Economic Growth

Highlights Uncertainty & Growth: There is currently a strong link between depressed global growth expectations and elevated levels of economic policy uncertainty (U.S.-China trade tensions, Brexit, etc). Monetary Policy: A growing number of central banks have taken “risk management” measures to try and prevent a deeper downturn in actual economic activity by shifting to a less hawkish policy bias – even with tight labor markets. Implications For Bond Yields: We do not expect the current soft patch for global growth to extend into a more prolonged period of weak activity, given that global policy rates remain at highly stimulative levels. This will set up the next wave of rising global bond yields, but likely not until the latter half of 2019 (and focused mostly on U.S. Treasury yields). Feature Central Banks Take Out Some Insurance The list of global central banks taking a more cautious stance on monetary policy expanded last week. The Bank of England and Reserve Bank of Australia both cut their growth forecasts for 2019 and signaled that there was no chance of interest rate increases in the near term. This follows similar guidance provided in recent weeks by the U.S. Federal Reserve, the Bank of Canada and Sweden’s Riksbank. There was even a dovish surprise in the emerging world, with the Reserve Bank of India delivering an unexpected rate cut last week. In Europe, the European Central Bank (ECB) has not yet shifted its already highly-dovish policy guidance (no rate hikes until at least September), but ECB President Mario Draghi recently noted that the downside risks to European growth have increased. The European Commission went a step further and downgraded its growth forecasts for 2019 last week. The Bank of Japan cut its inflation forecast for 2019 last month, also indicating that monetary policy would remain unchanged over at least the rest of the year. The language used by all of these policymakers to explain their dovish turn was eerily similar, highlighting elevated global uncertainty weighing on growth expectations and, through plunging asset prices, tightening financial conditions (Chart of the Week). The sources of that uncertainty are well known to investors: U.S.-China tariff negotiations, slowing global trade, Brexit, domestic U.S. political squabbles (i.e. government shutdowns over “The Wall”). Until those developments begin to get resolved, uncertainty will continue to weigh on economic confidence. Chart of the WeekThe “Risk Management” Approach To Setting Monetary Policy 21st Century central bankers mostly subscribe to a “risk management” approach to policymaking. This means setting policy dovish enough to cut off downside tail risks to growth during periods of elevated uncertainty about the economic outlook – especially when inflation is below policymaker targets. Yet central bankers remain devoted followers of the Phillips Curve framework. There is a limit to how dovish they can become while unemployment is low and wage growth is increasing. This limits how far government bond yields can fall if growth does not slow enough to cause unemployment to rise. So far, the softer global growth seen in recent quarters has not resulted in any increase in unemployment rates in the major developed economies. Of course, employment is a lagging variable. If the current soft patch for growth extends into a more prolonged slowdown in the coming months, resulting in companies cutting hiring or shedding labor to protect weakening profitability, then there is room for bond yields to continue to fall as markets begin to price in easier monetary policy. That is not our expectation. The U.S. economy remains on solid footing, and we anticipate additional policy actions from China to stabilize economic growth and put a floor under global trade activity. This will eventually cause central bankers to move back to a less dovish policy stance more consistent with trends in unemployment and inflation, with the U.S. Fed leading the way on that front in the latter half of 2019. The eventual result will be higher U.S. Treasury yields, both in absolute terms and relative to government bond yields of the other major developed economies. Bottom Line: There is currently a strong link between depressed global growth expectations and elevated levels of economic policy uncertainty. Central banks are taking the appropriate “risk management” measures to prevent a deeper downturn in actual economic activity by shifting to a less hawkish policy bias – even with tight labor markets. The Link Between Economic Confidence & Monetary Policy The pro-risk rally that opened 2019 endured its first test last week, with several major market prices – including the S&P 500 index, U.S. high-yield spreads, the 10-year Italy-Germany government bond yield differential and the DXY index of the U.S. dollar - bouncing off key medium-term moving averages (Chart 2). Purely from a technical analysis perspective, a test of the primary trends established in the latter half of 2018 (bearish equities and credit, bullish the U.S. dollar) was to be expected, particularly given the severity of the past selloff in global equity markets. Chart 2The First Test For The 2019 Risk Rally Investor sentiment towards global growth, however, remains pessimistic. Nervousness over the outcome for the U.S.-China trade talks, with the March 1 deadline fast approaching, is an obvious source of concern given how slowing Chinese import demand has spilled over so dramatically into weaker global trade activity (Chart 3). Yet there are several other dates for investors to fret about in the near term, including the deadline for a deal to avert another U.S. government shutdown (this Friday), the U.S. debt ceiling deadline (also March 1) and “Brexit day” in the U.K. (March 29). Chart 3A China-Led Slowing Of Global Trade Yet this current soft patch for the global economy is occurring alongside an extreme divergence between plunging growth expectations and more stable readings on current economic conditions. The fall in expectations is visible in the most countries, according to data series that measure confidence for businesses, consumers and investors. One such set of data that we pay close attention to is the ZEW survey. The ZEW survey, produced by a prominent German economic think tank, is most well-known for the data related to Germany itself. The ZEW also produces similar survey data measuring readings on “current conditions” and “expectations” for other major developed economies: the U.S., U.K., Japan, France, and Italy (as well as an aggregate measure for the entire euro area). This makes the ZEW data useful for conducting cross-country analysis of economic sentiment, as the survey structure and questions are consistent for each country. Looking at the individual country readings from the ZEW data, shown in Charts 4 and 5, it is clear that the depressed readings on global growth sentiment are similar across all major countries. Yet at the same time, the individual ZEW Current Conditions indices, while off their cyclical peaks, are exhibiting more diverse trends. The U.S., in particular, stands out as having a very robust reading on Current Conditions, which lines up with the overall firmness of the U.S. economic data. Chart 4A Co-Ordinated Decline Of Expectations, Not Actual Growth Chart 5The European Growth Slump Is Broad-Based The strong correlation between the ZEW Expectations readings suggests that there is a common factor causing market participants to become more worried about the outlook for global growth. These can all be summarized under “uncertainty”, for which we also have data available at the country level from the Economic Policy Uncertainty indices developed by researchers Scott Baker, Nick Bloom and Steven Davis.1 In Charts 6 and 7, we plot the Policy Uncertainty indices against the ZEW growth expectations indices for the individual countries/regions for which the ZEW conducts its surveys. The growth expectations data is shown inverted to correlate with the Policy Uncertainty indices. The visual relationship shows that the current period of elevated Policy Uncertainty has occurred alongside the plunge in growth expectations, seen most strongly in the U.S., U.K. and Italy. Chart 6Uncertainty Slamming Sentiment Hardest In The U.S. & U.K. Chart 7Germany Weathering The Storm Better Than Italy & France But can this link between uncertain and growth expectations result in an actual slowing of economic activity? Can slumping expectations become a self-fulfilling prophecy? One way to look at this is to see how growth expectations evolve relative to current economic growth. We show those gaps between the Current Conditions and Growth Expectations components of the ZEW survey in Charts 8 and 9. A rising line indicates a wide gap between Current Conditions and Expectations and vice versa. We also add real GDP growth in each panel of the charts, to compare that “ZEW Gap” to actual growth outcomes. Chart 8The “ZEW Gap” Now At Levels That Have Heralded Past Downturns … Chart 9… Within Europe Too … The current gap between the two measures is at or near the widest levels seen in the history of the ZEW data dating back to the early 1990s. The previous times that the ZEW Gap reached such levels, economic growth slowed for all the countries in the ZEW survey – most notably in the run-up to the recessions in the early 1990s, early 2000s and 2009. The ZEW Gap also accurately signaled the recessions seen within the euro area after the 2011 European Debt Crisis. The first implication of this result is large discrepencies between strong current growth and expectations almost always resolve themselves with actual weaker growth, if not outright recession – not a good sign for the global economy in the coming quarters. Yet one major difference between today and those prior episodes of a wide ZEW Gap is the level of monetary policy accommodation. In those prior episodes that ended in recession, central bankers raised policy rates to restrictive levels that eventually caused the growth slowdown. This can be seen in Chart 10, where we plot the ZEW Gaps vs the “Monetary Policy Gaps”, defined as the difference between actual central bank policy rates and an estimate of neutral rates derived from a simple Taylor Rule formula.2 Chart 10...But Monetary Policy Is Not Tight This Time Today, central banks are maintaining policy rates far below levels of neutral consistent with long-run potential growth and economies operating at or beyond full capacity – even with inflation rates that are below central bank targets. This should help cushion the blow from weakening growth expectations stemming from the current period of elevated economic uncertainty. The root cause of all recessions is always monetary policy that becomes too restrictive. Typically, that occurs directly through central banks hiking rates above neutral and actively engineering a growth slowdown. It can also occur if an external shock to growth is severe enough to depress economic activity faster than policymakers can identify the slowdown and respond with easier monetary policy. The latter appears to be the outcome that investors are most worried about today. Yet with central banks now turning more dovish in response to elevated uncertainty, at a time when monetary policy appears already highly stimulative, the odds of a monetary policy error crushing growth are low. We are more worried about the opposite outcome, where policymakers are giving more stimulus to a global economy that does not necessarily need it, given that overly tight monetary policy is not the main problem at the moment. In other words, policymakers who have become more dovish today will need to become less dovish later, if and when the current laundry list of uncertainties begin to get resolved. We think that is only a real issue in the U.S. at the moment, though. Our Central Bank Monitors continue to indicate that tighter monetary policy is still required in the U.S. (Chart 11), unlike the Monitors from the U.K., euro area and Japan – the other countries where we have looked at the expectations/uncertainty relationship. Thus, we expect U.S. Treasury yields to have more upside than German Bund, U.K. Gilt or Japanese government bonds over the next 6-12 months. Chart 11The Message From Our CB Monitors - Stay Underweight U.S. Treasuries Bottom Line: We do not expect the current soft patch for global growth to extend into a more prolonged period of weak activity, given that global policy rates remain at highly stimulative levels. This will set up the next wave of rising global bond yields, but likely not until the latter half of 2019 (and focused mostly on U.S. Treasury yields).   