the euro (Chart I-7). Moreover, while an undervalued euro benefits exporters, it hurts euro area household real incomes by raising the prices of dollar-denominated energy and food imports, whose demand is inelastic. German households are also deeply unhappy about the negligible interest on their savings. Chart I-7The Majority Of Germany's Hyper-Competitiveness Is Due To The Undervalued Euro The Way Forward, And Some Investment Considerations Ultra-accommodative policy was not the game changer that is sometimes claimed. The euro area's strong recovery started more than a year before the ECB even mooted its extreme accommodation. The turning point came in 2013 when euro area banks stopped aggressively de-levering their balance sheets ahead of the bank stress test (Chart I-8). Chart I-8The Euro Area Recovery Started In 2013 When Banks Ended Their Aggressive De-Levering Mario Draghi admits that policy today is considerably more accommodative than it would be absent the need to integrate the weaker euro area economies. But a strategy designed to integrate some is alienating others, both within the euro area and outside it. The ECB has a legal obligation to achieve price stability as its sole objective, but the precise definition of price stability is up to the central bank. To reintroduce some flexibility, it has two options: 'cross-sectional' flexibility, by reintroducing an inflation target range; or 'longitudinal' flexibility by a more relaxed interpretation of the 'medium term' timeframe required to achieve its point target. Of these two options, we expect a gradual move to greater longitudinal flexibility, especially as 'medium term' is already open to considerable interpretation. This will create three structural investment opportunities. The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. It follows that the 10% undervaluation of the euro - as calculated by the ECB itself - will eventually correct. As the euro area's structural over-competitiveness gradually corrects, the decade-long outperformance of consumer goods exporters versus consumer services will reverse, especially in Germany (Chart I-9 and Chart I-10). Overweight German consumer services versus consumer goods exporters. Chart I-9Consumer Services Have ##br##Underperformed In Europe... Chart I-10...But Are Starting To Turn ##br##Around In Germany Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Q4 2017 at an annualised rate. 2 Please see https://www.ecb.europa.eu/stats/balance_of_payments_and_external/hci/html/index.en.html The ECB uses three metrics to assess the euro area's competitiveness versus its major trading partners: GDP deflators, CPIs, and unit labour costs. The average of the three metrics suggests that the euro is undervalued by around 10%.The assessment of euro undervaluation assumes that the major euro area economies entered the monetary union at a broadly correct level of competitiveness against each other and against their other major trading partners. This assumption seems valid, given that the net external position of these economies were all in equilibrium at the onset of monetary union. Fractal Trading Model* This week, we note that the rally in the Spanish 10-year government bond is extended and ripe for a countertrend reversal. Implement this as a pair-trade: short the Spanish 10-year bond, long the German 10-year bund. The profit target and symmetrical stop-loss is 1%. Lever up to increase potential return. We are also pleased to report that our short Helsinki OMX / long Eurostoxx600 trade achieved its 3% profit target and is now closed. This leaves five open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 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 Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##Br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations