Kyle Jacobsen Updated as of 5/26/18

2Q 2018 Macro Views

U.S. Equities:
Following a Q1 categorized by a reemergence of volatility and geopolitical unease, it has been
difficult to pinpoint sectors primed for outperformance. It is becoming clear that spectacular
corporate earnings are no longer rewarded as they have been in the past and are simply a
standardized expectation at this phase in our bull cycle. A record-high of 77% of S&P 500
companies beat revenue estimates this past quarter and blended earnings grew at a rate (Y-o-Y*)
of 24.5% since the end of 2010.
Figure 1

For the past few quarters, it has been continually noted that fundamentals are taking the back seat
to thematic drivers. The biggest risks lie in our current trade war with China, relations with North
Korea, and Iran’s reaction to the U.S. post-sanction. The recent delay of the North Korea and
U.S. June summit by Trump could cause some immediate rotations into risk-off positions, but it
is likely no lasting developments will result. However, any unfavorable outcomes in China or
Iran could negatively impact U.S. exploration and productions companies, automakers, steel
companies, and industrials in the long run.
No theme, however, can overshadow U.S. interest rates and how quickly the fed will continue to
tighten monetary policy. The floating range of the FFOR* is still between 150 – 175 bps (1.50%
- 1.75%) and the effective current rate sits at 170 bps. The short end of the yield curve is rapidly
rising (2yr at 251 bps) while the 10-yr yield recently surpassed 300 bps. The spread between the
10 and 2yr is approximately 50 bps and continues to slowly narrow.
Kyle Jacobsen Updated as of 5/26/18

Equity Sectors in Focus:

From a sector-specific standpoint, financials, technology, and energy stand out as potential
outperformers.
Financials regain favorable tailwinds as a large rollback bill on Dodd-Frank passed both the
House and Senate on May 22nd. Impending a signing from President Trump the bill will no
longer automatically impose CCAR (Comprehensive Capital Analysis and Review) on firms
with $50B to $250B in assets. This historical “stress test” implemented after the ’08 crisis limits
lending activity and leverage within large institutions. The bill also allows for firms with less
than $10B in assets to be exempt from the Volcker rule that prohibits proprietary trading. While
this regulatory rollback doesn’t have a drastic impact on the largest investment banks, it is a huge
driver for commercial lending activity for regional banks and trading revenue for smaller firms.
Overall, the sector remains favorable based on expanding net interest margins, potential for
further deregulation, and increasing trading revenue across the board.
The technology sector continues to climb on the back of solid corporate earnings and solid late-
cycle momentum. I believe that the sector also remains partially unexposed to trade war derived
declines in comparison to other S&P sectors.
Energy has been the primary sector in focus since the late spring. Exploration and Production
companies are enjoying producing at profitable levels and have begun to reduce huge debt
obligations occurred during the global supply glut. The corporate tax cut and treatment for
depreciable assets encouraged higher capital expenditures (CAPEX) last quarter. Pipeline
construction and refinery activity has started to pick up. The potential decline in production
resulting from the U.S. withdrawal of the denuclearization agreement in Iran should also support
a bullish case for energy stocks into the next quarter. Overall, energy should see inflows as
continued favorable factors for E&P companies, positive crude signals, and developments in the
Middle East should support WTI levels above $65/bbl. in the coming weeks.
The U.S. equity market continues a slow rebound after sharp declines in February. Volatility has
lessened for the meantime, corporate earnings are likely to meet lofty Q2 expectations, and the
Fed is still cautiously monitoring the speed at which it tightens conditions. Chinese Trade war
developments, Iran, and North Korea will continue to dominate headlines and pose immediate
risks. At the core, U.S. equities still find backing from low unemployment, high consumer
confidence, and retail sales. A cautiously bullish case is likely to be maintained by most analysts
into year end.

U.S. Fixed Income

Government bonds have been the center of attention as U.S. rates have climbed higher since
April. The U.S. 10 year has climbed from nearly 270 bps in April to just over 300 bps in late
May. In comparison to EU peers the U.S. is beginning to gain some attention for widening
spreads over comparable bonds like the German Bund (See figure 2).
Kyle Jacobsen Updated as of 5/26/18

Figure 2

Rates in the U.S. are beginning to trade at a yield premium to European counterparts that haven’t
been seen in nearly 30 years. It is becoming clear that the ECB is further from ending it’s QE
program than originally anticipated and trails the U.S. in the implementation of less liquid
conditions. The pickup of the U.S. dollar has also been a large contributor to yield levels. The
DXY (dollar index) has increased from approximately 88.50 to 93.50 (+5.6%) since mid-April.
The fed minutes from May 23rd were digested as mildly dovish by most traders. It appears
Jerome Powell may allow inflation to run above the 2% target and slow the pace of rate hikes if
necessary. Sluggish inflation growth in both the U.S. and Europe could cap the increase in bond
yields if only two hikes occur for the remainder of 2018.
Investment Grade:
Medium-duration IG credit is currently trading at approximately a 100-110bp spread (G-spread)
above comparable U.S. Treasuries (see figure 3).
Kyle Jacobsen Updated as of 5/26/18

Figure 3

The largest risks to high-grade credit appear to be a stronger dollar, rapid rate hikes, increased
tapering, and unexpected inflation growth. Many of these factors don’t seem unlikely given the
fed’s trajectory and it is likely that IG investors will continue to trim duration as we move closer
to year end.
High-Yield and Municipals:
HY credit continues to have an unfavorable near-term outlook as risk premiums over treasuries
are still near relative lows. While the pickup in crude prices could assist the stability for many
HY energy bonds, the impact of shrinking liquidity is likely to push bond prices down in the
long-term.
Municipals remain relatively safe for tax-sensitive investors but continue to lose ground on the
short end of the curve as Treasury yields pickup. Call activity and overall reinvestment could
cause higher demand now that we are exiting tax season. Overall, HY and the municipal space
will rely on how quickly the fed moves to reduce liquidity and flow volume will likely
accumulate on shorter duration securities.

Europe
U.K.
In Britain, Theresa May and members of Parliament have avoided major headlines regarding
Brexit for the past few weeks. European leaders and global investors are anxiously awaiting the
Brussels Summit on June 28th, where the Brexit position paper will give leaders insight into
Britain’s dynamics exiting the EU. That initial proposal will lead to a highly anticipated meeting
on October 18th where the final Brexit deal will be presented and voted upon.
Kyle Jacobsen Updated as of 5/26/18

From an equity standpoint, the FTSE 100 sits at 7,780 points and has returned 1.2% YTD. The
marginal performance of the FTSE isn’t expected to get much better as the U.K. reported Q1
GDP growth of 0.1% on May 25th due to a cold front hurting cyclical commodity revenue. This
marks the worst quarterly growth rate in five years. While the GDP picture is gloomy, inflation
(CPI) is continuing to hover around 2.4% Y-o-Y and core around 2.1%. Inflation levels are
falling closer to the Bank of England’s and BoE Governor Mark Carney’s target. The probability
of a hike from the current 0.5% rate during the next BoE decision on June 21st is anything but
certain. Carney must weigh combating inflation following an ultra-low growth environment in
recent quarters.
Rates remain unattractive to the U.S. as the U.K. 10yr is yielding 132 bps and the 2yr sits at 71
bps. The sterling to dollar spot (GBP/USD) quickly breached support levels near 1.38 and
continues to downtrend (spot @ 1.331) in the face of a stronger dollar. Overall, Britain is likely
to lose trading flow to the U.S. until the intricacies of Brexit become clear and GDP growth
increases.
Eurozone (Portugal, Italy, Greece, Spain, and Germany):
A recent string of political developments in many eurozone countries has caused a spike in vol,
government yields, and equity declines. The escalating situations in the region are making it
harder for Mario Draghi of the European Central Bank (ECB) to wind down Europe’s QE
program, raise the benchmark rate from its current levels at 0% for fixed refinancing and – 0.4%
overnight deposit. The average 0.7% core inflation rate in the 19-country eurozone and
emergence of political unease could cause a consequential delay in the expected ECB exit from
easy monetary policy.
Portugal:
Portugal quietly remains one of the best-performing equity markets in 2018. The PSI 20 is up
6.1% YTD to 5,720 points and Prime Minister Antonio Costa has done a good job of reducing
unemployment since his start in office. Data points are remaining stable as CPI is 1.2% Y-o-Y,
GDP growth is 2.3% Y-o-Y, and unemployment is down approximately 4% from 2016 to 7.7%
currently.
Italy:
Italy will be at the top of the headlines for the summer after a leaked anti-establishment
agreement highlighted antigovernment party’s proposals for large debt-write offs and new
commitments to sizable spending commitments. This development follows the March election
where two anti-European parties (Lega and the 5 Star Movement) gained a small parliament
majority. Since the political development on May 15th, the FTSE MIB index has fallen from
24,300 to 22,400 points (-8.4%). Italian 10-year bond yields have risen from 190 bps to
approximately 246 bps in the same timeframe. All these present huge risks to the ECB and
opportunities for hedge funds looking to bet on widening credit spreads.
Greece:
Kyle Jacobsen Updated as of 5/26/18

In a risky European economic picture, Greece offers little sanctuary for investors. While the
country currently has muted political risks in comparison to its European counterparts, the data
points keep Greece unattractive. The unemployment rate sits at 20.9%, GDP growth remains at
1.3% Y-o-Y, and projected CPI is approximately 0.9% Y-o-Y. The combination of weak
economic data and the impending reduction of liquidity from the ECB reinforces the negative
backdrop in Greece.
Spain:
Spain experienced a neutral start to 2018 with solid GDP growth (3.1% Y-o-Y), lower
unemployment, and favorable financing conditions. However, these positive factors were
overshadowed by the political uncertainty following the secession crisis in Catalonia, Spain. On
May 25th, the political worries were realized as Prime Minister Mariano Rajoy began to receive
pressure to call for a snap election from the majority socialist party. Both the socialist party and
members of Rajoy’s party are pressing the Prime Minister towards a no-confidence motion (a
vote determining if a leader can continue to serve) or snap election. The Spanish IBEX 35 index
fell 2.6% on the news to 9,810 points, while the 10-year government bond yield climbed 8 bps to
1.47%.
Germany:
Following her fourth term of reelection, Angela Merkel has assisted in stabilizing the German
economy and encouraging relations with key trade partners. The cold spell hurting European
cyclical trade caused German GDP to fall to 0.3% for Q1 2018. GDP data aside, CPI sits at 1.6%
Y-o-Y and unemployment is low at 3.6%. The 10-year German Bund yield has been relatively
flat YTD at 46 bps. Germany is likely to lose attention to the governments offering higher risk-
adjusted yields. Overall, the country remains of the most stable in Europe and will be a key
negotiator during ongoing Brexit proposals.

Core EM
Brazil:
Brazil drew the attention of equity investors through Q1 as the Bovespa Index is up 8.6% YTD.
The BRL/USD spot has fallen from approximately 0.3150 at the beginning of the year to 0.2739
currently. Key metrics like CPI are at 1.7% Y-o-Y, unemployment has crept up to 13.1% overall,
Q1 GDP growth underperformed estimates at 2.1% Y-o-Y. The fundamental picture remained
solid and spurred the Banco Central de Brasil to leave overnight rates (SELIC) unchanged at 650
bps.
The stability in Brazil was disrupted recently as trucker unions went on strike and effectively
restricted the flow of goods to San Paulo. The immediate effect was felt as highways were
blocked, fuel shortages limited air travel, and food shortages have caused outrage in Brazil’s
largest city. Shares of infamous oil giant Petrobras (PBR) have shed nearly 20% as exports are
blocked until protests alleviate. On May 25th, a 15-day agreement was reached with some truck
Kyle Jacobsen Updated as of 5/26/18

unions to halt strikes while negotiations surrounding diesel prices occur. Overall, Brazil
experienced a fantastic run in Q1, but the trucker strikes could drastically hurt valuations in the
coming weeks.
Russia:
Russia has performed marginally in the face of sanctions and weakness of financial institutions.
However, estimated annual GDP growth is still above 2% and high energy prices have
contributed to 1.2% YTD equity returns (RTS Index). Inflation is expected to fall to 2.7% (CPI)
and the unemployment rate has remained flat at 5.5% suggesting two more key repo rate cut by
year-end.
India:
One of last year’s best EM performers has been battling multiple headwinds to maintain equity
gains throughout 2018. Meanwhile, the stronger U.S. dollar and higher oil prices are both driving
the Indian Rupee lower. The USD/INR spot started the year at 63.30 (inr) and trades at 67.77
today. The BSE Sensex is up 2.5% YTD and has been backed by reliable corporate activity and
an absence of data surprises. The developments in Russia and a potential OPEC dismantling
could allow India to outperform in the mid-term.
China:
China started 2018 as expected after widespread expectations of deleveraging and economic
restructuring. With President Xi prioritizing less credit speculation, equities trended lower
(Shanghai Comp. is trading at 3,140 pts and down 5% YTD) even as Q1 GDP beat estimates at
6.8% Y-o-Y. The dollar to Yuan pair has traded in a narrow range throughout the year with
USD/CNY at 6.392.
The greatest mid-term driver within China is the ongoing trade war with the United States. The
initial proposed 25% import tariff on steel, soybeans, and 10% on aluminum by Trump was met
with a wave of retaliation tariffs from China. The heated relations have been moderating in the
past few weeks as Trump recently reached a deal that could limit the effect of tariffs on ZTE
which is one of China’s largest telecom firms. The trade war is currently on hold as Trump has
until early June to renegotiate the terms of the imposed tariffs. As the world’s largest steel
exporter, China would lose a drastic amount of revenue to U.S. steel producers if an agreement
isn’t reached. U.S. automakers and soybeans farmers are also some notable losers from the
continuation of the tariff. Overall, the Chinese crackdown on debt is systematically cooling the
economy, but any unfavorable outcomes from a trade war with the U.S. could drive down GDP
and the Shanghai composite into year-end.
Japan
Japan is likely to join the list of countries who will keep monetary conditions constant
throughout 2018. Japanese Q1 GDP missed expectations at 0.9% Y-o-Y. The May 25th release
of Tokyo core CPI also underwhelmed investors at 0.4% Y-o-Y. The political front appears calm
under Prime Minister Abe and shouldn’t cause any unexpected policy shifts. At this stage, the
Kyle Jacobsen Updated as of 5/26/18

Bank of Japan (BoJ) is unlikely to change its overnight rate (- 10 bps) being so far from target
conditions. The USD/JPY (spot: 109.750) pair will still serve as a risk-off trade in times of U.S.
escalations with China and North Korea.
Oil
Crude has continued upward momentum since breaking through WTI resistance levels of $66.30
established in late January (see figure 4). U.S. E&P companies are enjoying profitable
production levels with crude above the breakeven point (approx. $52/bbl). The disconnect
between Brent and WTI is continuing as Brent trades $7 higher on average. Currently, WTI is
trading at $67.48 and Brent sits at $76.13. EIA estimated global demand remains high and
weekly crude inventory data has remained rangebound between -5M and +5M since January
2018.
Figure 4 (WTI Crude YTD performance with trendline at old resistance):

The greatest long-term threat to oil prices from a fundamental perspective is the rebound of the
dollar. Oil and the USD typically have an inverse relationship that is currently being
overshadowed by geopolitical developments in the Middle East. The near-term catalysts for
crude oil appear to be Iranian relations and a changing of the OPEC agreement. Following
Trump’s decision to withdrawal from the denuclearization accord, crude reacted positively at the
potential for future reduction of Iranian production and exports. Shortly following Trump’s
decision oil prices spiked past $70/bbl. at the probability of oil export reductions from Iran. On
May 24th, the rally reversed as Russia (Non-OPEC) reported it would begin talks with Saudi
Kyle Jacobsen Updated as of 5/26/18

Arabia and other OPEC producers about changing the current production agreement. Currently,
OPEC has limited production to around 32 million barrels per day. After seeing the U.S. ramp up
production for the past two years it is likely that the current agreement will be changed when
OPEC meets in Vienna on June 22nd.
Overall, baseline demand for crude could draw investors to an overly bullish stance heading into
year-end. With a high probability of OPEC increasing production, developments in Russia, and a
rebounding dollar I personally hold a 2018 price target of $58-$62 for WTI. Holding demand
steady, higher OPEC output and a stronger dollar should weigh prices down to a more realistic
level than currently reflected.

Thank you for reading and enjoy the summer. My normal market summary will resume in
the fall of 2018.