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Footnotes 1 The full set of global Policy Uncertainty Indices, with data downloads and methodological descriptions, can be found at  www.policyuncertainty.com. 2 Neutral Policy Rate = Potential GDP growth + central bank inflation target + (0.5 x (current inflation minus central bank inflation target)) +( 0.5 * the IMF estimate of the output gap)). 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 Hyman Minsky famously said that “stability begets instability.” The converse is also true: Instability begets stability. None of the preconditions for a U.S. recession are in place yet. The Fed’s decision to press the pause button on further rate hikes ensures that it will take at least another 18 months for monetary policy to turn restrictive. Global growth should accelerate by mid-2019, as Chinese stimulus kicks in and the headwinds facing Europe dissipate. Investors should overweight global equities and underweight bonds over the next 12 months. The leadership role in the equity space will gradually shift outside the United States. Feature The Long Shadow Of The Financial Crisis   "Stability begets instability” declared Hyman Minsky in his widely cited, seldom-read book.1 By this, Minsky meant that periods of economic tranquility often encourage excessive risk-taking, sowing the seeds of their own demise. We would not quarrel with Minsky’s assessment, but we would point out that the converse is also true: Instability begets stability. Following periods of intense financial stress, lenders become more circumspect about whom they lend to, while borrowers become reluctant to take on debt. The result is economically bittersweet. On the plus side, the newfound caution of lenders and borrowers alike ensures that financial imbalances are slow to build up again. On the negative side, sluggish credit growth restrains spending. The net effect is a recovery that is often slow and uneven, but one which lasts longer than expected. Few Signs Of Major U.S. Economic Imbalances This is the world in which we find ourselves today. It took a decade following the subprime crisis for the U.S. to return to full employment. Much of Europe is not even there yet. Lenders continue to take risks. However, they have been quicker than usual to scale back exposure at the first sign of trouble. For example, as U.S. auto loan defaults began rising in 2015, banks tightened lending standards. As a result, the share of auto loans transitioning into delinquency peaked in Q4 of 2016 and has since drifted down modestly (Chart 1). Chart 1Lenders Are More Circumspect These Days: The Case Of Autos A similar thing happened when corporate credit spreads blew out in 2015 following the crash in oil prices (Chart 2). Banks tightened lending standards starting in late 2015. Once defaults peaked in early 2017, banks started easing standards. Chart 2Banks Were Quick To Tighten Lending Standards In 2015 Tellingly, the distress in corporate debt markets in 2015-16 did not cause the financial system to seize up, as evidenced by the fact that financial stress indices only increased marginally during that period. This suggests that financial imbalances never had a chance to rise to a level that threatened the overall economy. The Preconditions For The Next U.S. Recession Are Not Yet In Place Today, the U.S. private-sector financial balance – the difference between what the private sector earns and spends – stands at a healthy surplus of 2.1% of GDP. Both of the last two recessions began when the private-sector balance was in deficit (Chart 3). Chart 3The Private Sector Is Not Living Beyond Its Means The Way It Was Before The Last Two Recessions This raises an intriguing question: If the U.S. private sector is not suffering from any major imbalances, what is going to cause the next recession? That’s a very good question, with no obvious answer! The past two recessions were triggered by the bursting of asset bubbles – first the dotcom bubble and then the housing bubble. Today, U.S. equities are far from cheap, but with the S&P 500 trading at 16.1-times forward earnings, they are hardly in a bubble (Chart 4). The housing market is also on much firmer footing: The homeowner vacancy rate is near all-time lows, while the quality of mortgage lending has been very high (Chart 5). Chart 4While U.S. Stocks Are Not Cheap, They Aren't In A Bubble Chart 5Housing Fundamentals Are Solid Of course, recessions can occur for reasons other than the bursting of asset bubbles. The 1973-74 recession and the recessions of the early 1980s were triggered by a surge in oil prices, requiring the Fed to hike rates aggressively. Luckily, such an oil-induced recession is highly unlikely today. Inflation expectations are better anchored, while oil consumption represents a much smaller share of GDP than it did back then (Chart 6). In addition, the U.S. has become a major oil producer, which implies that the drag to consumers from higher oil prices would be partly offset by increased capital spending in the energy sector. At any rate, the ability of shale producers to respond to higher prices with additional output limits the extent to which prices can rise in the first place. Chart 6An Oil Price Shock Is Unlikely To Cause A Recession Past economic downturns have also been caused by major adjustments in the cyclical parts of the economy. As a share of GDP, cyclical spending is lower today than it has been at the outset of most recessions (Chart 7). The proliferation of just-in-time inventory systems has also reduced the influence that inventory swings have on the economy (Chart 8). Chart 7Cyclical Spending Is Not Extended A severe tightening of fiscal policy can also trigger a recession.2 Fortunately, the end of the government shutdown reduces the risk of such an outcome. Rightly or wrongly, voters blamed President Trump for the recent closure (Chart 9). As we speak, the Trump administration is negotiating with Democrats to avert another shutdown slated to begin on February 15. The key item of contention concerns funding for a border wall with Mexico. Even if a deal falls through, rather than shuttering the government again, Trump will probably pursue funding for the wall by declaring a national emergency. Our geopolitical strategists believe such an action will be challenged by the Democrats, but is likely to be upheld by the Supreme Court. Chart 9''I Am Proud To Shut Down The Government'' Global Growth Should Improve Admittedly, the external environment now has a greater influence on the U.S. economy than in the past. Nevertheless, given that exports are only 12% of GDP, it would take a sizeable external shock to knock the U.S. into recession. We think that such a shock is not in the cards. The trade war is likely to go on hiatus as Trump seeks to take credit for a deal with China. In addition, as we discussed two weeks ago, China will scale back its deleveraging campaign now that credit growth has fallen close to nominal GDP growth (Chart 10).3    Chart 10China: Time To Scale Back Deleveraging Euro area growth should reaccelerate over the coming months thanks to lower oil prices, a revival in EM demand, modestly more stimulative fiscal policy, and the palliative effects from the decline in government bond yields across the region. We have also argued that the risks of a “Hard Brexit” should abate.4   Waiting... And Waiting For Inflation To Rise When the next recession rolls around, it will probably be sparked by a surge in inflation, which forces the Fed to raise interest rates much more rapidly than it has so far. Here is the thing though: Inflation is a highly lagging indicator. It usually only peaks long after a downturn has started and troughs after the recovery is well underway (Chart 11).   Consider the example of the 1960s. The unemployment rate fell below NAIRU in 1964, but it took another four years for inflation to break out in earnest (Chart 12). The U.S. unemployment rate has been below NAIRU only since 2017. The unemployment rate in Germany and Japan has been below NAIRU for much longer, yet inflation remains stubbornly low in both countries (Chart 13). Chart 12It Took An Overheated Economy For Inflation To Take Off In The Late-1960s Chart 13The U.S., Japanese, And German Economies Are At Full Employment Cheer Up This leaves us with a striking conclusion: Perhaps the next U.S. recession is not around the corner, as some grumpy economists seem to think. Perhaps this economic expansion can endure beyond 2020. The recent U.S. data has certainly been consistent with that thesis. The ISM manufacturing index rose 2.3 percentage points to 56.6 in January. New orders jumped by 6.9 percentage points to 58.2. Payroll growth has also accelerated. Real aggregate earnings are up 4.2% from a year earlier, the fastest pace since October 2015 (Chart 14). Chart 14U.S. Labor Income Growth Has Been Accelerating Housing data are showing tentative evidence of stabilization. New home sales are rebounding, while mortgage applications are back near cycle-highs (Chart 15). Chart 15Housing Activity Is Stabilizing After Last Year's Weakness Reflecting these positive developments, the Citigroup economic surprise index has jumped into positive territory (Chart 16). The New York Fed’s estimate for Q1 2019 GDP growth has also moved up to 2.4%. Chart 16U.S. Economic Data Are Beating Low Expectations Investment Conclusions Recessions and bear markets usually overlap (Chart 17). With the next recession still at least 18 months away, it is premature to turn bearish on equities. We upgraded stocks in December following the post-FOMC sell-off. Although our tactical MacroQuant model is pointing to an elevated risk of a setback over the next few weeks, we continue to see global equities finishing the year 5%-to-10% above current levels. As global growth bottoms out mid-year, the leadership role in equity markets should increasingly move away from the U.S. towards EM and Europe. Chart 17Recessions And Bear Markets Usually Overlap Bonds are a tougher call. We do not expect the Fed to raise rates again at least until June. This will limit the upside for bond yields, as well as the dollar, in the near term. Nevertheless, with the fed funds futures pricing in no rate hikes for the next few years, even a modest shift back to tightening in the second half of this year and beyond will push up bond yields, dampening total returns to fixed income. Looking beyond 2019, the case for maintaining a short duration stance in fixed-income portfolios is very strong. The longer the Fed allows the economy to overheat, the greater the eventual overshoot in inflation will be. Inflation expectations have fallen over the past few months (Chart 18). They should have risen. Ultimately, Gentle Jay Powell’s decision to press the pause button on further rate hikes means that rates will end up peaking at a higher level during this cycle than they would have otherwise. Chart 18Inflation Expectations Have Declined   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      As argued in Hyman P. Minsky, “Stabilizing an Unstable Economy,” Yale University Press, (1986). 2      Severe episodes of fiscal tightening have normally followed military demobilizations. These include the recessions following WW1, WW2, and the Korean War, and to a much lesser extent, the 1990-91 recession which was exacerbated by cuts to the defense budget at the end of the Cold War. 3      Please see Global Investment Strategy Weekly Report, “China’s Savings Problem,” dated January 25, 2019. 4      Please see Global Investment Strategy Weekly Report, “Patient Jay,” dated January 18, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Highlights The main headwinds to euro area growth in 2018 are easing in 2019, at least in part and for the time being. The two main tail-risks are a messy Brexit and financial market volatility, but these are not our central case. Stay overweight the Eurostoxx50 versus the S&P500. Go underweight German bunds. Go overweight the German DAX versus German long-dated bunds. Add the German DAX as a new long position to the existing long basket holdings in France, Ireland and Switzerland. Maintain the short basket holdings in Norway and Denmark. Feature Chart of the WeekThe Underperformance Of German Equities Vs. German Bonds Is At A Euro Debt Crisis Extreme! Economies do not grow in straight lines. Rather, the process of economic expansion is a never-ending ebb and flow, creating clockwork-like oscillations in economic activity. As a perfect illustration, the growth in the euro area wage bill has trended higher through the past five years and is now running at very healthy 4 percent clip. Yet this strong uptrend has been interspersed with wobbles that have occurred with a remarkable regularity (Chart I-2). Chart I-2Economies Have Regular Wobbles... The recent setback in euro area activity has spooked some economy watchers. Even the ECB has just moved its risk assessment surrounding the growth outlook to the downside. But the downgrade was largely a result of its ‘data-dependency’ which, by definition, is always backward looking. This meant that the downgrade had a negligible effect on the financial markets which are always forward looking. For the markets, there is a much more important issue: is the recent setback the start of something serious, or can we expect a bounce back? The Setback The explanation for the regular wobbles in euro area growth comes from the oscillations in global economic activity (Chart I-3). But here we need to be wary of a potentially circular argument. As Europe is a dominant component of the global economy, euro area domestic demand setbacks could themselves be the root cause of the over-arching global growth oscillations. Chart I-3...Because Of Clockwork-Like Oscillations In Global Economic Activity Recently, Italy and Germany have suffered idiosyncratic ‘country and sector specific’ setbacks. The spat between Rome and Brussels over Italy’s 2019 budget caused Italian bond yields to soar and Italian bank lending to contract viciously (Chart I-4). Meanwhile, the auto sector – a major engine of the German economy – spluttered as it absorbed the new WLTP emissions testing standard. Through the middle of 2018 German vehicle exports suffered a €20 billion hit which shaved 0.6 percent from the €3.4 trillion German economy (Chart I-5).  Chart I-4Italian Bank Lending Contracted Viciously, But Will Now Recover Chart I-5German Auto Exports Plunged, But Will Now Recover Despite all of this, the epicentre of the 2018 growth setback was not inside Europe, but outside Europe. The ECB correctly blames the recent down-oscillation not on domestic causes, but on softer external demand, specifically “vulnerabilities in emerging markets”. The central bank argues that once there is clarity on the exports and the trade sector, much of the euro area’s weakness will wash out.  Another very important driver of European growth oscillations is the oil price. In recent years, the growth in GDP in excess of wages has perfectly and inversely tracked oscillations in the oil price (Chart I-6). The simple reason is that Europeans are net importers of energy, and the amount of energy they consume tends to be price inelastic. Hence, when energy prices soar as they did for most of 2018, it squeezes European real spending. Conversely, when energy prices plunge as they have more recently, it boosts real spending. Chart I-6Oil: Another Driver Of European Growth Somewhat contrary to received wisdom, one thing that does not generally drive euro area growth oscillations is the euro exchange rate. When the euro weakens, it does of course make the euro area’s exporters more competitive. But working against this, a weaker euro also raises the prices of imported energy and food, thereby squeezing euro area consumers’ real incomes. And vice-versa when the euro strengthens. Hence, while the euro’s moves do create growth winners and losers within the euro area, these tend to cancel out at the aggregate economy level. The Bounce Back The main headwinds to euro area growth in 2018 are easing in 2019, at least in part and for the time being. Regarding the vulnerabilities in emerging markets, many ECB governors argue that “everything we know says that the Chinese government is taking strong measures to address its slowdown”. Recent improvements in China’s monetary statistics provide strong evidence for this view (Chart I-7). Chart I-76-Month Credit Impulses Are Bouncing Back Everywhere Meanwhile, credit growth in the euro area itself is also accelerating, albeit modestly. This is hardly surprising given that financing conditions are very favourable. Even though the ECB has done nothing to policy interest rates, more dovish forward guidance has effectively made euro area monetary policy more accommodative: since October, core euro area 10-year bond yields are down 40 bps. And with banks’ balance sheets stronger, the ECB claims “the conditions for a continuation of credit to the economy are in place.”  Over the same three month period, the crude oil price has plunged by 35 percent (Chart I-8). Draghi confirmed our observation above: lower energy prices support real disposable income for euro area households. Chart I-8Double Boost: Lower Bond Yields And Lower Oil Draghi also pointed out another positive impulse: fiscal policy in the euro area has now flipped from contractionary to slightly expansionary. As regards the idiosyncratic sector specific setbacks, the Italian 10-year BTP yield has unwound its budget spat spike, and is down 100 bps since October. It follows that Italian bank credit growth is likely to recover. And Draghi explained that “the specific episode of the car industry in Germany will soon wash out because there is going to be a rebound in the sector.” Still, two significant tail-risks could smother the bounce back: Uncertainties related to geopolitical factors and the threat of protectionism, specifically, a messy Brexit. Financial market volatility. The Investment Implications Our central case is that the tail-risks do not materialise. And that the recent combination of more favourable financing conditions in the euro area and globally, lower energy prices, fiscal thrust, and the removal of specific setbacks in Italy and Germany should engineer some sort of growth bounce back in the euro area.  One important implication is that the strong recent rally in German bunds is close to exhaustion, and even vulnerable to a short-term retracement. This is supported by our trusted technical indicator warning of an imminent liquidity shortage and a corrective price reversal (Chart I-9). Go underweight German bunds on a short term horizon. Chart I-9The Rally In The German Bund Is Exhausted A mirror-image implication is that the underperformance of the German DAX relative to German long-dated bunds is now at euro debt crisis extremes (Chart I-1 and Chart I-10). This relative performance also appears technically exhausted and ripe for a reversal. As an asset allocation position, go overweight the DAX versus German long-dated bunds on a tactical. Chart I-10The Extreme Underperformance Of The DAX Will Reverse In line with the growth rebound thesis, stock market selection – through the underlying sector exposures – should now have a modest tilt towards cyclicality. Stay overweight the Eurostoxx50 versus the S&P500. Within Europe, our current long positions in France, Ireland, and Switzerland combined with short positions in Norway and Denmark do provide the required tilt towards cyclicality. Nevertheless, today we are adding the oversold German DAX to our long stock markets basket. Fractal Trading System* In line with the fundamentals-based arguments in the main body of this report, this week’s recommended trade is to go long the DAX versus the 30-year bund. Set a profit target of 2.5 percent 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-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com   Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation 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: The U.S. economic data show few signs of restrictive monetary policy, despite the fact that the market is now priced for an end to the Fed’s rate hike cycle. Investors should position for further rate hikes this year. Practically, this means keeping portfolio duration low and avoiding the 5-year/7-year part of the Treasury curve. Corporate Spreads: Corporate breakeven spreads are too wide for this phase of the cycle, especially for the Baa and junk credit tiers. Our default-adjusted spread shows that high-yield bonds offer adequate compensation for default losses, in line with the historical average. Corporate Defaults: A simple model using gross nonfinancial corporate leverage pegs fair value for the 12-month speculative grade default rate at 4.1%. This fair value estimate should decline slightly in the months ahead, as long as pre-tax profit growth stays above 7%, the approximate rate of debt growth. Feature Fed rate hikes have been completely priced out of the curve. As of last Friday’s close, the overnight index swap market was priced for 2 basis points of rate hikes during the next 12 months and 9 bps of cuts during the next 24 months (Chart 1). The sharp drop in rate hike expectations is an overreaction, and investors should position for a near-term rise in rate expectations. The Fed’s rate hike cycle still has room to run before interest rates peak. Chart 1Market Says "No More Hikes" In this week’s report we survey the recent economic data, searching for any signal that interest rates are high enough to choke off the recovery. We conclude that monetary conditions remain accommodative, and that the Fed’s rate hike cycle will re-start in the second half of this year. Searching For Signs Of Tight Money Policymakers frequently talk about the concept of the neutral (or equilibrium) fed funds rate. In essence, the neutral rate is the interest rate that is consistent with trend economic growth and stable inflation. If the fed funds rate is set above neutral, then we should expect growth to slow and inflation to fall. Conversely, if the fed funds rate is set below neutral, we should expect growth to accelerate and inflation to rise. The slope of the yield curve can help distill this concept for bond investors. An inverted yield curve signals that the market is priced for interest rate cuts in the future. This is what we would expect to see in an environment where the fed funds rate is above neutral and monetary conditions are restrictive. Conversely, a very steep yield curve means that investors expect rate hikes in the future. This is usually consistent with accommodative monetary policy and an interest rate well below neutral. We find the neutral rate to be a useful concept, though like Fed Chairman Powell we think it is unwise to place too much stock in point estimates of its level.1 Such estimates are very difficult to make in real time, and tend to be heavily revised with hindsight.2 For investors, a wiser strategy is to look for signs in the economic data that interest rates are too high, and to use those signs to decide when interest rates have peaked for the cycle. We review a few of those potential signs below. Nominal GDP Growth One simple signal of restrictive monetary policy is when interest rates rise above the year-over-year growth rate in nominal GDP. In the last cycle, Treasury returns versus cash didn’t move materially higher until after year-over-year nominal GDP growth was below both the 10-year Treasury yield and the 3-month T-bill rate (Chart 2). At present, year-over-year nominal GDP growth is running at 5.5%. Though it is very likely to slow during the next few quarters, it still has a long way to go before it falls below 2.76%, the current 10-year Treasury yield. Chart 2GDP Growth Suggests That Monetary Policy Remains Accommodative Verdict: An assessment of nominal GDP growth shows that monetary policy remains accommodative. The Housing Market Given that the mortgage market provides the most direct link between interest rates and real economic activity, it makes sense that signs of tight money might show up first in the housing data. Empirical investigation backs up this claim. As was observed by Edward Leamer in his 2007 paper, of the ten post-WWII U.S. recessions, eight were preceded by a significant slowdown in residential investment.3 Our own reading of the data is consistent with this message. Downtrends in the 12-month moving averages of both single-family housing starts and new home sales preceded inflection points higher in excess Treasury returns in each of the past two cycles (Chart 3). Chart 3No Signal From Housing While these housing metrics certainly deteriorated during the past nine months, it appears that the worst is now behind us. The recent moderation in mortgage rates has already led to a significant bounce in mortgage purchase applications and a pop in homebuilder confidence (Chart 4). This will translate into increased housing starts and new home sales during the next few months. Chart 4Housing Rebound Underway Verdict: The housing data are most likely consistent with still-accommodative monetary policy. However, if single-family housing starts and new home sales do not respond as expected to the recent drop in the mortgage rate, then we will be forced to re-visit this view. The Labor Market Of all the available labor market statistics, initial unemployment claims tend to be the most leading and have historically provided the best signal of tight monetary conditions. In each of the past two cycles a significant increase in jobless claims has coincided with the inflection point higher in Treasury excess returns (Chart 5). While there was some concern toward the end of last year that claims were trending up, this has now been dashed and claims actually fell below 200k last week. Notice in Chart 5 that the 13-week change in claims remains negative. In prior cycles it rose above zero around the same time that Treasury returns started to improve.. Chart 5No Signal From Labor Market Verdict: The labor market data remain consistent with accommodative monetary policy. Bottom Line: It seems very likely that U.S. monetary policy remains accommodative. Nominal GDP growth and the labor market both strongly support this claim. The housing data have been weaker, but are already showing signs of rebounding. The implication for bond investors is that the Fed is not done lifting interest rates, even though the market is priced for exactly that outcome. Investors should maintain below-benchmark portfolio duration on the view that rate hikes will re-start in the second half of this year. The 5-year/7-year part of the Treasury curve is especially vulnerable to an increase in rate hike expectations. Investors should avoid this part of the curve, focusing on the very long and short maturities.4 The Weakness Is Global The analysis in the above section begs the question: If the economic data do not suggest that monetary policy is restrictive, then why is the market priced for an end to the Fed’s rate hike cycle? The answer is that everything is not rosy in the economic outlook. Specifically, we have already seen a significant slowdown in non-U.S. economic growth that weighed significantly on financial markets near the end of last year and is starting to impact the most externally-exposed segments of the U.S. economy. Chart 6 shows that a slowdown in the Global ex. U.S. Leading Economic Indicator (LEI) is now dragging the U.S. LEI down with it. Chart 6Global Weakness Infects U.S. Not surprisingly, the components of the U.S. LEI that have weakened are those related to financial markets and the corporate sector. Given that corporate profits are determined globally, a slowdown in global growth often shows up first in downward revisions to investors’ corporate profit expectations. This weighs on equity prices and causes business owners to re-assess their future investment plans. Consistent with this narrative, we have seen significant downward moves in ISM New Orders and NFIB Capital Spending Plans, shown averaged together in the top panel of Chart 7. Capital spending plans as reported in regional Fed surveys have also moderated (Chart 7, panel 2), and CEO confidence has plunged (Chart 7, bottom panel). All of these indicators suggest that weaker global growth will weigh on the nonresidential investment component of U.S. GDP during the next few quarters. Chart 7Weaker Nonresidential Investment... But while corporate investment is poised to weaken, the U.S. consumer is in rude health (Chart 8). Core retail sales are growing strongly, though the most recent data only extend through November. For more timely data we can look at the Johnson Redbook measure of same-store sales which has accelerated into the New Year (Chart 8, top panel). The University of Michigan survey of consumers shows that expectations dipped last month (Chart 8, panel 2), but also that consumers still view current conditions as extremely positive (Chart 8, bottom panel). Chart 8...And Resilient Consumer Spending The overall picture is reminiscent of 2015/16. The U.S. consumer and labor market are in good shape, but slowing foreign growth and a strong U.S. dollar are weighing on the corporate profit outlook and U.S. corporate investment spending. As in 2016, the solution is for the Fed to temporarily pause its rate hike cycle. This will allow the dollar’s uptrend to moderate and will take some pressure off the corporate profit and investment outlooks. With a Fed pause discounted in the market, the conditions are already in place for renewed optimism on the corporate sector. It is for this reason that we upgraded our recommended allocation to corporate bonds two weeks ago.5 We expect this optimism will cause financial conditions to ease during the next few months, allowing the Fed to resume its rate hike cycle in the second half of this year. Corporate Bond Valuation Update As mentioned above, we increased our recommended exposure to corporate credit (both investment grade and junk) two weeks ago, partly due to valuations that had become too attractive to pass up. The Breakeven Spread One of our preferred valuation techniques is to look at 12-month breakeven spreads for each corporate credit tier as a percentile rank versus history.6 We like this method for three reasons: First, focusing on each individual credit tier controls for the fact that the average credit rating of bond indexes can change over time. Second, using the breakeven spread instead of the average index option-adjusted spread allows us to control for the changing average duration of the bond indexes. Finally, we find that the percentile rank is often a better representation of credit spreads than the spread itself. This is because credit spreads often tighten to very low levels and then remain tight for an extended period of time. By showing us the percentage of time that a given spread has been tighter than its current level, the percentile rank gives a better sense of this pattern than the actual spread. At present, Baa-rated debt and all junk credit tiers have 12-month breakeven spreads at or above their historical medians. Aa and A rated bonds have breakeven spreads that rank near the 40th percentile, and Aaa-rated debt remains expensive with a 12-month breakeven spread below the 10th percentile since 1989. To appreciate how cheap these spreads are, especially for Baa-rated and junk credits, consider that the current 12-month breakeven spread for a Baa-rated corporate bond is 24 bps (Chart 9). In our analysis of the different phases of the economic cycle, we determined that in an environment where the slope of the 3/10 Treasury curve is between 0 bps and 50 bps (it is 18 bps today), the 12-month Baa-rated breakeven spread averages 18 bps.7 Chart 9Attractive Baa Valuation Given current index duration, if the 12-month Baa-rated breakeven spread returned to the 18 bps level that is typical for this stage of the cycle, it would imply a tightening in the option-adjusted spread from 169 bps to 129 bps – a 40 bps tightening! Default-Adjusted Spread Another valuation measure to consider is our high-yield default-adjusted spread. This is the excess spread available in the high-yield index after subtracting expected default losses. To determine expected default losses we use Moody’s baseline forecast for the 12-month default rate and our own forecast for the 12-month recovery rate. At present, this gives us a default-adjusted spread of 237 bps, right in line with the historical average (Chart 10). In other words, if default losses during the next 12 months match those embedded in our calculation, then investors should expect an excess return that is in line with the historical average, assuming also no capital gains/losses from spread tightening/widening. Chart 10In Line With Historical Average But how likely is it that default losses fall in line with that expectation? In its last Monthly Default Report, Moody’s revised its baseline 12-month default rate forecast up to 3.4%, from 2.6% previously. The new 3.4% forecast seems reasonable to us. A simple model of the 12-month trailing default rate based only on our measure of gross leverage for the nonfinancial corporate sector puts fair value for the 12-month default rate at 4.1% (Chart 11). Our measure of gross leverage is simply total debt divided by pre-tax profits. This measure fell during the past year because pre-tax profits grew by 17% and total debt grew by only 7%. Chart 11Default Expectations Going forward, profit growth will almost certainly moderate during the next 12 months, driven by the combination of weaker global growth and rising wage pressures. However, it needs to fall a long way, to below 7%, before our measure of leverage starts to rise. In other words, a further slight decline in our measure of gross leverage is a reasonable expectation at the current juncture, which would bring the fair value from our simple default rate model close to the current Moody’s projection. All in all, our default-adjusted spread tells us that high-yield bonds offer historically average compensation given reasonable default expectations. Bottom Line: Corporate breakeven spreads are too wide for this phase of the cycle, especially for the Baa and junk credit tiers. Our default-adjusted spread shows that high-yield valuation is in line with the historical average, given a reasonable expectation for default losses. Overall, we conclude that corporate spreads are attractive at current levels and we recommend an overweight allocation to both investment grade and high-yield corporate debt in a U.S. bond portfolio.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “The Powell Doctrine Emerges”, dated September 4, 2018, available at usbs.bcaresearch.com 2 Chairman Powell cites a few examples of this in his Jackson Hole address from last fall. https://www.federalreserve.gov/newsevents/speech/powell20180824a.htm 3 http://www.nber.org/papers/w13428  4 Please see U.S. Bond Strategy Weekly Report, “Don’t Position For Curve Inversion”, dated January 22, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com 6 The 12-month breakeven spread is the spread widening required on a 12-month investment horizon for a corporate bond to break even with a duration-matched position in Treasury securities. It can be quickly approximated by dividing the bond’s option-adjusted spread by its duration. 7 For a more complete analysis of the economic cycle based on the slope of the yield curve please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification