Asset Allocation

Highlights We do not view October's equity downdraft as a signal to further trim risk assets to underweight. Nonetheless, stocks have not yet fallen enough to justify buying either. The economic divergence between the U.S. and the rest of the world is intensifying and showing up in relative EPS trends. We believe earnings growth is set to drop sharply in the Eurozone and Japan. The viciousness of the bond selloff in October is worrying. The good news is that the Treasury curve steepened and the selloff mostly reflected higher real yields, rather than inflation expectations. Both facts suggest that the Treasury rout was reflective of strong U.S. growth, rather than a signal that the Fed is overly restrictive. Our sense is that the fed funds rate has not yet reached the economic choke point, but it is critical to watch for signs of trouble. This month we focus on key monetary indicators. Our "R-Star" indicator is deteriorating, but is not yet in the danger zone for risk assets. It is possible that we will upgrade risk assets back to overweight if stocks in the developed markets cheapen further, as long as our monetary indicators are not flashing red and the U.S. earnings backdrop remains upbeat. However, the risks are formidable and show no signs of abating. Indeed, our global economic indicators continue to deteriorate and we might be headed for a brief manufacturing recession outside of the U.S. A Democratic win in the U.S. mid-terms might spark a knee-jerk equity selloff, but Congress is unlikely to unravel any of the fiscal stimulus currently in place through 2019. The Administration's foreign policy remains a larger risk for equities. Our high conviction view is that President Trump will continue to use a "maximum pressure" approach for Iran and China that will spark additional fireworks. Another growing risk is an oil price spike above US$100/bbl in early 2019, causing significant economic damage. Chinese policy stimulus is underwhelming and the credit impulse remains weak. In the absence of real policy action in China, the prospect of continuing Fed tightening means that it is too early to bottom-fish in emerging markets. The market is still underestimating the U.S. inflation outlook and the amount of Fed tightening over the next 12-18 months. We continue to recommend a neutral stance on global equities (with a preference for developed over emerging markets), a below-benchmark duration bias, and an overweight allocation in cash. Feature October's market action confirmed that we have entered a period of elevated volatility as investors digest the inevitability of rising U.S. interest rates. We do not view the downdraft in equity markets as a signal to further trim risk asset exposure to underweight. Nonetheless, stocks have not yet fallen enough to justify buying either. We took profits and downgraded risk assets to benchmark in June, placing the proceeds into cash. Our primary motivation was the advanced nature of the U.S. economic cycle, stretched valuations, heightened geopolitical tensions, the risk of a Chinese "hard landing" and upside potential for U.S. inflation and global bond yields. We did not foresee a recession either in the U.S. or the other major economies in the near future. Nonetheless, we concluded that the risk/reward balance did not favor staying overweight risk assets. A number of culprits could be blamed for October's pullback, but in reality the market has been primed for some profit-taking for a long while and so any little excuse could have been used by investors to sell. Fed Chair Powell's "long way to go" comment seemed to push the teetering equity market over the edge. He challenged the market's view that the fed funds rate is getting close to neutral, implying that the Fed is not close to pushing the pause button. The Treasury curve steepened as the market discounted a higher cyclical peak in the fed funds rate. Could it be that bond yields have reached a "choke point" where tightening financial conditions are derailing the economic expansion? The global economic deceleration is intensifying, but the U.S. economy still appears to be enjoying solid momentum outside of housing. We do not yet see any major dark clouds forming in the U.S. corporate earnings picture either, as discussed below. Moreover, the bond selloff in October mostly reflected rising real yields (rather than inflation expectations), and the curve steepened. Both facts suggest that the Treasury selloff was reflective of U.S. strong growth, rather than a signal that the Fed is now outright restrictive. Nonetheless, the issue is particularly tricky in this cycle because the equilibrium, or neutral, fed funds rate is undoubtedly somewhat lower than in past expansions. Given the uncertain level of the neutral rate, investors must be on the lookout for signs that interest rates are beginning to bite. Markets And The Fed Cycle BCA has long viewed financial markets through the lens of money and credit. This includes a framework that involves the Fed policy cycle. We begin by decomposing the fed funds rate cycle into four phases based on the interaction between the level of rates and their direction, as follows (Chart I-1 and Chart I-2): Phase I begins with the first rate hike of a new tightening cycle and ends when the fed funds rate crosses above our estimate of the equilibrium rate (shown as a dashed line in Charts I-1 and I-2). Phase II represents the latter stages of the tightening cycle, when the Fed hikes its target rate above equilibrium in a deliberate effort to cool an overheating economy. Phase III represents the early stage of the easing cycle. It begins with the first rate cut from the peak and lasts until the Fed cuts its target rate below equilibrium. Phase IV represents the late stage of the easing cycle. It encompasses both the period when the fed funds rate breaks below its equilibrium level until it bottoms. Chart I-1Stylized Fed Rate Cycle Chart I-2Fed Funds Rate And Equilibrium The tough part is estimating the neutral level of the fed funds rate. It is a theoretical concept - the level that is consistent with an economy at full employment with no upward or downward pressure on inflation or growth. The Fed lifts the fed funds rate above neutral when it wishes to dampen the economy and temper inflationary pressure. Economic theory ties the equilibrium interest rate to the pace of expansion of the supply side of the economy, or potential GDP growth. Our approach is to combine the CBO's estimate of potential GDP growth with a smoothed version of the actual fed funds rate, to account for the fact that the equilibrium rate periodically deviates from potential growth. The historical track record of this framework is compelling. The latest update of our analysis of equity returns during the four phases was published by BCA's U.S. Investment Strategy Service.1 The level of the fed funds rate relative to its equilibrium has mattered much more than the direction of rates for historical S&P 500 price returns (Table I-1 and I-2). Price returns during Phases I and IV (when the fed funds rate is below equilibrium) trounce returns during Phases II and III (when the funds rate is in restrictive territory). This is especially the case after adjusting returns for inflation. Table I-1Tight Policy Is Hazardous To Stocks' Health, ... Table I-2...Especially In Real Terms Further breaking down the historical returns into 12-month forward EPS estimates and 12-month forward multiples, it turns out that multiples usually contract when the Fed is tightening. However, during Phase I this is more than offset by the increase in forward earnings estimates, such that equity investors enjoy positive returns until rates move into restrictive territory in Phase II. Our sense is that we are still in Phase I, implying that it is too early to expect more than a correction in risk assets based solely on the U.S. monetary policy cycle. The fed funds rate has been rising, but so too has the equilibrium rate according on our measure. Powell's latest comments suggest that the Fed agrees. That said, it is a cliche to say that this cycle has been different in many ways. Nobody knows exactly where the neutral rate is today. This means that we must be on watch for signs that the fed funds rate has already crossed into restrictive territory. We looked at the behavior of a raft of monetary and credit indicators around the time that the fed funds rate broke above the estimated neutral rate in the past. None of them have been reliable across all business cycles since the 1970s, but the best ones are shown in Chart I-3: Growth in M1 generally begins to decelerate as the fed funds rate approaches neutral and falls into negative territory shortly thereafter. Bank liquidity is defined as short-term assets as a percent of total bank credit. It usually peaks just before rates become restrictive, and begins to fall quickly as the fed funds rate surpasses the equilibrium level. We interpret bank liquidity as a proxy for banks' willingness to provide funding liquidity that enables institutional investors to take positions. The peak level of bank liquidity differs across tightening cycles, but it is never a good sign when it begins to trend lower. Consumer credit growth has a somewhat spotty track record as an indicator of monetary restraint, but it has often peaked around the time that the Fed enters Phase II. The BCA Fed Monitor is an indicator designed to gauge the pressure on the Fed to adjust policy one way or the other. It generally peaks in "tight money required" territory just before, or coincident with, the shift from Phase I to Phase II. A shift of the Monitor into "easy money required" territory would suggest that policy has become outright restrictive, and that a peak in the fed funds rate is approaching. Chart I-3BCA R-Star Indicator And Its Components Combining the four into one indicator removes some of the noise of the individual series. The BCA "R-Star" Indicator is shown in the top panel of Chart I-3. A dip in this indicator below the zero line would warn that we have entered Phase II and that the equity bull market is out of time. Chart I-4 shows the BCA R-Star indicator again, along with the S&P 500, EPS growth and profit margins. It is shaded for periods when the R-Star indicator is below zero. The lead time has varied across the economic cycles and it is far from a perfect predictor. Nonetheless, when the indicator is negative it has generally been associated with falling stock prices, decelerating profit growth and eroding profit margins. The indicator has edged lower this year, but is not yet in the danger zone. Chart I-4BCA R-Star Indicator And The U.S. Profit Cycle Finally, we are of course watching the yield curve. Its recent steepening suggests that U.S. growth justifies higher bond yields and that policy has not yet become outright restrictive. Global Growth Divergence Continues... We do not see compelling evidence from the flow of U.S. economic data that higher rates are derailing the expansion, although there are a couple of worrying signs, suggesting that growth has peaked. The backdrop is quite supportive for consumer spending: tax cuts, robust employment gains, rising wages and elevated confidence. The fact that the household saving rate is relatively high means that consumers have the wherewithal to boost the pace of spending if they wish. Motor vehicle sales have moderated, but this is to be expected when the economic cycle is advanced. The replacement cycle for U.S. business investment still has further to run. The average age of the non-residential housing stock is the highest since 1963. Both capex intention surveys and the recent easing in lending standards for commercial and industrial loans suggest that U.S. capital expenditures will be well supported, although there has been some softness in the former recently (Chart I-5). Chart I-5U.S. Capex Outlook Is Bright That said, the soft U.S. housing data are a concern, especially because a peak in residential investment as a share of GDP has been a good (albeit quite early) leading indicator of recessions. It is difficult to fully explain why housing is losing altitude given all the tailwinds supporting demand, including solid household formation (see last month's Overview). Mortgage rates have increased but affordability is still favorable. It could be that the supply side, rather than demand, is the problem: tight lending standards, zoning restrictions and the high cost of building. Still, a continued housing downtrend relative to GDP would be a challenge to our view that there will be no recession in 2019. While the U.S. economy is enjoying strong momentum, the same cannot be said for the rest of the global economy. A raft of items has weighed on CEO confidence outside of the U.S., including trade wars, a strong dollar, rising oil prices, emerging market turbulence, the return of Italian debt woes and the continuing slowdown in the Chinese economy. The global PMI is beginning to erode from a high level (Chart I-6). The softening in world activity appears to be concentrated in capital spending. Growth in capital goods imports for an aggregate of 20 countries continues to decelerate, along with industrial production for capital goods and machinery & electrical equipment in the major advanced economies. Chart I-6Global Capex Is Softening Meanwhile, our favorite global leading indicators are flashing red (Chart I-7). BCA's Global LEI has broken below the boom/bust line and its diffusion index suggests further downside. The Global ZEW and the BCA Boom/Bust indicator are holding just below zero. The global credit impulse is also still pointing down. Chart I-7Global Leading Indicators Flashing Red Among the advanced economies, Europe and Japan are most vulnerable to the slowdown in global trade and capital spending. Industrial production growth has already stalled in both economies and their respective LEIs are heading south fast (Chart I-8). Chart I-8Global Divergence ...Affecting Relative Earnings Trends It is thus not surprising that corporate EPS growth has peaked in the Eurozone and Japan. The macro data that drive our top-down EPS growth models suggest that the profit situation is going to deteriorate quickly in the coming quarters. The peak in industrial production growth suggests that the corporate top line will lose more steam. Meanwhile, nominal GDP growth has decelerated sharply in both economies, in absolute terms and relative to the aggregate wage bill (Chart I-9). These trends suggest that profit margins are coming under significant downward pressure. Even when we build in a modest growth pickup and slight rebound in margins in 2019, EPS growth falls close to zero by year-end according to our model (Chart I-10). Chart I-9Diverging Macro Trends... Chart I-10...Implies Different EPS Outlook The earnings situation is completely different in the U.S. It is still early in Q3 earnings season, but company reports have been upbeat so far. The macro variables that feed into our top-down U.S. EPS model point to both continuing margin expansion and robust top line growth (Chart I-9). Nominal GDP growth has surged to more than 5% on a year-ago basis, while the expansion in the economy's wage bill has been steady at under 5%. It is also very impressive that industrial production growth continues to accelerate, bucking the global trend. We assume that U.S. GDP growth moderates from this year's hectic pace in 2019, but stays well above-trend because of the lingering fiscal tailwind. Impressively, the indicators we are following suggest that S&P 500 profit margins still have some upside potential, at least in the next quarter or two (Chart I-11). Nonetheless, we make the conservative assumption that margins will narrow somewhat in 2019. Plugging this macro scenario into our model, it suggests that EPS growth will decelerate to a still-solid 10% pace by the end of 2019. The impact on corporate profits from the rise in bond yields so far will be minimal. It is only now that the yield on the average corporate bond has reached the average coupon on outstanding debt. This means that it will require further increases in yields from here to have any meaningful impact on corporate interest expense. Chart I-11U.S. Margin Indicators Still Upbeat The U.S. economic and earnings backdrop is robust enough that we would be tempted to upgrade our risk asset allocation back to overweight if the S&P 500 moves even lower in the near term. Nonetheless, a number of key risks keep us at benchmark for now. (1) U.S. Foreign Policy The U.S. mid-term election is less than two weeks away as we go to press. Our geopolitical team places the odds of a Democratic House takeover at 65%, and the odds of a Senate takeover at 40%. Investors should expect a knee-jerk equity selloff if the Democrats manage to grab both parts of Congress. However, any damage to risk assets should be fleeting because the Democrats would not be able to unravel any of President Trump's main economic policies. Voters are not demanding budget discipline from either party, despite the surging federal deficit (Chart I-12). We highlighted in a recent Special Report that we foresee little political backlash against fiscal profligacy because of the shift-to-the-left by the median voter.2 The Trump tax cuts are here to stay. Chart I-12No Political Backlash To Big Deficits In fact, our geopolitical team argues that the odds would increase for an infrastructure plan and even of an immigration deal, if President Trump comes to the middle ground on some of his demands.3 The implication is that fiscal policy will remain highly stimulative in 2019, before the initial thrust begins to wear off in 2020. The Administration's foreign policy, however, remains a key risk for equities. Our high conviction view is that President Trump will continue pursuing unorthodox foreign and trade policies regardless of the midterm outcome. The just-announced 10% tariff on $200 billion of Chinese imports confirms our alarmist view on trade tensions. President Trump has threatened to lift the tariff to 25% by the end of the year in order to pile even more pressure on Beijing. This would represent a significant escalation in the trade war, one that we do not expect Chinese policymakers to simply roll over and accept. The risk is that the Chinese government not only hikes tariffs on U.S. exports, but also retaliates against U.S. firms with operations in China. Even more dangerously, a trade war with China could escalate into a military conflict in the South China Sea. Meanwhile, the U.S. embargo on Iranian oil exports will officially begin on November 4, just two days before the midterm election. We expect President Trump to turn the screws on Iranian exports in ways that President Obama did not. Once the election is out of the way, President Trump will refocus on his "maximum pressure" tactic, which he believes led to a breakthrough with North Korea. Unfortunately for the markets, we do not expect that this tactic will work as smoothly with Iran and China. (2) Rising Probability Of An Oil Shock The Administration's pressure on Iran adds to the already high risk of an oil price spike above US$100 per barrel in early 2019. While oil demand growth is slowing somewhat, exports from two of OPEC's largest producers - Iran and Venezuela - are falling precipitously. Global oil inventories are drawing down, while spare capacity is perilously low, leaving little in the way of readily available backup supply to deal with an unplanned production outage. The confluence of these factors is setting the global oil market up for a supply shock according to our energy experts (Chart I-13). Chart I-13Increasing Risk Of An Oil Spike It is important to differentiate between a steady demand-driven rise in the price of oil and a rapid supply-driven oil price spike. The former can be bond-bearish by forcing inflation expectations higher at a time when strong economic growth is also pushing up real bond yields. Nonetheless, equity prices could continue rising in this scenario as the robust economic backdrop outweighs the impact of higher yields. In contrast, an oil price spike that is driven by supply restrictions might initially be negative for bond prices, but ultimately would produce a deflationary impulse by depressing real economic activity. It could even be the catalyst for a recession. A supply-driven oil spike would be outright bearish for risk assets and may prove to be the trigger for a shift from benchmark to underweight for global stocks and corporate bonds. The risk facing corporates in the next economic downturn is one of the topics covered in this month's Special Report, beginning on page 21. The report looks at the structural changes to the economy and financial markets that have occurred because of the Great Recession and financial crisis. (3) EM Pain Is Not Over In the absence of policy stimulus in China, the prospect of continuing Fed tightening means that it is too early to bottom-fish in emerging markets. Emerging Asia is at the epicenter of the global trade and capital spending slowdown. The sharp deceleration in Taiwanese and Korean export growth rates suggests that growth in world industrial production and forward earnings estimates are not yet near a bottom (Chart I-14). Chart I-14Asian Exports Softening... Softening Chinese domestic demand is adding to the gloom. Chart I-15 shows that efforts by the Chinese authorities to curtail corporate debt have been bearing fruit. In response to the regulatory and administrative tightening, smaller financial institutions are not building up the working capital required to expand their loan book. As a result, the Chinese credit impulse remains weak and shows no sign of a bottom, despite the uptick in the latest reading on M3 growth. Chinese policy stimulus is underwhelming, confirming the view we expressed in the September BCA Overview. Xi Jinping has not yet abandoned his structural goals and shadow bank crackdown, which are weighing on overall credit expansion. Chart I-15...And No Growth Impulse From China Second, EM financial conditions continue to tighten (Chart I-15). Our currency strategists point out that many factors lie behind this deterioration in the EM financial conditions index, including the collapse in performance of carry trades, the dollar's ascent, and rising U.S. interest rates that are boosting the cost of servicing foreign currency EM debt. In turn, tighter EM financial conditions are contributing to the global manufacturing slowdown in a self-reinforcing negative feedback loop. EM Asia is particularly at risk to this loop, but Europe, Japan and commodity producers are also vulnerable. Some market commentators have argued that the Fed will soon have to back off its rate hike campaign in the face of global financial market stress. However, the FOMC's pain threshold is higher than at any time since the Great Recession because the domestic economy is showing signs of overheating. The correction in risk assets would have to get a lot worse before the Fed blinks. Meanwhile, the U.S. again passed on the chance to label China a currency manipulator. This opens the door to another downleg in the RMB, especially if the U.S./China trade war escalates. Additional RMB weakness would spell more trouble for EM assets. The implication is that any bounce in EM currencies or asset prices represents a selling opportunity for those investors not already short. Our EM strategists expect at least another 15% drop in share prices before the risk-reward profile of this asset class improves. (4) Italian Debt Crisis The main problem with the Italian economy is that the private sector saves too much and spends too little. A shrinking population has reduced the need for firms to invest in new capacity. Unlike Germany, Italy cannot export its savings to the rest of the world through a large trade surplus because it does not have a hypercompetitive economy. Nor can the Italian government risk running afoul of the bond vigilantes by emulating Japan's strategy of absorbing private-sector savings with large budget deficits. The implication is that Italy is stuck in a low-growth trap that is feeding political pressure to shed the EU's fiscal straight jacket. We believe that the populist government will be the first to blink, but it may require more bouts of financial stress to force capitulation. A 4% level on the 10 year BTP yield is a likely threshold for a compromise. Above that level, Italian banks become insolvent based on the market value of their holdings of Italian debt. In the meantime, rising global bond yields worsen Italy's tenuous financial situation, with possible contagion into global financial markets. Investment Conclusions: The U.S. bond market is waking up to the likelihood that U.S. short-term rates are going higher than previously expected, suggesting that recent investment themes will persist for a while longer. We continue to recommend a neutral stance on global equities (with a preference for developed over emerging markets), a below-benchmark duration bias, and an overweight allocation in cash. The bond market is only priced for the Fed to maintain its quarterly rate hike pace until June of next year (Chart I-16). Investors judge that some combination of tepid global economic momentum and tame U.S. core inflation temper the Fed's need or ability to take rates much higher. We disagree, based our own assessment of the U.S. economy and our out-of-consensus inflation view (see this month's Special Report). Rising volatility and/or a weaker global growth pulse are unlikely to prompt the Fed to bail out of its tightening campaign as quickly as it did in early 2016. Chart I-16Market Expectations For The Fed Still Too Complacent Meanwhile, our indicators suggest that the divergence between the red-hot U.S. economy and cooling global activity will continue, implying more upside potential for the U.S. dollar. We expect another 5-10% rise against most currencies, with the possible exception of the Canadian dollar. It is difficult to identify a "choke point" for bond yields in advance. A 10-year Treasury yield north of 3.7% might cause us to call the peak in yields and to become even more defensive on risk assets, but it will be critical to watch our monetary indicators. Indeed, we would be tempted to upgrade stocks back to overweight if the global selloff progresses much further, in the absence of negative reading from the monetary indicators or an inverted yield curve. The earnings backdrop will continue to be a tailwind for the U.S. equity market at least into early 2019. In contrast, profit growth in the Eurozone and Japan is set to disappoint market expectations. The U.S. equity market will therefore outperform, particularly in unhedged terms. Stay at benchmark on corporate bonds versus governments in the U.S. and Eurozone. Avoid emerging market assets and commodities. The main exception is oil, which is increasingly at risk of a spike above $100/bbl. Mark McClellan Senior Vice President The Bank Credit Analyst October 25, 2018 Next Report: November 29, 2018 1 Please see U.S. Investment Strategy Special Report "Revisiting The Fed Funds Rate Cycle," dated September 3, 2018, available at usis.bcaresearch.com 2 Please see The Bank Credit Analyst "U.S. Fiscal Policy: An Unprecedented Macro Experiment," dated July 2018, available at bca.bcaresearch.com 3 Please see BCA Geopolitical Strategy Weekly Report "A Story Told Through Charts: The U.S. Midterm Election," dated September 19, 2018, available at gps.bcaresearch.com II. The Long Shadow Of The Financial Crisis The Great Recession and financial crisis cast a long shadow that will affect economies, policymakers and investors for years to come. The roots of the crisis are already well known. The first of a two-part series looks forward by examining the areas where we believe structural change has occurred related to the economy or financial markets. First, the financial crisis transformed the corporate bond market in several ways that heighten the risk for quality spreads in the next downturn. Debt and market liquidity are two key concerns. Corporate leverage will not cause the next recession. Nonetheless, when one does occur, corporate spreads in the U.S. and (to a lesser extent) the Eurozone will widen by more for any given degree of recession. This reflects a low interest coverage ratio, poor market liquidity, the downward trend in credit quality and covenant erosion. Second, the shock of the Great Recession and its aftermath appears to have affected the relationship between economic slack and inflation. Firms have been extra reluctant to grant wage gains. However, we argue that the "shell shock" effect will wane. The fact that inflation has been depressed for so long may actually cultivate the risk that inflation will surprise on the upside in the coming years. Investors should hold inflation-protection in the inflation swaps market, or by overweighting inflation-linked bonds versus conventional issues. Third, the events of the last decade have left a lasting impression on monetary policymakers. They will err on the side of allowing the economy to overheat and inflation to modestly overshoot the target in the major economies, despite signs of financial froth. The Fed will respond only with a lag to the current fiscally-driven surge in U.S. growth, leading to a boom/bust economic scenario. Central bankers will have no trouble employing unorthodox policies again in the future, and will be willing to push the boundaries even further during the next recession. Expect aggressive manipulation of the long-end of the yield curve when the time arrives to ease policy. We may also observe more coordination between monetary and fiscal policies. Fourth, global bond yields fell to unprecedented levels, reflecting both structural and cyclical headwinds to demand growth. A dismal productivity performance is another culprit. Productivity growth is poised to recover to some extent, while some of the growth headwinds have reached an inflection point. We do not expect nominal bond yields to return to pre-Lehman norms, and yields could even fall back to previous lows in the case of a recession. Nonetheless, we expect a yield pattern of higher lows and higher highs over the coming business cycles. The 10-year anniversary of the Lehman shock this autumn sparked an avalanche of analysis on the events and underlying causes of the Great Recession and financial crisis. It is a woeful story of greed, a classic bubble, inadequate regulation, new-fangled financial instruments, and a globalized financial system that spread the shock around the world. The crisis cast a long shadow that will affect economies, policymakers and investors for many years to come. The roots of the crisis are well known, so we will not spend any time going over well-trodden ground. Rather, this Special Report looks forward by examining the areas where we believe structural change has occurred related to the economy or financial markets. In Part I, we cover the corporate bond market, the inflation outlook, central bank policymaking and equilibrium bond yields. Part II will look at the debt overhang, systemic risk in the financial sector, asset correlations, the cult of equity and the rise of populism. While not an exhaustive list, we believe these are the key areas of structural change. (1) Corporate Bond Market: Leverage And Downgrade Risk The financial crisis transformed the corporate bond market in several ways that heighten the risk for quality spreads in the next downturn. Debt and market liquidity are two key concerns. An extraordinarily long period of extremely low interest rates was too much for corporate CEOs to pass up. However, because the durability of the economic recovery was so uncertain, it seemed more attractive to hand over the borrowed cash to shareholders than to use it to aggressively expand productive capacity. The ongoing equity bull market rewarded CEOs for the financial engineering, serving to create a self-reinforcing feedback loop. And so far, corporate bondholders have not policed this activity. The result is that the U.S. corporate bond market has grown in leaps and bounds since 2009 (Chart II-1A and Chart II-1B). The average duration of the Bloomberg Barclays index has also risen as firms locked in attractive financing rates. The same is true, although to a lesser extent, in the Eurozone. Chart II-1AU.S. BBB-Rated Share Rising... Chart II-1B...Same In The Eurozone Balance sheet health is obviously not the key driver of corporate bond relative returns at the moment. Nonetheless, investors will begin to worry about the growth outlook if interest rates continue to rise. The U.S. national accounts data suggest that interest coverage remains relatively healthy, but this includes large companies such as some of the FAANGs that have little debt and a lot of cash. The national accounts data are unrepresentative of the companies that are included in the Bloomberg Barclays corporate bond index, which are heavy debt issuers. To gain a clearer picture, we calculated a bottom-up Corporate Health Monitor (CHM) for a sample of U.S. companies that provides a sector and credit-quality composition that roughly matches the Bloomberg Barclay's index. The CHM is the composite of six critical financial ratios. Chart II-2 highlights that the investment-grade (IG) CHM has improved over the past two years due to the profitability sub-components. However, the debt/equity ratio has been in a steep uptrend. Interest coverage does not appear alarming by historical standards at the moment, but one can argue that it should be much higher given the extremely low average coupon on corporate bonds, and given that profit margins are extraordinarily high in the U.S. The rapid accumulation of debt has overwhelmed these other factors. Evidence of rising leverage is broadly based across sectors and ratings. Chart II-2U.S. IG Corporate Health Unfortunately, the profit tailwind won't last forever. At some point, earnings growth will stall and this cycle's debt accumulation will start to bite in the context of rising interest rates. To gauge the risk, we estimate the change in the interest coverage ratio over the next three years for a 100 basis-point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt.1 For our universe of Investment-grade U.S. companies, the interest coverage ratio would drop from a little over 7 to under 6, which is close to the lows of the Great Recession (denoted as "x" in Chart II-3). Of course, the decline in interest coverage will be much worse if the Fed steps too far and monetary tightening sparks a recession. The "o" in Chart II-3 denotes the combination of a 100 basis-point interest rate shock and a mild recession in which the S&P 500 suffers a 25% peak-to-trough decline in EPS. The overall interest coverage ratio plunges close to all-time lows at 4½. Chart II-3Interest Coverage To Plunge... These simulations imply that, for any given size of recession, the next economic downturn will have a larger negative impact on corporate health than in the past. Rating agencies have undertaken some downgrading related to shareholder-friendly activity, but downgrades will proliferate when the agencies realize that the economy is turning and the profit boom is over (Chart II-4). Banks will belatedly tighten lending standards, adding to funding pressure for the corporate sector. Chart II-4...And Ratings To Be Slashed Fallen Angels The potential for a large wave of fallen angels means that downgrade activity will be particularly painful for corporate bond investors. The surge in lower-quality issuance has led to a downward trend in the average credit rating and has significantly raised the size of the BBB-rated bonds relative to the IG index and relative to the broader universe of corporate bonds including high yield (Chart II-5, and Chart II-1A).2 The downward trend in credit quality predates Lehman, but events since the Great Recession have likely reinforced the trend. Chart II-5Lower Ratings And Longer Duration Studies show that bonds that get downgraded into junk status can perform well for a period thereafter, suggesting that investors holding a fallen angel should not necessarily sell immediately. Nonetheless, the process of transitioning from investment-grade to high-yield involves return underperformance as the spread widens. Poor market liquidity and covenant erosion will intensify pressure for corporate spreads to widen when the bear market arrives. Market turnover has decreased substantially since the pre-Lehman years, especially for IG (Chart II-6). The poor liquidity backdrop appears to be structural, reflecting regulation that has curtailed banks' market-making activity and prop trading, among other factors. Chart II-6Poor Market Liquidity The Eurozone corporate bond market has also seen rapid growth and a deterioration in the average credit rating. Liquidity is an issue there as well. That said, the Eurozone corporate sector is less advanced in the leverage cycle than the U.S. Interest coverage ratios will fall during the next recession, but this will be concentrated among foreign issuers - domestic issuers are much less at risk to rising interest rates and/or an economic downturn.3 Bottom Line: Corporate leverage will not cause the next recession. Nonetheless, when one does occur, corporate spreads in the U.S. and (to a lesser extent) Eurozone will widen by more for any given degree of recession. Current spreads do not compensate for this risk. (2) Inflation Undershoot Breeds Overshoot Inflation in the U.S. and other developed economies has been sticky since the financial crisis. First, inflation did not fall as much in the recession and early years of the recovery as many had predicted, despite the worst economic contraction in the post-war period. Subsequently, central banks have had trouble raising inflation back to target. In the U.S., core PCE inflation has only recently returned to 2%. Several structural factors have been blamed, but continuing tepid wage growth in the face of a very tight labor market raises the possibility that the inflation-generating process has been fundamentally altered by the Great Recession. In other words, the relationship between slack in the labor market (or market for goods and services) and inflation has changed. In theory, inflation should rise when the economy's output is above its potential level or when the unemployment rate is below its full-employment level. Inflation should fall when the reverse is true. This means that the change (not the level) in inflation should be positively correlated with the level of the output gap or the labor market gap. Chart II-7 presents the change in U.S. core inflation with the output gap. Although inflation appears to have become less responsive to shifts in the output gap after 1990, it has been particularly insensitive in the post-Lehman period. Chart II-7The U.S. Phillips Curve: RIP? One reason may be that the business sector was shell-shocked by the Great Recession and financial crisis to such an extent that business leaders have been more reluctant to grant wage gains than in past cycles. Equally-unnerved workers felt lucky just to have a job, and have been less willing to demand raises. Dampened inflation expectations meant that low actual inflation became self-reinforcing. We have some sympathy with this view. Long-term inflation expectations have been sticky at levels that are inconsistent with the major central banks meeting their inflation targets over the long term. This suggests that people believe that central banks lack the tools necessary to overwhelm the deflationary forces. The lesson for investors and policymakers is that, while unorthodox monetary policies helped to limit the downside for inflation and inflation expectations during and just after the recession, these policies have had limited success in reversing even the modest decline that did occur. That said, readers should keep in mind a few important points: One should not expect inflation to rise much until economies break through their non-inflationary limits. The major advanced economies have only recently reached that point to varying degrees; Inflation lags the business cycle (Chart II-8). This is especially the case in long 'slow burn' economic expansions, as we have demonstrated in previous research; and The historical relationship between inflation and economic slack has been non-linear. As shown in Chart II-9, U.S. inflation has tended to accelerate quickly when unemployment drops below 4½%. Chart II-8U.S. Inflation Lags The Cycle Chart II-9A Kinked Phillips Curve Shell Shock Is Fading We believe that the "shell shock" effect of the Great Recession on inflation will wane over time. Indeed, my colleague Peter Berezin has made the case that the fact that inflation has been depressed for so long actually cultivates the risk that inflation will surprise on the upside in the coming years.4 Central bankers have been alarmed by the economic and financial events of the last decade. They also cast a wary eye on Japan's inability to generate inflation even in the face of massive and prolonged monetary stimulus. Policymakers at the FOMC are determined to boost inflation and inflation expectations before the next economic downturn strikes. They are also willing to not only tolerate, but actively encourage, an overshoot of the 2% inflation target in order to ensure that long-term inflation expectations return "sustainably" to a level consistent with meeting the 2% target over the long term. In other words, the Fed is going to err on the side of too much stimulus rather than too little. This is an important legacy of the last recession (see below). Meanwhile, other structural explanations for low inflation are less powerful than many believe. For example, globalization has leveled off and rising tariff and non-tariff barriers will hinder important global supply chains. Our research also suggests that the rising industrial use of robots and the e-commerce effect on retail prices have had only a small depressing effect on U.S. inflation. Bottom Line: The Phillips curve relationship has probably not changed in a permanent way since Lehman went down. It is quite flat when the labor market is not far away from full employment, but the relationship is probably non-linear. As the unemployment rate drops further, the business sector will have no choice but to lift wages as labor becomes increasingly scarce. The kinked nature of the Phillips curve augments the odds that the Fed will eventually find itself behind the curve, and inflation will rise more than the market is expecting. The same arguments apply to the Bank of England and possibly even the European Central Bank. Gold offers some protection against inflation risk, but the precious metal is still quite expensive in real terms. Investors would be better off simply buying inflation-protection in the inflation swaps market or overweighting inflation-linked bonds over conventional issues. (3) Monetary Policy: Destined To Fight The Last War There are several reasons to believe that the shocking events of the crisis and its aftermath have left a lasting impression on monetary policymakers. Several factors suggest that they will err on the side of allowing the economy to overheat and inflation to modestly overshoot the target: Inflation Persistence: As discussed above, there is a greater awareness that it is difficult to lift both actual inflation and inflation expectations once they have fallen. Some FOMC members believe that long-term inflation expectations are still too low to be consistent with the Fed meeting its 2% inflation target over the long term. A modest inflation overshoot in this cycle would be beneficial, according to this view, in the sense that it would boost inflation expectations and thereby raise the probability that the FOMC will indeed meet its goals over the long term. It might also encourage some discouraged workers to re-enter the labor market. Some policymakers also believe that the Fed is not taking much of a risk by pushing the economy hard, because the Phillips curve is so flat. Zero Bound: Low inflation expectations, among other factors, have combined to dramatically reduce the level of so-called r-star - the short-term rate of interest that is neither accommodative nor restrictive in terms of growth and inflation. R-star is thought to be rising now, at least for the U.S., but it is probably still low by historical standards across the major economies. This increases the risk that policy rates will again hit the lower bound during the next recession, making it difficult for central banks to engineer a real policy rate that is low enough to generate faster growth.5 Fighting the Last War: Memories of the crisis linger in the minds of policymakers. The global economy came dangerously close to a replay of the Great Depression, and policymakers want to ensure that it never happens again. Some monetary officials have argued that a risk-based approach means that it is better to take some inflation risks to limit the possibility of making a deflationary policy mistake down the road. Fears that the major economies are now more vulnerable to deflationary shocks seem destined to keep central banks too-easy-for-too-long. Central bankers will also be quicker and more aggressive in responding when negative shocks arrive in the future. This applies more to the U.S., the U.K. and Japan than the European Central Bank, but even for the latter there has been a clear change in the monetary committee's reaction function since Mario Draghi took over the reins. Financial Stability Concerns Policymakers are also more concerned about financial stability. Pre-crisis, the consensus among the monetary elite was that financial stability should play second fiddle to the inflation target. It was felt that central banks should focus on the latter, and pay attention to signs of financial froth only when they affect the inflation outlook. In practice, this meant paying only lip service to financial excess until it was too late. It was difficult to justify rate increases when inflation was not threatening. It was thought that macro-prudential regulation on its own was enough to contain financial excesses. Today, policymakers see financial stability as playing a key role in meeting the inflation target. It is abundantly clear that a burst bubble can be highly deflationary. Some policymakers still believe that aggressive macro-prudential policies can be effective in directly targeting financial excesses. However, others feel there is no substitute for higher interest rates; as ex-Governor Jeremy Stein stated, interest rates get "in all the cracks". Moreover, the Fed does not regulate the shadow banking sector. The Fed is thus balancing concerns over signs of financial froth against the zero-bound problem and fears of the next deflationary shock. We believe that the latter will dominate their policy choices, because it will still be difficult to justify rate hikes to the public when there is no obvious inflation problem. In the U.S., this implies that the economic risks are skewed toward a boom/bust scenario in which the FOMC is slow to respond to a fiscally-driven late cycle mini-boom. Inflation and inflation expectations react with a lag, but a subsequent acceleration in both forces the Fed to aggressively choke off growth. Policy Toolkit Central bankers will be quite willing to employ their new-found policy tools again in the next recession. The new toolbox includes asset purchases, aggressive forms of forward guidance, negative interest rates, and low-cost direct lending to banks and non-banks in some countries. Policymakers generally view these tools as being at least somewhat effective, although some have argued that the costs of using negative interest rates have outweighed the benefits in Europe and Japan. The debate on how to deal with the zero-bound problem in the U.S. has focused on lifting r-star, including raising the inflation target, adopting a price level target, policies to boost productivity, and traditional fiscal stimulus. Nonetheless, ex-Fed Chair Yellen's comments at the Jackson Hole conference in 2016 underscored that it will be more of the same in the event that the zero bound is again reached - quantitative easing and forward guidance.6 No doubt, the major central banks will rely heavily on both of these tools in order to manipulate yields far out the curve. Forward guidance may be threshold-based. For example, policymakers could promise to keep the policy rate frozen until unemployment or inflation reaches a given level. Now that central bankers have crossed the line into unorthodox monetary policy and inflation did not surge, future policymakers will be willing to stretch the boundaries even further in the event of a recession. For example, they may consider price-level targeting, which would institutionalize inflation overshoots to make up for past inflation undershoots. It is also possible that we will observe more coordination between monetary and fiscal policies in the next recession. The combination of fiscal stimulus and a cap on bond yields would be highly stimulative in theory, in part by driving the currency lower. Japan has gone half way in this direction by implementing a yield curve control (YCC) policy. However, it has failed so far to provide any meaningful fiscal stimulus since the yield cap has been in place. It also appears likely that central bank balance sheets will not return to levels as a percent of GDP that existed before the crisis. An abundance of bank deposits at the central bank will help to satisfy a structural increase in the demand for cash-like risk-free assets. Maintaining a bloated balance sheet will also allow central banks to provide substantial amounts of reverse repos (RRPs) into the market, which should improve the functioning of money markets that have been impaired to some degree by regulation. We do not expect that a structural increase in central bank balance sheets will have any material lasting impact on asset prices or inflation. We believe that inflation will surprise on the upside, but not because central banks will continue to hold significant amounts of government bonds on their balance sheets over the medium term. Bottom Line: The implication is that the monetary authorities will have a greater tolerance for an overshoot of the inflation target than in the past. The Fed will respond only with a lag to the fiscally-driven surge in U.S. growth, leading to a boom/bust economic scenario. During the next recession, policymakers will rely heavily on quantitative easing and forward guidance to manipulate the yield curve (after the policy rate reaches the lower bound). (4) Bond Prices: Structural Factors Turning Less Bullish Perhaps the most dramatic and lasting impact of the GFC has been evident in the global bond market. Government yields fell to levels never before observed across the developed countries and have remained extremely depressed, even as the expansion matured and economic slack was gradually absorbed. Real government bond yields are still negative even at the medium and long parts of the curve in the Eurozone and Japan (Chart II-10). It is tempting to conclude that there has been a permanent shift down in global bond yields. Chart II-10Real Yields Still Depressed Equilibrium bond yields are tied to the supply side of the economy. Potential GDP growth is the sum of trend productivity growth and the pace of expansion of the labor force. Equilibrium bond yields may fall below the potential growth rate for extended periods to the extent that aggregate demand faces persistent headwinds. The headwinds in place over the past decade include fiscal austerity, demographics, household deleveraging, increased regulation and lingering problems in the banking sector that limited the expansion of credit, among others. These headwinds either affect the desire to save or the desire to invest, the interplay of which affects equilibrium bond yields. Some of these economic headwinds predate 2007, but the financial crisis reinforced the desire to save more and invest less. Space limitations prevent a full review of the forces that depressed bond yields, but a summary is contained in Appendix 1 and we encourage interested readers to see our 2017 Special Report for full details.7 The Great Supply-Side Shortfall Falling potential output growth in the major advanced economies also helped to drag down equilibrium bond yields. The pace of expansion in the global labor force has plunged from 1¾% in 2005, to under 1% today (Chart II-11). The labor force has peaked in absolute terms in the G7, and is already shrinking in China. Chart II-11Slower Labor Force Expansion... Productivity growth took a dramatic turn for the worst after 2007 (Chart II-12). The dismal productivity performance is not fully understood, but likely reflected the peaking in globalization, increased regulation and the dramatic decline in capital spending relative to GDP. The latter was reflected in a collapse in the growth rate of the global capital stock (Chart II-13). In the U.S., for which we have a longer history of data, growth in the capital stocks has lead shifts in productivity growth with a 3-year lag. Firms have also been slower to adopt new technologies over the past decade. Chart II-12...And Lower Productivity Chart II-13Productivity And Investment The resulting impact on the level of GDP today has been nothing short of remarkable. The current IMF estimate for the level of potential GDP in 2018 is 10% lower than was projected by the IMF in 2008 (Chart II-14). There has been a similar downgrading of capacity in Europe, Japan and the U.K. Actual GDP has closed the gap with potential GDP to varying degrees in the major countries, but at a much lower level than was projected a decade ago. Paul Krugman has dubbed this the "Great Shortfall". Chart II-14A Permanent Loss Of Output The Great Shortfall was even greater with respect to capital spending. For 2017, the IMF estimates that global investment was more than 20% below the level implied by the pre-crisis trend (Chart II-15). Reduced credit intermediation, from a combination of supply and demand factors, was a significant factor behind the structural loss of economic capacity according to the IMF study.8 Chart II-15Permanent Scars On Capital Spending By curtailing the business investment relative to GDP for a prolonged period, major economic slumps can have a permanent effect on an economy's long-term prospects. The loss of output since the financial crisis will never be regained. That said, bond yields in theory are related to the growth rate of productivity, not its level. The IMF report noted that there may even be some long-lasting effects on the growth rate of productivity. The crisis left lingering scars on future growth due to both reduced global labor force migration and fertility rates. The latter rose in the decade before the crisis in several advanced economies, only to decline afterward. Households postponed births in the face of the economic and financial upheaval. The IMF argues that not all of the decline in fertility rates will be reversed. An Inflection Point In Global Bond Yields On a positive note, the pickup in business capital spending in the major countries in recent years implies an acceleration in the growth rate of the capital stock and, thus, productivity. In the U.S., this relationship suggests that productivity growth could rise by a percentage point over the coming few years (Chart II-13). This should correspond to a roughly equivalent rise in equilibrium bond yields. Moreover, some of the other structural factors behind ultra-low interest rates have waned, while others have reached an inflection point. For example, the age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool as people retire and begin to deplete their nest eggs. Household savings rates will trend sharply lower in the coming years. Again, we encourage readers to read the 2017 Special Report for a full account of the structural factors that are shifting in a less bond-bullish direction. QE Reversal To Weigh On Bond Prices And let's not forget the unwinding of central bank balance sheets. The idea that central bank asset purchases on their own had a significant depressing effect on global bond yields is controversial. Some argue that the impact on yields occurred more via forward guidance; quantitative easing was a signal to markets that the central bank would stay on hold for an extended period, which pulled down yields far out the curve. This publication believes that QE had a meaningful impact on global bond yields on its own (Chart II-16). Nonetheless, either way, the Fed is now shrinking its balance sheet and the European Central Bank will soon end asset purchases. This means that the private sector this year is being forced to absorb a net increase in government bonds available to the private sector for the first time since 2014 (Chart II-17). Investors may demand juicier yields in order to boost their allocation to fixed-income assets. Chart II-16Reverse QE To Weigh On Bonds Chart II-17Private Investors Will Have To Buy More We are not making the case that real global bond yields are going to quickly revert to pre-Lehman averages. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations suggest that investors still have an overly benign view on the outlook for yields. For example, implied real short-term rates remain negative until 2027 in the Eurozone, while they stay negative out to 2030 in the U.K. (Chart II-18). The implied path of real rates in the U.S. looks more reasonable, but there is still upside potential. Moreover, there is room for the inflation expectations component of nominal yields to shift up, as discussed above. Chart II-18Real Yields Still Too Low Another way of making this point is shown in Chart II-19. The market expects the 10-year Treasury yield in ten years to be only slightly above today's spot yield, which itself is still very low by historical standards. Market expectations are equally depressed for the 5-year/5-year forward rate for the U.S. and the other major economies. Chart II-19Market Expectations Still Low Bottom Line: Global bond yields fell to unprecedented levels due to a combination of cyclical and structural factors. The bond-bullish structural factors were reinforced by shifts in desired savings and business investment as a result of the Great Recession and financial crisis. Some of these structural factors will linger in the coming years, but others are shifting in a less bond-bullish direction. We do not expect nominal bond yields to return to pre-Lehman norms, and yields could even return close to previous lows in the case of a recession. Nonetheless, we expect a yield pattern of higher lows and higher highs over the coming business cycles. Mark McClellan Senior Vice President The Bank Credit Analyst Appendix 1: Key Factors Behind The Decline In Equilibrium Global Bond Yields The so-called Global Savings Glut has been a bullish structural force for bonds for the past couple of decades. A key factor is population aging in the advanced economies. Ex-ante desired savings rose as baby boomers entered their high-income years. China became a major source of global savings after it joined the WTO, and its large trade surplus was recycled into the global pool of savings. A slower pace of labor force growth in the developed countries resulted in a permanently lower level of capital spending relative to GDP. Slower consumer spending growth, as a result of a more moderate expansion in the working-age population, meant a reduced appetite for new factories, malls, and apartment buildings. The integration of the Chinese and Eastern European workforces into the global labor pool during the 1990s and 2000s resulted in an effective doubling of global labor supply in a short period of time. The sudden abundance of cheap labor depressed real wages from what they otherwise would have been, thus incentivizing firms to use more labor and less capital at the margin. The combination of slower working-age population growth in the advanced economies and a surge in the global labor force resulted in a decline in desired global capital spending. The increase in ex-ante savings and reduction in ex-ante capital spending resulted in a substantial drop in equilibrium global interest rates. The wave of cheap labor also aggravated the trend toward greater inequality in the advanced economies and the downward trend in labor's share of the income pie. A positive labor supply shock should benefit global living standards in the long run, but the adjustment costs related to China's integration into the global economy imposed on the advanced economies were huge and long-lasting. The lingering adjustment phase contributed to greater inequality in the major countries. Management was able to use the threat of outsourcing to gain the upper hand in wage negotiations. Moreover, technology appears to be resulting in faster, wider and deeper degrees of hollowing-out than in previous periods of massive technological change. The result has been a rise in the share of income going to high-income earners in the Advanced Economies, at the expense of low- and middle-income earners. This represents a headwind to growth that requires lower interest rates all along the curve. In other words, firms in the developed world either replaced workers with machinery in areas where technology permitted, or outsourced jobs to lower-wage countries in areas that remained labor-intensive. Both trends undermined labor's bargaining power, depressed labor's share of income, and contributed to inequality. 1 We make the simplifying assumptions that companies do not issue any more debt over the three years, and that EBIT is unchanged, in order to isolate the impact of higher interest rates. 2 The average credit rating for the U.S. is unavailable before 2000 in the Bloomberg Barclays index. However, other data sources confirm the long-term downward trend. 3 Please see The Bank Credit Analyst Special Report "Leverage And Sensitivity To Rising Rates: The Eurozone Corporate Sector," dated May 31, 2018, available at bca.bcaresearch.com 4 Please see Global Investment Strategy Special Reports "1970s-Style Inflation: Could It Happen Again? (Part 1)," dated August 10, 2018 and "1970s-Style Inflation: Could It Happen Again? (Part 2)," dated August 24, 2018, available at gis.bcaresearch.com 5 The lower bound is zero in the U.S., but is in negative territory for those central banks willing to impose negative rates on the banking sector. 6 For more background on the zero bound debate, the usefulness of a large central bank balance sheet and ways to lift r-star, please see The Bank Credit Analyst Special Report "Herding Cats At the Fed," dated October 2016, available at bca.bcaresearch.com 7 Please see The Bank Credit Analyst Special Report "Beware Inflection Points In The Secular Drivers Of Global Bonds," dated April 27, 2017, available at bca.bcaresearch.com 8 The Global Economic Recovery 10 Years After the 2008 Financial Meltdown. IMF World Economic Outlook, October 2018. III. Indicators And Reference Charts Our proprietary equity indicators remained bearish in October and valuation is still stretched, suggesting that it is too early to buy stocks. Our Willingness-to-Pay (WTP) indicators for the U.S. and Japan are both heading down. The Eurozone WTP has flattened-off recently, but is certainly not bullish. The WTP indicators track flows, and this provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Our Revealed Preference Indicator (RPI) for stocks continues to issue a sell signal. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Momentum remains out of sync with valuation and policy, underlining the idea that caution is warranted. Our Monetary Indicator continues to hover in negative territory for stocks, but interestingly it is not deteriorating even as the Fed tightening campaign endures and bond yields have risen. Our Technical Equity Indicator appears poised to break down, but as of the end of October it was not giving a sell signal. The Speculation Indicator is still elevated, but the Composite Sentiment Indicator is in the middle of the range. It does not appear that the latest equity selloff was driven mainly by an unwinding of frothy market sentiment. Nonetheless, value has not improved enough to justify bottom-feeding on its own. On balance, our indicators continue to suggest that the underlying supports of the U.S. equity bull market are eroding. The U.S. earnings backdrop is still providing support overall, although there was a tick down in October in the U.S. net earnings revisions ratio and in positive-minus-negative earnings surprises. The backdrop for Treasurys has not changed, despite October's painful selloff. Valuation (still slightly cheap) and technicals (oversold by almost 2 standard deviations) imply that the countertrend pullback near month-end will continue into November. Beyond a near-term correction, though, complacency about inflation and the Fed's ability to hike rates to at least the level of the FOMC voters' median projection points to looming capital losses. The dollar is quite expensive on a purchasing power parity basis, and its long-term outlook is not constructive, but policy and growth divergences with other major economies will likely keep the wind at its back in the near term. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights Asset allocation: overweight industrial commodities versus equities... ...and neutral equities versus bonds. The euro: neutral for a broad basket but stay long JPY/EUR. The pound: long-term upside, but a better entry point awaits for those who can fine tune. Italian assets: buy when the 10-year BTP yield moves closer to 3 percent. Feature Some people ascribe this year's market action to economics, others ascribe it to geopolitics, but we put it down to mathematics (Chart of the Week). Chart of the WeekEquities Are In 'No Man's Land' As my colleague Peter Berezin recently pointed out, economies and markets can undergo disruptive 'phase transitions' analogous to when water transitions to ice. For water, a 4 degree drop in temperature from 6 degrees to 2 degrees produces no discernible effect, but the same 4 degree drop from 2 degrees to minus 2 degrees produces major disruption, as roads freeze over, pipes burst, and so forth.1 Similarly, as economic or financial stresses build, nothing discernible happens until a phase transition is reached, at which point everything goes haywire. Our thesis is that markets may be near such a phase transition. To explain why, we first need to correct the great misunderstanding of finance, the misunderstanding of risk. The Evolutionary Basis Of Investment Risk One of the major breakthroughs in behavioural finance was the discovery that we care deeply about the asymmetry of an investment's potential returns. Rationally, this asymmetry shouldn't matter if the expected value of the gains equals or exceeds the expected value of the losses. But it does matter, and the reason is that we significantly overestimate the probabilities of extreme tail-events (Chart I-2). Chart I-2We Overestimate The Probability Of Tail-Events Evolutionary biologists argue that this bias originated tens of thousands of years ago, when our distant ancestors had to survive daily 'fight or flight' threats. Faced with constant mortal danger, there was no time for measured analysis. Survival depended on a quick processing of choices into simple chunks: no risk, low risk, high risk. Thereby, our brains evolved to process a one in thousand and, say, a one in hundred chance of danger simply into the 'low risk' chunk, meaning that the 0.1 percent risk is overestimated to 1 percent - or whatever we define as low risk. Fast forward to today's financial markets, and our brains still overestimate extreme tail-events. It follows that for investments whose return distributions are asymmetric, the more extreme tail dominates the perception of its risk. Put simply, investors assess the risk of an investment in terms of its most extreme potential loss versus its most extreme potential gain in a short space of time (Chart I-3). Chart I-3Investors Assess Risk As The Most Extreme Potential Loss Versus Gain Why in a short space of time? The answer is that while most professional investors have long-term objectives, they must report mark-to-market performances every quarter or half-year. Unfortunately, a fund manager who delivers a deep short-term loss is in grave danger of being fired - the modern day equivalent of our distant ancestors' daily fight for survival. And it is nominal losses that matter because even in a period of deflation, any decline in the price level is unlikely to boost real returns over a period of a few months. Correcting The Great Misunderstanding Of Finance So the great misunderstanding of finance is to equate risk with volatility. Risky assets, such as equities, are risky not because they are volatile in the conventional (root mean squared) sense. After all, nobody worries if the price goes up sharply! Also, it is a great misunderstanding to think that equities do not provide diversification benefits. They clearly do - witness the protection that equities provided to bondholders in the bond bloodbath that followed President Trump's surprise victory in 2016 (Chart I-4). Chart I-4Equities Protected Bondholders In The Post Trump Victory Bond Bloodbath The real reason that risky assets are risky is because they have the propensity to experience much larger short-term losses than short-term gains - captured in the saying: equities climb up the stairs on the way up, but they jump out of the window on the way down. But here's the key point. At very low bond yields, bond returns develop the same (or worse) asymmetry as equity returns. Given the lower bound to yields, bond prices have no more stairs to climb... only a window to jump out of! (Chart I-5) The upshot is that equities lose their excess riskiness versus bonds, meaning that their valuations experience a phase transition sharply upwards. The corollary is that when bond yields normalise, equities regain their excess riskiness versus bonds - and their valuations must suffer a phase transition sharply downwards. Chart I-5At A 2% Bond Yield, Bond Returns Have the Same Negative Asymmetry As Equity Returns According to our empirical and theoretical analysis, this phase transition sharply downwards is most pronounced when the global (10-year) bond yield rises through 2 percent. In rule of thumb terms, this is when the sum of the yields on the T-bond, German bund and JGB breaches and remains above 4 percent (Chart I-6). At such a phase transition, it would be prudent to de-risk portfolios and sit aside, at least for a while. Chart I-6When The Sum Of 10-Year Yields On The T-Bond, Bund, And JGB = 4%, The Global 10-Year Yield = 2% Just below this level, a sum in the 3-4 percent range defines a kind of 'no man's land' in which equities drift sideways, perfectly explaining the behaviour of the market through the past year. With the sum now at 3.75 percent, the current message is to remain at neutral allocation to equities versus bonds. Instead, our main asset allocation recommendation is a relative value position: long industrial commodities versus equities - and the position has already gained 4 percent in the past two weeks. The Main Risk For European Institutions Is Existential Sticking with this week's theme of risk, the main risk confronting Europe's major institutions such as the ECB, the EU Council, and the EU Commission is an existential risk. This is because the very existence of the pan-European project relies on the ongoing (largely) unanimous support of a collection of sovereign European nations. As these sponsoring nations often have conflicting claims and interests, Europe's major institutions have intentionally designed themselves as rules-based organisations. Adherence to the rules is essential to avoid the bias, exceptionalism, and moral hazard that could tear apart the pan-European project. And this simple unifying principle explains the current stance of the ECB towards monetary policy, the stance of the EU Council towards Brexit, and the stance of the EU Commission towards the Italian budget. For the ECB, its main policy tools - interest rates, forward guidance on interest rates, and asset purchases - are calibrated to deliver its single objective: aggregate euro area CPI inflation 'below but close to 2 percent'. After a recent wobble in euro area growth, the 6-month credit impulse has ticked up (Chart I-7). Hence, it would be hard for the ECB to conclude that the convergence of inflation to its medium-term target has been blown off course (Chart I-8) - so we expect no major changes to the ECB's forward guidance. Leaving our overall stance to the EUR as neutral, with a preferred long exposure to JPY/EUR. Chart I-7The Euro Area 6-Month Credit Impulse Has Ticked Up Chart I-8Euro Area Inflation Has Been Drifting Up To Target Turning to the EU Council's strategy for Brexit, it will be unyielding on the indivisibility of the EU's four freedoms: goods, services, capital, and people. To do otherwise would be to undermine the strength and integrity of one of the EU's greatest achievements: the largest single market in the world. To give the U.K. special favours would risk giving it an unfair competitive advantage, as well as setting a dangerous precedent for other EU countries that wanted out. Hence, to avoid a hard North/South or East/West border for Ireland, the U.K.'s only option will be to remain indefinitely in a customs union with the EU. Once this is recognised and accepted by the U.K. parliament, the pound will rally.2 Finally, relating to the Italian budget, the EU Commission will adhere to the broad principle of its fiscal rules - again, because it cannot set a dangerous precedent for others. However, there may be some 'give' on the 2019 deficit in return for some 'take' on the 2020 and 2021 deficits. Ultimately, we expect de-escalation and compromise in this battle - but we recommend remaining neutral towards Italian assets until the 10-year BTP yield moves closer to 3 percent (Chart I-9). Chart i-9Remain Neutral Italian Assets Until The 10-Year BTP Yield Moves Closer To 3% Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the Global Investment Strategy Weekly Report 'Phase Transitions In Financial Markets: Lessons For Today' October 19, 2018 available at gis.bcaresearch.com 2 Please see the European Investment Strategy Weekly Report 'Understanding Brexit, Scandinavian Markets, And Semiconductors' October 18, 2018 available at eis.bcaresearch.com Fractal Trading Model* This week we note that the sharp sell-off in the Portuguese stock market is technically exhausted and ripe for a countertrend move. We prefer to express this as a market neutral pair-trade: long Portugal/short Hungary. Set the profit target at 6% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 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 - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Highlights Duration Strategy: The recent market turmoil was a long overdue risk asset correction that does not change any fundamental underpinnings for rising global bond yields. Stay below-benchmark on overall global duration exposure, concentrated in an underweight stance on U.S. Treasuries. Country Allocations: Continue allocating duration risk for global government bond portfolios in favor of countries where central banks will have difficulty raising interest rates (Australia, U.K., Japan core Europe) relative to countries where rate hikes are more necessary and likely to happen (U.S., Canada). Feature Repricing "Central Banker Puts" Can Be Painful By a quirk of our scheduling, we have not published a regular Weekly Report since September, during what became a period of more turbulent global financial markets. While we trust that our clients have enjoyed the Special Reports that we have published instead, we are certain that many are asking an obvious question: have the more jittery markets triggered any change in BCA's views on global fixed income? The answer is "no". Just like the sharp "Vol-mageddon" risk asset selloff back in early February, the origin of the recent volatility spike was soaring U.S. Treasury yields driven by a rapid upward revision of Fed rate hike expectations (Chart of the Week). We had been expecting such an adjustment based on our positive assessment of the underlying momentum of both economic growth and inflation in the U.S. This remains a critical underpinning for our below-benchmark call on U.S. duration exposure, and our increased caution on U.S. spread product. Chart of the WeekRisk Assets Struggling As Bond Yields Rise There is more to the story than just the Fed, however. Throughout the course of 2018, we have been warning that global central banks moving away from accommodative monetary policies would be the greatest threat to market stability. This is not only a story of Fed rate hikes. A reduction in the pace of asset purchases by the European Central Bank (ECB) and the Bank of Japan (BoJ), combined with outright contraction of the Fed's swollen balance sheet, has created a backdrop more conducive to volatile spikes - especially if the global economy is losing upward momentum at the same time. The OECD leading economic indicator has been steadily declining throughout 2018, a reflection of the more challenging backdrop for non-U.S. growth. It is no coincidence that, without the support from accelerating liquidity or positive economic momentum, many of last year's best performing investments (Italian government bonds, the Turkish lira, Emerging Market (EM) hard currency corporate debt) have been some of 2018's worst (Chart 2). Investors were willing to ignore the poor structural fundamentals underlying those markets when times were good, but have been much more cautious in 2018 with a less supportive macro environment. Chart 2The Darlings Of 2017 Are The Duds Of 2018 While there have been numerous political headlines that have caused bouts of market turbulence in the past few months - the escalating U.S.-China "tariff war", the Italian fiscal debate with the European Union - the short-term impact of these moves is magnified when global monetary policy is being tightened and global growth is cooling. The reason why central banks have been forced to turn more hawkish (or at least less dovish) is that diminished economic slack has forced their hands. For policymakers with an inflation-targeting mandate, the Phillips curve framework remains the primary analytical framework. When they see low unemployment, they get nervous. When they see low unemployment AND rising inflation, then become hawkish. Three-quarters of OECD countries now have an unemployment rate below the estimate of the full-employment NAIRU - the highest level in a decade - and realized inflation rates are accelerating in the major developed economies (Chart 3). Our own Central Bank Monitors are signaling the need for tighter monetary policy in most countries, while yields at the front-ends of government bond curves are steadily rising. Chart 3Central Bankers Still Believe In The Phillips Curve Looking ahead, we continue to see more upward pressure on global bond yields in the next 6-12 months. Market pricing for the future policy actions of the major central bank did not move much even with the surge in volatility earlier this month. The markets now understand that the "policymaker put" that central bankers have implicitly sold to investors has a much lower strike price when labor markets are tight and inflation is accelerating. It will take much larger selloffs to cause central banks to become less hawkish. We still see the decisions we made in late June, moving to a more cautious recommended stance on overall risk in fixed income portfolios, as appropriate. Staying below-benchmark on overall global duration risk, while underweighting those countries where the central banks are under the greatest pressure to tighten policy, is the most sensible way to allocate a fully-investment government bond portfolio. That means underweighting the U.S. and Canada and overweighting Japan, Australia and the U.K. (Chart 4). In terms of credit, we are maintaining an overall neutral stance, but favoring the U.S. versus European equivalents and a maximum underweight on EM credit. Chart 4Interest Rates Remain Unfazed By More Jittery Markets Bottom Line: The recent market turmoil was a long-overdue risk asset correction that does not change any fundamental underpinnings for rising global bond yields. Stay below-benchmark on overall global duration exposure, concentrated in an underweight stance on U.S. Treasuries. The Most Important Charts For Our Most Important Country Duration Views When determining our recommended fixed income country allocation, there are a few critical indicators we are watching to assess if those views should be maintained. We now go over each of those indicators for the most important developed economy bond markets: U.S. (Underweight): Watch TIPS Breakevens & The Employment/Population Ratio U.S. Treasuries have been the one major government bond market this year that has seen a rise in both inflation expectations and real yields. The breakeven inflation rate implied by the spread between 10-year nominal Treasuries and TIPS has gone up from 1.97% to 2.10% since the start of 2018, while the real 10-year TIPS yield has climbed from 0.44% to 1.09% over the same period. The rise in inflation expectations has occurred alongside an acceleration of U.S. economic growth and a generalized rise in inflation pressures. Reliable cyclical leading indicators like the ISM Manufacturing index and the New York Fed's Underlying Inflation Gauge are pointing to an acceleration of U.S. core CPI inflation towards the 2.5-3% range over the next year (Chart 5). This would be enough to push 10-year TIPS breakevens comfortably into the 2.3-2.5% range that we deem consistent with the Fed's price stability target (core PCE inflation at 2%). Chart 5U.S.: Both Real Yields & Inflation Expectations Are Rising Any larger move in inflation expectations would only occur if the Fed were to accommodate it by not continuing to hike rates at the current 25bps/quarter pace. That is unlikely with the strength of the U.S. labor market suggesting that the Fed is behind the curve on rate hikes. The U.S. employment/population ratio for prime age (25-54 years old) workers has almost returned back to the peak levels of the mid-2000s near 80% (bottom panel). The Fed had to push the real funds rate to over 3% during that cycle to get policy to a restrictive setting above the Fed's estimate of the r-star neutral real rate. While it is unlikely that the Fed will need to push the real funds rate to as high a level as in the mid-2000s, the current real rate has not even caught up to the Fed's r-star estimate, which is starting to slowly increase alongside the stronger U.S. economy. That implies a higher nominal funds rate would be needed to push up the real rate to neutral levels, with even more nominal increases needed if inflation continues to accelerate. With only 62bps of rate hikes over the next year currently discounted in the USD Overnight Index Swap (OIS) curve, there is scope for Treasury yields to rise further over the next 6-12 months. Core Europe (Underweight): Watch Realized Inflation Relative to ECB Forecasts In the euro area, the evolution of unemployment, wage growth and core inflation compared to the ECB's positive forecasts will be the critical driver of the future direction of government bond yields. In its latest set of economic projections published last month, the ECB expects the overall euro area unemployment rate to be 8.3% in 2018, 7.8% in 2019 and 7.4% in 2020.1 With the actual unemployment rate falling to 8.1% in August, the realized outcomes are already exceeding the ECB's forecasts (Chart 6). The same can be said for euro area wages, where the growth in compensation per employee (2.45%) is already running above the 2018 ECB projection of 2.2%. The ECB expects no acceleration of wage growth in 2019 (2.2%), but a further ratcheting up in 2020 (2.7%). Chart 6Euro Area: Expect Higher Yields If ECB Forecasts Materialize In a recent Special Report, we identified a leading relationship between wage growth and core HICP inflation in the euro area of around nine months.2 This would suggest that core HICP inflation should rise towards 1.5% within the next six months based on the current acceleration of wage growth (second panel). This would be above the ECB's current projection for 2018 (1.1%), but in line with the 2019 forecast (1.5%). Core inflation is projected to rise to 1.8% in 2020. If unemployment and inflation even just match the ECB's forecasts, there is likely to be a material repricing of core European bond yields through higher inflation expectations. At 1.7%, 10-year EUR CPI swaps are well below the +2% levels that occurred during the past two ECB rate hike cycles in the mid-2000s and 2010-11 (third panel). Both wage and core price inflation in the euro area were around the ECB's current 2019-2020 projections during both of those prior tightening episodes, suggesting that the past may indeed be prologue when it comes to inflation expectations. Given growing U.S.-China trade tensions, and uncertainties over the future path for Chinese economic growth, there is a risk that the ECB's growth and unemployment forecasts are too optimistic. The euro area economy remains highly levered to exports, and to Chinese demand in particular. Furthermore, the ECB continues to provide very dovish forward guidance, with no rate hikes expected until at least September 2019. Yet with a mere 12bps of rate hikes over the next year currently discounted in the EUR OIS curve, there is scope for core European bond yields to rise further over the next 6-12 months if euro area inflation surprises to the upside. Italy (Underweight): Watch Non-Italian Bond Spreads & The Euro The Italian budget battle with the European Union has been a gripping drama for investors in recent months. Italian bond yields have been under steady upward pressure, with the benchmark 10-year yield getting as high as 3.78%. Yet the story remains as much about sluggish Italian growth as it is about Italian fiscal policy. The populist Italian government has pushed for larger deficits, but has toned down the anti-euro language that dominated the election campaign earlier this year. This is why there has been very minimal contagion from higher Italian bond yields into other Peripheral European bond yields or euro area corporate bond spreads, or into the euro itself which remains very firm on a trade-weighted basis (Chart 7). Chart 7Italy: A Story Of Weak Growth, Not Euro Break-Up We continue to view Italian government bonds as a growth-sensitive credit instrument, like corporate bonds. In other words, faster Italian economic growth implies greater tax revenues, smaller budget deficits and a less worrisome trajectory for Italy's debt/GDP ratio. The opposite holds true when Italian economic growth is slowing. This is why there is a reliable directional relationship between Italy-Germany bond yield spreads and the OECD's leading economic indicator (LEI) for Italy (top panel). With the Italy LEI still in a downtrend, we do not yet see a cyclical case for shifting away from an underweight stance on Italian government bonds. Yet if the 10-year Italian yield were to reach 4%, the implied mark-to-market loss would wipe out the capital of Italy's banks, who own large quantities of government bonds. In that scenario, the ECB would likely get involved to stem the crisis, possibly by further delaying rate hikes of ramping up asset purchases. This would especially be likely if there was significant widening of non-Italian credit spreads and a sharply weaker euro. Hence, watch those markets for signs that the Italy fiscal crisis could trigger a monetary policy response. U.K. (Overweight): Watch Real Wage Growth & Business Confidence In the U.K., our non-consensus call to stay overweight Gilts has not been based on any long-run value considerations. Real yields remain depressed and the Bank of England (BoE) has kept monetary policy settings at extremely accommodative levels. The BoE continues to expect that a rise in real wage growth is likely due to the very tight U.K. labor market. This would support consumer spending and eventually require higher interest rates. The only problem is that this is happening very slowly. The annual growth in U.K. wage growth is now up to 3.1%, the fastest rate since 2008. This is above the pace of headline CPI inflation of 2.5%, thus real wages are finally starting to perk up (Chart 8). A continuation of this trend would feed into faster consumer spending and, eventually, trigger BoE rate hikes. Chart 8U.K.: Brexit Uncertainty + Middling Inflation = BoE Doing Little One other big impediment to the BoE turning more hawkish is the uncertainty over the U.K. government's Brexit negotiations with the EU. The extended Brexit drama has weighed on both U.K. business and consumer confidence, both of which have struggled since the 2016 Brexit vote (third panel). With the March 2019 deadline for the U.K. "officially" leaving the EU fast approaching, the odds of no deal being reached in time are increasing. U.K. Prime Minister Theresa May is desperately trying to avoid a no-deal Brexit, but such an outcome would create further instability in U.K. financial markets and close any near-term window of opportunity for the BoE to try and hike rates. For now, we see the depressed confidence from Brexit uncertainty offsetting the bump up in real wage growth, leaving Gilts on a path to continue modestly outperforming as they have throughout 2018 (bottom panel). An announcement of a Brexit deal would be a likely trigger for us to downgrade Gilts to neutral, and perhaps even to underweight given the developing uptrend in real wage growth. Bottom Line: Continue allocating duration risk for global government bond portfolios in favor of countries where central banks will have difficulty raising interest rates (Australia, U.K., Japan core Europe) relative to countries where rate hikes are more necessary and likely to happen (U.S., Canada). Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1https://www.ecb.europa.eu/pub/pdf/other/ecb.ecbstaffprojections201809.en.pdf 2 Please see BCA Foreign Exchange Strategy/Global Fixed Income Strategy Special Report, "Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan?", dated October 5th 2018, available at fes.bcaresearch.com and gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy Debt saddled small caps have to wrestle with rising interest rates at a time when they lack a valuation cushion. Tack on their high beta status and investors should continue to avoid small caps and instead prefer large caps. Upbeat global demand for U.S. defense goods, firming defense industry operating metrics and a flurry of M&A will more than offset the defense contractors' valuation overshoot. Stay structurally overweight. Recent Changes There are no changes to the portfolio this week. Table 1 Feature In Greek mythology, Daedalus warned his son Icarus not to fly too close to the sun when the pair of them were escaping from Crete, as his wax-made wings would melt. Icarus ignored his father's warning and soared toward the sun that eventually led to his drowning in the Aegean Sea when his wings melted. Is the equity market experiencing an Icarus moment? The S&P 500 is undergoing a healthy reset during crash-prone October, but post-midterms it should make an attempt to vault to fresh all-time highs into year-end. The selloff in the bond market (largely driven by the real component) most likely caused the consternation in stocks, but our sense is that the backup in yields is reflective and not yet restrictive both for stocks and, most importantly, the economy. In the coming weeks we expect a retest, and hold, of the recent lows before waving the all clear sign. Nevertheless, the latest bout of volatility is a cause for concern especially given that the SPX pullback is not sentiment/technical driven as it was earlier in the year when on January 221 and again on January 292 we cautioned clients that the equity market advance was too good to be true and complacency reigned supreme. As a reminder in late-January, equities looked extremely stretched on a number of sentiment and technical indicators. This was not the case, however, heading into October (Charts 1 & 2), and it raises the question: what are stocks discounting with regard to the economic backdrop? Chart 1Leading Into The Recent Pullback Sentiment And Technicals... Chart 2...Were Not As Extended As In Late-January Our biggest worry is that the 2018 goosing of the economy will soon fall flat as President Trump runs out of firepower to further buoy the economy. In other words, we have likely brought demand/consumption forward which should get reflected in softer 2019 output data, especially if there is gridlock in Congress post the midterms. Keep in mind, that most of the fiscal easing that pertains to stocks is front loaded to this year. The drop in corporate taxes is a one-off EPS boost for 2018, as is the surge in buybacks that was driven by cash repatriation. Buybacks are on pace to reach $1tn in 2018, but are likely to fall back to the more typical $400bn/annum rate next year. The U.S. economy and stock market will have to grapple with both of these fading tailwinds in 2019. One simple way to depict this is our newly conceived BCA Economic Impulse Indicator (EII). Chart 3 shows six economic indicators gauging the state of the U.S. economy. The EII comprises housing, capex, manufacturing, confidence, employment and credit; it is equally weighted shown as a Z-score. At present it is wobbling and diverging negatively from euphoric SPX EPS growth rates. Chart 3 Mind The Gap Not only is the economy humming at an unsustainable pace, but the Fed is also tightening monetary policy and letting maturing securities run off its balance sheet at approximately $50bn/month. If the Fed hikes rates three more times by June 2019, as both the bond market and our fixed income strategists expect, the fed funds rate will reach a range of 2.75%-3%. It then becomes plausible that any letdown in economic data could cause the yield curve to invert. The elimination of the unemployment gap increases the probability of curve inversion (see Chart 1 from the October 23, 2017 Weekly Report), as does another indicator of labor market tightness that recently dropped below zero (Chart 4). Chart 4Full Employment And Yield Curve Joined At The Hip But, we are not there yet and want to be systematic in calling the end of the business cycle, and thus equity bull market, using the three signposts we deemed most important earlier in the year: a yield curve inversion (leading indicator), doubling in year-over-year oil prices based on monthly dataset (coincident indicator) and a mega-merger announcement either in tech or biotech space (confirming anecdotal indicator). With regard to the latter, the rumored Uber IPO fetching a valuation of $120bn may also qualify as an end of cycle anecdotal indicator. Still, none of these three boxes have yet been ticked. Moreover, two other catalysts may assist in prolonging the cycle and breathe a sigh of relief not only in U.S. equities, but also in global bourses: a trade deal with China, and/or a reversal in U.S. dollar strength that would boost global ex-U.S. growth. Netting it all out, while the recent equity market swoon is worrisome it is still too early to call the end of the cycle and we do not think we are in an "Icarus moment". Our broad equity market strategy is to "buy the dip" as we expect EPS to do all the heavy lifting next year with the multiple drifting lower, and we continue to recommend a cyclical over defensive portfolio bent. This week we highlight a deep cyclical capital goods subsector and revisit our size bias. The Bigger The Better The days in the sun are over for small cap stocks. Similar to the double top formation in the early 1980s, small cap stocks have hit a wall and are giving in to their larger brethren. There are high odds that the small over large multi-year ascendancy is over and a reversion, at least, to the historical time trend mean is in order (Chart 5). Chart 5Double Top Since changing our size bias to a large cap bias on May 10, 2018, the S&P 500 has bested the S&P 600 index by over 300bps. Small caps however remain fully valued using different metrics and are extremely overvalued versus the SPX according to the Shiller P/E (or cyclically adjusted P/E, CAPE) methodology of smoothing the earnings cycle over a decade (Chart 6). In fact, this 40% CAPE premium leaves no space for any small cap profit mishaps. Chart 6Small Caps Valuations Are Stretched... Unfortunately, on a number of fronts small cap EPS will underwhelm and significantly trail SPX EPS, the opposite of what optimistic sell-side analysts expect. First, small caps are severely debt saddled as we have highlighted in our recent research. Sustained small cap balance sheet degradation is worrying, with S&P 600 net debt-to-EBITDA close to 4 (compared with 1.5 for the SPX, middle panel, Chart 7). Such gearing is fraught with danger as the default rate has nowhere to go but higher. Chart 7...Amidst Balance Sheet Degradation... Second, small and medium businesses have a higher dependency on bank credit as opposed to the bond market access that mega caps enjoy. Most bank credit is floating rate debt and so are lines of credit, and as the Fed remains firm on tightening monetary policy, interest expense costs are skyrocketing for SMEs. In a relative sense this will weigh on net profits. More generally, given the high indebtedness, small caps are a lot more sensitive to interest rates, and the selloff in the 10-year Treasury note heralds more pain in 2019 (10-year Treasury yield shown inverted, Chart 8). Chart 8 ...And With Rates Rising... Third, relative wage costs are flashing red for small caps. Small cap margins are thin - roughly mid-single digits or 800bps below large caps, and rising labor costs (according to the latest NFIB survey) are warning that this delta will widen, further suppressing relative margins and profitability as large cap wage costs are still well contained (Chart 9). Chart 9...And Labor Costs Perking Up, A Margin Squeeze Looms Fourth, small caps are high(er) beta stocks and when volatility spikes they underperform large caps. When the Fed ballooned its balance sheet and dropped the fed funds rate to zero it suppressed volatility. Now that the Fed has been decreasing the size of its balance sheet and raising interest rates, this is working in reverse and volatility is making a comeback as we have been highlighting in our research, and will continue to weigh on small caps (VIX shown inverted, top panel, Chart 10). Chart 10Large Caps Have The Upper Hand Another way to showcase small caps' riskier status is the close correlation they have with the relative EM equity share price ratio. When EMs outperform the SPX, small caps follow suit and vice versa. Importantly a wide gap has opened recently and we suspect that it will narrow via small caps following the EM higher beta stocks lower (SPX vs. EM ratio shown inverted, bottom panel, Chart 10). Adding it up, a high small cap debt burden, rising interest rates, lack of a valuation cushion, and their high beta status all signal that investors should continue to avoid small caps and instead prefer large caps. Bottom Line: Stick with a large cap bias. Stay With Defense Stocks For The Long-Term We have been overweight the pure-play BCA defense index since late-2015 and there are high odds that this juggernaut that really commenced with the George Walker Bush presidency remains in a secular growth trajectory (top panel, Chart 11). Our strategy is to add exposure on any meaningful pullbacks and keep this index as a structural overweight within the GICS1 S&P industrials index. Chart 11Defense Stocks Are A Secular Growth Play The rise of global "multipolarity" - or competition between the world's great nations - and the decline of globalization, along with a global arms race and increased risk of cyber-attacks, have been documented in our "Brothers In Arms" Special Report. These trends all signal that global defense related spending will remain upbeat in the coming decade.3 In the U.S. in particular, where military spending in absolute terms is greater that the rest of the world put together, defense spending and investment have bottomed and will continue to accelerate. In fact, the CBO continues to project that defense outlays will jump further next year (middle panel, Chart 12). While such a breakneck pace is clearly unsustainable, President Trump is serious about upgrading and updating the U.S. military in order to keep China's geopolitical and military ascendancy in check (as well as to deal with Russia and Iran).4 The upshot is that defense outlays will continue to expand into the 2020s. Chart 12Upbeat Defense Outlays... Such a buoyant demand backdrop is music to the ears of defense contractor CEOs, and represents a boost to defense equity revenue growth prospects. This capital goods sub-industry has extremely high fixed costs and thus any increase in top line growth flows straight to the bottom line. Put differently, defense contractors enjoy high operating leverage. No wonder M&A activity is robust: at least four large deals have been announced in the past year that are underpinning both takeout premia and relative share prices (bottom panel, Chart 13). Chart 13 ...And A Flurry Of M&A Is A Boon For Defense Stocks A closer look at operating metrics corroborates that defense goods manufacturers are firing on all cylinders. New orders recently jumped to fresh all-time highs and the industry's shipments-to-inventories ratio is rising, on track to surpass the 2008 peak. Unfilled orders are also running at a high rate, signaling that factories will keep on humming at least for the next few quarters (Chart 14). Chart 14Firming Operating Metrics Importantly, the industry is not standing still and is making significant investments. U.S. defense capex as reported in the financial statements of constituent firms is growing at roughly 20%/annum or twice as fast as overall capex (Chart 15). Chart 15Industry Is Not Standing Still True, industry indebtedness is also on the rise as some of the expansion has been debt financed, but net debt-to-EBITDA trails the overall market (ex-financials). Similarly, interest coverage has been modestly deteriorating, but is twice as high as the overall market. Impressively, defense ROE is running near 30%, again roughly double the rate of the broad market (Chart 16). Chart 16Healthy B/S With High ROE... Nevertheless, undoubtedly valuations are on the expensive side. Not only is recent M&A fever the culprit, but global investors' insatiable appetite for pure-play defense stocks has also driven valuations into overshoot territory (Chart 17). This is a clear risk to our secular overweight view, however, if our thesis pans out, then these stocks will grow into their pricey valuations as happened in the back half of the 1960s.5 Chart 17 ...But Valuations Are Expensive In sum, upbeat global demand for U.S. defense goods, firming industry operating metrics and a flurry of M&A will more than offset the defense contractors' valuation overshoot. Bottom Line: The secular advance in pure-play defense stocks remains in place. We continue to recommend an above benchmark allocation. The ticker symbols for the stocks in the BCA defense index are: LMT, LLL, NOC, GD and RTN. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Corporate Pricing Power Update," dated January 29, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "A Global Show Of Force?" dated October 10, 2018, available at gps.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights The current market action in the EM equity space qualifies as a bear market, not a correction. Yet the magnitude of this drawdown (25%) is still considerably smaller than the median stock price drop (45%) of previous bear markets. Hence, more downside in EM share prices in dollar terms is to be expected. The Federal Reserve is not about to rescue EM - not until U.S. share prices fall considerably and the dollar appreciates sharply. For EM dedicated equity portfolios, we are downgrading Taiwan from overweight to neutral (please see page 11). We reiterate our underweight stance on Peruvian stocks (please see page 14). Feature All happy families are alike; each unhappy family is unhappy in its own way. Leo Tolstoy, Anna Karenina To rephrase Leo Tolstoy's famous quote from Anna Karenina: All bull markets are alike; but, each bear market is distinctive in its own way. The emerging market stock index has dropped by 25% from its January high. We reckon EMs are in a bear market - not a correction. Thus, there is still meaningful downside in EM financial markets, and it is still too early to bottom-fish. Many commentators and investors are comparing the current selloff with other bear markets, most notably those that occurred in 1997-'98 and 2014-'15. Our answer to these comparisons is the above quote from Tolstoy. This EM rout is different from the previous ones, including the most recent one that occurred in 2015. Yet just because this selloff is in certain aspects unlike previous bear markets does not mean it is not a full-fledged bear market. Bear Markets Versus Corrections There is no scientific distinction between a bear market and a correction. The below considerations suggest to us that EMs are in a genuine bear market, not a correction. These deliberations complement rather than substitute our fundamental analysis that foreshadows weakening growth and deteriorating profitability in EM/China - the topics that we regularly discuss at great length in our weekly reports. Chart I-1 portrays EM share prices since the mid-1980s and identifies periods of bear markets. Bear markets differ from corrections not only by the magnitude of drawdowns but also by duration. We define an EM bear market as a drawdown that either lasted longer than six months or in which peak-to-trough price declines exceeded 25%. Chart I-1EM Stock Prices: A Long-Term Perspective Of Bear Markets Table I-1 and Table I-2 illustrate EM equity corrections and bear markets over the past 30+ years, respectively. Median and mean EM equity market corrections have historically lasted one and a half to two months, with price drawdowns of 18% in U.S. dollar terms each (Table I-1). On the other hand, median and mean EM equity bear markets have lasted eight to 10 months, with share prices falling by 45% (Table I-2). The current selloff is already more than eight months old, with share prices down 25% in dollar terms. Its duration has by far surpassed that of previous corrections. Therefore, the current market action in the EM equity space qualifies as a bear market. If this bear market produces a drawdown of 45%, on par with the median bear market, it would require another 30% drop in EM share prices in dollar terms from current levels. The range of price declines of previous EM equity bear markets is between 31% and 67%. For the current selloff to match the lowest point of this range (31%), share prices should fall another 10%. These estimates should help investors conduct their own scenario analyses. Our bias is that there will likely be at least another 15% drop in EM share prices before the risk-reward profile of this asset class improves. The way this EM selloff has been evolving is more consistent with a bear market than a correction. As a rule, EM equity corrections are sharp but short-lived. Table 1 shows that EM equity corrections have typically lasted from one to three months. In corrections, all markets drop together at once. In contrast, bear markets are drawn out, and domino effects leading to rotational selloffs are the norm. The current episode corresponds more to this pattern. Initially, the EM market riot was concentrated among discernably vulnerable markets such as Turkey, Argentina and Brazil. Then, the epicenter of the selloff rotated to emerging Asia, where large equity markets including China, Korea, Taiwan and Hong Kong took a beating1 (Chart I-2). Chart I-2EM: Rotational Selloffs A similar pattern of rotational selloffs prevailed in the 1997-'98 bear market in EM and in 2007-'08 in the U.S. (Chart I-3A and Chart I-3B). Chart I-3ARotational Selloffs During EM Bear Markets Chart I-3BRotational Selloffs During U.S. Credit Crisis In 2007-08 With the exception of bombed-out cases like Turkey and Argentina, there has been no panic-selling or forced liquidation. Although the current EM selloff has already been stretched out, it appears that selling has been rather reluctant. It would be unusual if a selloff of this magnitude and duration, occurring amid worsening EM/China growth and Fed tightening, does not culminate into liquidation/capitulation. We still expect such capitulation to occur. In fact, this would be one of the signposts for us to turn positive on EM. Bottom Line: Taking into account the duration and disposition of the current selloff, EM stocks are in a bear market, not a correction. That said, the magnitude of this drawdown (25%) is still smaller than the median price falloff (45%) and the range of price declines of previous EM bear markets. Hence, there is potentially another 10-30% price drop for EM stocks in dollar terms for this bear market to be on par with the smallest and median EM bear markets, respectively. Technical Signposts Of A Bear Market There are a number of technical signposts that are consistent with further downside in EM risk assets and currencies: Relative share price performance of EM versus DM has failed to break above its long-term moving average that has in the past served as an important technical support or resistance (Chart I-4). This entails that the relative bear market in EM versus DM is intact, and major fresh lows lie ahead. Chart I-4EM Versus DM: Relative Stock Prices In U.S. Dollars In absolute terms, the crest in EM share prices early this year was typical of a major top. The EM equity index has failed to break above its previous tops (Chart I-1 on page 1). This represents bearish price formation. Usually, when a market fails to break above its previous tops, a major downslide ensues. In short, the chart formation of EM stocks is in line with a bear market - not a correction. The breadth of the EM equity selloff has been extensive, entailing a genuine bear market. The stock market selloff has not been limited to large-cap names. Both the EM small-cap and equally-weighted stock indexes have in fact sold off more (Chart I-5). Chart I-5EM Equity Selloff Is Broad-Based The global equity sectors exposed to EM/China growth such as industrials, chemicals, mining and steel have all relapsed after failing to break above their 200-day moving averages (Chart I-6). This entails more downside in their share prices, and corroborates our view that global trade growth will deteriorate further. Chart I-6Global Cyclicals Are Breaking Down Asian semiconductor stocks are breaking down - another bad omen for global trade and Asian growth (Chart I-7). Chart I-7Asian Semiconductor Stocks Are Plunging U.S. Treasury yields as well as U.S. TIPS yields have broken out, and there is more upside to come. Odds are that U.S. interest rate expectations will continue to ratchet higher, which will weigh on EM currencies and risk assets. In terms of risks to our view, the technical profile of the U.S. dollar looks worrisome (Chart I-8). The broad trade-weighted greenback might potentially be forming a head-and-shoulder pattern. If the dollar relapses, EM risk assets will rally, and our negative stance on EM will turn out wrong. Chart I-8Trade-Weighted Broad U.S. Dollar: At A Vulnerable Spot? For now, however, we maintain that current global macro dynamics warrant a stronger dollar. In particular, a stronger dollar is required to redistribute growth away from the U.S. and towards the rest of the world.2 Specifically, the U.S. needs a strong dollar to cap budding inflation. For now, we view the recent dollar's softness as a short-term correction from overbought levels. Is A Replay Of February 2016 In Cards? A number of clients have been questioning whether current global macro dynamics - in certain aspects - is reminiscent of the peak in the dollar and the bottom in EM and global equity and credit markets that occurred in February 2016. Back then, the Fed paused its tightening cycle, and China's fiscal and credit stimulus put a floor under mainland growth. These measures combined marked a major top in the dollar and a bottom in EM risk assets. Presently, conditions are substantially different from those that prevailed during that time. In particular: Presently, there is no basis for the Fed to halt its tightening. The U.S. economy is now much stronger - nominal GDP growth is 5.4% versus 2.4% in the first quarter of 2016 (Chart I-9, top panel). Manufacturing production - excluding oil and mining output - is presently very robust (Chart I-9, middle panel). This stands in stark contrast to early 2016 when it was shrinking. Chart I-9U.S. Growth Is Much Stronger Today Than In Early 2016 Importantly, the U.S. output gap is positive, and core inflation is 2% and rising (Chart I-9, bottom panel). Overall, the Fed is not about to pause. On the contrary, U.S. interest rate expectations are still low relative to what is required to restrain America's growth and cap budding inflation. In short, the Fed is not about to rescue EM - not until the latter's financial and economic conditions deteriorate much more, U.S. asset prices fall considerably and the dollar appreciates sharply. In China, the fiscal and credit stimulus implemented so far has been insufficient to bolster growth. The impact of previous tightening is working its way through the economy, and the recent liquidity and fiscal stimuli have so far been insufficient to kick off a new business cycle upturn. We will re-visit this issue in next week's report. EM equities are not yet as cheap as they were at their 2016 lows, according to their cyclically adjusted P/E (CAPE) ratio (Chart I-10). Another 15% decline in EM share prices will bring the EM CAPE ratio to one standard deviation below its mean - the level where the EM CAPE ratio bottomed in early 2016. Chart I-10EM Cyclically-Adjusted P/E Ratio: Not Very Cheap Crucially, the CAPE ratio is a structural valuation metric. It matters for investment horizons beyond two to three years. It is not a useful gauge for the next 12 months or so. As such, even for long-term investors, the risk-reward trade-off for EM stocks is not yet favorable. Bottom Line: Conditions do not exist for the Fed to halt its tightening campaign. This, along with the currently limited stimulus from China and not-so-cheap EM equity valuations, entail that a major bottom in EM stocks is not in the cards. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Downgrading Taiwanese Stocks 18 October 2018 We have been overweighting Taiwanese stocks within an EM equity portfolio since 2007, and this bourse has outperformed the EM index by 30% since that time (Chart II-1). Presently, odds of a pullback in relative performance have risen considerably, and we recommend reducing allocation to this bourse from overweight to neutral. Chart II-1Take Profits On Overweight Taiwanese Stocks Position With the exception of DRAM prices, semiconductor prices are collapsing (Chart II-2). This is a nail in the coffin for this semi- and technology hardware-heavy bourse. Chart II-2Deflation In Semiconductor Prices In the past, Taiwan has depreciated its currency to offset the impact of falling export prices in dollar terms on corporate profitability. This option is no longer available to the authorities. It seems the Trump administration has made it clear to the island that its political and military support partially hinges on Taiwan not intervening in the currency market. In short, the authorities will not be able to resort to material currency depreciation to fight deflation in manufacturing goods as they have in the past. This is bad news for Taiwan's manufacturing-heavy economy, and especially corporate profitability. Exports and manufacturing are decelerating (Chart II-3). Chart II-3Taiwan's Business Cycle Exports of electronic products parts lead non-financial EBITDA, and currently foreshadow a deteriorating profit outlook (Chart II-4). Chart II-4Taiwan: Corporate Profits Are At Risk The recent underperformance of Taiwanese small-cap stocks versus their EM peers is a red flag for the relative performance of large caps. Last but not least, Taiwan is extremely exposed to U.S.-China strategic tensions, as our geopolitical team has argued.3 Escalating geopolitical and strategic tensions between the U.S. and China are taking us closer to a point where these risks are set to materialize, and the risk premium on Taiwanese equities to rise. This will hurt Taiwanese stocks' performance in both absolute and relative terms. Bottom Line: We are downgrading our allocation to Taiwanese stocks from overweight to neutral within an EM equity portfolio. This bourse is also vulnerable in absolute terms. This shift is also consistent with our overall portfolio strategy of reducing equity allocations to Asia in favor of Latin America, as well as with our new equity trade of shorting emerging Asia versus Latin America - a recommendation we made last week. In emerging Asia, having downgraded Taiwan, we now remain overweight only in Korea and Thailand. Peru: An Unsustainable Divergence 18 October 2018 Relative performance of Peruvian equities to EM has been resilient over the past nine months despite falling industrial and precious metals prices and a buoyant dollar (Chart III-1, top panel). Banks, and in particular Peru's financial behemoth, Credicorp, have been the primary contributors to Peruvian market outperformance.4 Excluding banks from the stock index shows that non-financials stocks have not outperformed the EM benchmark since early 2017 (Chart III-1, bottom panel). Chart III-1Peruvian Relative Equity Performance Has Diverged From Metals Prices Is such a divergence between metals prices and Peru's relative equity performance sustainable over the coming year? We think not. Balance of payment (BoP) dynamics has historically driven the macro cycle in Peru. In 2016-17, a favorable external backdrop - high commodity prices and capital inflows into EM - led to a stable exchange rate that in turn allowed the Peruvian central bank to cut interest rates by 150bps. Domestic demand has recovered briskly. However, based on our overall global macro view, we expect Peru's BoP to deteriorate and the virtuous cycle to reverse for the time being. Terms of trade are set to deteriorate with lower industrial and precious metals prices. Mining exports represent 60% of total exports, and the drop in copper and gold prices will dampen the value of exports. Historically, the currency and share prices perform poorly when the trade balance deteriorates (Chart III-2). Chart III-2Current Account Dictates Currency And Equity Trends Importantly, a strong dollar and a global EM riot will lead to diminishing foreign portfolio inflows. Foreigners own 42% of the local fixed-income market and any currency weakness could prompt hedging of currency risk. This will necessitate the central bank (the BCRP) to intervene in the foreign exchange market to defend the sol. By doing so, the central bank will withdraw domestic liquidity - banks' excess reserves at the BCRP will shrink (Chart III-3). Tightening local currency liquidity will lead to higher interbank rates (Chart III-4). Chart III-3Central Bank Selling FX Reserves = Lower Domestic Liquidity Chart III-4Lower Domestic Liquidity = Higher Rates Rising interbank rates will dampen banks' net interest margin as well as constrain loan growth in the process. In short, banks' profitability will be materially affected. Interestingly, interest rates, shown as inverted in the chart, correlate with banks' share prices (Chart III-5, top panel). Chart III-5Higher Rates Will Hurt Bank Stocks Finally, a slowdown in the economy and higher borrowing costs, both local and U.S. dollar, will cause non-performing loans (NPLs) to rise. Banks will be forced to increase provisions for non-performing assets, hurting bank profits in the process (Chart III-5, bottom panel). In terms of financial markets implications, we have the following observations and recommendations to make: Peruvian stock prices have been unable to break above their previous highs in absolute terms, pointing to a major top (Chart III-6). Chart III-6A Major Top? We recommend maintaining an underweight allocation to Peru in an EM dedicated equity portfolio. A negative external backdrop - rising U.S. interest rates, a strong dollar and falling commodities prices - constitute a major headwind for this equity market. Fixed income investors with local market exposure should consider betting on curve flattening given the outlook of higher short-term rates and decelerating growth. Andrija Vesic, Research Analyst andrijav@bcaresearch.com 1 We discussed the domino effect in Emerging Markets Strategy Weekly Report "EM: Sustained Decoupling, Or Domino Effect?" dated June 14, 2018, the link is available on page 19. 2 Please see Emerging Markets Strategy Weekly Report "Desynchronization Compels Currency Adjustments," dated September 20, 2018, the link is available on page 19. 3 Please see Geopolitical Strategy/Emerging Markets Strategy Special Report "Taiwan Is A Potential Black Swan," dated March 30, 2018, the link is available on ems.bcaresearch.com 4 Credicorp constitutes 70% of the Peru MSCI Index. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The long term direction for the pound is higher... ...but as the EU withdrawal bill passes through the U.K. parliament, expect a very hairy ride. The stock markets in Norway, Sweden and Denmark are driven by energy, industrials, and biotech respectively. Upgrade Sweden to neutral and downgrade Denmark to underweight. Think of semiconductors as twenty-first century commodities. Overweight the semiconductor sector versus broader technology indexes. Chart of the WeekBritish Public Opinion On Brexit Is Shifting Feature The Brexit drama is playing out exactly as scripted (Chart I-2). Chart I-2The Pound Is Following The Brexit Drama In July, we wrote: "The U.K. government's much hyped 'Chequers' proposal for Brexit risks getting a cold shower... the EU27 will almost instantaneously reject the proposed division between goods and services as 'cherry-picking' from its indivisible four freedoms - goods, services, capital, and people... the rejection will be based not just on the EU's founding principles, but also on the practical realities of a modern economy - specifically, the distinction between goods and services has become increasingly blurred." 1 Hence, the Chequers proposal to avoid a hard border between Northern Ireland and the Irish Republic is just wishful thinking: "The Irish border trilemma will remain unsolved, leaving a 'backstop' option of Northern Ireland remaining in the EU single market - an outcome that will be politically unpalatable." 2 What happens next? Understanding Brexit In a sense, Brexit is very simple. The EU27 sees only three options for the long-term political and economic relationship between the U.K. and the EU. Remain in the EU (no Brexit). Plug into an off-the-shelf setup, either the European Economic Area (EEA), European Free Trade Association (EFTA), or a permanent customs union, which already establish the EU relationship with Norway, Iceland, Liechtenstein, and Switzerland (soft Brexit). Become a 'third country' to the EU like, for example, Canada (hard Brexit). The first option, to stay in the EU, is politically impossible unless a new U.K. referendum overturned the original referendum's vote to leave. The second option, to join the EEA, EFTA, or permanent customs union is very difficult for Theresa May - because it is strongly opposed by many of the Conservative government's ministers and members of parliament who regard the option as 'Brino' (Brexit in name only). However, in a significant recent development, the opposition leader Jeremy Corbyn has committed the Labour party to a Brexit that keeps the U.K. in a permanent customs union.3 The third option, to become a 'third country', would very likely require some sort of border in Ireland. As already discussed, the only way to avoid a border would be a perfect alignment between the U.K and EU on tariffs and regulations for goods and services. But then, there would be little point in becoming a third country. Here's the crucial issue. The EU27 does not know which option the U.K. will eventually take, yet it must provide an 'all-weather' safeguard for the Good Friday peace agreement, requiring no border between Northern Ireland and the Irish Republic. Therefore, the EU27 will need the withdrawal agreement to commit: either the whole of the U.K. to a potentially permanent customs union with the EU; or Northern Ireland to a potentially permanent customs separation from the rest of the U.K. - in effect, breaking up the U.K by creating a border between Britain and Northern Ireland. Clearly, the hard Brexiters and/or Northern Ireland unionist MPs will vote down a withdrawal bill which contains either of these commitments, thereby wiping out Theresa May's slender majority. The intriguing question is: might Labour MPs - or enough of them - vote for a potentially permanent customs union to get the soft Brexit they want? Labour would be torn between the national interest and the party interest, as it would be missing a golden opportunity to topple the Conservative government. If the withdrawal bill musters a majority, it would remove the prospect of a 'no deal' Brexit and the pound would rally - because it would liberate the Bank of England to hike interest rates more aggressively (Chart I-3 and Chart I-4). If the bill failed, the government and specifically Theresa May would be badly wounded. She might call a general election there and then. Chart I-3Absent Brexit, U.K. Interest Rates Would Be Higher Chart I-4Absent Brexit, U.K. Interest Rates Would Be Higher If May limped on, parliament would nevertheless have the final say on whether to proceed with a no deal Brexit. And the parliamentary arithmetic indicates that a clear majority of MPs would vote against proceeding over the cliff-edge. At this point with the government paralysed, the only way to unlock the paralysis would be to go back to the people. Either in a general election or in a new referendum, the key issue for the public would be a choice between one of the three aforementioned options for the U.K./EU long-term relationship - because by then, it would be clear that those are the only options on offer. Based on a clear recent shift in British public opinion, the preference is more likely to be for a soft (or no) Brexit than to become a third country (Chart of the Week). Bottom Line: The long term direction for the pound is higher but, as the withdrawal bill passes through parliament, expect a very hairy ride. Understanding Scandinavian Stock Markets The Scandinavian countries - Norway, Sweden, and Denmark - have many things in common: their languages, cultures, and lifestyles, to name just a few. However, when it comes to their stock markets, the three countries could not be more different. Looking at the three bourses, each has a defining dominant sector (or sectors) whose market weighting swamps all others. In Norway, oil and gas accounts for over 40 percent of the market; in Sweden, industrials accounts for 30 percent of the market and financials accounts for another 30 percent; and in Denmark, healthcare accounts for 50 percent of the market (Table I-1). Table I-1The Scandinavian Stock Markets Could Not Be More Different! In a sense, the dominant equity market sectors in Norway and Sweden just reflect their economies. Norway has a large energy sector; Sweden specializes in advanced industrial equipment and machinery and it also has very high level of private sector indebtedness, explaining the outsized weighting in banks. However, Denmark's equity market - dominated as it is by Novo Nordisk, which is essentially a biotech company - has little connection with Denmark's economy. The important point is that the four dominant sectors - oil and gas, industrials, financials, and biotech - each outperform or underperform as global (or at least pan-regional) sectors. If oil and gas outperforms, it outperforms everywhere and not just locally. It follows that the relative performance of the four dominant equity sectors drives the relative stock market performances of Norway, Sweden, and Denmark. Norway versus Sweden = Energy versus Industrials (Chart I-5) Chart I-5Norway Vs. Sweden = Energy Vs. Industrials Norway versus Denmark = Energy versus Biotech (Chart I-6) Chart I-6Norway Vs. Denmark = Energy Vs. Biotech Sweden versus Denmark = Industrials and Financials versus Biotech (Chart I-7) Chart I-7Sweden Vs. Denmark = Industrials And Financials Vs. Biotech Last week, we upgraded some of the more classical cyclical sectors to a relative overweight. Our argument was that if an inflationary impulse is dominating, beaten-down cyclicals have more upside than the more richly-valued equity sectors; and if a disinflationary impulse from higher bond yields is dominating, its main casualty will be the more richly-valued equity sectors. On this basis, our ranking of the four sectors is: Industrials, Financials, Energy, Biotech. Which means the ranking of the Scandinavian stock markets is: Sweden, Norway, Denmark. Bottom Line: From a pan-European perspective, upgrade Sweden to neutral and downgrade Denmark to underweight. Understanding Semiconductors The best way to understand semiconductors is to think of them as twenty-first century commodities. In the twentieth century, many everyday goods and products contained a classical commodity such as copper. Today, the ubiquity of electronic gadgets, devices, and screens contains a twenty-first century equivalent: the microchip. Hence, semiconductors are to the tech world what classical commodities are to the non-tech world. They exhibit exactly the same cycle of relative performance. If, as we expect, beaten-down industrial commodities outperform, it follows that the beaten-down semiconductor sector will outperform broader technology indexes (Chart I-8). Chart I-8Semiconductors Follow The Commodity Cycle Bottom Line: Overweight the semiconductor sector versus technology. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 For example, the sale of a car is no longer the sale of just a good. As car companies often structure the financing of the car purchase, a car purchase can be a hybrid of a good - the car itself, and a service - the financing package. Therefore, a single market for cars requires a single market for both goods and services. 2 The Irish border trilemma comprises: 1. the U.K./EU land border between Northern Ireland and the Irish Republic; 2. the Good Friday peace agreement requiring the absence of any physical border within Ireland; 3.the Northern Ireland unionists' refusal to countenance a U.K./EU border at the Irish Sea, which would entail a customs border between Northern Ireland and the rest of the U.K. 3 At the Labour Party's just-held 2018 conference, Jeremy Corbyn made a commitment to joining a permanent U.K./EU customs union. Fractal Trading Model* This week's recommended trade comes from Down Under. The 25% outperformance of Australian telecoms (driven by Telstra) versus insurers (driven by IAG and AMP) over the past 3 months appears technically extended, with a 65-day fractal dimension at a level that has regularly indicated the start of a countertrend move. Therefore, the recommended trade is short Australian telecoms versus insurers, setting a profit target of 7% and a symmetrical stop-loss. In other trades, long CRB Industrial commodities versus MSCI World Index achieved its profit target very quickly, leaving four 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-9 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 I-1Indicators To Watch - Bond Yields Chart I-2Indicators To Watch - Bond Yields Chart I-3Indicators To Watch - Bond Yields Chart I-4Indicators To Watch - Bond Yields Interest Rate Chart I-5Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations

Highlights Rising U.S. bond yields will continue to put downward pressure on global stocks in the near term, but will not trigger an equity bear market until rates reach restrictive territory. We are still at least 12 months away from that point. The blowout in Italian bond yields has further to go, which will also weigh on global risk assets. Nevertheless, we would buy BTPs for a tactical trade if the 10-year yield rose above 4%, because at that level EU policymakers will call out the fire engines. We downgraded global equities from overweight to neutral in June, while maintaining our bias for DM stocks over EM stocks. Barring any major new developments, we would turn bullish again if global stocks were to fall by 8% from current levels. Remain cyclically underweight interest rate duration. We would move to neutral on duration if the U.S. 10-year yield were to rise to 3.7%. We are still bullish on the dollar, but would shift to neutral if the DXY rose above 100. Feature Bond Yields: Up, Up, And Away Global risk assets remained on the back foot this week. The MSCI All-Country World stock market index has now fallen by 6.3% in dollar terms since last Wednesday. Even the mighty S&P 500 has finally buckled under the pressure. The vulnerability of U.S. stocks had been accumulating beneath the surface for some time, as evidenced by the fact that the advance-decline line has been deteriorating since the late summer. The small cap Russell 2000 is down 11.3% from its August 31st highs (Charts 1A& 1B). Chart 1ABreadth Deteriorated In The Lead-Up To The Correction Chart 1BStocks Under Pressure Bond yields usually fall when equities swoon. This time around, it is the increase in bond yields itself that has undermined stocks. In the U.S., yields have risen in response to better-than-expected growth, a wider budget deficit, rising oil prices, and an increasingly hawkish Fed. In Italy, worries about debt sustainability have been the primary driver of rising yields. Neither factor spells doom for global risk assets. However, a period of indigestion is likely over the coming weeks, which could see global equities go down before they go up again. The U.S. Economy: Too Much Winning? We have argued for much of this year that investors were underappreciating the extent to which the Federal Reserve can raise rates without choking off growth. The past few weeks have seen a growing recognition among investors that the Fed may be behind the curve in normalizing monetary policy. This has led to a steepening in the expected path of U.S. short-term rates, which, together with an increase in the term premium, have pushed up yields at the longer-dated maturities. Both better economic data and Fedspeak contributed to the bond sell-off. On the data front, the non-manufacturing ISM index clocked in at 61.6. The all-important employment component of the index hit a record high. Confirming the encouraging labor market signal from the ISM, the unemployment rate fell to a 48-year low of 3.68% in September. While average hourly earnings ticked down to 2.75% on a year-over-year basis, this was entirely due to base effects. On a month-over-month basis, average hourly earnings have risen by 0.3% for three straight months. If this trend continues, the year-over-year rate will rise to 3.2% by the end of this year. Tellingly, recent wage growth has been concentrated among workers at the bottom of the income distribution (Chart 2). This is important because not only do the wages of low-income workers correlate better with labor market slack than those of high-income workers, but low-income workers are also more likely to spend the bulk of their paychecks. Chart 2Wage Growth Has Accelerated At The Bottom Of The Income Distribution Higher wage growth will boost consumer spending. Indeed, it is probable that consumption will rise more than income, given that the personal savings rate has plenty of scope to fall from the current elevated level of 6.6%. Rising wages will incentivize companies to invest more in labor-saving technologies, translating into an increase in capital spending.1 Add in ongoing fiscal stimulus, and we have a recipe for an overheated economy. Starstruck No More As of today, the market has priced in one Fed rate hike in December but only two rate hikes in 2019 (Chart 3). Investors expect no rate hikes in 2020 and beyond. That still seems implausible to us, which suggests that the bond sell-off has further to go. Chart 3The Market Still Thinks The Fed Can't Raise Rates Above 3% In contrast to the past, the Fed no longer seems interested in talking down rate expectations. Speaking with Judy Woodruff at The Atlantic Festival, Chairman Powell stated the Fed "may go past neutral, but we are a long way from neutral at this point, probably."2 Even uber-dove Chicago Fed President Charles Evans appears to have jettisoned his worries about deflation, noting in a speech last Wednesday that "I am more comfortable with the inflation outlook today than I have been for the past several years."3 The Fed has also increasingly downplayed the importance of estimates of the neutral rate of interest, the concept on which the long-term "dots" in the Summary of Economic Projections are based. The Fed's new mantra is that economic data, rather than some theoretical model, should guide monetary policy. Ironically, it was New York Fed President John Williams, who developed one of the most widely used models of r-star, the eponymously named Holston-Laubach-Williams model, that best articulated the Fed's position. At a speech last Monday, Williams argued that the neutral rate of interest, or r-star, has "gotten too much attention in commentary about Fed policy." He went on to say that "Back when interest rates were well below neutral, r-star appropriately acted as a pole star for navigation. But, as we have gotten closer to the range of estimates of neutral, what appeared to be a bright point of light is really a fuzzy blur, reflecting the inherent uncertainty in measuring r-star."4 Trump And Bonds President Trump was quick to blame the Fed for this week's stock market sell-off. Within the span of 24 hours, he used the words "crazy," "loco," "ridiculous," "too cute," "too aggressive," and "big mistake" to describe recent Fed policy. We doubt Trump's rhetoric will have any immediate effect on Fed decision-making. But even if it did sway the Fed to slow the pace of rate hikes, the result will be higher bond yields, not lower yields. This is simply because any further delays in raising rates will lead to even more overheating, and ultimately, higher inflation and the need for higher rates down the road. Bond Sell-Off Will Produce A Correction In Stocks, Not A Bear Market At the height of this week's bond sell-off, the 10-year Treasury yield breached its 200-month moving average for the first time since ... October 1987 (Chart 4). While that sounds pretty ominous, keep in mind that the 10-year yield had reached almost 10% on the eve of the 1987 stock market crash, or about 6% in real terms. Chart 4Two Lines Meet After Three Decades As my colleague, Doug Peta, discussed two weeks ago, it is the level of interest rates that tends to matter more for stocks rather than the change in rates.5 Specifically, equity returns tend to be lowest at times when monetary policy is already in restrictive territory (Chart 5 and Tables 1 and 2). That was the case in 1987. It is not the case today. Chart 5The Fed Funds Rate Cycle Table 1Tight Policy Is Hazardous To Stocks' Health... Table 2...Especially In Real Terms The fact that stocks do worse in environments where monetary policy is tight makes perfect sense. A restrictive monetary policy is usually a prelude to a recession. As Chart 6 illustrates, bear markets and recessions almost always coincide, with the latter usually leading the former by about six-to-twelve months. None of our favorite leading recession indicators are flashing red now (Chart 7). Even the yield curve has steepened in recent weeks. Chart 6Recessions And Bear Markets Usually Overlap Still, higher long-term bond yields do reduce the long-term attractiveness of stocks compared with bonds. The S&P 500 earnings yield has risen modestly since 2016 due to the fact that earnings have grown somewhat more quickly than equity prices. However, the U.S. real 10-year yield has surged by almost 120 basis points over this period. On balance, this has caused the equity risk premium to decline (Chart 8).6 In order to bring the equity risk premium back down to mid-2016 levels, the S&P 500 would need to fall by about 15% from today's levels. We do not expect stocks to fall by that much, partly because the economic environment is more robust than back then, but a further drop of 5%-to-10% from current levels is certainly plausible. Chart 7A U.S. Recession Is Not Imminent Chart 8Stocks Versus Bonds Italy: Heading For A Debt Crisis? The rise in Treasury yields has reduced the attractiveness of other global government bond markets, causing them to sell off in sympathy. Notably, German bund yields have increased by 33 basis points since their May lows (Chart 9). Chart 9Global Bond Yields Moving Higher Rising German bund yields are bad news for Italy. All things equal, a higher "risk free" bund yield implies a higher Italian bond yield. To make matters worse, as Italian borrowing costs have risen, the perceived likelihood that Italy will be unable to repay its debt has increased. This has caused the spread between German bunds and Italian BTPs to widen, thereby magnifying the effect on Italian bond yields from the increase in risk-free yields. All this has happened at the worst possible moment. Italy's populist government and the European Commission are locked in a battle of wills over next year's budget. The Italian government is targeting a fiscal deficit of 2.4% of GDP for 2019, compared with a deficit of 0.8% that the outgoing caretaker government had proposed in May. Strictly speaking, the new deficit target is still consistent with the 3% limit under the Maastricht Treaty. Nevertheless, it is still causing consternation in Brussels. There are at least three reasons for this: While the government's program has a lot of specifics about how it will increase the deficit - more public investment; a universal minimum income scheme; the ability to retire earlier than under current law; corporate tax cuts; no VAT hike in 2019, etc. - it does not specify which items in the budget will be cut. The program also provides few details on revenue measures, other than proposing a one-off tax amnesty, which will arguably reduce tax receipts over the long haul. The proposed budget assumes real GDP growth of 1.5% in 2019. This is higher than the May projection of 1.4%, and well above the IMF's most recent projection of 1%. The government's real GDP projections for 2020-21 are also about 0.7 percentage points above the IMF's estimates. While Italy's proposed fiscal deficit is below the Maastricht Treaty limit, its current debt-to-GDP ratio of 132% is well above the ceiling of 60% (Chart 10). This implies that Italy should be aiming for a smaller deficit target than what it is currently proposing. Chart 10Italy's Public Debt Mountain We expect the Italian government to ultimately acquiesce to the EU's demands, but not before the bond vigilantes have pushed them into a corner. For their part, the EU establishment would love nothing more than to embarrass the Five Star-Lega coalition in order to send a message to voters across Europe about the dangers of voting for populist parties. This means that the Italian 10-year yield may need to break above 4% - the level at which Italian banks would likely be technically insolvent based on the market value of their BTP holdings - before a compromise is reached. We would put on a tactical trade to buy 10-year BTPs at that level, but not before then. Investment Conclusions Goldilocks will survive, but the next couple of months will be challenging. Our soon-to-be-launched MacroQuant model is signaling a bearish outlook for stocks over the next 30 days (Chart 11). On the bond side, the model currently pegs the fair value for the U.S. 10-year yield at 3.7% (Chart 12). Bond sentiment is quite bearish at the moment, which makes a brief countertrend bond rally quite likely. However, the cyclical trend in yields remains to the upside. Chart 11MacroQuant* Recommends That Caution Is Warranted Towards Equities Chart 12MacroQuant Sees 10-Year Treasury Yields Still Below Fair Value We stated last week that investors should consider scaling back risk if they are currently overweight risk assets. We continue to favor this more cautious stance. For the first time in over a decade, short-term U.S. rates are above the dividend yield on the S&P 500 (Chart 13). Holding a bit more cash is finally an attractive option, at least for U.S.-based investors. Chart 13Cash Anyone? If the sell-off in global equities continues, it will present a buying opportunity, given that the next major global economic downturn is probably at least another two years away. Barring any major new developments, we would turn bullish on stocks again if the MSCI All-Country World Index were to fall by 12% 10% 8% from current levels.7 We would recommend that investors move from an underweight to a neutral interest rate duration position in global bond portfolios if the U.S. 10-year Treasury yield rose to 3.7%. We are still bullish on the dollar, but would shift to neutral if the DXY rose above 100. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 It is true that additional investment spending will raise aggregate supply, but normally it takes a while for that to happen. For example, it may take a few years to build an office tower or a new factory. Corporate R&D investment may not generate tangible benefits for a long time, especially in cases where the research is focused on something complicated (i.e., the design of new computer chips or pharmaceuticals). And even if investment spending could be transformed into additional productive capacity instantaneously, aggregate demand would still rise more than aggregate supply, at least temporarily. Here is the reason: The nonresidential private-sector capital stock is about 120% of GDP in the United States. As such, a one percent increase in investment spending would raise the capital stock by four-fifths of a percentage point. Assuming a capital share of income of 40% of national income, a one percent increase in the capital stock would lift output by 0.4%. Thus, a one-dollar increase in business investment would boost aggregate demand by one dollar in the year it is undertaken, while increasing supply by only 4/5*0.4 = roughly 32 cents. 2 Please see "WATCH: Powell says Fed is focused on 'controlling the controllable,' not politics," PBS News Hour, October 3, 2018; and Jeff Cox, "Powell says we're 'a long way' from neutral on interest rates, indicating more hike are coming," CNBC, October 3, 2018. 3 Charles Evans, "Monetary Policy 2.0?" OMFIF City Lecture on the U.S. Economic Outlook, London, England, October 3, 2018. 4 John C. Williams, "Remarks at the 42nd Annual Central Banking Seminar," Bank for International Settlements, October 1, 2018. 5 Please see U.S. Investment Strategy Special Report, "When Will Higher Rates Hurt Stocks?" dated September 24, 2018; and Special Report, "Revisiting The Fed Funds Rate Cycle," dated September 3, 2018. 6 For this exercise, we define the equity risk premium as the difference between the S&P 500 earnings yield (the inverse of the forward P/E ratio) and the real 10-year bond yield (using CPI swaps as our measure of expected inflation). 7 The perils of writing a report during a week when markets are moving fast. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Please note that a Special Alert titled "Brazil: A Regime Shift?" discussing investment implications of the weekend elections was published on Tuesday. Highlights The combination of rising U.S. bond yields and slumping growth in EM/China heralds further downside in EM risk assets and currencies. Watch for a breakdown in Asian risk assets and currencies. As a market-neutral trade for the next several months, we recommend going long Latin American and short emerging Asian stocks in common currency terms. We are downgrading Hong Kong stocks from neutral to underweight within an Asian or EM equity portfolio. Feature U.S. bond prices have broken down, and yields have broken out (Chart I-1). The bond selloff will continue as U.S. growth is very strong and inflationary pressures are accumulating. Chart I-1U.S. Bond Yields Have Broken Out, More Upside How will EM financial markets react to a further rise in U.S. bond yields? If EM growth were robust and fundamentals healthy, financial markets in developing countries would have no problem digesting higher U.S. interest rates. However, the fact is that EM fundamentals are poor and growth is weakening. Consequently, financial markets in the developing world are very vulnerable to higher U.S. bond yields. For now, U.S. bond yields will continue to rise, the U.S. dollar will strengthen further, and the EM bear market will endure. Stay short/underweight EM risk assets. Understanding The Nexus Between EM Assets And U.S. Bonds Rising U.S. bond yields pose a threat to EM risk assets if the former leads to a stronger U.S. dollar and by extension weaker EM currencies. Notably, risks to EM share prices will magnify if dollar borrowing costs for EM (corporate and sovereign bond yields) increase further (Chart I-2). In short, if rising U.S. bond yields are not offset by narrowing EM credit spreads, EM dollar bond yields will climb. This in turn will weigh on EM share prices. Chart I-2Rising Dollar Borrowing Costs: A Bad Omen For EM Stocks Chart I-3 highlights that the divergence between U.S. and EM share prices this year can be attributed to the decoupling in their credit spreads. Chart I-3Diverging Credit Spreads Between EM & U.S Credit spreads, meanwhile, are steered by EM exchange rates (Chart I-4). When EM currencies depreciate, debtors' ability to service U.S. dollar debt worsens, and credit spreads widen to reflect higher risk. The opposite also holds true. Chart I-4EM Credit Spreads Are A Function Of EM Currencies Overall, getting EM exchange rates right is of paramount importance. Hence, a vital question: Do EM currencies always depreciate when U.S. bond yields are rising or the Federal Reserve is tightening? Chart I-5 suggests not. Before 2013, EM currencies appreciated with rising U.S. bond yields. Since 2013, the correlation has been mixed. Chart I-5No Stable Relationship Between U.S. Bond Yields & EM Currencies The key difference between these periods is the performance of EM/Chinese economies. When EM/China growth is robust or accelerating, financial markets in developing economies have no trouble digesting higher U.S. interest rates and their currencies tend to appreciate. By contrast, when EM/China growth is weak or slumping, EM asset prices and currencies tumble regardless of the trajectory of U.S. interest rates. A pertinent question at the moment is why robust U.S. growth is not helping EM weather higher U.S. interest rates. The caveat is that EM as a whole is more exposed to the Chinese economy than the American one. Hence, barring a meaningful improvement in Chinese growth, higher U.S. bond yields will be overwhelming for EM financial markets. This is why we have been focusing on China's growth dynamics. Bottom Line: Desynchronization between the U.S. and Chinese economies will persist. The resulting combination of rising U.S. bond yields, a stronger greenback and depreciating EM currencies foreshadows further downside in EM risk assets. Emerging Asia: Do Not Catch A Falling Knife The latest export data from Korea and Taiwan point to a continued slowdown in their exports (Chart I-6). Corroborating the deepening slump in Asian growth and global trade, emerging Asian equity and credit markets are plunging. In particular: Chart I-6Global Trade Is Slowing The relative performance of emerging Asian stocks versus the global equity benchmark failed to break above important technical long-term resistance lines earlier this year, and will likely breach below their early 2016 lows (Chart I-7). Chart I-7Emerging Asian Equities Vs. Global: Further Underperformance Ahead Both high-yield and investment-grade emerging Asian corporate dollar-denominated bond yields continue to climb - a worrisome development for emerging Asian share prices (high-yield corporate bond yields are shown inverted in Chart I-8). Chart I-8Rising Corporate Bond Yields In Emerging Asia = Lower Stock Prices The equity selloff in emerging Asia is broad-based. Chart I-9 shows that the emerging Asian small-cap equity index is in freefall. Chart I-9Emerging Asian Small Caps Are In Freefall Net earnings revisions in China, Korea and Taiwan have dropped into negative territory (Chart I-10). Chart I-10Net Earnings Revisions Are Negative In China, Korea And Taiwan The Chinese MSCI All-Share Index - all stocks listed on the mainland and offshore (worldwide) - has plunged close to its early 2016 lows (Chart I-11). Chart I-11Chinese Broad Equity Index Is Back To Its 2016 Lows In China, the property market and construction remain at substantial risk. The budding slump in the real estate market will likely offset the government spending stimulus on infrastructure investment. Plunging share prices of property developers listed in both onshore and in Hong Kong point to a looming major downtrend in real estate market (Chart I-12). Chart I-12An Imminent Slump In Chinese Real Estate? For Asian equity portfolio managers whose mandate is to make a decision on Hong Kong and Singapore stocks, we recommend downgrading Hong Kong equities from neutral to underweight while maintaining Singapore at neutral within an Asian and overall EM equity portfolio. Our basis is that rising interest rates in the U.S. will translate into higher borrowing costs in Hong Kong due to the currency peg (Chart I-13). Simultaneously, Hong Kong's economy will suffer from a slowdown in China. Hence, a combination of weaker growth and rising borrowing costs will spell trouble for this interest rate-sensitive bourse. Chart I-13Higher U.S. Rates = Higher Hong Kong Rates Bottom Line: Equity and credit markets in emerging Asia are trading extremely poorly, and further downside is very likely. This week, we are downgrading allocations to Hong Kong stocks from neutral to underweight within an Asian or EM equity portfolio. A Relative Equity Trade: Short Asia / Long Latin America Common currency relative performance of emerging Asian versus Latin American stocks has broken down (Chart I-14). We reckon emerging Asian equities are set to underperform their Latin American peers for the next several months. Chart I-14Long Latin American / Short Emerging Asian Stocks The main culprit will likely be further depreciation in the RMB and an intensifying economic downturn in Asia, which will propel emerging Asian currencies and share prices lower. In regard to Latin America, elections in Mexico and Colombia have produced governments that will on the margin be positive for their respective economies. In Brazil too, first round election results are pointing to a market friendly result. We have been shifting our country equity allocation in favor of Latin America at the expense of Asia since late last year. In particular, we downgraded Chinese stocks in December 2017, Indonesian equities this past May and the Indian bourse last week. At the same time, we have been raising our equity allocation to Latin America by upgrading Mexico to overweight in April 2018, Colombia last week and Brazil earlier this week.1 Given we are also overweight Chilean stocks, our fully invested EM equity model portfolio noticeably overweights Latin America versus Asia. Notwithstanding our broad underweight in emerging Asia, we are still overweight Korea, Taiwan and Thailand within an EM equity portfolio. However, these overweights are paltry relative to both the size of the Asian equity universe and our overweights in Latin America. Bottom Line: Go long Latin American and short emerging Asian stocks in common currency terms as a trade for the next several months. Our Fully-Invested Equity Model Portfolio Chart I-15 demonstrates the performance of our fully invested EM equity portfolio versus the EM MSCI benchmark. This portfolio is constructed based on our country recommendations. Hence, it is a measure of alpha that clients could derive from our country calls and geographical equity allocations. Chart I-15EMS's Fully-Invested Model Equity Portfolio Performance We make explicit country equity recommendations (overweight, underweight and neutral) based on qualitative assessments of all relevant variables - the business cycle, liquidity, currency risks, policy, politics, valuations, and the structural backdrop among other things - for each country. This model portfolio is not a quantitative black box, but rather a combination of several factors: macro themes on the overall EM space, in-depth research on each individual country and various quantitative indicators. The table with our recommended country equity allocation is published at the end of our weekly reports (please refer to page 11). This fully invested equity model portfolio has outperformed the MSCI EM equity benchmark by about 65% with very low volatility since its initiation in May 2008. This translates into 500-basis-points of compounded outperformance per year. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EM: Staring At A Grey Swan?" dated October 4, 2018 and Emerging Markets Strategy Special Alert "Brazil: A Regime Shift?" dated October 9, 2018; links are available on page 11. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Portfolio Strategy A playable sector rotation opportunity has emerged, as we first argued at the recent BCA investment conference: Financials, industrials and select tech subgroups will lead the next phase of the market advance, a result of the bond market selloff gaining steam into year-end and beyond. In contrast, rising interest rates, a vibrant U.S. economy, softening operating metrics and high indebtedness signal that it is time to shed utility stocks. Recent Changes Trim the S&P Utilities sector to underweight today. Table 1 Feature On the eve of earnings season, the SPX remains close to an all-time high. The most recent spate of investor optimism was driven by President Trump cementing another deal last week, this time with Canada. While the renaming of NAFTA to USMCA is a step in the right direction (i.e. a deal was struck), a deal with China remains the elephant in the room. On that front, U.S. hawkish trade rhetoric should remain in vogue and any deal will have to wait until at least after the election, if not until Q1/2019. Up to now Trump's trade hawkishness has not infiltrated U.S. profits, but we continue to closely monitor IBES reported profit growth expectations. Following up from last week, the rest of the world is bearing the brunt of the U.S. trade-related rhetoric according to our profit growth models, a message sell-side analysts' forecasts also corroborate (we use forward EBITDA in order to gauge trend profit growth and filter out the tax-induced jump in U.S. EPS, Chart 1). Meanwhile, at the margin, seasonality can prop up stocks. While September - a historically negative return month, but not this year - is behind us, stock market crash-prone October is upon us, and thus a pick-up in volatility would not come as a surprise. Beyond October's dreaded crash history, the Presidential cycle has piqued our interest, especially years two and three. Building on our sister Geopolitical Strategy publication's research,1 and given the upcoming midterm elections, we created a cycle-on-cycle profile of SPX returns during these two middle Presidential cycle years (Chart 2). Chart 1U.S. Has The Upper Hand Chart 2Seasonality Boost Until Midyear 2019? In more detail, we analyzed 17 cycles starting in 1950 using S&P 500 daily data (reconstructed S&P 500 prior to 1957). During these iterations, only two two-year periods ended in the red, 1974/75 and 2002/03. The first coincided with a recession and the second took place in the aftermath of the dotcom bust. In addition, two other cycles produced roughly 5% two-year returns, 1962/63 and 1966/67. Finally, 1954/55 was the outlier when the SPX went parabolic and nearly doubled. While every cycle is different, it is clear from Chart 2 that the Presidential cycle should continue to underpin the SPX, if history is an accurate guide, especially given our forecast of no recession in the coming 9-to-12 months. In fact, the S&P could rise another 10%, in line with our 2019 expectation, predicated upon a 10% increase in profits and a lateral multiple move. Interestingly, according to the median Presidential cycle-on-cycle roadmap, while the back half of 2019 is likely to prove more challenging, the first half of next year should enjoy most of the returns (Chart 2). An assessment of recent data releases in the U.S. and abroad is also revealing. Chart 3 shows that the domestic economy is firing on all cylinders. Consumer confidence and sentiment hit multi-decade highs recently. Similarly, the job market remains vibrant and small business euphoria reigns supreme. Not only are small business owners optimistic on all employment-related subcomponents of the NFIB survey, but SME capex intentions are also as good as they get. The ISM manufacturing survey ticked down from the August peak, but remains close to 60. Its close sibling, the ISM services survey, vaulted into uncharted territory. All of this is reflected in the still-growing U.S. leading economic indicator and signals that the U.S. equity market remains on a solid footing. Outside U.S. shores, the bearish narrative is well established with EMs, especially the U.S. dollar debt-saddled fragile five that have to contend with twin deficits, sinking in a bear market. China's debt load is also coming under intense scrutiny as U.S. tariffs are all but certain to weigh on Chinese output growth. Nonetheless, there is a chance that the EMs have depreciated their currencies by enough to engineer a modest rebound (bottom panel, Chart 4). In other words, absent the currency peg straightjacket that dominated the region in the late-1990s, free-floating FX devaluations may serve as a relief valve in order to boost exports. The latest Korean MARKIT manufacturing PMI spiked above the boom/bust line to a multi-year high signaling that already humming Korean factories (industrial production is accelerating) will likely remain busy in the coming months. Other hard economic data also confirm these greenshoots: Korean manufacturing exports are expanding smartly. In particular, exports to China are soaring. Reaccelerating manufacturing selling prices also corroborate this budding Korean recovery (third panel, Chart 4). Chart 3U.S. Is On Fire Chart 4Reflationary Impulse? While it is premature to call an end to the EM carnage, most of the bad news on global export volumes and prices may be nearing an end and the EMs may even export some of their inflation to the U.S. Play The Sector Rotation Into Financials And Industrials... In recent research, we have been highlighting that inflation is slowly rearing its ugly head and there are high odds that the selloff in the bond market gains steam into year-end and beyond2 (as a reminder BCA's fixed income publications continue to recommend below-benchmark portfolio duration). Against such a backdrop, sectors that benefit from rising interest rates and that serve as inflation hedges should outperform in the coming quarters. The "FIT" market refers to financials, industrials and select technology stocks. In more detail, we expect a sector rotation, especially into financials and industrials that have been laggards and remain compellingly valued (Chart 5). With regard to financials, Chart 6 shows that this early cyclical sector enjoys a positive correlation with interest rates and inflation expectations, and a catch up phase in relative share prices looms in the coming quarters. Chart 5Rotate Into Financials... Chart 6...And Industrials Industrials stocks also benefit from rising inflation and interest rates as large parts of this deep cyclical sector are levered to the commodity cycle (Chart 7). In other words, industrials stocks are an indirect inflation hedge and trouble surfaces only when capital goods producers cannot pass rising input costs down the supply chain or to the consumer. But, we are not there yet. Keep in mind that during the last cycle, relative (and absolute) industrials performance peaked prior to relative energy stock prices. Similarly, the relative industrials stock price ratio troughed in early 2009 before their deep cyclical brethren put in a (temporary) bottom a year later (Chart 8). Chart 7Industrials Lead Chart 8Undervalued True, energy stocks are also going to perform well if our thesis of higher interest rates/inflation pans out in the coming quarters and especially if BCA's Commodity & Energy Strategy service's view of a looming oil price spike materializes (Chart 9). Thus, we sustain the high-conviction overweight stance in the broad sector and reaffirm our recent upgrade to an above benchmark allocation in the S&P oil & gas exploration & production (E&P) subgroup.3 We also reiterate our recent market-neutral and intra-commodity pair trade: long S&P oil & gas E&P / short global gold miners.4 This trade is off to a great start up 10.3% since inception and will benefit further from an inflationary impulse. Chart 9Energy Remains A High-Conviction Overweight While tech stocks have really delivered and led the market advance year-to-date, a bifurcated tech market should remain in place with capex levered S&P software and S&P tech hardware, storage & peripherals indexes (both are high-conviction overweights) outperforming early cyclical tech groups, semi and semi equipment stocks (we remain underweight both semi subindexes). Bottom Line: A playable rotation into financials and industrials is in the offing especially if the selloff in the bond market accelerates on the back of an inflationary whim. We continue to recommend an overweight allocation to both the S&P financials and S&P industrials sectors. ...But Lights Are Out For Utilities Utilities stocks are the ultimate loser from a backup in interest rates as they serve as premier fixed income proxies in the equity space and we are compelled to trim exposure to below benchmark. The niche S&P utilities sector yields 3.5% and when the competing risk free asset is near 3.2% and rising, investors prefer to shed, at the margin, riskier high-yielding equities and park the proceeds in U.S. Treasurys (Chart 10). While arguably most of the bad news is already reflected in washed out technicals and bombed out short and even long-term profit expectations (Chart 11), the selling will only accelerate into yearend and 2019. Chart 10Higher Yields Bite Chart 11Oversold And Unloved... Apart from the tight inverse correlation utilities have with interest rates, they are also a defensive sector that outperforms the broad market when the economy is in retreat. Currently a plethora of recent economic releases are signaling that the U.S. economy is overheating. Chart 12 illustrates the safe haven status of utility stocks (ISM surveys shown inverted). On the operating front, despite the upbeat economic data, electricity capacity utilization remains anemic. Capacity growth is likely responsible for this weak resource utilization signal as utilities construction continues unabated (private construction shown inverted, top panel, Chart 13). Adding insult to injury, inventory accumulation is also weighing on the sector (turbine inventories shown inverted, middle panel, Chart 13). Chart 12...But More Pain Looms Chart 13Weak Operating Metrics Worrisomely, all these expansion plans have been financed with debt. While this is not typically an issue for stable cash flow generating utilities, the sector's net debt-to-EBITDA profile has gone parabolic, nearly doubling since the GFC and even overtaking the early 2000s when a California deregulation wave first led to exuberance and then an electricity crisis (Chart 14). Any letdown in cash flow growth will be disruptive, especially given that the sector has no valuation cushion (bottom panel, Chart 14). Nevertheless, there are some risks that could put our underweight position offside. Natural gas prices have spiked of late and given that they are the marginal price setter for the sector they could boost utility pricing power and thus profits (top & middle panels, Chart 15). As the U.S. economy is firing on all cylinders, electricity demand should remain brisk and provide an offset to the otherwise weakening utility operating backdrop (bottom panel, Chart 15). Chart 14Heavily Indebted And Pricey Chart 15Risks To Underweight View Netting it all out, rising interest rates, a vibrant U.S. economy, softening operating metrics and high indebtedness signal that the time is ripe to sell utility stocks. Bottom Line: Downgrade the S&P utilities sector to underweight. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Fade The Midterms, Not Iraq Or Brexit," dated September 12, 2018, available at gps.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Deflation - Reflation - Inflation," dated August 20, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Soldiering On," dated July 16, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Deflation - Reflation - Inflation," dated August 20, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Duration: Last week's bond market rout was driven by strong U.S. data. Global growth (ex. U.S.) continues to weaken. Weak foreign growth that migrates stateside via a stronger dollar remains the biggest risk to our below-benchmark duration stance. For now, we prefer to hedge that risk by owning curve steepeners and maintaining only a neutral allocation to spread product. High-Yield: A supply shock in the oil market would most likely lead to steep backwardation in the oil futures curve and an increase in implied oil volatility. An increase in implied oil volatility will translate into a higher risk premium embedded in junk spreads. Emerging Market Sovereigns: All of the recent widening in USD-denominated EM sovereign spreads has been concentrated in Turkey and Argentina, two nations that remain highly exposed to global growth divergences and a stronger U.S. dollar. Most other EM countries offer less attractive spreads than comparable U.S. corporate debt. Remain underweight USD-denominated EM sovereign bonds. Feature Bond Breakout Chart 1The Long End Breaks Out Bond markets sold off sharply last week and long-dated Treasury yields took out some noteworthy technical levels in the process. The 10-year Treasury yield broke above its May 2018 peak of 3.11% and settled at 3.23% as of last Friday. The next big test for the 10-year's cyclical uptrend is the 2011 peak of 3.75% (Chart 1). The 30-year yield similarly broke above its May 2018 peak of 3.25%, settling at 3.39% as of last Friday. The next resistance for the 30-year occurs at the early-2014 peak of 3.96%. Removing our, admittedly uncomfortable, technical analysis hat, it is instructive to note which macro factors were responsible for last week's large bear-steepening of the Treasury curve and which weren't. Strong U.S. economic data - the non-manufacturing ISM survey hit its highest level since 1997 (Chart 2) - and Fed Chairman Powell commenting that the fed funds rate is "a long way from neutral at this point, probably" were the key drivers of the move.1 Taken together, these two developments suggest that the Fed is further behind the curve than was previously thought. This is consistent with an upward revision to the market's assessment of the neutral fed funds rate, which explains why the yield curve steepened and the price of gold edged higher.2 But it's equally important to note the factors that didn't drive the increase in yields. In this case, yields weren't driven by a rebound in growth outside of the U.S., which continues to flag (Chart 2, panel 2). The Global Manufacturing PMI fell for the fifth consecutive month in September. While our diffusion index based on the number of countries with PMIs above versus below the 50 boom/bust line ticked higher (Chart 2, panel 3), our diffusion index based on the number of countries with rising versus falling PMIs remained deeply negative (Chart 2, bottom panel). Chart 2Growth Divergences Deepen Chart 3Global PMIs Taken together, our diffusion indexes are consistent with an environment where most countries are experiencing decelerating growth from high levels. This message is confirmed by looking at the PMIs from the five largest economic blocs (Chart 3). The Eurozone PMI continues to fall rapidly, though it remains well above 50. The Emerging Markets (ex. China) PMI is also trending lower from a relatively high level, while the Chinese PMI is threatening to break below 50. Only the U.S. and Japan have healthy looking PMIs. The precariousness of non-U.S. growth leads us to reiterate the biggest risk to our below-benchmark duration view. The risk is that weak foreign growth eventually migrates to the U.S. via a stronger dollar and forces the Fed to pause its +25 bps per quarter rate hike cycle. If current trends continue, it is highly likely that U.S. growth will slow in the first half of next year, though it is unclear whether such a slowdown would be severe enough for the Fed to pause rate hikes.3 In any event, the bond market is only priced for the Fed to maintain its quarterly rate hike pace until June of next year (3 more hikes) before going on hold (Chart 4). Essentially, the market already discounts a rate hike pause, even after last week's large increase in yields. Chart 4Market's Rate Expectations Still Too Low For this reason, we prefer to maintain our below-benchmark portfolio duration stance, and to hedge the risk of weakening foreign growth by owning curve steepeners,4 and maintaining only a neutral allocation to spread product. Bottom Line: Last week's bond market rout was driven by strong U.S. data. Global growth (ex. U.S.) continues to weaken. Weak foreign growth that migrates stateside via a stronger dollar remains the biggest risk to our below-benchmark duration stance. For now, we prefer to hedge that risk by owning curve steepeners and maintaining only a neutral allocation to spread product. In Case You Needed Another Reason To Be Nervous About Junk As Treasury yields broke higher last week, the average high-yield index option-adjusted spread tightened to a fresh cyclical low of 303 bps. It has since rebounded to 316 bps (Chart 5). Our measure of the excess spread available in the high-yield index after adjusting for expected default losses is now at 196 bps, well below its historical average of 247 bps (Chart 5, panel 2). We have previously pointed out that even this below-average excess spread embeds a very low 12-month default loss expectation of 1.07%.5 Rarely have default losses been below that level. With job cut announcements forming a tentative bottom (Chart 5, bottom panel), we see high odds that default losses surprise to the upside during the next 12 months. In the absence of further spread tightening, that would translate to 12-month excess junk returns of 196 bps or less. But this week we want to highlight an additional risk to junk spreads. That risk being our Commodity & Energy Strategy service's view that crude oil prices could experience a positive supply shock in the first quarter of next year. At present, our strategists see high odds of $100 per barrel Brent crude oil in the first quarter of next year, and are forecasting an average price of $95 per barrel for 2019. At publication time, the Brent crude oil price was $85.6 At first blush it isn't obvious why high oil prices would pose a risk to junk spreads, and in fact there is no consistent correlation between the level of oil prices and junk spreads. However, there is a correlation between implied volatility in the crude oil market and junk spreads, with higher implied vol coinciding with wider spreads and vice-versa (Chart 6). Chart 5Default Loss Expectations Too Low Chart 6Higher Oil Vol = Wider Junk Spreads Would higher oil prices necessarily induce a spike in implied volatility? Not necessarily. It turns out that what matters for implied oil volatility is the slope of the futures curve.7 A contangoed futures curve where long-dated futures trade at a higher price than short-dated futures tends to be associated with high implied volatility. A steeply backwardated futures curve where long-dated futures trade well below short-dated futures is equally associated with elevated implied vol (Chart 7). Implied volatility tends to be lowest when the futures curve is in mild backwardation. A mild backwardation is typical when crude prices are in a gradual uptrend, as is the case at present. All in all, the following features provide a reasonable description of the current environment: Gradual uptrend in crude oil price Mild oil futures curve backwardation Low implied crude volatility Tight junk spreads However, as we head into next year, our commodity strategists anticipate that supply constraints will bite in the oil market. The U.S. is poised to implement an oil embargo against Iran in November, and Venezuela - another important oil exporter - remains on the brink of collapse. With global oil inventories already tight, and the loss of further production from Venezuela and Iran looming, our strategists anticipate that the number of days of demand covered by crude oil inventories will decline sharply. This decline will lead to a steep backwardation of the futures curve (Chart 8). Chart 7Brent Crude Oil Volatility Vs. Forward Slope Chart 8Supply Shock Will Lead To Steep Backwardation The bottom line for junk investors is that a supply shock in the oil market would most likely lead to a steep backwardation in the futures curve and an increase in implied oil volatility. An increase in implied oil volatility will translate into a higher risk premium embedded in junk spreads. We continue to recommend only a neutral allocation to high-yield in U.S. bond portfolios. We will await a signal that profit growth is set to deteriorate before advocating for a further reduction in exposure. Still No Buying Opportunity In EM Sovereigns Chart 9EM Index Spread Looks Cheap As growth divergences between the U.S. and the rest of the world increase, we are on high alert for an opportunity to shift some allocation out of U.S. corporate credit and into USD-denominated emerging market (EM) sovereign debt. However, so far EM spreads are simply not wide enough to merit attention from U.S. bond investors. This is not apparent from the average index spreads. In fact, a quick glance at the indexes shows that EM sovereign spreads have widened a lot relative to duration- and quality-matched U.S. corporates, and actually offer a healthy spread pick-up (Chart 9). However, a more detailed look at the spreads from individual countries shows that the spread advantage in EM is only available in a select few markets (Charts 10A & 10B). At the lower-end of the credit spectrum: Turkey, Argentina, Ukraine and Lebanon all offer higher breakeven spreads than comparable U.S. corporates. In the upper credit tiers: Saudi Arabia, Qatar and United Arab Emirates (UAE) look attractive. All other EM countries off lower breakeven spreads than comparable U.S. corporates. Chart 10ABreakeven Spreads: USD EM Sovereigns Vs. U.S. Corporates Chart 10BBreakeven Spreads: USD EM Sovereigns Vs. U.S. Corporates We would be very reluctant to shift any allocation out of U.S. corporates and into either Turkey or Argentina. Both of those countries are highly exposed to the tightening in global liquidity conditions that occurs alongside a strengthening U.S. dollar. Our Foreign Exchange and Global Investment Strategy teams created a Vulnerability Heat Map to identify which EM countries are likely to struggle as the U.S. dollar appreciates (Chart 11).8 These tend to be countries with large current account deficits and high external debt balances, though several other factors are also considered. The results show that Argentina and Turkey are the two most exposed nations. Chart 11Vulnerability Heat Map For Key EM Markets At the upper-end of the credit spectrum, the USD bonds from Saudi Arabia, Qatar and UAE are more interesting. Our geopolitical strategists anticipate an escalation of tensions between the U.S. and Iran following the U.S. midterm elections, and such tensions could increase the political risk premium embedded in all Middle Eastern debt. But for longer-term U.S. fixed income investors, it is worth noting that extra spread is available in the hard currency sovereign debt of Saudi Arabia, Qatar and UAE compared to A-rated U.S. corporates. Bottom Line: All of the recent widening in USD-denominated EM sovereign spreads has been concentrated in Turkey and Argentina, two nations that remain highly exposed to global growth divergences and a stronger U.S. dollar. Most other EM countries offer less attractive spreads than comparable U.S. corporate debt. Remain underweight USD-denominated EM sovereign bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Powell's full interview can be viewed here: https://www.youtube.com/watch?v=-CqaBSSl6ok 2 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com, where we note that every time the Global (ex. US) LEI has dipped below zero since 1993, the U.S. LEI has eventually followed. 4 Please see U.S. Bond Strategy Weekly Report, "More Than One Reason To Own Steepeners", dated September 25, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 6 Please see Commodity & Energy Strategy Weekly Report, "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl", dated September 20, 2018, available at usbs.bcaresearch.com 7 Please see Commodity & Energy Strategy Weekly Report, "Calm Before The Storm In Oil Markets", dated August 2, 2018, available at ces.bcaresearch.com 8 Please see Foreign Exchange Strategy/Geopolitical Strategy Special Report, "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification