Financial Markets

The Fed’s near-term capitulation on its rates-normalization policy highlighted by our fixed-income desks will provide a tailwind for EM oil demand this year by weakening the USD. This will reduce refined-products’ costs in local-currency terms ex-U.S., as it buoys EM growth prospects.1 If, as we expect, Chinese policymakers also deploy modest stimulus, global oil demand still will remain on track to grow 1.4mm b/d this year, per our forecast. We are mindful of potential upside surprises on the demand side, particularly, if, as we noted in our last balances update, the 100th anniversary of the Chinese Communist Party in 2021 provokes policymakers to deploy large-scale stimulus in 2H19 or 2020.2 The odds of this occurring before 2H19 are low, and we are not yet raising our demand estimates. A partial defusing of the Sino – U.S. trade war is possible, as the 90-day negotiating window agreed at the December G20 meeting starts to close next month. This could trigger a short-term rally in commodities, but, absent durable agreements on the technology front, this potential thawing will be transitory. Highlights Energy: Overweight. China’s crude oil imports surged 30% y/y in December 2018, which helped lift total 2018 imports by 10% vs. 2017 levels. This partly was the result of independent refiners scrambling to use up 2018 import quotas at year-end, so that they could retain those levels this year, according to S&P Global’s Platts.3 Base Metals: Neutral. China’s copper ore and concentrate imports were down 11.5% y/y in December – the largest y/y decline since May 2017 – in line with slowing growth there. Precious Metals: Neutral. We expect gold to continue to rally over the next 3 – 6 months on the back of a weaker USD in 1H19, as the Fed likely pauses on its rate-hiking schedule. Ags/Softs: Underweight. Grains likely will get a short-term price lift as the Fed dials back its rates-normalization policy. Feature For the moment, the Fed’s apparent capitulation on its rates-normalization policy reduces the risk the U.S. central bank will err on the side of being overly aggressive, which would have thrown a spanner into EM growth prospects this year. An easier Fed monetary policy will buoy EM GDP and weaken the USD over the short term, which will, support oil prices via stronger demand (Chart of the Week). Chart of the WeekEM GDP Growth On Track, Keeping Oil Demand Growth On Track On the supply side, we remain convinced OPEC 2.0 is resolved to drain the global inventory overhang as quickly as possible. This unintended inventory accumulation resulted from OPEC 2.0’s production surge and the granting of waivers on U.S. export sanctions against Iran by the Trump administration in November (Chart 2). This conviction was strengthened earlier this week, following the announcement of a proposed earlier-than-expected meeting of the coalition’s market monitoring committee in Baku, Azerbaijan, in mid-March to assess global supply and demand conditions. This could be followed by a full OPEC 2.0 meeting in Vienna in mid-April, following up on their December meeting in Vienna, according to S&P Global Platts.4 Chart 2OPEC 2.0 Is Resolved To Drain Inventory Overhang Pieces Of The Price Puzzle Falling Into Place The Fed is signaling it has put its rates normalization policy on hold, given indications global economic growth is slowing in a manner similar to what occurred in 2014 – 15. Then, the U.S. central bank was attempting to escape the zero lower bound of its monetary policy, following the end of its QE program. In the event, the Fed only raised rates once in December 2015, as the slowdown in growth stayed its hand. Our colleagues at BCA’s Global Fixed Income Strategy note, “the downturn in cyclical growth indicators like manufacturing purchasing managers indices (PMI) and the global leading economic indicator (LEI) … reached levels last seen after that 2014/15 episode” as 2019 unfolded (Chart 3).5 The slowdown in global growth could stabilize, as the LEI diffusion index suggests, but the Fed, at least for now, appears to be comfortable waiting for clear evidence this is the case. Chart 3Global Growth Slowdown Provokes Fed Restraint In and of itself, the Fed’s near-term capitulation to the market will not be sufficient to reverse the “darkening prospects” foreseen by the World Bank in its most recent forecast, but it will be supportive of oil prices.6 On the back of our expectation the Fed will take a break from its rate-normalization, we are expecting a weaker USD over the short term, which will support oil demand and EM GDP growth. All else equal, this will create a tailwind for oil prices, given EM is the main driver of demand growth (Chart 4). Chart 4USD Near-Term Trajectory Will Support Oil Prices The Chart of the Week introduces a new model we developed to understand the effect of EM GDP growth on oil prices. The level of EM demand is mean reverting to a linear trend, and anchors other variables – oil prices and FX rates, for example – that oscillate randomly with the arrival of new information to the market. Our modeling indicates Brent and WTI prices can be expected to increase (decrease) 94bp and 73bp for every 1 percent increase (decrease) in EM GDP, assuming the broad trade-weighted index (TWIB) for the USD remains unchanged. A 1 percent decrease (increase) in the USD TWIB (holding EM GDP constant) translates into an increase (decrease) in Brent and WTI prices of ~ 4.0% and 3.6%, respectively. We have found EM GDP levels to be as useful an explanatory variable for Brent and WTI prices as non-OECD oil consumption, our proxy for EM demand. Indeed, it is perhaps even cleaner, since using it directly in our models does not require us to estimate an income elasticity of demand for EM economies, in order to forecast prices.7 We are not raising our expectation for demand growth on the back of the Fed’s apparent moderation in its rates policy. We are keeping our 2019 demand growth estimate at 1.4mm b/d, with 1.0mm b/d of that coming from EM and the remainder from DM. Should the Fed signal a further pause in its rates-normalization policy – extending perhaps deep into 2H19 – we would be inclined to raise our demand-growth estimates. Additional Stimulus Coming From China? China is not the be-all and end-all of EM growth. All the same, next to the U.S., it is the second-largest consumer in the world, accounting for ~ 14% of the 103.75mm b/d of global demand we expect this year. Next in line is India, which accounts for ~ 5% of global demand. The news coming out of China at the moment is confusing. While the Xi administration prosecutes its “Three Tough Battles” – i.e., deleveraging, pollution and poverty – it also is pulling policy levers to counter the economic damage inflicted by its trade war with the U.S.8 Government policymakers are signaling fiscal and monetary stimulus will be forthcoming via tax cuts and bond issuance this year, to counter these headwinds.9 However, we do not expect a massive deployment of stimulus. More than likely, the big stimulative measures arrive in 2H19 or next year. The key target dates for policymakers are further in the future, and are focused on the upcoming 100th Anniversary of the Communist Party in 2021. By 2020, the Xi administration is targeting a doubling of real GDP vs. 2010 levels, and a doubling of rural and urban incomes (Chart 5). Chart 5China Keeping Powder Dry For 2021 "Centenary Goal" So the real stimulus out of China likely comes later this year or next year. As our Geopolitical Strategy service notes: “If China launches a large-scale stimulus now, peak output will occur in 2020 and the economy will be decelerating into 2021. This would be bad timing for the centenary. It would make more sense for China to save some dry powder for 2019 or 2020 to ensure a positive economic backdrop in 2021.” There is, as we noted in our last balances update, a low-probability chance stimulus could surprise to the upside if growth – particularly employment – falls precipitously. For now, we are comfortable with our House view that the more extensive fiscal and monetary stimulus will be saved for later this year or next in the run-up to the Communist Party’s anniversary.10 Bottom Line: The Fed appears to have capitulated to markets in the short term, and likely will hold off on another rate hike in 1H19. All else equal, this will weaken the USD and buoy EM GDP over the short term. Together, these effects will keep oil demand on track to growth 1.4mm b/d, per our forecast. Markets are reacting to news of fiscal and monetary stimulus coming out of China. We have been expecting modest stimulus to be deployed this year, most likely in 2H19. We continue to expect a larger package of fiscal and monetary stimulus later in the year and next year in the run-up to the Communist Party’s 100th anniversary.   Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      Please see “Enough With the Gloom: Upgrade Global Corporates On A Tactical Basis,” published January 15, 2019, by BCA Research’s Global Fixed Income Strategy. It is available at gfis.bcaresearch.com. See also “Buy Corporate Credit,” published by BCA’s U.S. Bond Strategy January 15, 2019. It is available at usbs.bcaresearch.com. 2      Please see “Oil Volatility Will Persist; 2019 Brent Forecast Lowered to $80/bbl,” published January 3, 2019, by BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 3      Please see “China’s 2018 crude oil imports rise 10% to 9.28 mil b/d,” published by S&P Global Platts January 14, 2019, online. 4      OPEC 2.0 ministerial meetings usually are held in May/June and again November/December. Please see “OPEC eyes mid-March monitoring committee meeting, mid-April full ministerial,” published by S&P Platts Global January 14, 2019. The cartel also will meet in early February to put the finishing touches on a charter formalizing the coalition. We will be delving deeper into the supply side next week, when we update our balances. 5      Please see footnote 1 above. 6      The World Bank’s most recent forecast can be found in its Global Economic Prospects, published January 8, 2019. The lead article is entitled “Darkening Skies.” 7      We use forecasts of EM GDP and GDP growth published by the World Bank and IMF in our modeling. This is useful for us for a number of reasons, particularly since it is calculated externally by well-regarded global institutions tasked with this function. Like other estimates and projections – e.g., the EIA’s, IEA’s and OPEC’s supply/demand estimates – we can take a view on these data relative to our House view or our own Commodity & Energy Strategy view. NB: Because these are cointegrated systems, regressions in levels is appropriate. 8      This campaign is discussed in depth in “China Sticks To The ‘Three Battles’,” published by BCA Research’s Geopolitical Strategy October 24, 2018. It is available at gps.bcaresearch.com. 9      Please see “China signals more stimulus as economic slowdown deepens,” published by uk.reuters.com January 15, 2019. 10     Please see footnote 2 above. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 4Q18 Commodity Prices and Plays Reference Table   Trades Closed in 2019 Summary of Trades Closed in 2018

Highlights Buy the pound as soon as the U.K. parliament coalesces a majority around an action plan to counter a no-deal Brexit. For equity investors the best play is a FTSE Small Company Index ETF and/or U.K. REITS. Beaten-down banks, industrials and materials can continue their recent countertrend outperformances. This necessarily means that the cyclical-heavy Eurostoxx50 can continue its recent countertrend outperformance versus the S&P500. Go overweight industrials versus utilities as a tactical trade. Feature Chart of the WeekWere It Not For Brexit, U.K. Interest Rates Would be 1 Percent Higher Please join me for a webcast today at 10.00 AM EST (3.00 PM GMT, 4.00 PM CET, 11.00 PM HKT) when I will be elaborating on some of the ideas in this report as well as other major investment themes. For those of you who cannot participate live, the webcast will also be available as a playback. Were it not for the psychodrama called Brexit, the pound would be trading at $1.50 rather than at $1.28. We can say this with utmost confidence because ‘cable’ is very closely tracking the difference in 2-year interest rates in the U.K. versus the U.S. Absent the Brexit shenanigans, U.K. interest rates would be around 1 percent closer to those in the U.S., implying that pound/dollar would be around 15 percent higher ( Chart I-2 and Chart I-3 ). Chart I-2Absent The Brexit Discount On U.K. Interest Rates... Chart I-3...The Pound Would Be At $1.50 Explaining Brexit’s Impact On U.K. Interest Rates And The Pound The difference in U.K. versus U.S. interest rates usually tracks the difference in their inflation rates, in effect equalizing real interest rates in the two economies. But the Brexit referendum in 2016 forced the Bank of England into an ‘emergency monetary policy’ mode, whereby interest rates were left depressed relative to the inflation fundamentals, and U.K. real interest rates collapsed. Applying the BoE’s pre-Brexit reaction function to the current inflation dynamics, U.K. interest rates – and therefore the pound – would be in a completely different ballpark. After all, U.K. and U.S. core inflation rates and unemployment rates are virtually identical ( Chart of the Week  ). It follows that the pound’s trajectory will be higher in any negotiated Brexit – or indeed ‘no Brexit’ – which avoids a complete and overnight no-deal divorce. The simple reason is that a transition period lasting several years that continues to give the U.K. access to the EU single market will allow the BoE to revert to its pre-Brexit monetary policy reaction function. But any workable alternative to a no-deal Brexit must satisfy two conditions: the way forward must be acceptable to the EU27; and it must command a majority in the U.K. parliament. From the perspective of investors, what this way forward turns out to be – Common Market 2.0, permanent customs union, second referendum, or general election – does not really matter. What matters is that a parliamentary majority exists for a course of action that avoids no-deal. The investment strategy is to buy the pound as soon as the U.K. parliament coalesces a majority around an action plan to counter a no-deal Brexit . In this event, do not buy the FTSE100. Whenever the pound strengthens, the weaker translation of the FTSE100 companies’ dollar-denominated earnings tends to weigh down this large-cap index. A better play is the FTSE250 mid-cap index ( Chart I-4 ), but for equity investors t he best play is a FTSE Small Company Index ETF and/or U.K. REITS ( Chart I-5 ). Chart I-4A Negotiated Brexit Would Favour The FTSE250... Chart I-5...And U.K. Small Companies Europeans Are Celebrating Lower Oil Europeans will be celebrating the near halving of the crude oil price from its $86 high just three months ago. The simple reason is that Europeans are net importers of energy, and the amount of energy they consume tends to be price inelastic. After all, Europeans have to do the school run and stay warm in winter, irrespective of the oil price. 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-6 ). A second transmission mechanism is via credit creation: higher inflation, through its implication for tighter monetary policy, lifts bond yields and depresses credit impulses; lower inflation does the opposite, it depresses bond yields and lifts credit impulses. The upshot is that higher oil weighed on European growth in 2018 while lower oil should boost growth in early 2019. Chart I-6Inflation Is Likely To Plunge, Boosting Real Incomes Compelling proof comes from the oscillations in the euro area economy. For several years, these growth oscillations have perfectly and inversely tracked oscillations in the oil price ( Chart I-7 ). The economic implication is that the recent collapse in energy prices should engineer some sort of growth rebound in the euro area. The investment implication is that such a growth rebound will support the classically cyclical equity sectors – banks, industrials and materials – because of their very high operational leverage to economic growth. Chart I-7Euro Area Growth Oscillations Inversely Track Oil Price Oscillations Profit is a small number created from the difference between two large numbers: sales minus the cost of generating those sales. But the dominant cost – the wage bill – tends to be quite sticky. Hence, if a company’s sales are highly sensitive to the economy, the power of operational leverage means that a small change in GDP can have a dramatically large proportional impact on profit. This is a simple principle, but it turns out to be an excellent explanation for the Eurostoxx50 earnings per share (eps) cycle. Because the index is dominated by the classically economic-sensitive sectors, Eurostoxx50 eps growth has a very high operational leverage to changes in euro area GDP growth, potentially as high as 50 times over short periods such as six months ( Chart I-8 ). In contrast the less cyclical S&P500 has an operational leverage to economic growth of less than 10 ( Chart I-9 ). Chart I-8Eurostoxx50 Profits Growth Is Highly Geared To Economic Growth Chart I-9S&P500 Profits Growth Is Less Geared To Economic Growth On the expectation that euro area growth will rebound modestly in early 2019, the beaten-down banks, industrials and materials can continue their recent countertrend outperformances. And this necessarily means that the cyclical-heavy Eurostoxx50 can continue its recent countertrend outperformance versus the S&P500. Explaining The ‘Unexplainable’ Moves In Markets During the recent Christmas holiday period, financial markets experienced sharp moves with no explainable catalyst. Such reversals leave many strategists and analysts scratching their heads in bewilderment, wondering: what was the catalyst for that reversal? The answer is there was no fundamental catalyst; the market reversed because liquidity dried up . But to explain why liquidity dried up and markets ‘unexplainably’ reversed, we first need to understand what creates market liquidity in the first place. Market liquidity is the ability to convert cash into an investment quickly and in volume without affecting its price. But for an investor to convert a large amount of cash into an investment without affecting its price, another investor must be willing to do the exact opposite – convert a large amount of the investment into cash at the given price. Therefore, market liquidity comes from a disagreement about the attractiveness of an investment at that given price. Investors disagree about the attractiveness of an investment at a given price because investors with different time horizons interpret the same facts and information very differently. Hence, a market remains stable when it possesses investors with many different time horizons. The reason is that when a day-trader experiences a ‘six-sigma’ price move, an investor with a longer investment horizon, for example 65 days, will step in and stabilize the market. The longer-term investor will do so because, within his investment horizon, the day-trader’s six-sigma price move is not unusual. As long as another investor has a longer trading horizon than the investor experiencing an extreme event, the market will stabilize itself. Therefore, the market’s liquidity and stability are maximized when its participants possess a variation of investment horizons, say, both the 1 day horizon and the 65 day horizon. The corollary is that the market’s liquidity and stability disappear when its participants no longer possesses this healthy variation in horizons. In technical terms, this occurs when the market’s 65-day fractal dimension collapses to its lower bound. Without a shadow of a doubt, this is what happened to the S&P500 on Christmas Eve and triggered a 5 percent market rebound on Boxing Day ( Chart I-10 ). And this is now what is happening to the relative performance of industrials versus utilities, which is also in the process of a similar liquidity-triggered rebound ( Chart I-11 ). Chart I-10A Liquidity Shortage Triggered A Sharp Rebound In The S&P500   Chart I-11Expect A Liquidity-Triggered Rebound In Industrials Versus Utilities   Fractal Trading System* This week we note that the strong rally in the Indian rupee versus the Pakistan rupee has reached a point where an imminent liquidity shortage could trigger a countertrend move. Go short the Indian rupee versus the Pakistan rupee with a profit target of 3 percent, and 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-12 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  

Special Report

Highlights Our market-based China growth indicator has risen meaningfully since mid-December, but mostly due to the equity components. For now, we regard this as a mixed signal, rather than a green light for Chinese stocks. Our research suggests that the odds of a serious earnings contraction for Chinese investable stocks over the coming year are high. Stocks are only likely to bottom near the end of the earnings adjustment process, if the 2014-2015 episode is a guide. Despite reasonable relative valuation, the long-term downtrend in sales-to-GDP suggests that Chinese stocks may be a “value trap” even over a multi-year time horizon. Feature Over the past several months BCA’s China Investment Strategy service has focused heavily on the cyclical condition of China’s economy, and whether any “green shoots” are evident from the key indicators that we track. We noted in last week’s report that our leading indicator for China’s old economy continues to point to slower growth over the coming months,1 a conclusion that is generally supported by the December trade, money, and credit data. In today's special report we address six questions concerning the outlook for Chinese stocks in light of passive outperformance versus the global benchmark over the past 3 months. We highlighted in last week’s report that investors should not view recent outperformance as a positive cyclical sign for Chinese stocks, and our answers to the questions below will hopefully provide readers with a fuller understanding of our neutral stance over a 6- to 12-month time horizon. The bottom line of our analysis is that a cyclical (6-12 month) overweight stance toward Chinese investable stocks versus the global benchmark remains uncompelling until the earnings contraction that is likely to occur this year is well underway. Chinese stocks offer reasonable-to-good valuation relative to global stocks, but may be cheap for a reason even over a multi-year time horizon. We remain tactically overweight Chinese investable stocks in recognition of the fact that investors may bid up the market in the lead-up to a possible trade deal with the U.S., but a legitimate improvement in domestic fundamentals is likely needed before we recommend investors upgrade their medium-term equity allocation to China. Q: Are the market signals from China-related assets bullish or bearish for Chinese stocks? A: Our market-based China growth indicator has risen meaningfully since mid-December, but mostly due to the equity components. For now, we regard this as a mixed signal, rather than a green light for Chinese stocks. Chart 1 presents our market-based China growth indicator, its four asset class subcomponents, and the range between the strongest and weakest components. Table 1 shows the change in the indicator and its 17 individual components since December 10, when the indicator clearly broke out. Chart 1Largely Driven By EM Equity Relative Performance Both the chart and the table make it clear that the recent rise in the indicator is not uniform. While it is true that most of the individual components have improved over the past month, the equity components and two currency measures (the inverse of the dollar and Asian currencies), especially CNY-USD have accounted for most of the gains. Table 1(Anomalous) Equity Relative Performance Has Driven The Recent Improvement In Our MBCGI As we noted in last week’s report, the Q4 outperformance of Chinese / emerging market stocks has been passive in nature, meaning that they have outperformed simply because developed market equities have collapsed. This, in combination with the fact that the strongest currency components have been linked to declining interest rate expectations in the U.S., tell us that the aggregate indicator has largely risen due to a 1) generalized selloff in global risk assets, 2) perceptions of easier Fed policy, and 3) a modest improvement in sentiment concerning the U.S.-China trade war. While it would not normally be the case that a global equity selloff would cause the equity component of our indicator to rise, December was atypical because many China-related assets had already declined in advance of the selloff. Are the latter two factors noted above reason enough move to an overweight stance towards Chinese stocks over the coming 6- to 12-months? In our view, the answer is “not yet”. While easier U.S. monetary policy is certainly welcome (particularly given our view that a recession is unlikely), it is not yet clear that either of the negative factors waiting on Chinese stocks in absolute terms will be resolved over the coming year. The first factor is the trade war with the U.S. We agree that the odds of some sort of a deal that avoids further tariff imposition have risen significantly over the past two months, more than we anticipated in the lead-up to the G20 meeting in Argentina. However, given the deep, structural nature of the dispute between the U.S. and China, we think it is dangerous to pre-emptively act on an agreement that may not come or may take much longer to be reached than investors currently hope. This risk is in addition to what is likely to be a deceleration in export growth over the coming few months regardless of the outcome of negotiations, as the export front-running effect that has boosted trade volume over the past several months wanes. But as we address in the next question, the second negative factor impacting Chinese stocks is the upcoming impact of a slowing domestic economy on Chinese earnings, an effect that is not likely to be impacted by the changes in the global economy implied by financial markets since mid-December. Q: What is the outlook for Chinese earnings growth over the coming year? A: Our research suggests that the odds of a serious earnings contraction over the coming year are high. Chart 2 presents an update to a model for Chinese ex-tech (or “old economy”) earnings growth that is part of our analytical toolkit.2 The model paints a rosy outlook for earnings growth, suggesting that it is set to decelerate over the coming year but will continue to grow at a double-digit rate. Chart 2The Li Keqiang Index Suggests Ex-Tech Earnings Growth Will Stay Positive... However, one problem with the approach used in Chart 2 is the fact that we have used the Li Keqiang index (LKI) as the independent variable in the model. Historically the LKI has reliably led ex-tech earnings growth, but we have highlighted several times over the past few months that the index is currently being supported by trade front-running activity that is very likely to wane, a view that is strongly consistent with the very negative December trade data that was released earlier this week. Chart 3 presents a different approach, namely the prediction of the odds of a serious investable equity earnings contraction over the coming 12-months (defined as earnings growth falling below -5%). The statistical approach taken in Chart 3 (logistic regression) is similar to that often employed by researchers attempting to predict the odds of a recession, and the chart shows that the model successfully warned of the two major earnings contractions over the past decade. Crucially, the odds of a major contraction did not rise about the 50% mark in 2012, when investable earnings growth decelerated significantly and fell briefly into negative territory. Chart 3...But Other Measures Imply High Odds Of An Outright Contraction The current message from the model is clear: the odds of a significant earnings contraction over the coming 12-months are as high as 70%, implying that the deceleration in 12-onth trailing earnings growth shown in panel 2 of Chart 3 is likely to continue. Q: If earnings are set to contract, when will investors anticipate a recovery? A: Near the end of the earnings adjustment process (for investable stocks), if the 2014-2015 episode is any guide. Chart 4 presents some perspective on the issue of when investors are likely to anticipate an eventual bottom in earnings if a contraction does indeed occur. The chart shows the level of 12-month forward earnings for investable and domestic stocks, and circles at what point stocks in each market bottomed during the massive selloff in the Chinese equity market from 2014-2015. Chart 4The Forward Earnings Adjustment Process Has Yet To Begin The chart shows that the domestic market bottomed roughly halfway through the earnings adjustment process, whereas the investable market bottomed almost at the end of the process. The chart also shows that this adjustment process has barely begun, which (in combination with Chart 3) currently argues against a cyclically overweight stance towards global stocks. Q: In the developed world (particularly the U.S.), elevated profit margins are viewed as a potential risk to earnings over the coming few years. Is profit margin mean-reversion a risk in China? A: Based on the absolute level of profit margins, no. Relative to the history of poor profitability for Chinese stocks, yes. Chart 5 shows the 12-month trailing profit margins for global and investable Chinese stocks. It shows how global margins have now moved past their previous cycle highs, a circumstance that is even more extreme in the case of the U.S. Chart 5Chinese Profit Margins Are Very Low, But Very Elevated Relative To Their History Investable Chinese margins are very low, which at first blush implies less risk of a mean-reversion assuming a common mean. However, panel 2 shows that Chinese investable margins are as high relative to their own history as they are for global stocks, and they have followed a similar pattern over the past few years. This suggests that the central tendency for Chinese margins is indeed significantly lower than it is for the global benchmark, and that the risk of mean reversion is similarly elevated in the face of a major economic shock. How is it possible that Chinese investable ROE has been similar or even higher than that of the global benchmark, but that profit margins are substantially lower? The answer, with very high likelihood, is leverage. Panel 1 of Chart 6 shows ROE for both markets, whereas panel 2 shows ROE divided by the profit margins shown in Chart 5. Using the DuPont approach to decomposing ROE, ROE divided by profit margins is equal to sales over equity, or the product of the asset turnover (sales/assets) and leverage (assets/equity) ratios. Panel 2 shows that product of turnover and leverage is more than twice that of global stocks, implying that Chinese companies are either extremely efficient in the use of their assets to generate sales, or they are very highly levered compared with global stocks. Chart 6High Chinese ROE The Result Of High Leverage The latter is overwhelmingly more likely. We presented evidence in our August 29 Special Report suggesting that Chinese state-owned enterprises (SOEs) now have a negative net return on borrowed funds,3 a situation that has been caused by persistent leveraging since 2010. Not only does this explain the low profitability of Chinese stocks, it also magnifies the risk of significant mean reversion beyond a 6-12 month time horizon if Chinese policymakers panic and aggressively stimulate credit to stabilize a slowing economy. Q: Are Chinese stocks relatively cheap? A: The domestic equity market, yes. The investable market, somewhat. We presented Charts 7 and 8 in our final report of 2018,4 which showed the following: The forward P/E ratio for both domestic and investable Chinese stocks has improved substantially over the past several months. In relative terms, Chinese stocks are not as cheap as they have ever been but, depending on the measure employed, usually haven’t been cheaper (at least over the past decade). The A-share market particularly stands out, with all four relative valuation measures near, at, or above their 2014 levels. Chart 7Chinese Stocks Have Become Cheaper In Absolute Terms…   Chart 8…And Relative To Global Stocks Since we published our December report, global stocks sold off severely, which has somewhat diminished the relative cheapness of investable Chinese stocks. But the bottom line for investors is that Chinese stocks are not expensive in absolute terms, relative to global stocks, or compared with the history of relative valuation. Q: Given reasonable-to-good valuation, are Chinese stocks a good long-term buy? A: Not necessarily. It is distinctly possible that Chinese investable stocks are an example of a “value trap”. When discussing equity valuations in our last report of the year, we also mused about whether Chinese stocks are a great long-term buy. We noted that valuation is normally a powerful predictor of 10-year future performance, but that deviations from this relationship can exist. Chart 9 shows a vivid example of such a deviation, by presenting the profile of investable and domestic equities versus U.S. and global stocks, all rebased to the start of the U.S. recession in December 2007. The chart shows that for every $100 invested in equities at the end of 2007, local currency prices have fallen to $52 for domestic stocks and $86 for investable stocks. This is in sharp contrast to $128 for global equities, and a whopping $176 for the S&P 500. Chart 9A (Largely) Lost Decade For Chinese Stocks Excessive Chinese stock market valuation at the end of the last economic cycle has certainly contributed to the divergence shown in Chart 9. But Chart 10 shows another, less discussed factor: Chinese fundamental performance has not kept up with GDP growth, in contrast to developed markets. The chart shows the indexed ratio of sales per share to nominal GDP growth for the U.S. and China, and highlights that the latter has not only trended downward over time but has collapsed over the past four years. Chart 10Are Chinese Stocks Really A Play On Higher Chinese Growth? At root, the secularly bullish narrative surrounding Chinese stocks is based on the fact that China’s rate of economic growth is considerably higher than that of the developed world. But if the fundamental performance of China’s listed equities cannot keep pace with the economy, are they such a compelling buy simply because they are not expensive? An alternative view is that Chinese stocks are cheap for a reason, i.e. that they are a value trap. In combination with the sizeable risks facing the Chinese economy from extremely elevated levels of corporate debt, the best answer that we can give investors looking out over a multi-year horizon is that Chinese stocks are a great long-term buy for those who do not share our structural concerns. On a risk-adjusted basis, we do not yet find the value proposition to be compelling, meaning that our recommended multi-year allocation to Chinese stocks is neutral. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Footnotes 1 Please see China Investment Strategy Weekly Report “Monitoring The (Weak) Pulse Of The Data”, dated January 9, 2019, available at cis.bcaresearch.com. 2 Owing to the recent changes to the global industrial classification system (GICS), the chart shows Chinese earnings growth excluding the information technology and communication services sectors. 3 Please see China Investment Strategy Special Report “Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging”, dated August 29, 2018, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report “Legacies of 2018”, dated December 19, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Global Corporates: The Fed is now clearly signaling a near-term capitulation to tightening financial conditions alongside slowing global growth and inflation. A pause in the U.S. rate hiking cycle, after credit spread valuations have cheapened up, opens up a window of opportunity for global corporate bond market outperformance versus government debt over the next 3-6 months. Country Allocation: Move to overweight (4 of 5) on both U.S. investment grade and high-yield corporates, while downgrading U.S. Treasuries to underweight (2 of 5). Upgrade euro area investment grade and high-yield corporates to neutral (3 of 5), while downgrading euro area governments to underweight (2 of 5). Upgrade emerging market U.S. dollar denominated debt (both sovereign and corporate) from maximum underweight to underweight (2 of 5). Feature We downgraded our overall recommended investment stance on global corporate debt to neutral on June 26 of last year.1 That decision reflected our concern at the time that less accommodative central banks, a rising U.S. dollar, weakening global growth momentum and intensifying U.S.-China trade tensions had all significantly worsened the near-term risk/reward tradeoff for owning corporate bonds. This accompanied a firm-wide call at BCA to pare back our recommended exposure to global equities for the same reasons. We now see an opportunity, driven by better value and diminished market volatility after the Fed has clearly signaled a pause on U.S. rate hikes (Chart of the Week), to go back to an overweight stance on corporate credit on a tactical basis (3-6 months). Chart of the WeekTime For A Pause In Corporate Spread Widening To be clear, we still see medium-term risks for corporate credit once global growth stabilizes and a resilient U.S. economy forces the Fed to restart the rate hikes in the latter half of 2019. A move to a restrictive stance by the Fed toward year-end, signaled by an inversion of the U.S. Treasury yield curve, will raise recession risks and be the eventual death knell for this credit cycle. In the meantime, corporate debt is likely to outperform government bonds, justifying a tactical overweight position. This mirrors the recent change in the BCA House View, returning to a tactical overweight stance on global equities. On a regional basis, we prefer taking more of our upgraded credit risk in U.S. corporates over European and emerging market (EM) equivalents. The outlook for growth remains more favorable on a relative basis to Europe or China, the latter being most critical for the outperformance of EM assets. Why The Spread Widening Will Pause: A Patient Fed Is Taking A Break Global corporate bond spreads have widened since we did our downgrade in June, across all countries and credit tiers (Chart 2). Typically, some underperformance of corporate credit should occur when global growth momentum slows, as was the case throughout 2018. Yet the most violent period of spread widening only began once the Fed began signaling that it would continue with its interest hikes and balance sheet runoff, despite softening global growth. This set off yet another clash between policy and the markets – one of BCA’s key investment themes for 2018 that still applies in 2019 – resulting in a sharp selloff in global risk assets, including corporate debt. The result was a tightening of U.S. financial conditions, first through a stronger U.S. dollar (supported by rate hike expectations) and later through lower equity prices and wider corporate spreads. This echoed the 2014/15 period when the Fed was trying to lift rates off the zero bound after ending its quantitative easing program. The Fed was only able to deliver a single rate hike in December 2015 before pausing because of severely slumping global growth (most notably in China) and a sharp tightening in financial conditions, both of which knocked the wind out of the U.S. economy. Turning to 2019, the downturn in cyclical growth indicators like manufacturing purchasing managers indices (PMI) and the global leading economic indicator (LEI) has reached levels last seen after that 2014/15 episode (Chart 3). Importantly, our global LEI diffusion index, which measures the number of countries with rising LEIs compared to falling LEIs and is itself a reliable leading indicator of the global LEI, is bottoming out at the same level that preceded the 2016 LEI revival (middle panel). This suggests that a stabilization of the global LEI could unfold in the next few months, which would also signal a potential rebound in corporate credit returns (bottom panel). Chart 3Credit Returns Already Reflect Slowing Growth Given the many similarities between today and the 2014/15 backdrop, it is sensible to look for other indicators that accurately heralded the end of that period of spread widening to help time a potential increase in recommended exposure to corporates. Over the past several weeks, our colleagues at our sister BCA service, U.S. Bond Strategy, have been following a checklist of market-based signals to determine the timing of a potential peak in U.S. credit spreads.2 These are grouped into two categories: signals of rebounding global growth and signals of Fed capitulation on rate hikes. For global growth, the indicators monitored are shown in Chart 4: Chart 4Checklist For Peak U.S. Spreads: Global Growth the CRB raw industrials index of commodity prices (a broader measure that excludes highly volatile oil prices) the BCA Market-Based China Growth Indicator (created by our China Investment Strategy team as a proxy of investor expectations of Chinese growth3) the Global Industrial Mining equity price index For Fed capitulation, the indicators monitored are shown in Chart 5: Chart 5Checklist For Peak U.S. Spreads: Fed Capitulation our 12-month fed funds discounter, which measures the amount of expected Fed rate hikes over the next year discounted in the U.S. Overnight Index Swap (OIS) curve the price of gold in dollars (a higher price correlating with perceptions of easier U.S. monetary policy and vice versa) the nominal trade-weighted U.S. dollar index Among the growth-focused elements of the checklist, only the China Growth Indicator is in a clear uptrend. Non-oil commodity prices had been stabilizing at the end of 2018 but appear to be rolling over, while it is not yet clear if the downturn in Mining stocks has ended. With momentum in global PMIs and LEIs still having not yet bottomed out, it may be too early to expect a cyclical rebound in non-oil commodities and related equities. At a minimum, that will require even greater signs that China’s economy is regaining some vigor. However, as we discussed last week, Chinese policymakers’ options to stimulate growth are far more limited now than they were in 2015 and 2016 when a rebounding China boosted commodity demand and EM asset performance.4 Within the Fed-focused components of the “Peak Spreads Checklist”, the near-term bullish signal for credit is much stronger. Our fed funds discounter has rapidly priced out all rate hikes for 2019. Since November, gold is up nearly 8% and the nominal trade-weighted U.S. dollar is down 2%. The shift in recent Fed messaging from signaling a “gradual pace” of tightening to exhibiting “patience” on any future policy moves was a highly dovish signal for investors. This alone has been enough to stabilize equity and credit markets, which had been discounting that Fed tightening in 2019 would drive the U.S. into a possible recession. In the constant battle between financial conditions and the Fed, the former has won this latest round. How long will this Fed pause last? Continuing with the comparison to the 2014/15 episode, a critical difference is that underlying trends in U.S. economic growth and inflation are firmer today. This is evident in the BCA Fed Monitor, which is comprised of economic and financial data that indicate pressure on the Fed to tighten or ease monetary policy. Chart 6 shows a “cycle-on-cycle” comparison of the Fed Monitor (and its subcomponents) today versus 2014/15. The Fed Monitor is still signaling a need for the Fed to continue tightening because the Economic Growth and Inflation Components remain elevated. Yet the Monitor has declined from its recent peak thanks entirely to the plunge in the Financial Conditions Component, which has fallen even faster than it did in 2014/15. Chart 6BCA Fed Monitor: Today Vs 2014/15 The implication from our Fed Monitor is that there needs to be more evidence of slowing U.S. economic growth and reduced inflation pressures for the Fed to stay on hold for longer. If the data stay firm, but financial conditions ease because investors expect a prolonged pause from the Fed, then the Fed could quickly return to a hawkish bias later this year. This is now our base case scenario for how 2019 will play out. This is also why we are only upgrading corporate debt on a tactical basis. We do not expect U.S. growth or inflation to slow enough to prevent more Fed tightening later this year – an outcome that will weigh on credit returns as the Fed moves to a restrictive policy stance. Yet even if we are wrong and the U.S. economy decelerates more sharply, that is also a bad outcome for credit because it means weaker corporate profits and rising downgrades and defaults. For bond investors with longer-time horizons than 3-6 months, the credit rally that we are anticipating can actually provide an opportunity to reduce credit exposure for the final leg of the Fed’s monetary policy cycle and the multi-year corporate credit cycle. In other words, selling into the rally rather than chasing it. For now, we are choosing to play for the shorter-term move by upgrading our recommended global credit allocations. Yet we do not envision this turning into a long-term position. The medium-term outlook for corporates is far more challenging given the advanced age of the monetary, business and credit cycles. Bottom Line: The Fed is now clearly signaling a near-term capitulation to tightening global financial conditions alongside slowing global growth and inflation. A pause in the U.S. rate hiking cycle, after credit spread valuations have cheapened up, opens up a window of opportunity for global corporate bond market outperformance versus government debt over the next 3-6 months. The Specific Changes To Our Recommended Asset Allocation As part of our tactical upgrade of global corporate debt, we are making the following changes to our recommended portfolio allocation tables (see Page 13): Upgrade overall global credit exposure to overweight (4 out of 5) Upgrade both U.S. investment grade and high-yield corporate exposure to overweight (4 out of 5), while downgrading U.S. Treasury exposure to underweight (2 out of 5) Upgrade euro area investment grade and high-yield corporate exposure to neutral (3 out of 5) and downgrade euro area government bond exposure to underweight (2 out of 5) Upgrade EM U.S. dollar denominated debt from maximum underweight to underweight (2 out of 5), both for sovereign and corporate debt. The changes all represent a one-notch upgrade from our previous allocations, based on our more positive tactical view on overall global credit risk, while still maintaining our relative preference for U.S. corporates over non-U.S. equivalents. We prefer U.S. credit not only because we expect better relative economic growth momentum in the U.S., but also because our preferred valuation metrics indicate that U.S. corporate bond spreads now look relatively attractive. Our estimate of the default-adjusted spread on U.S. high-yield corporates, which is simply the current spread minus losses from defaults, has risen to 302bps, well above the long-run average of 268bps (Chart 7). That is a function of the high-yield spread now discounting a 2019 default rate of nearly 6%, well above our forecasted default rate of 2.5%.5 Chart 7Too Much Default Risk Priced Into U.S. Junk Corporate credit spreads in the U.S. also look attractive on a volatility-adjusted basis. Our estimates of Breakeven Spreads – the amount of spread widening required for corporate returns to break-even with duration-matched U.S. Treasuries on a one-year horizon – shows that credit spreads have cheapened to levels that are in the upper end of the historical range for both investment grade and high-yield debt (Charts 8 & 9). Chart 8Vol-Adjusted IG Spreads Have Cheapened   Chart 9Vol-Adjusted HY Spreads Are Cheap Credit spreads have also cheapened up in Europe and EM, and a “risk-on” rally from a Fed pause will likely benefit spread product in those regions. However, the performance of U.S. credit versus non-U.S. credit remains largely determined by relative growth trends (Charts 10 & 11). Given our more positive view on U.S. growth on a relative basis, we are maintaining a higher recommended allocation to U.S. corporates versus euro area and EM equivalents, even as we upgrade overall global corporate exposure. This is also a way to provide a partial hedge to the specific risks in the latter regions coming from: Chart 10Global Corporates: Continue Favoring U.S. Over Europe   Chart 11Global Corporates: Continue Favoring U.S. Over EM a) an end of the ECB’s corporate bond buying as part of its Asset Purchase Program, which takes a major buyer out of the euro area corporate market b) a more persistent slowing of Chinese growth momentum and softer non-oil commodity prices, both of which would be negatives for EM assets On a final note, we are also changing the specific weighting in our Model Bond Portfolio on Page 12 to reflect all of the above changes. The allocations to all U.S., euro area and EM corporates are increased – with bigger allocation changes in the U.S. – funded out of reduced weightings in U.S., German and French government bonds. Note that we are not making any changes to our relative U.K. exposures this week, given the unique risk for U.K. financial markets from the Brexit uncertainty. Thus, we are maintaining an overweight stance on U.K. Gilts in the government bond portion of the model portfolio, while remaining underweight U.K. corporates on the credit side.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “Time To Take Some Chips Off The Table: Downgrade Global Corporate Bond Exposure To Neutral”, dated June 26th 2018, available at gfis.bcaresearch.com. 2 Please see BCA U.S. Bond Strategy Weekly Report, “A Checklist For Peak Credit Spreads”, dated November 27th 2018, available at usbs.bcaresearch.com. 3 Please see BCA China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21st 2018, available at cis.bcaresearch.com. 4 Please see BCA Global Fixed Income Strategy Weekly Report, “Three Big Questions To Start Off 2019”, dated January 8th 2019, available at gfis.bcaresearch.com. 5 That forecasted default rate is taken from Moody’s, who have a similarly positive outlook on 2019 U.S. growth as BCA. Therefore, we see no reason to use a different default rate assumption in our high-yield valuation estimate. 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 Corporates: The same indicators that called the early-2016 peak in credit spreads are once again sending a positive signal. Investors should tactically increase exposure to corporate bonds at the expense of Treasuries. Duration: Treasury yields will rise in the coming months as credit spreads tighten and financial conditions ease. Maintain below-benchmark portfolio duration. TIPS: The 10-year TIPS breakeven inflation rate has fallen too far, and it is now well below the fair value reading from our Adaptive Expectations model. Remain overweight TIPS versus nominal Treasury securities. Feature We continue to view the 2015/16 episode as the appropriate comparable for current market behavior, and the same indicators that called the early-2016 peak in credit spreads are once again sending a positive signal. As such, we recommend increasing portfolio allocations to both investment grade and high-yield corporate bonds at the expense of Treasury securities (see the Recommended Portfolio Specification Table on the last page of this report). Importantly, our cyclical view of the credit cycle has not changed. Elevated corporate debt balances and a relatively flat yield curve suggest that we are in the awkward middle phase of the cycle when excess returns from corporate credit tend to be positive, but low.1  However, recent spread widening has been excessive for this middle phase of the cycle, and we expect spreads to tighten from oversold levels during the next few months. Three Reasons To Upgrade Credit (& One Key Risk) Reason 1: Elevated Spreads The first reason to upgrade corporate credit is the attractive entry point (Chart 1). Outside of the Aaa space, 12-month breakeven spreads for every credit tier (encompassing both investment grade and junk) are above their respective historical medians. For example, the 12-month breakeven spread for the Baa credit tier is at 59%. This means that the spread has been tighter than its current level 59% of the time since 1988 and wider than its current level 41% of the time. Historically, spreads tend to hover within the tight-end of their historical range during this middle phase of the credit cycle, and only cheapen significantly when the yield curve inverts and the default rate moves higher. Chart 1Corporate Bonds: Attractive Entry Point Reason 2: Fed Capitulation The 2015/16 roadmap is applicable to the current market because in both cases credit spread widening was driven by the combination of weaker global growth and relatively hawkish Fed policy.2 With that in mind, an important pre-condition for spread tightening is a shift in the market’s expectations for Fed policy. Investor psyche must change from viewing monetary policy as restrictive to viewing it as accommodative. Chart 2 shows the three indicators we’ve been monitoring to signal when this shift occurs. All three called the early-2016 peak in credit spreads, and all are sending a strong buy signal at the moment. Chart 2Fed Capitulation Indicators Send A Strong Signal... Our 12-month Fed Funds Discounter, the change in the fed funds rate that is priced into the overnight index swap curve for the next 12 months, has collapsed from an early-November peak of 66 bps all the way to -4 bps (Chart 2, top panel). The gold price has also rebounded smartly (Chart 2, panel 2). Gold tends to rally when the market perceives that monetary policy is becoming more accommodative because the increased risk of future inflation makes gold’s “store of value” characteristics more appealing.3 Finally, the trade-weighted dollar has started to depreciate (Chart 2, bottom panel). This signals that U.S. monetary policy is easing relative to the rest of the world, and is historically correlated with stronger global growth. Reason 3: Imminent Global Growth Rebound The high-frequency global growth indicators that called the early-2016 peak in credit spreads are not sending as strong a signal as the monetary policy indicators, but there has been some positive movement (Chart 3). Chart 3...While There Is Positive Movement In Global Growth Indicators The CRB Raw Industrials index has only flattened-off in recent weeks (Chart 3, top panel), but the Market-Based China Growth Indicator created by our China Investment Strategy team has been rising quickly (Chart 3, panel 2).4  Finally, the price of global industrial mining stocks is no longer in free-fall. Rather, it is showing some signs of stabilization (Chart 3, bottom panel). Of the six indicators shown in Charts 2 and 3, four are sending strong buy signals and the other two are more or less neutral. In sum, we think this is enough of a signal to upgrade exposure to corporate bonds. One Key Risk The key risk to our tactical upgrade is that there is no follow-through from Fed easing to stronger global growth. In 2016, Fed capitulation coincided with a ramp-up in Chinese stimulus efforts. Chart 4 shows that our China Investment Strategy team’s Li Keqiang Leading Indicator moved sharply higher in early 2016.5 Moreover, all six components of the indicator participated in the uptrend. At present, only some components of the Leading Index have rebounded and the overall index has merely leveled-off. Chart 4Chinese Growth Is The One Key Risk When it comes to Chinese growth, a trade deal with the U.S. would certainly help matters. However, the risk remains that Chinese policymakers continue to curb credit growth so much that the pass through from easier Fed policy to global growth is weaker than in 2016. Bottom Line: With Fed rate hikes priced out of the market and signs of stabilization in high-frequency global growth indicators, the toxic combination of tight Fed policy and weak global growth is disappearing. This should allow credit spreads to tighten from current oversold levels. The rapid shift in monetary policy expectations makes us think that spread tightening could occur over a relatively short timeframe. As such, we would recommend this upgrade only to tactical (3-6 month) investors. Those with longer investment horizons may be better served by waiting for spreads to tighten and then using that opportunity to reduce cyclical corporate bond exposure. A Note On Portfolio Duration As mentioned above, the market has completely priced out Fed rate hikes. At present, the overnight index swap curve discounts 4 bps of rate cuts over the next 12 months and 17 bps of rate cuts over the next 24 months. This shift in market rate expectations is the main reason for our rosier outlook on corporate spreads, but it’s important to remember that the causation between credit spreads and policy expectations runs both ways (Chart 5). It is the recent spread widening and sharp tightening in financial conditions that caused the Fed to adopt a more accommodative policy stance in the first place (Chart 6). In the background, the U.S. economic data remain robust. The New York Fed’s GDP Nowcast model projects above-trend real GDP growth of 2.5% in 2018 Q4 and 2.1% in 2019 Q1. The corollary is that once credit spreads tighten and financial conditions ease, the Fed will have no further reason to stay on hold. Chart 6Financial Conditions Likely Going To Ease Going Forward If financial conditions ease during the next few months, as we expect, then it is very likely that the Fed will be ready to lift rates again at the June FOMC meeting. The fed funds futures curve currently discounts less than a 20% chance of that happening.  Bottom Line: The U.S. economic data are solid. The sharp fall in rate hike expectations and Treasury yields is purely a reaction to tighter financial conditions. Treasury yields will rise in the coming months as credit spreads tighten and financial conditions ease. Maintain below-benchmark portfolio duration. Inflation & TIPS The main reason why the Fed feels comfortable responding to tighter financial conditions by adopting a more dovish policy stance is that inflation remains well contained. Last week’s CPI report showed that core CPI grew by 2.2% in 2018, somewhat below levels that are consistent with the Fed’s target (Chart 7).6 Chart 7Inflation Remains Well Contained Looking at the monthly changes, we also see that core CPI has increased by roughly 0.2% in each of the past three months. This translates to an annualized rate of approximately 2.4%, in line with the Fed’s target (Chart 8). The monthly changes shown in Chart 8 also reveal that the year-over-year growth rate in core CPI will almost certainly decline next month when the strong 0.35% print from last January falls out of the trailing 12-month sample. Chart 8Muted Inflationary Pressures For Now However, after next month base effects start to turn supportive. Our Base Effects Indicator, an indicator that compares rates of change in core CPI ranging from 1 to 11 months, predicts that year-over-year core CPI inflation will be higher six months from now (Chart 9). Chart 9Expect Higher Inflation Six Months From Now The conclusion is that inflationary pressures appear muted right now, and will continue to appear muted through the end of February. However, we expect them to ramp up again as we head into March. Come June, it is quite likely that the Fed will be feeling the pressure to lift rates as inflation approaches target. Coincident with a renewed uptick in inflation, TIPS breakeven inflation rates are also biased higher during the next six months. Slowing global growth and falling oil prices drove long-maturity breakevens lower during the past few months, with the result that the 10-year TIPS breakeven inflation rate is now 1.83%, 14 bps below the fair value reading from our Adaptive Expectations model (Chart 10).7  Chart 10Message From Our Adaptive Expectations Model Our Adaptive Expectations model contains three independent variables: The 10-year trailing rate of change in core CPI (Chart 10, panel 3) The 12-month trailing rate of change in headline CPI (Chart 10, panel 4) The New York Fed’s Underlying Inflation Gauge (Chart 10, bottom panel) Of those three variables, the 10-year trailing rate of change in core CPI carries the largest weight. This long-run measure of core inflation is currently running at an annualized pace of 1.83%. This translates roughly to an average monthly increase of 0.15%. In other words, as long as monthly core inflation prints above the 0.15% level, the fair value from our Adaptive Expectations model will continue to rise. Bottom Line: Core inflation has been steady during the past few months, but base effects will turn positive after next month’s report. This means that we will probably see higher year-over-year core CPI inflation in six months. With the 10-year TIPS breakeven inflation rate already well below the fair value reading from our Adaptive Expectations model, we expect TIPS will outperform nominal Treasuries during the next six months.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 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 2 Please see U.S. Bond Strategy Weekly Report, “An Oasis Of Prosperity?”, dated August 21, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “A Signal From Gold?”, dated May 1, 2018, available at usbs.bcaresearch.com 4 For further details on how this indicator is constructed please see China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com 5 The Li Keqiang Leading Indicator is a composite indicator of money and credit growth measures designed to predict changes in the Li Keqiang Index (a coincident indicator of Chinese economic activity). For further details on how the Leading Index is constructed please see China Investment Strategy Special Report, “The Data Lab: Testing The Predictability Of China’s Business Cycle”, dated November 30, 2017, available at cis.bcaresearch.com 6 The Fed targets 2% PCE inflation. CPI inflation tends to run about 0.4%-0.5% higher than PCE, which means the Fed’s target is roughly 2.4%-2.5% for CPI. 7 For further details on the model please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy The budding recovery in Chinese infrastructure outlays and easing in monetary conditions, a pause in the U.S. dollar’s rally on the back of a more dovish Fed and improving domestic steel final-demand dynamics along with compelling valuations and technicals, all suggest it no longer pays to be bearish the S&P 1500 steel index. Boost to overweight. A marginally improving China monetary backdrop, a de-escalation in the U.S./China trade tussle, recovering EM market internals and a brightening profit backdrop, all signal that a re-rating phase looms in the S&P materials sector. Upgrade to a modest overweight. Recent Changes Boost the niche S&P 1500 Steel Index to overweight today. This move also lifts the S&P Materials Index to a modest overweight. Table 1 Feature The S&P 500 convulsed following the December 19th Fed meeting and suffered a cathartic 450 point peak-to-trough fall last month. The Fed likely made a policy error, and Fed Chair Powell’s resolve is getting tested as has happened with every Chair since Volcker (Chart 1).1 Chart 1Powell's Resolve Getting Tested The top panel of Chart 2 shows that the 2018 peak in the SPX occurred one week prior to the September Fed meeting. That meeting, when the Fed raised rates for the third time that year, was the straw that broke the camel's back. Indeed, the bond market has been signaling that the U.S. economy has reached the neutral rate last year, as the 10-year UST yield stalled near the 3.10% mark on several occasions (middle panel, Chart 2). Chart 2Fed Policy Mistake Our recent research also suggests that the Fed’s tightening cycle (from trough-to-peak) is now above the historical median and at least a pause is warranted.2 To put last year’s discount rate increases into further perspective, bottom panel of Chart 2 shows that a 100bps increase in the fed funds rate caused a roughly 30% collapse in the forward P/E. Not only is this multiple compression overdone, but prices also corrected 19% from peak-to-trough, likely paving the way for a smart recovery. Our running assumption remains that the U.S. economy will avoid recession this year and EPS will continue to expand. True, the yield curve inversions have widened beyond the 5/3 and 5/2 slopes to the 7/1, and we heed the bond market’s message (Chart 3). However, as we highlighted last month, yield curve inversions occur before stock market peaks. Keep in mind that the most important yield curve slope, the 10/2, has not yet inverted. The upshot is that the SPX has yet to peter out for the cycle.3 Chart 3Yield Curve Inversion Is Spreading With regard to our end-2019 SPX target we are revising our base case scenario to 3,000 (from 3,150 previously),4 based on a 2020 EPS revision to $181 (from $191 previously),5 but we are sustaining the multiple at 16.5 times (Table 2). Assuming 2018 EPS end near $162, this represents a 6% EPS CAGR, in line with the still mid-single digit expansion signal from our EPS growth model (Chart 4). Table 2SPX EPS & Multiple SensitivityChart 4EPS Growth Model Still Expects Mid-Single Digit Expansion Adding it up, stocks hit rock bottom late-last year and a pause in the Fed tightening cycle, at least for the first half of the year, will likely serve as a welcome catalyst; any positive news on the trade tussle front with China will also act as a tonic for stocks, especially beaten down deep cyclicals. This week we are upgrading a U.S./China trade war GICS1 sector victim to a modest overweight position, via boosting a niche deep cyclical sub-index to an above benchmark allocation. Made Of Steel We are booking gains of 2.3% in the niche S&P 1500 steel index and boosting it from underweight all the way to an overweight stance. Beyond the contrary buy signal that bombed out technicals and depressed valuations are sending (Chart 5), there are high odds that relative profit outperformance is in the early innings. Chart 5Steel Is A Steal While U.S. steel stocks should have benefitted enormously from the U.S./China trade war and steel import tariffs, China macro dictates the fate of the S&P 1500 steel index. China’s waning fiscal and credit impulses have weighed heavily on U.S. steel stocks (top panel, Chart 6). Chinese authorities have been trying to engineer a soft landing, but the Chinese manufacturing PMI has now dipped below the boom/bust line (middle panel, Chart 6). Chart 6Mixed China Signals... Nevertheless, the recovering Li KEQIANG index is sending a positive signal (bottom panel, Chart 6). In addition, recent news of a mini fiscal package centered on high speed rail infrastructure spending is a step in the right direction. Historically, Chinese infrastructure outlays and relative share prices have been joined at the hip (middle panel, Chart 7). Chart 7...But Monetary And Fiscal Taps Are Opening On the monetary front, the easing in the banks’ reserve-requirement-ratio (RRR), albeit with a delayed effect, should also aid infrastructure spending uptake (RRR shown inverted, bottom panel, Chart 7). Similarly, the steepening in the Chinese yield curve underscores that easing financial conditions are conducive to a pickup in capital outlays (top panel, Chart 7). The U.S. dollar is another important macro variable driving U.S. steel stocks performance. The greenback’s steep appreciation since April 2018 has dealt a dual blow to domestic steel producers: not only is the underlying commodity quoted globally in U.S. dollars, but also FX translation losses have dented sector profitability. Despite the grim U.S. dollar news, there is light at the end of the tunnel. Were the Fed to pause its hiking cycle, at least in the front half of the year, the greenback’s advance may go on hiatus. Importantly, J.P. Morgan’s EM FX index is staging a comeback and steel prices are holding their own (top and bottom panels, Chart 8). Chart 8Bright Profit Drivers On the domestic front, news is also encouraging. Ever since President Trump came into power, blast furnaces have been running around the clock. Industry resource utilization rates are in a V-shaped recovery since 2016 and only recently returned to levels last seen prior to the Great Recession (middle panel, Chart 8). Steel new order growth is running at a healthy clip and is even surpassing inventory accumulation. This bright demand backdrop is a boon for steelmaking earnings (Chart 9). Chart 9Domestic Operating Backdrop... With regard to the domestic demand front, while automobile sales have been flirting with the zero growth line for the better part of the past three years, non-residential construction has been a primary beneficiary from the easing in fiscal policy (bottom panel, Chart 10). Fiscal thrust will continue to goose the U.S. economy in 2019, according to the IMF’s October 2018 World Economic Outlook update, and a new infrastructure spending bill, however modest, will, at the margin, buoy steel profits. Finally, according to the Fed’s latest Senior Loan Officer Survey, bankers are far from constricting the flow of credit toward the key end-demand segments, autos and commercial real estate. Chart 10...And Domestic Demand Will Buoy Steel Profits In sum, compelling valuations and technicals, the budding recovery in Chinese infrastructure outlays and easing in monetary conditions, a pause in the U.S. dollar’s rally on the back of a more dovish Fed and improving domestic steel final-demand dynamics, all suggest that it no longer pays to be bearish the S&P 1500 steel index. Bottom Line: Lift the S&P 1500 steel index from underweight to overweight and lock in gains of 2.3%. The ticker symbols for the stocks in the S&P 1500 steel index are: BLBG: S15STEL – NUE, STLD, RS, X, ATI, CMC, CRS, WOR, AKS, SXC, TMST, HAYN and ZEUS. Time To Dip Into Materials Raising the S&P 1500 steel index to an above benchmark allocation shifts the S&P materials sector into the overweight column. China macro dominates the direction of U.S. materials stocks. On the monetary front, the easing cycle continues unabated and the near 150bps year-over-year drop in the 10-year Chinese Treasury yield will soon start to bear fruit (yield change shown inverted and advanced, bottom panel, Chart 11). Chart 11Buy Materials As China's Monetary Spigots Are Loosening The renminbi also moves in lockstep with relative share prices. The apparent de-escalation in the U.S./China trade tensions has boosted the CNYUSD and is signaling that a playable reflation trade is in the offing in the S&P materials sector (top panel, Chart 11). Beyond the budding recovery in some key Chinese data (bottom panel, Chart 12), the troughing in emerging markets (EM) currencies versus the greenback also suggests that U.S. materials stocks have put in a bottom (top panel, Chart 12). Chart 12Shifting EM Internals Are A Boon For Materials The EM stock outperformance compared with the global benchmark (second panel, Chart 12) along with EM market internals corroborate the EM FX message. In more detail, EM Latin American equities have been significantly outperforming EM Asian bourses. This real time proxy of commodity producers versus consumers has been an excellent indicator of relative share prices and the current message is to expect more relative gains in the S&P materials sector (third panel, Chart 12). On the earnings front, while last year’s trade dispute related collapse in relative share prices is signaling profit trouble in the coming months, our EPS growth model (comprising the U.S. dollar, interest rates and commodity prices) has ticked up. Similar to the 2012 and 2016 lows, there are good odds that our model is picking up a soft landing in profits (second panel, Chart 13). Chart 13Profit Growth Model Has Troughed S&P materials sub-sector EPS breadth has slingshot higher compared with the overall market and relative long-term EPS growth forecasts are trying to bottom near the 2016 nadir (third & bottom panels, Chart 13). With regard to the sector’s financial health, materials’ indebtedness profile remains in recovery mode, still in the aftermath of the late-2015/early-2016 manufacturing recession with net debt-to-EBITDA in a free fall and a steeply accelerating interest coverage ratio. Capital outlays are also expanding smartly and are now on an even keel with sales growth (Chart 14). Given this improvement in corporate health, there are low odds of debt-related materials sector deflation. Chart 14Clean Bill Of Corporate Health Taking the pulse of investor sentiment toward this niche deep cyclical sector reveals that technical conditions are as oversold as can be; in fact our Technical Indicator sits at one standard deviation below the historical mean, a level that has preceded previous recovery rallies (Chart 15). Chart 15Contrary Buy Alert: Under-owned... Finally, according to our Valuation Indicator, relative valuations have crumbled to the lowest level since the GFC, and even relative EV/EBITDA has also corrected to the historical mean (Chart 16). Chart 16...And Unloved Netting it out, a marginally improving China monetary backdrop along with a de-escalation in the U.S./China trade tussle, recovering EM market internals and a brightening profit backdrop, all signal that a re-rating phase looms in the S&P materials sector. Bottom Line: Lift the S&P materials sector to a modest overweight position.   Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Will The Market Test Powell?” dated November 13, 2017, available at uses.bcaresearch.com. 2      Please see BCA U.S. Equity Strategy Weekly Report, “Manic Market” dated November 19, 2018, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise” dated December 17, 2018, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Weekly Report, “Lifting SPX Target” dated April 30, 2018, available at uses.bcaresearch.com. 5      Ibid. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps