Financial Markets

Special Report

Highlights Rates are going higher ... : Flight-to-quality episodes aside, the bond bear market that began in July 2016 remains in force. Investors should maintain below-benchmark Treasury duration. ... but that doesn't necessarily spell immediate trouble for stocks: Consistent with our work on the fed funds rate cycle, it appears that the level of rates matters more for equity returns than their direction. Empirical evidence of a rates tipping point is elusive ... : The notion that investors migrate from stocks to bonds at a particular level of rates exerts a powerful intuitive appeal, but the data fail to validate it. ... but a 10-year yield Treasury of 3.75 - 4% might halt the bull market in its tracks: Higher rates reliably slow equities only when they rise enough to slow the economy. We estimate that the pinch point is somewhere in the neighborhood of a 3.75 - 4% 10-year Treasury yield. Feature A share of stock is a pro rata claim on the future earnings of the company that issued it. Holding future earnings constant, the price an investor will be willing to pay for a share is wholly a function of the rate used to discount its earnings back to the present day. The simplicity and ubiquity of this valuation approach suggest that equity returns should be predictably related to moves in interest rates. It may also point the way to a tipping point - either in the level of rates, or the magnitude of their rise - at which capital and savings migrate from stocks to bonds. This Special Report reviews the historical record to see how U.S. equities have interacted with real 10-year Treasury yields. It considers the key variables that would logically seem to bear on equity performance and investors' propensity to rotate between asset classes. We find that the relationship between rates and equity returns is conditional, depending on which crosscurrent dominates in any given episode. We did not uncover any predictable rotation pattern. Do The Math As noted above, valuing a stream of future cash flows is a simple mechanical process once one settles on an appropriate discount rate for converting future dollars to current dollars. According to the security analysis textbooks, then, moves in stock prices are inversely related to changes in interest rates. But the textbooks leave out one key point: changes in interest rates don't occur in a vacuum. When they change, earnings estimates are likely to change, too, most often in the same direction as real rates. To be sure, the denominator discounting future cash flows rises when real rates rise, but the future-earnings numerator most likely rises, too. If real rates are rising, the economy is probably gaining momentum, and earnings estimates should probably be revised higher as well. Conversely, falling rates lead to a higher earnings multiple (ex-the not insignificant animal-spirits wild card), but will regularly be accompanied by downward revisions in future earnings. The net effect is uncertain, and depends on whether the multiple change outweighs the change in earnings or vice versa. Bonds Are A Snap Compared To Stocks It's far simpler to compute the impact on a bond portfolio from a given increase in interest rates because the denominator is the only variable that changes. The future-cash-flows numerator is contractually fixed, and it takes a big shift in the state of the economy to spark an economy-wide change in perceived repayment potential.1 This is why bonds' sensitivity to changes in interest rates can be captured in a single universal metric (duration). Stocks are pulled in so many different directions by factors affecting future cash flows that duration has no equity analogue. Investors should therefore be cautious about pinning too much on interest rates as they relate to equities. Bonds move in fixed orbits around the interest-rate sun, according to strictly ordered rules that establish a very clear cause-and-effect relationship. Equities improvise as they go along, taking their cues from a rotating cast of variables that interact differently over time. Attempts to stretch the concept of interest-rate sensitivity beyond bonds regularly trip up equity investors; we cannot know in advance how rates will come together with the other factors that influence equities. Confounding Intuition, Part 1: Equities Prefer Rising Rates (And Multiples Don't Care) U.S. postwar history makes it clear that equity investors need not run from rising rates. The S&P 500 has fared considerably better when real 10-year yields have risen by at least 100 basis points ("bps") than it has when they've declined by that magnitude (Chart 1), gaining 9.4% and 5%, respectively (Chart 2). Rates do not exhibit any sort of a consistent relationship with either forward (Chart 3) or trailing (Chart 4) S&P 500 multiples, though extremely high and extremely low real yields are both associated with lower trailing P/Es. Negative real yields carry an unwelcome whiff of deflation, and their scatterplot data points tend to cluster at below-the-mean forward and trailing multiples. Chart 1Stocks Actually Do Better When Rates Rise ... Chart 2... Considerably Better When Do Higher Rates Hurt The Economy? Charts 3 and 4 show that both forward and trailing multiples almost always decline when real 10-year Treasury yields cross above 5%. What's bad for multiples isn't necessarily bad for earnings, however, and a 5% real threshold is irrelevant to today's cycle. The steady decline in the average fed funds rate over the last several completed cycles (Chart 5) makes it clear that neutral rate thresholds are not constant across time periods. Assessing interest rates' impact on the economy over time requires a sliding scale. Chart 3Hard To See A Trend Through The Windshield ... Chart 4... Or The Rear-View Mirror Estimates of potential economic growth provide a useful yardstick for measuring the impact of real yields. Comparing real long rates to potential output offers insight into the burden of servicing debt across the economy. If real rates exceed the economy's potential growth rate by a material amount, several marginal borrowers are likely to be gasping for air, and their travails will weigh on the economy. Conversely, servicing debt should be easy when real rates are below potential growth, and investors are more likely to invest, businesses are more likely to expand, and consumers are more likely to spend. Chart 5One Size Does Not Fit All There have been 22 instances in the postwar era when real 10-year Treasury yields have increased by at least 100 bps, and Table 1 lists all of them, grouped by their relationship to real GDP's potential five-year growth rate. There are three possible states for interest rate increases in relation to potential output: starting and ending below trend growth, starting below trend growth and ending above it, and starting and ending above trend. The S&P 500 comfortably tops its overall postwar returns when rates go from Below-to-Below and Below-to-Above, but declines outright when rates start above potential growth and go even higher. Earnings consistently rise when rates start below potential growth, making multiples the swing factor - when they expand, S&P 500 gains tend to be very large (Box 1). Table 1Real Rates Versus Potential GDP Growth Box 1 Decomposing S&P 500 Returns Table 2 details the decomposition of S&P 500 returns during rising real rate episodes occurring after S&P 500 earnings estimates began to be compiled in 1979. Except in the crucible of 2009, when they were flat, forward earnings estimates have always risen when rates rise from a below-trend starting point, putting a tailwind behind the S&P 500 that regularly overcomes the multiple contraction that occurs in half of the Below/Above instances. Multiples are the swing factor; when they expand in conjunction with rising earnings estimates, U.S. equities soar. They always contract when rates go from high to higher, dragging stocks down against a mixed earnings expectations backdrop. The action is consistent with our fed funds rate cycle work: stocks do best when rates are below equilibrium and falling because earnings and multiples expand in tandem in that setting, but they do nearly as well after rate hikes commence, in spite of multiple contraction. Earnings surge when the Fed is confident enough about the economy to embark on a tightening cycle, but has not yet hiked enough to choke off the expansion. Multiple expansion in a majority of the Below/Above instances reveals that investors do not rotate out of equities en masse when rates rise, even by a considerable amount. The rotation story has intuitive appeal, but it doesn't show up in these data. Table 2Decomposition Of S&P 500 Returns During Rising Rate Periods A Little More Slicing And Dicing (Potential GDP Matters) Chart 6Mind The Gap Defining Below-to-Below and Below-to-Above states is easy in hindsight, but an investor cannot know in real time where a rising-rate instance that begins with rates below potential output will end. Earnings rise no matter where rates end relative to potential GDP, but re-rating in Below/Below can flip to de-rating in Below/Above, slamming the brakes on phase gains. The empirical data say investors should lighten up on S&P 500 exposure when real rates cross above real potential GDP. S&P 500 returns trounce their overall postwar gain when rates rise from below potential GDP to potential GDP but lag it once rates cross above potential GDP (Chart 6). Confounding Intuition, Part 2: Institutional Investors Don't Rotate Even if S&P 500 returns fail to demonstrate any consistent relationship with interest rates, one would expect that professional investors' asset-class positioning would. Bonds and stocks are alternatives for one another, and institutional investors presumably shift their allocations in line with the asset classes' relative prospects. We examine Pension Funds', Life Insurers', and Mutual Funds' asset-allocation profiles over time using balance-sheet data from the Federal Reserve's quarterly Flow of Funds report. The data show that asset-allocation decisions are made without apparent regard for relative valuations, at least as proxied by the equity risk premium. Pension funds' steady increase in equity allocations across the '90s appears to have been less a function of rate moves than buying into the bull market (Chart 7). Since the dot-com bubble burst in 2000, bond and equity allocations have mainly reflected the performance tides. The extended trend in pension funds' equity-to-bond allocation ratio suggests that the funds set a long-range goal and grind steadily toward achieving it, regardless of relative valuation movements. It also suggests that the funds may not bother with rebalancing, much less dynamic asset allocation. Life insurers kept their fixed income and equity allocations more or less fixed across the '70s (not shown) and most of the '80s. They then reduced equity exposure for three years after 1987's Black Monday, assiduously built it up across the '90s, and have more or less let it drift since the millennium (Chart 8). The equity risk premium does not appear to have been a consideration. Asset-allocation stasis may simply be a reflection of life insurers' stringent regulatory constraints, but their portfolio managers' limited discretion precludes opportunistic allocation shifts. Mutual fund allocations tend to depend much more on past events than future expectations. Equity holdings peak when the equity risk premium bottoms and bottom when the equity risk premium peaks (Chart 9). The problem is that mutual fund managers are structurally hostage to their investors' whims. They are sorted into narrow silos and then straitjacketed by the rigid allocation rules written into their fund prospectuses. Even if they think asset-class rotation is a great idea, only a tiny minority of fund managers can act upon it. Chart 7Pension Funds Don't Allocate Based On Yields Or The ERP ... Chart 8... While Life Insurers Appear To Allocate In Defiance Of Them Chart 9Mutual Funds##BR##Obey Their Owners ... Confounding Darwin's Intuition: Human Investors Never Learn Chart 10... Who Act On Real Emotion, Not Real Yields Kahneman and Tversky's groundbreaking research into decision-making under uncertainty revealed that our species is wired to make suboptimal investment decisions. Prospect theory, loss aversion and an unhealthy fixation on recent data all encourage retail investors to repeatedly shoot themselves in the foot. When it comes to asset allocation, households appear to focus exclusively on the action in the rear-view mirror (Chart 10). Retail investors as a group rotate between equities and fixed income retroactively, in response to recent past returns, not proactively in response to cues about future relative-return prospects. Investment Implications Despite the compelling intuition that investors should set their course by the interest-rate stars, there is no evidence in the flow of funds data that they have done so in the past. We posit that structural constraints on institutional investors, combined with humans' durable cognitive biases, offer no reason to expect that they will do so in the future. While there may not be any predictable rotation pattern, rising rates have given rise to a predictable performance pattern. Equities reliably perform better when real rates are rising by at least 100 basis points than they do when they're falling. Decomposition of S&P 500 returns indicates that the pattern holds because earnings rise a good bit more in rising-rate periods than multiples decline. And multiples don't always decline when rates rise, anyway; sometimes emotion overrides cash flow discounting mechanics. Investors should lighten up on Treasury allocations, while keeping the exposures they do hold at below-benchmark duration. They should not flee equities, however. Rates have not yet risen enough to cool off the economy in any material way, and we judge that they won't until somewhere around a 3.75% 10-year Treasury yield.2 Tight supplies in labor and goods markets will eventually stoke realized inflation and provoke the Fed into tightening enough to cut off the rally, but it hasn't happened yet, and it is far too early to de-risk portfolios on account of interest rates. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 An unusually large drop in rates may well be associated with economic distress, but default-adjusted bond payment streams are much less variable than near- and intermediate-term earnings estimates. 2 Based on the evolution of the Congressional Budget Office's longer-run estimates of real potential GDP growth, and the trend in our own model of long-term inflation expectations, it appears as if nominal potential GDP growth will be somewhere in the neighborhood of 3.75-4% next year. This is a much lower estimate than one would get from adding the Fed's 2% inflation target to the current rate of GDP growth, but we need to look past the immediate boost of the stimulus package to get a read on its longer-run effects. As with all of the estimates produced by our models, we look to it for a general guide to the future, not a precise point estimate.

Highlights We review last year's "Three Tantalizing Trades" and offer four additional ones: Trade #1: Long June 2019 Fed funds futures contract/short Dec 2020 Fed funds futures contract Trade #2: Long USD/CNY Trade #3: Short AUD/CAD Trade #4: Long EM stocks with near-term downside put protection Feature A Review Of Last Year's "Three Tantalizing Trades" I had the pleasure of speaking at BCA's last Annual Investment Conference on September 25th, 2017, where I presented the following three trade ideas (Chart 1): 1. Short December 2018 Fed funds futures We closed this trade for a profit of 70 basis points. Had we held on, it would be up 92 basis points as of the time of this writing. 2. Long global industrial equities/short utilities We closed this trade on February 1st for a gain of 12%, as downside risks to global growth began to mount. This proved to be a timely decision, as the trade would be up only 6.1% had we kept it on. We would not re-enter this trade at present. 3. Short 20-year JGBs/long 5-year JGBs This trade struggled for much of 2018 but sprung back to life in August. It is up 0.6% since we initiated it. We still like the trade over the long haul. Investors are grossly underestimating the risk that Japanese inflation will move materially higher as an aging population creates a shortage of workers and a concomitant decline in the national savings rate. We also think the government will try to egg on any acceleration in consumer prices in order to inflate away its debt burden. In the near term, however, the trade could struggle if a combination of weaker EM growth and an increase in the value of the trade-weighted yen cause inflation expectations to decline. Four Additional Trades Trade #1: Long June 2019 Fed funds futures contract/short December 2020 Fed funds futures contract Investors expect U.S. short-term rates to rise to 2.38% by the end of 2018 and 2.85% by the end of 2019. The 47 basis points in tightening priced in for next year is less than the 75 basis points in hikes implied by the Fed dots. Investors appear to have bought into Larry Summers' secular stagnation thesis. They are convinced that short rates will not be able to rise above 3% without triggering a recession (Chart 2). Chart 1Revisiting Last Year's Three Tantalizing Trades Chart 2Markets Expect No Fed Hikes Beyond Next Year Regardless of what one thinks of Summers' thesis, it must be acknowledged that it is a theory about the long-term drivers of the neutral rate of interest. Over a shorter-term cyclical horizon, many factors can influence the neutral rate. Critically, most of these factors are pushing it higher: Fiscal policy is extremely stimulative. The IMF estimates that the U.S. cyclically-adjusted budget deficit will reach 6.8% of GDP in 2019 compared to 3.6% of GDP in 2015. In contrast, the euro area is projected to run a deficit of only 0.8% of GDP next year, little changed from a deficit of 0.9% it ran in 2015 (Chart 3). The relatively more expansionary nature of U.S. fiscal policy is one key reason why the Fed can raise rates while the ECB cannot. Credit growth has picked up. After a prolonged deleveraging cycle, private-sector nonfinancial debt is rising faster than GDP (Chart 4). The recent easing in The Conference Board's Leading Credit Index suggests that this trend will continue (Chart 5). Wage growth is accelerating. Average hourly earnings surprised on the upside in August, with the year-over-year change rising to a cycle high of 2.9%. This followed a stronger reading in the Employment Cost Index in the second quarter. A simple correlation with the quits rate suggests that there is plenty of upside for wage growth (Chart 6). Faster wage growth will put more money into workers pockets who will then spend it. The savings rate has scope to fall. The personal savings rate currently stands at 6.7%, more than two percentage points higher than what one would expect based on the current ratio of household net worth-to-disposable income (Chart 7). If the savings rate were to fall by two points over the next two years, it would add 1.5% of GDP to aggregate demand. Chart 3U.S. Fiscal Policy Is More Expansionary Than The Euro Area Chart 4U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend Chart 5U.S. Credit Growth Will Remain Strong Chart 6Quits Rate Is Signaling That There Is Upside For Wage Growth Chart 7The Personal Savings Rate Has Room To Fall A back-of-the-envelope calculation suggests that these cyclical factors will permit the Fed to raise rates to 5% by 2020, almost double what the market is discounting.1 A more hawkish-than-expected Fed will bid up the value of the greenback. A stronger dollar, in turn, will undermine emerging markets, which have seen foreign-currency debts balloon over the past six years (Chart 8). The deflationary effects of a stronger dollar and falling commodity prices could temporarily cause investors to price out some hikes over the next few quarters. With that in mind, we recommend shorting the December 2020 Fed funds futures contract, while going long the June 2019 contract. The first leg of the trade captures our expectation that the market will revise up its estimate the terminal rate, while the second leg captures near-term risks to global growth. The gap between the two contracts has widened over the past few days as we have prepared this report, but at 21 basis points, it has plenty of room to increase further (Chart 9). Chart 8EM Dollar Debt Is High Chart 9U.S. Rate Expectations Are Too Low Beyond Mid-2019 Trade #2: Long USD/CNY China's economy is slowing, which has prompted the government to inject liquidity into the financial system. The spread in 1-year swap rates between the U.S. and China has fallen from about 3% earlier this year to 0.6% at present, taking the yuan down with it (Chart 10). It is doubtful that China will be willing to match - let alone exceed - U.S. rate hikes. This suggests that USD/CNY will appreciate. China's real trade-weighted exchange rate has weakened during the past four months, but is up 25% over the past decade (Chart 11). U.S. tariffs on $250 billion (and counting) of Chinese imports threaten to erode export competitiveness, making a further devaluation necessary. Chart 10USD/CNY Has Tracked China-U.S. Interest Rate Differentials Chart 11The RMB Is Still Quite Strong President Trump will oppose a weaker yuan. However, just as China's actions earlier this year to strengthen its currency did not prevent the U.S. from imposing tariffs, it is doubtful that efforts by the Chinese authorities to talk up the yuan would appease Trump. Besides, China needs a weaker currency. The Chinese economy produces too much and spends too little. The result is excess savings, epitomized most clearly in a national savings rate of 46%. As a matter of arithmetic, national savings need to be transformed either into domestic investment or exported abroad via a current account surplus. China has concentrated on the former strategy over the past decade. The problem is that this approach has run into diminishing returns. Chart 12 shows that the capital stock has risen dramatically as a share of GDP. As my colleague Jonathan LaBerge has documented, the rate of return on assets among Chinese state-owned companies, which have been the main driver of rising corporate leverage, has fallen below their borrowing costs (Chart 13).2 Chart 12China's Capital Stock Has Grown Alongside Rising Debt Levels Chart 13China: Rate Of Return On Assets Below Borrowing Costs For State-Owned Companies Now that the economy is awash in excess capacity, the authorities will need to steer more excess production abroad. This will require a larger current account surplus which, in turn, will necessitate a relatively cheap currency. The dollar is currently working off overbought technical conditions, a risk we flagged in our August 31st report.3 That process should be complete over the next few weeks. Meanwhile, hopes of a massive Chinese stimulus focused on fiscal/credit easing will fade. The combination of these two forces will push up USD/CNY above the psychologically-critical 7 handle by the end of the year. Trade #3: Short AUD/CAD A weaker yuan will raise raw material costs to Chinese firms. This will hurt commodity prices. Industrial metals are much more vulnerable to slower Chinese growth than oil. Chart 14 shows that China consumes close to half of all the copper, nickel, aluminum, zinc, and iron ore produced in the world, compared to only 15% of oil output. Our expectation that developed economy growth will hold up better than EM growth over the next few quarters implies that oil will outperform industrial metals. Oil is also supported by a tighter supply backdrop, particularly given the downside risks to Iranian and Venezuelan crude exports. A bet on oil over metals is a bet on DM over EM growth in general, and the Canadian dollar over the Australian dollar specifically (Chart 15). Canada exports more oil than metals, while Australian exports are dominated by ores and metals. In terms of valuations, the Canadian dollar is still somewhat cheap relative to the Aussie dollar based on our FX team's long-term valuation model (Chart 16). Chart 14China Is A More Dominant Consumer Of Metals Than Oil Chart 15Oil Over Metals = CAD Over AUD Chart 16Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar The loonie has been weighed down by ongoing fears that Canada will be left out of a renegotiated NAFTA. However, our geopolitical strategists believe that the Trump administration is trying to focus more on China, against whom the case for unfair trade practices is far easier to make. The U.S. has already negotiated a trade deal with Mexico and an agreement with Canada is more likely than not. If a new deal is struck, the Canadian dollar will rally. We recommended going short AUD/CAD on June 28. The trade is up 3.4%, carry-adjusted, since then. Stick with it. Trade #4: Long EM stocks with near-term downside put protection It is too early to call a bottom in EM assets. Valuations have not yet reached washed-out levels (Chart 17). Bottom fishers still abound, as evidenced by the fact that the number of shares outstanding in the MSCI iShares Turkish ETF has almost tripled since early April (Chart 18). However, at some point - probably in the first half of next year - investors will liquidate their remaining bullish EM bets. During the 1990s, this capitulation point occurred shortly after the collapse of Long-Term Capital Management in September 1998. EM equities fell by 26% between April 21, 1998 and June 15, 1998. After a half-hearted attempt at a rally, EM stocks tumbled again in July, falling by 35% between July 17 and September 10. The second leg of the EM selloff brought down the S&P 500 by 22%. Thanks to a series of well-telegraphed Fed rate cuts, global markets stabilized on October 8th (Chart 19). The S&P 500 surged by 68% over the next 18 months. The MSCI EM index more than doubled in dollar terms over this period. EM stocks outperformed U.S. equities by a whopping 71% between February 1999 and February 2000. Europe also outperformed the U.S. starting in mid-1999. Value stocks, which had lagged growth stocks over the prior six years, also finally gained the upper hand. Chart 17EM Assets: Valuations Not Yet At Washed Out Levels Chart 18EM Bottom Fishers Still Abound Chart 19The ''Great Equity Rotation'' Is Coming: A Roadmap From The 1990s The "Great Equity Rotation" is coming. All the trades that have suffered lately - overweight EM, long Europe/short U.S., long cyclicals/short defensives, long value/short growth - will get their day in the sun. Investors can prepare for this inflection point by scaling into EM equities today, but guarding against near-term downside risk by buying puts. With that in mind, we are going long the iShares MSCI Emerging Market ETF (EEM), while purchasing March 15, 2019 out-of-the-money puts with a strike price of $41. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Depending on which specification of the Taylor rule one uses, a one percent of GDP increase in aggregate demand will increase the neutral rate of interest by half a point (John Taylor's original specification) or by a full point (Janet Yellen's preferred specification). Fiscal policy is currently about 3% of GDP too simulative compared to a baseline where government debt-to-GDP is stable over time. Assuming a fiscal multiplier of 0.5, fiscal policy is thus boosting aggregate demand by 1.5% of GDP. Nonfinancial private credit has increased by an average of 1.5 percentage points of GDP per year since 2016. Assuming that every additional one dollar of credit increases aggregate demand by 50 cents, the revival in credit growth is raising aggregate demand by 0.75% of GDP, compared to a baseline where credit-to-GDP is flat. The labor share of income has increased by 1.25% of GDP from its lows in 2015. Assuming that every one dollar shift in income from capital to labor boosts overall spending on net by 20 cents, this would have raised aggregate demand by 0.25% of GDP. Lastly, if the savings rate falls by two points over the next two years, this would raise aggregate demand by 1.5% of GDP. Taken together, these factors are boosting the neutral rate by anywhere from 2% (Taylor's specification) to 4% (Yellen's specification). This is obviously a lot, and easily overwhelms other factors such as a stronger dollar that may be weighing on the neutral rate. 2 Please see China Investment Strategy Special Report, "Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging," dated August 29, 2018. 3 Please see Global Investment Strategy Weekly Report, "The Dollar And Global Growth: Are The Tables About To Turn?" dated August 31, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights So What? President Trump is treating the midterm election as a hurdle. Once cleared, he will restart "Maximum Pressure" policy towards China and Iran that will induce market volatility. The outcome of the election, however, has only a marginal investment relevance. Why? A Democrat-held Congress will not have the votes to overturn President Trump's signature economic policies: tax cuts, deregulation, and stimulus. Removal from power requires 67 votes in the Senate, out of the reach for Democrats. President Trump will pursue aggressive foreign and trade policies, regardless of the midterm outcome. As such, the midterm outcome is a non-diagnostic variable. Also... Rising stroke-of-pen risk, combined with President Trump's unorthodox foreign and trade policies, will likely intensify following the midterm election. Therefore, it is difficult to "buy on (midterm-related) dips," despite our call that the election does not matter. Feature Should investors care about the upcoming midterm election? The answer is yes, but marginally. A gridlocked Congress, our most likely outcome, is historically less positive for equities than an electoral outcome that results in a unified executive and legislature (Chart 1). The reality, however, is that economic and monetary variables are overwhelmingly more important for investors than politics.1 Table 1 illustrates the impact of four factors on monthly S&P 500 price returns. The first two columns demonstrate the effect on returns of recessions and tightening monetary policy, respectively, whereas the last two columns measure the effects of gridlock and reduced uncertainty in the 12-months following presidential and midterm elections.2 The table presents the beta of a simple regression based on dummy variables for each of the four components (t-statistics are shown in parentheses). Chart 1A Unified Congress Is A Boon For Stocks Table 1A Divided Government Is Marginally Negative For Stocks As expected, the macro context has a much larger impact on stock returns than politically driven effects. The impact of political gridlock is shown to be negative regardless of the timeframe, but only just. Could 2018 be different? Given the extraordinary level of polarization - captured in Chart 2 by the difference in presidential approval by party identification - this time could, indeed, be different. But, we do not think it will be. As we discussed last week,3 Democrats in Congress would not be able to impact the three crucial pillars of the Trump Reflation Trade: De-regulatory agenda: The executive branch is in charge of the deregulatory agenda, which investors should note kindled corporate animal spirits on day 1 of the Trump presidency (Chart 3). Chart 2Presidential Approval Variance Signals Peak Polarization Chart 3Trump's Mere Election Stoked Animal Spirits Tax cuts: Without 67 votes in the Senate, the Democrats cannot overturn a presidential veto that is certain to be used on any tax-hikes as long as President Trump is in power. They won't even get to the 60 votes necessarily to invoke cloture and thus avoid a Republican filibuster on tax, immigration, or other policy reforms. Fiscal policy: We see no chance of the Democratic Party becoming the party of fiscal discipline ahead of the 2020 election. Voters are not demanding budget discipline, despite the obvious rise in budget deficits (Chart 4), so why would the Democratic Party nail itself to the fiscal conservative cross over the next two years? What of the impeachment risk? There is no empirical evidence that impeachment proceedings have any impact on U.S. equity markets.4 And we would fade any concerns that an impeachment push would cause President Trump to seek relevancy abroad with aggressive foreign and trade policies because we expect him to do so regardless of the midterm outcome! Nonetheless, we do think that investors are in for a mild surprise this November (Chart 5). First, the data suggests that Democrats will have a wave election. In fact, we are raising our probability of a Democratic House victory to 70%, largely in line with current expectations. Second, we are also raising our call on the Senate to a "too-close-to-call." Essentially, we think that the Democratic Party may be able to pick up a Senate seat, which would be an extraordinary outcome given that they are defending 26 seats out of the 35 in contention.5 While such an electoral surprise may not have immediate investment implications in 2018 and 2019, it could have implications beyond 2020. The Senate electoral math significantly changes in 2020, with Republicans currently set to defend 21 seats out of 33 in contention (a number that could grow due to retirements). A Democratic sweep of U.S. institutions in 2020 could significantly alter the long-term earnings outlook in the U.S., especially if America's center-left party swings further to the left by then. Such an outcome would put an end to the two-decade long divergence in profits and wages as share of the total economy (Chart 6). But more on that at a later point. In this report, we focus on the upcoming election itself. Chart 4Voter Fiscal Preferences Are Not Fixed Chart 5Our Senate Call Is Out Of Consensus Chart 6What Is Not Sustainable Will Stop Midterm Election: The Twenty Charts To Watch History is stacked against the Republican Party. Chart 7 shows that the president's party has lost, on average, 24 seats since the 1950 midterm election. Only Clinton in 1998 - at the top of an epic bull market and with an approval rating of 66% (!) - and Bush Jr. in 2002 - following a once-in-a-generation terrorist attack on the U.S. homeland - managed to eke out positive gains. Even in those Goldilocks conditions, Clinton's Democrats only picked up a paltry five seats in the House (none in the Senate), while Bush's GOP gained two Senate and eight House seats. Chart 7Midterm Elections Normally Spell Doom For The President's Party Polls suggest that this time will not be different. Both the congressional generic ballot (Chart 8) and President Trump's popularity - at just 39% - (Chart 9) are signaling a wave election for the Democrats. Chart 8Polling Gives Dems The Advantage Chart 9President Trump Is A Drag On The GOP... But what about the roaring economy? Astonishingly, economic performance has a negative correlation with electoral outcomes in congressional elections (Chart 10)! This data point is so counterintuitive that it must be wrong. At the very least, history suggests that there is no clear relationship between the economy and congressional returns. Chart 10...Whereas The Economy Is Unlikely To Provide A Tailwind The economy only matters when things are going wrong. Current polls, in other words, are already pricing in a solid economic context, with the Democratic lead over the Republicans having narrowed from double-digits since the economy began roaring in January (Chart 11). At this point, however, it is highly unlikely that two more months of solid economic performance will have much of an effect on voter preferences. In fact, the importance of the economy, jobs, and budget deficits to voters has been declining since 2014 (Chart 12). Chart 11The Economy Is Already Baked In The (Polling) Cake Chart 12Voters Care Less About Economic Issues In addition, investors should remember that voter experience of the economic recovery is highly polarized. During Obama's presidency, Republican voter consumer sentiment and expectations were at recession levels. Magically, on November 8, 2016, both Republicans and Democrats changed their sentiment (Chart 13). Independent voters are, unsurprisingly, somewhere in the middle. Chart 13Voters Cannot Agree On Economic Performance Anyway Primary election turnouts are confirming that the economy is not the primary driver of voter enthusiasm. Democrats have seen 8.9 million more voters vote in the 2018 primaries, compared to the 2014 midterm election. Meanwhile, GOP voters - who are presumably more enthused about the economy - have only seen a pickup of 3.8 million new primary voters. The pattern of primary voting is similar to the one in 2010, when the Tea Party revolt energized the Republican base in opposition to President Obama. In 2010, Republicans increased primary turnout in 186 congressional districts compared to the 2006 election. Satisfied with President Obama's win in 2008, Democrats only increased the primary turnout in 35 districts. As a result, the GOP picked up 63 House seats and gained control of the lower chamber of Congress. This time around, the numbers foreshadow a similar wave, but in favor of the left. Democrats have seen their turnout increase in 123 electoral districts, compared to the 2014 election. This includes 20 of the most competitive races this year. Republicans, meanwhile, have seen an increase in enthusiasm in only 19 congressional districts this year. The death knell for Republicans in the House of Representatives, in our view, will be the abnormally large number of retirements (Chart 14). Incumbency has a powerful effect in congressional races. On average, incumbents easily win over 90% of their races for the House (Chart 15). Chart 14Double More GOP Retirements This Year Chart 15Incumbents Normally Carry The Day The average margin of victory for the Republican representatives not running for re-election in the 42 electoral districts in 2016 was 28.3%6 (Table 2). This sounds like too high of a hurdle for Democrats to leap over. However, that is precisely what Democratic candidates have done in the House and Senate special elections in 2017 and 2018. The average GOP lead in those races is down from 29.2% in 2016 to just 8.5% today, a 20.7% swing (Table 3). This math explains why the Cook Political Report, the premier U.S. election forecasting consultancy, sees the number of competitive Republican-held seats more than doubling in 2018 (Chart 16), whereas the number of competitive Democratic-held seats has collapsed. Table 2Republicans Not Seeking Re-Election In 2018 Table 3Non-Incumbent Republicans Lost 20% Advantage In Special Elections Our Senate model is similarly flashing red for the Republican Party. Despite an overwhelming structural advantage in the 2018 cohort - having to only defend nine seats - our model is predicting that the Democrats will hold all their Senate seats and pick up one (in Nevada) (Chart 17). Chart 16Number Of GOP Seats At Risk Has More Than Doubled! Chart 17Our Senate Model Is Generous To The Democrats We modeled the individual Senate races by combining the state and national economic and political variables with the latest available opinion polling.7 We only focused on the races that we believe are currently competitive and we may change the mix as new information becomes available. The results of our "beta" model, expressed as a margin of victory by the Republican candidate (GOP total vote minus Democrat total vote), show that the Democrats have a surprisingly decent chance of picking up the Senate. Highly concerning for President Trump and the GOP is that the Democratic Senate candidates have a healthy lead in three out of the four contested Midwest races (Chart 18), suggesting that Trump's crossover appeal to blue-collar voters is not working when he is not the candidate (or perhaps, even more alarming for the GOP, when Hillary Clinton is not his opponent). The only tight Midwest election is in Indiana, where Democratic incumbent Joe Donnelly's lead is within the margin of error. Another concern for the Republicans is that the Democrats have largely fielded centrist candidates in the House and Senate races. For example, former Tennessee Governor (2003-2011), Phil Bredesen, is a conservative Democrat currently leading in the polls against his Republican opponent. Democratic candidates for election in Republican-held Arizona and Nevada are similarly centrists and thus competitive (Chart 19). Furthermore, in the 42 seats where Republicans are fielding non-incumbents, our research suggests that Democrats only fielded 14 left-wing/progressive candidates.8 Despite the media's focus on left-wing/progressive candidates - such as Alexandria Ocasio-Cortez in the Bronx or Ayanna Pressley in Boston - the vast majority of Democratic candidates in the non-coastal U.S. have been centrists. This means that GOP candidates will have very few "lay-ups" in November. Putting it all together, we would give Democrats a 70% chance of picking up the necessary 23 seats to take over the House. In the Senate, the next two months will determine the outlook for GOP candidates. Investors should fade the message from the current polling - and thus our model - as voters have paid very little attention to local races before Labor Day. However, if the current trajectory in the congressional generic poll and Trump's popularity holds until November, the likelihood of a GOP hold in the Senate will fall. For President Trump, a result where he loses the House and the Senate would be a political disaster. Should investors prepare for the volatility of impeachment in that case? The midterm election is a non-diagnostic variable. The Senate requires 67 votes to convict the president and thus remove him from power. A 50 +1 majority will not help Democrats get to that level any more than a 50 -1 minority would. They will need Republican Senators to join them in the impeachment endeavor. For that to happen, Republican voters will have to lose confidence in President Trump in droves, as they once did in President Nixon. As Chart 20 clearly illustrates, we are nowhere near that point today. Chart 18The Midwest: Is The Trump Magic Gone? Chart 19The Sun-Belt: No Place To Hide For The GOP? Chart 20Trump Is Not Nixon (Yet) Investment Implications: Much Ado About Nothing Putting it all together, this year's midterm election has a good chance of dominating the news flow by producing a shocking electoral surprise. In the immediacy of an outcome that hands the control of the entire Congress to the fired-up Democrats, it would be smart to bet on a brief risk asset pullback. However, the Democrats will not be able to unravel any of President Trump's main economic policies. In fact, investors may be presented with higher odds of an infrastructure plan and even of an immigration deal, if President Trump faces reality and comes to the middle ground on some of his demands (as President Clinton did after his disastrous 1994 midterm election). As for impeachment and the risk of President Trump "seeking relevancy abroad," our high conviction view is that he will continue pursuing unorthodox foreign and trade policies regardless of the midterm outcome. The just-announced 10% tariff on $200 billion of Chinese imports confirms our alarmist view on trade tensions. In fact, President Trump has explicitly threatened an increase of the tariff rate to 25% by the end of the year in order to put more pressure on Beijing. The increase in the tariff rate would be a significant escalation in the trade war, one that we do not expect Chinese policymakers to simply roll over and accept. Meanwhile, the U.S. embargo on Iranian oil exports will officially begin on November 4, just two days before the midterm election date. This is not a coincidence, but a product of White House design. We expect President Trump to turn the screws on Iranian exports in ways that President Obama did not.9 Given the potential impact on domestic gasoline prices, the White House has decided to coincide the pressure on Tehran with the end of the election season. The midterm election, therefore, is important only in terms of timing. Once it is out of the way, President Trump will refocus on his "maximum pressure" tactic, which he believes (and we agree) led to a breakthrough in North Korea policy. Unfortunately for the markets, we do not expect that the maximum pressure tactic will work as smoothly with Iran and China.10 The final risk to markets is the creeping "stroke of pen" risk from potential regulation of technology enterprises. Joseph Simons, the Trump appointed new chair of the Federal Trade Commission, recently said that "the broad antitrust consensus that has existed... for about 25 years is being challenged... the U.S. economy has grown more concentrated and less competitive."11 His comments have dovetailed the threat to FAANG stocks that exists from a shift in U.S. anti-trust enforcement, one that would take the anti-trust practice away from the consumer-friendly approach of the "Chicago School."12 Chart 21FAANG Stocks + Microsoft Have Dramatically Outperformed... Table 4...Generating 50% Of The 2018 S&P 500 Return! This is a big risk for the ongoing bull market as the reason why the S&P 500 has performed well is due to the performance of a few (enormous) technology stocks that have seen both earnings and valuation multiples expand amid one of the longest economic growth phases in history (Chart 21 and Table 4). And yet the one thing that a plurality of Democrats and Republicans seem to agree with is that major tech companies should be regulated (Chart 22). Privacy advocates - who tend to lean left or libertarian - and conservatives, who feel that their commentators are being silenced by Silicon Valley, could form a classic "bootleggers and abolitionists" coalition against the FAANGs post midterm election. In fact, it is the one thing that Trump, and his supporters may (Chart 23), have in common with a potentially left-leaning Congress. Chart 22Majority Of Americans Want Tech Regulated Chart 23Conservatives Distrust Tech Companies How should investors play the midterm election? It is tough to say. We do not think the Democrats' takeover of Congress will be a catalyst for the markets. However, there are a slew of concerning geopolitical developments that will accelerate post-election, some specifically because President Trump will become more aggressive following the electoral hurdle. As such, we would be cautious. While it may serve investors well to "buy on dips" related to the fear of a "Socialist" takeover of Congress, it will be difficult to disassociate such hysteria from genuinely bearish narratives emanating from the Middle East, with trade policy, or stroke of pen risks looming over FAANG stocks. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Ekaterina Shtrevensky, Research Associate ekaterinas@bcaresearch.com 1 Please see BCA U.S. Investment Strategy Weekly Report, "A Party On The QE2," dated November 8, 2010, available at usis.bcaresearch.com. 2 We include the last factor in the regression because it could be that the market responds positively in the post-election period, irrespective of the election outcome, simply because political uncertainty is diminished. 3 Please see BCA Geopolitical Strategy Weekly Report, "Fade The Midterms, Not Iraq Or Brexit," dated September 12, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 5 We are counting Senators Angus King (Maine) and Bernie Sanders (Vermont) as "Democrats" in this tally as they both caucus with the Democratic Party and generally vote very much in line with their left-leaning peers. 6 Excludes Pennsylvania due to redistricting in early 2018, and OK-01, as the candidate ran unopposed. 7 The state variables include the annual percent change in personal income, the annual change in the Philadelphia Fed Coincident index, and incumbency. The national variables include presidential approval ratings, a variable indicating whether the last presidential election was close, and the annual percent change in real GDP, CPI, industrial production, and the DXY. We add to this mix of national and state data the latest opinion polling by state race and the generic congressional ballot. 8 This number is largely our judgement call based on the statements from the Democratic primary winners. However, the fact that there is no unified progressive movement - akin to the 2010 Tea Party revolution - confirms our view. 9 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Are You Ready For 'Maximum Pressure?'," dated May 16, 2018, available at gps.bcaresearch.com. 11 Please see Diane Bartz, "Trump's antitrust enforcer considers shifting up a gear," dated September 13, 2018, available at reuters.com. 12 Please see BCA Geopolitical Strategy and U.S. Equity Strategy Special Report, "Is The Stock Rally Long In The FAANG?" dated August 1, 2018, available at gps.bcaresearch.com.

Highlights Portfolio Strategy Stick with a neutral weighting in the tech sector as rising interest rates, higher inflation and a firming greenback offset improving industry operating metrics on the back of the virtuous capex upcycle. Chip and chip equipment stocks will remain under pressure as global semi sales are under attack and leading indicators of semi demand suggest that more pain lies ahead at a time when chip selling prices are steeply decelerating. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equities regained their footing last week and remain perched near all-time highs. Investors are largely ignoring the trade-related uncertainty and are instead focusing on the upbeat economic backdrop. Both soft and hard data continue to send an unambiguously healthy signal for the U.S. economy, a potent tonic for corporate profitability. Chart 1EPS Will Do All The Heavy Lifting While a lot of parallels have been drawn between today and the late-1990s, our sense is that the current financial market and economic outlooks resemble more the mid-2000s. Chart 1 shows that, between 2004 and the stock market peak in late-October 2007, forward profit growth estimates peaked at over 20%/annum and the forward multiple drifted steadily lower. Nevertheless, stocks remained well bid and rose alongside forward EPS (top and third panels, Chart 1). In other words, despite decelerating forward profit growth estimates and a contracting forward multiple, expanding forward EPS did the heavy lifting, explaining all of the advance in the SPX. The similarities to today are eerie: while profit growth peaked in Q1/2018, 10% EPS growth is elevated for the tenth year of an expansion, and the forward multiple is coming in (Chart 1). On the policy front, the Bush tax cuts hit in the mid-2000s with the elimination of the double taxation of dividends and a drop in personal income tax rates, along with a one-time cash repatriation of corporate profits stashed abroad. With regard to the economic backdrop, capex was roaring and nominal GDP was firing on all cylinders as a housing bubble was getting inflated. The GDP deflator also hit a high mark. The ISM manufacturing survey eclipsed 61 in 2004 and non-farm payrolls were expanding smartly (Chart 2). But despite all that apparent overheating especially in the housing market, the real fed funds rate was near zero in 2004 (top panel, Chart 3). Finally, a number of financial market metrics were also similar to today. Oil prices were on their way to triple digits, high yield spreads were below 400bps and the VIX probed, at the time, all-time lows (Chart 3). However, one key difference between the mid-2000s and today is the strengthening U.S. dollar. The firming greenback remains a key risk to our positive equity market view (bottom panel, Chart 3), as it will eventually infiltrate EPS. Netting it all out, if history at least rhymes, an earnings-led advance in the SPX is the most likely outcome. Our sanguine cyclical (9-12 month) equity market view remains predicated on a 10%/annum increase in EPS and a sideways-to-lower move in the forward multiple. Meanwhile, wage inflation is slowly starting to rear its ugly head. In fact, we are surprised by the fits and starts in average hourly earnings growth. At this stage of the cycle, wage growth should start galloping higher as executives aggressively bid up the price of labor in order to fill job openings and bring expansion plans to fruition. A simple wage growth indicator comprising resource utilization and the unemployment gap suggests that wage inflation will really kick into higher gear in the coming 12 months (shown as a Z-score, Chart 4). Chart 2Eerie... Chart 3...Parallels With 2004 Chart 4Mind The Return Of Inflation Two weeks ago we highlighted that the S&P 500's profit margins are benefiting from lower corporate taxes and muted wage growth, a goldilocks backdrop. Despite evidence of a pending inflationary impulse, as long as businesses are successful in passing rising input costs down the supply chain and onto the consumer, then margins and EPS will continue to expand. Nevertheless, deconstructing the SPX's all-time high profit margins is in order. Chart 5 & Chart 6 show the 11 GICS1 sector profit margin time series using Standard & Poor's data, and Chart 7 is a snapshot of Q2/2018 profit margins for the 11 sectors and the broad market. Chart 5Sectorial Profit ... Chart 6...Margin Breakdown Chart 7Tech Is A Clear Outlier Five sectors (tech, industrials, materials, consumer discretionary and utilities) are enjoying record-high profit margins, and four (financials, consumer staples, telecom services and real estate) are on the verge of joining that club. This leaves two sectors with declining margin profiles: health care and energy. While most sectors are +/- five percentage points away from the S&P 500, the tech sector sports profit margins at twice the level of the SPX or eleven percentage points higher and is the clear outlier (Chart 7). The implication is that the broad market's EPS fortunes are closely tied to the high-flying tech sector that commands a 26% market cap weight. Thus, this week we are compelled to highlight the deep cyclical tech sector, and two of its hyper-sensitive and foreign exposed subcomponents. Tech On Steroids In late-August we published a chart on tech margins (which we are reprinting today) showing the upward force they have exerted on the broad equity market for the better part of the past decade (top panel, Chart 8). Naturally, stratospheric profits must underpin these parabolic margins. The middle panel of Chart 8 highlights that since 2006 tech EPS have almost quadrupled, pulling SPX profits higher. As a reminder, the S&P tech sector commands a 24% profit weight in the S&P 500, the highest since the history of this data series and almost double the weight during the previous cycle's peak (bottom panel, Chart 8). The implication is that in order for the broad market to suffer a severe blow, tech has to take a hit, and vice versa. Chart 8Secular Tech EPS Growth Has Boosted Margins Chart 9EPS Growth Model Flashing Green On the EPS front, our profit growth model has recently ticked higher from an already extended level, signaling that the profit outlook remains bright (Chart 9). The virtuous capex upcycle - BCA's key theme for the year - remains the key driver behind our EPS model. Chart 10 shows that the tech sector continues to make inroads in the overall capex pie, according to financial statement-reported data, and has now doubled its share since the GFC trough to roughly 12%. National accounts corroborate this data and underscore that pent up demand is getting unleashed, following a near 15-year hibernation period (bottom panel, Chart 10). The news on the operating front is equally encouraging. The San Francisco Fed's tech pulse index - an index of coincident indicators of technology sector activity1 - is reaccelerating. Tech new orders-to-inventories are also picking up steam and suggest that sell side analysts have set the relative EPS bar too low (Chart 11). Finally, the latest PCE report revealed that consumer outlays on tech goods are also gaining momentum, even relative to overall consumer spending. While this upbeat backdrop would point to an above benchmark tech allocation, three risks keep us at bay. First, the tech sector garners 60% of its revenues from abroad and thus the appreciating U.S. dollar is a significant profit headwind, especially for 2019 when the delayed negative FX translation effects will most likely emerge (third panel, Chart 12). Chart 10Capex On The Upswing... Chart 11...Underpinning Tech Operating Metrics... Chart 12...But Three Risks Keep Us At Bay Second, a rising U.S. inflation backdrop along with the related looming selloff in the bond market should knock the wind out of the tech sector's sails. Tech business models are built to withstand deflation and thrive in a disinflationary environment. Thus, when inflation re-emerges, tech stocks suffer (CPI and 10-year UST yield shown inverted, top two panels, Chart 12). Third, leading indicators of emerging Asian demand are souring rapidly and were the trade war to re-escalate, EM in general and tech-laden Korean and Taiwanese economic data in particular would retrench further (bottom panel, Chart 12). Bottom Line: We prefer to remain on the sidelines in the S&P information technology sector and sustain a barbell portfolio within the sector. As a reminder we continue to express our bullishness via two high-conviction overweight defensive tech sub-sectors, S&P software and S&P tech hardware, storage & peripherals (THSP), and our bearishness via avoiding their early cyclical peers, S&P semis and S&P semi equipment. Avoid Chip Stocks At All Costs While we are neutral the broad tech sector and prefer secular growth defensive tech sub-sectors, we continue to recommend shying away from chip and chip equipment stocks. Chart 13 shows the extreme sensitivity to changes in final demand of chip related stocks versus their defensive tech peers. In more detail, software and THSP indexes are in a secular advance with regard to EPS outperformance, whereas semis and semi equipment profits are hyper-cyclical with mean-reverting relative profit profiles. Granted, the commoditization of semiconductors explains this close correlation with the business cycle. But, as we highlighted last November when we put the semi equipment index on the high-conviction underweight list, extrapolating EPS growth euphoria far into the future was fraught with danger.2 In fact, late-November 2017 marked the peak in semi equipment performance versus the overall IT sector, confirming the early cyclical nature of chip stocks (Chart 14). Chart 13Bifurcated EPS Chart 14Good Times... Three factors have weighed heavily on this industry's growth prospects and there is no light at the end of the tunnel yet. Bitcoin's (and other cryptocurrencies) collapse is dealing a blow, at the margin, to demand for semi equipment (top panel, Chart 15). Taiwan's financials statement-reported data on IT capex and national data on overall Taiwanese capital outlays corroborates this downbeat demand backdrop (Chart 16). Finally, the drubbing in EM currencies is sapping purchasing power from the consumer and also warns that things will get worse for U.S. semi equipment stocks before they get better (bottom panel, Chart 15). Chart 15...Do Not Last Forever Chart 16Semi-Heavy Taiwan Emits A Grim Signal The outlook for their brethren, semi producers, is equally downtrodden. Global semi sales have crested and leading indicators of future semi revenue growth are sending a warning signal. Chinese imports of electronics have come to an abrupt halt, and the U.S. dollar's appreciation is also waving a red flag (second & bottom panels, Chart 17). BCA's calculated global leading economic indicator excluding the U.S. and BCA's calculated global ZEW Indicator of Economic Sentiment excluding the U.S. both herald a steep deceleration in global semi sales (Chart 17). On the pricing power front, using Asian DRAM prices as an industry pricing power gauge, DRAM momentum is on a trajectory to contract some time in Q1/2019. The implication is that semi earnings will surprise to the downside. Still expanding global chip inventories are not providing an offset and also confirm that semi EPS optimism is unwarranted (middle & bottom panels, Chart 18). Finally, another source of demand for chip stocks has reversed, as industry M&A activity has plummeted toward decade lows. Not only is this negative for pricing power, but inflated premia are also now working in reverse especially given this year's QCOM/NXPI and AVGO/QCOM flops (top panel, Chart 18). Our Chip Stock Timing Model (CSTM) does an excellent job encapsulating all these moving parts and is currently in the sell zone (bottom panel, Chart 19). Chart 17Global Semi Sales Trouble... Chart 18...Abound Chart 19Chip Stock Timing Model Says Sell Bottom Line: Continue to avoid the S&P semis and S&P semi equipment indexes. The ticker symbols for the stocks in these indexes are: BLBG: S5SECO - INTC, NVDA, QCOM, TXN, AVGO, MU, ADI, AMD, MCHP, XLNX, SWKS, QRVO, and BLBG: S5SEEQ - AMAT, LRCX, KLAC, respectively. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 https://www.frbsf.org/economic-research/indicators-data/tech-pulse/ 2 Please see BCA U.S. Equity Strategy Weekly Report, "2018 High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights The USD remains supported by fundamentals, especially now that its late-2016 excesses have been purged. Solid U.S. growth contrasts with weaker growth in the rest of the world, which will incentivize further inflows into the U.S. dollar. Despite this positive cyclical view, the tactical outlook remains risky for dollar bulls. In the immediate term, the euro will benefit from easing Italian tensions and as well as from the dollar's correction, but its six-month outlook remains poor. The AUD could also rebound right now, but any such rally should be used to build further short positions. Feature After a furious rally from February to August, the dollar has been weakening since the middle of last month. Since July, we have been worried that the dollar could stage a bit of a correction,1 but we remained committed to the view that ultimately the greenback would rise further in 2018. It is now time to review whether this thesis still holds. BCA believes that the USD's correction could run through the fall, but that the final quarter of 2018 should still prove a rewarding period for dollar bulls. Ultimately, policy divergences will remain a crucial support for the dollar, especially as EM weakness continues to affect the distribution of growth across the globe. USD: Not Yet Extended The dollar ultimately follows the path implied by its fundamental drivers - whether they are interest rate spreads, growth and inflation differentials, relative equity prices, or even relative money-supply growth. However, the path taken by the USD around its drivers is rather wide, and the dollar regularly overshoots and undershoots the equilibrium implied by the aggregation of all these fundamentals (Chart I-1). Academics call this the "band of agnosticism." Chart I-1The Dollar To Follow Fundamentals Higher This cycle was no exception. BCA's Fundamentals Index for the dollar hooked up in 2011, a move associated with a turning point in the greenback itself. However, the dollar remained in undershoot territory for many years. Then suddenly, in 2014, the coiled spring was released and the dollar surged higher, moving above its "band of agnosticism" in 2015 - a moved exacerbated by the sudden rally that followed the election of Donald Trump in November 2016. Once the dollar had become over-loved, over-owned and expensive, it also became vulnerable. The pick-up in global growth that was so evident in 2017 caused a serious correction in this vulnerable currency. However, the selloff had a positive impact: U.S. growth, interest rates, equities and so on continued to move favorably, and the dollar is now positioned to rebound anew, having purged its most egregious excesses. The global economic backdrop is also positive for the dollar. For one, the theme of monetary divergences is still at play. Boosted by a healthy banking sector, healthy household balance sheets and an untimely fiscal stimulus of 1.7% of GDP, U.S. growth has hit 2.8%, well above potential. Moreover, growth has been above potential for eight years, and now U.S. capacity utilization is at its tightest level since the late 1980s. Historically, so large an absence of slack has been linked to higher U.S. interest rates (Chart I-2). Yet interest rate markets are pricing in roughly four increases over the next 24 months, even as Lael Brainard warned that the Federal Reserve could move beyond the hikes implied by its own forecast, the "dot plots." Chart I-2Tight Capacity Utilization Implies Higher U.S. Rates... The U.S. economy continues to fare well, as U.S. real interest rates remain 60 basis points below neutral rates and the yield curve has yet to invert. However, U.S. rates matter for the rest of the world as well. There, the picture is less pretty. EM dollar debt stands near record levels (Chart I-3). Hence, EM financial conditions have been hit by the combined assault of higher U.S. rates and an appreciating dollar. Nowhere is this clearer than when looking at the interplay between U.S. bond yields and the South African rand or AUD/JPY, a cross highly correlated to EM currencies. This cycle, rising U.S. bond yields have most often been associated with a rising ZAR or a rising AUD/JPY (Chart I-4). However, this time around, as was the case during the May 2013 Taper Tantrum, rising bond yields are linked to these pro-cyclical currency pairs falling. This suggests that rising yields are not reflecting global growth anymore, and are in fact restrictive for the rest of the world, even if they are not a problem for the U.S. Chart I-3... Which Will Hurt EM Economies Chart I-4Higher U.S. Rates Now Hurt Global Growth This inference is underpinned by the decline in BCA's U.S. Financial Liquidity Index, which heralds additional weakness in global growth and commodity prices (Chart I-5). Already we are seeing symptoms of the malaise. Japanese foreign machine tool orders are contracting, and BCA's Asian Leading Economic Indicator is in deep contraction (Chart I-6). Chart I-5Dollar Liquidity Is A Problem For Growth Chart I-6Signs That Global Growth Is Already Suffering A rising fed funds rate and falling ex-U.S. growth is likely to continue to support the dollar. The dollar loves nothing more than falling global growth. The U.S. economy has low exposure to global trade and to the global industrial sector, and therefore when global growth slows, the U.S. economy is relatively insulated from foreign shocks. This means that U.S. rates of return do not suffer as much as foreign ones. This is even truer in the rare instances when global growth slows while U.S. economic activity continues to power ahead, especially when artificially inflated by untimely fiscal stimulus. This is a characterization of the current environment. Hence, money will continue to flow into the U.S. economy on a two- to three-quarter horizon. In fact, portfolio flows into the U.S. remain well below the levels that prevailed during the previous decade (Chart I-7). The current account deficit is also smaller, hence, if net foreign portfolio flows can increase due to the attraction of higher U.S. rates of return, the U.S. balance of payments will move into a greater surplus, creating a strong underpinning for the dollar. This positive cyclical backdrop for the greenback is not without impediments. Most crucially are the short-term dynamics. Since July, we have been warning clients that a tactical correction in the dollar was likely. While EUR/USD has indeed rebounded, most other currencies have displayed rather tepid performances. This does not mean that the tactical risks to the dollar have abated. Quite the opposite, they are rising. As Chart I-8 illustrates, a large buildup in dollar longs has materialized, yet the G10 economic surprise index is making a trough. Moreover, the diffusion index of the BCA Global Leading Economic indicator is also stabilizing. Additionally, USD /CNY has failed to make new highs and the Turkish central bank just raised rates to 24% - which if Argentina is any guide is likely to provide only temporary relief for the TRY. This means that a period of risk-on sentiment in EM could emerge. Stretched dollar positioning, a temporary stabilization in global growth and EM inflows could precipitate a serious correction in the dollar. Chart I-7Dollar Favorable Flows Chart I-8Tactical Risks To The Dollar Bottom Line: The dollar is still supported by potent cyclical tailwinds. The U.S. economy is roaring and at full employment, yet global growth is suffering because global liquidity conditions are deteriorating. Higher rates of return in the U.S. will therefore attract additional capital, supporting the greenback in the process. Despite this positive cyclical backdrop, the short-term outlook is murkier. Speculators have aggressively bought the dollar, leaving them vulnerable to any positive surprises in global growth, even temporary ones. Fade The Euro Rebound The euro has benefited from the cool-off in Italian politics. The populist Five Star Movement / Lega Nord coalition is backing away from a budget confrontation with Brussels, as Giovanni Tria, Italy's minister of finance, wants a 2% budget deficit, while Deputy Prime Minister Matteo Salvini is arguing for a 2.9% budget hole - well south of the 6% levels touted during the campaign. As a result, the spread between Italian BTPs and German bunds has fallen from 193 basis points at the beginning of the month to 150 basis points this week (Chart I-9). Since gyrations in Italian spreads reflect the evolution of the perceived probability that the euro area will fall apart, the fall in the spreads has implied a fall in the euro area-breakup risk premium. This has created a boon for the euro. Another support for the euro emerged yesterday. At his press conference, European Central Bank President Mario Draghi divulged that the ECB has curtailed its growth forecast for 2018 and 2019, but not its inflation forecast. In fact, Draghi went as far as mentioning that his confidence that euro area inflation would move back to target in the medium term has increased. There is no denying that the inflationary backdrop has improved as European wages and labor costs have indeed starting to recover (Chart I-10). However, the picture is not that straightforward. The lagged impact of the previous fall in euro area inflation relative to the U.S. is likely to continue to be felt in EUR/USD moving forward, as has been the case over the past 10 years (Chart I-11). Chart I-9The Euro Area Break Up Risk Premium Is Declining Chart I-10Rising Euro Area Labor Costs Chart I-11Relative Inflation Backdrop Is Still Euro Bearish This risk is compounded by developments in China. As we have often argued, the growth differential between the euro area and China can largely be explained by growth dynamics in China. As Chart I-12 illustrates, when Chinese monetary conditions tighten, or when China's marginal propensity to consume - as approximated by the gap between M1 and M2 - declines, this often leads to underperformance of European economic activity relative to the U.S. Chart I-12AChinese Economy Still Hurting Euro Area Vs U.S. (I) Chart I-12BChinese Economy Still Hurting Euro Area Vs U.S. (II) Today, Chinese monetary conditions have improved somewhat as the Chinese authorities try to combat the shock to the Chinese economy created by the growing trade war between the U.S. and China. However, Matt Gertken, BCA's Geopolitical Strategy service's expert on Chinese policy, believes that Chinese policymakers do not intent to actually cause economic growth to pick up. Indeed, they are committed to reform and deleveraging, and only want to limit downside to the Chinese economy.2 Thus, the large growth gap between the U.S. and the euro area is here to stay. As markets absorb news of Chinese stimulus, EUR/USD could rebound toward 1.19, but we are inclined to fade such a rebound. For one, the growth and inflation gap between the U.S. and the euro area remains euro bearish. Additionaly BCA's Central Bank Monitor for the Fed clearly points toward the need to tighten U.S. monetary policy, while our indicator for the ECB points to the need to maintain an extremely loose policy setting in Europe (Chart I-13). With the euro still trading above its intermediate-term fair value estimate (Chart I-14), beyond any short-term rally the euro still possesses ample downside in the fourth quarter. As such, we would use the current rebound in the euro as an opportunity to buy the dollar once again. Chart I-13The U.S. Needs More Tightening, Europe Does Not Chart I-14The Euro Possesses Downside Bottom Line: Falling risk premia in Italy, a pick-up in European wages and signs of stimulus in China are creating some support under the euro. However, European growth and inflation are set to continue to lag well behind the U.S. as China's stimulus is not designed to reverse its deleveraging campaign and boost growth, but instead to limit downside to growth created by the U.S.-China trade war. Hence, we will use the current rebound in the euro and correction in the USD to buy the greenback again in the coming weeks. What's Going On Down Under? In recent months, the Australian economy has managed to generate some impressive numbers on the employment front. However, until recently this was not enough to prompt investors to push the AUD higher. In fact, as recently as Monday, AUD/USD was trading at 0.71. Investors are skeptical about the Australian economy's underlying strength. The NAB Business Confidence for the Next Period has weakened sharply, while mortgage approvals and house prices have also sagged. This suggests that new orders, employment and consumption could follow lower (Chart I-15). This represents a big problem for the Aussie, as our central bank monitor for the Reserve Bank of Australia is already in "easing required" territory (Chart I-16). The RBA will therefore not be able to hike rates any time soon, despite the fact that U.S. interest rates are currently in an uptrend. As such, interest rate differentials between Australia and the U.S. will continue to deteriorate. Chart I-15Australia Is Set To Slowdown Chart I-16China And Australia Are Joined At The Hip Moreover, Australia has been hit directly by the decline in Chinese industrial activity. As Chart I-17 illustrates, Australian exports are a direct function of China's Li-Keqiang index. This has two implications. First, the current rebound in the Li-Keqiang index suggests that investors could bid up the AUD with great alacrity if the USD were to correct further, a thesis we espouse. However, since we do not anticipate the rebound in the Li-Keqiang indicator to have much longevity, nor do we anticipate the greenback's correction to morph into a bear market, this also means that we would use any rebound in the AUD to sell more of it. Beyond China, EM at large still constitutes a risk for AUD/USD. Arthur Budaghyan, our Chief EM strategist, argues that the period of weakness in EM assets has further to run. Our views on the U.S. dollar, on declining global liquidity and on Chinese policy corroborate this assessment. If EM economies slow further, the still-elevated expected long-term growth rate in EM earnings could decline further as well. Since growth expectations on EM EPS are indicative of expected interest rates and terms-of-trade for Australia, this also suggests that the AUD could suffer significant downside in the coming quarters (Chart I-18). Finally, the AUD remains a pricey currency. AUD/USD continues to trade significantly above its purchasing-power-parity fair value, and the real trade-weighted AUD remains above its long-term average (Chart I-19). As such, the AUD does not possess the required valuation cushion to make it a buy in this challenging context. Chart I-17RBA ##br##Cannot Hike Chart I-18EM Has Yet To Be Fully Re-Rated, ##br##And So Does The AUD Chart I-19No Valuation Cushion##br## In The AUD Bottom Line: The Australian economy has posted some solid employment numbers, but the trends in business confidence and the housing market augur poorly. Australian monetary policy will have to remain very loose. Moreover, since China's stimulus is likely to be limited, any rebound in the AUD on the back of a dollar correction should be faded, especially as the Aussie does not offer any valuation cushion. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Time To Pause And Breathe", dated July 6, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled "China: How Stimulating is The Stimulus?", dated August 24, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Recent data in the U.S. has been mixed: Average hourly earnings growth outperformed expectations significantly, coming in at 2.9%. Moreover, nonfarm payrolls also surprised to the upside, coming in at 201 thousand, but this was mitigated by large downward revisions to the previous two months. Additionally initial jobless claims surprised positively, coming in at 203 thousand. However, core inflation underperformed expectations, coming in at 2.2%. Finally, DXY has been flat for the past couple of weeks. We continue to be bullish on the dollar on a cyclical basis, as inflationary pressures will continue to accumulate in the U.S., causing the fed to hike more than expected, particularly in 2019. Moreover, high U.S. borrowing cost will likely weigh on global growth, giving an additional boost to the dollar, as the U.S. has a lower beta than other DM economies to the global economic cycle. Report Links: The Dollar And Risk Assets Are Beholden To China’s Stimulus - August 3, 2018 Rhetoric Is Not Always Policy - July 27, 2018 Time To Pause And Breathe - July 6, 2018 Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The Euro Recent data in the euro area has been negative: Both headline and core inflation surprised to the downside, coming in at 2% and 1% respectively. Moreover, industrial production yearly growth also surprised to the downside, coming in at -0.1%. Finally, retail sales yearly growth also underperformed expectations, coming in at 1.1%. EUR/USD has been flat the past two weeks. Yesterday, however the market rallied as the ECB confirmed that it expects to wind down its bond-buying program. Nevertheless, it also lowered growth forecast for this year and next. We continue to believe that the euro will have downside until the end of the year, as a policy and regulatory tightening in China will weigh on the global industrial cycle, to which Europe is highly levered. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The Yen Recent data in Japan has been mixed: Tokyo ex fresh food inflation outperformed expectations, coming in at 0.9%. Moreover, overall household spending yearly growth also surprised positively, coming in at 0.1%. However, labor cash earnings yearly growth underperformed expectations substantially, coming in at 1.5%. Finally, Markit Services PMI surprised to the downside, coming in at 51.5. USD/JPY has been flat the past couple of weeks. Overall, we are bullish on the yen against the euro and the commodity currencies, as the tightening in monetary policy in the U.S. as well as in China should create a risk off environment where safe heavens like the yen benefits and cyclical currencies suffer. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 British Pound Recent data in the U.K. has been mixed: Average hourly earnings yearly growth excluding and including bonuses both came in above expectations, at 2.9% and 2.6% respectively. Moreover, Markit Services PMI also outperformed expectations, coming in at 54.3. However, industrial production surprised to the downside, coming in at 0.9%. Finally, nationwide housing prices yearly growth also surprised negatively, coming in at 2%. GBP/USD has rallied by roughly 0.5% the past couple of weeks. We believe that the pound could have some short term upside, as positioning continues to be significantly bearish. That being said, we are bearish on the pound on a cyclical basis, particularly against the yen. At this moment, the pound does not appear to have much of a geopolitical risk premium embedded in its price. Thus, any turbulence in the Brexit negotiations could result in significant downside for the GBP. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Australian Dollar Recent data in Australia has been mixed: Gross domestic product yearly growth came in above expectations, at 3.4%. However, building permits month-on-month growth surprised to the downside, coming in at -5.2%. Finally, the RBA Commodity Index SDR yearly growth surprised positive, coming in at 6.7%. After a bout of pronounced weakness, AUD/USD has been flat for the past couple of weeks. We believe that the Australian dollar has further downside particularly against the yen and the dollar. Australia's economy is very sensitive to the Chinese industrial cycle, as iron ore is Australia's main commodity export. However, the overleveraged industrial complex is precisely the economic sector where Chinese policymakers want to rein in credit excesses. This will curb industrial activity in China, and hurt the economies of commodity supplies like Australia. Report Links: What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 New Zealand Dollar Recent data in New Zealand has been mixed: Retail sales and retail sales ex autos yearly growth both outperformed expectations, coming in at 1.1% and 1.4% respectively. Moreover, the trade balance also surprised to the upside, coming in at -4.4 billion dollars/ However, the terms of trade Index underperformed expectations, coming in at 0.6%. NZD/USD has fallen by roughly 0.8% against the dollar for the past couple of weeks. We continue to be bearish on kiwi on a cyclical basis. The combination of high U.S. rates and deleveraging in China will weigh on carry currencies like the NZD. Furthermore, we also hold a bearish view on a structural basis, given that the new government has vowed to curb immigration and add an unemployment mandate to the RBNZ, both developments which are negative for the currency. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Canadian Dollar Recent data in Canada has been mixed: Both core and headline inflation outperformed expectations, coming in at 1.6% and 3% respectively. Moreover, manufacturing shipments month-on-month growth also outperformed expectations, coming in at 1.1%. However, retail sales month-on-month growth surprised to the downside, coming in at -0.2%. USD/CAD has been flat for the past couple of weeks. We are short this cross as a hedge to our dollar bullish view, as inflationary pressures in Canada remain strong. Moreover, the CAD will continue to outperform the AUD, as the divergence between Canada's and Australia's main export markets- China and the U.S. - will persist. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Swiss Franc Recent data in Switzerland has been mixed: Gross domestic product yearly growth outperformed expectations, coming in at 3.4%. The SVME PMI also surprised to the upside, coming in at 64.8. However, the KOF leading indicator surprised negatively, coming in at 100.3. Finally, real retail sales growth also underperformed expectations, coming in at -0.3%. EUR/CHF has risen by roughly 0.5% this past two weeks. We continue to be bearish on the franc on a long-term basis, as inflationary pressures in Switzerland are still too weak for the SNB to remove its accommodative monetary policy, or stop its currency intervention. That being said, the CHF could experience some short term upside if the sell-off in emerging markets continues. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Norwegian Krone Recent data in Norway has been mixed: Both headline and core inflation outperform expectations, coming in at 3.4% and 1.9%. Moreover, the Labour Force survey also surprised to the upside, coming in at 3.9%. However, retail sales growth underperformed expectations, coming in at 0.7%. USD/NOK has fallen by nearly 2% over the last two weeks. We are bullish on the NOK against other commodity currencies like the AUD and the NZD. This is because oil will likely outperform within the commodity space. After all, Our commodity strategist have explained at length why political risk in Iraq and Venezuela could cause a shortage of supply in the oil markets, while Chinese deleveraging in the industrial sector will weigh on base metal demand. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Swedish Krona Recent data in Sweden has been mixed: Retail sales yearly growth surprised to the downside, coming in at -1.2%. However, consumer confidence outperformed expectations, coming in at 102.6. The krona has been the best performing currency during the past two weeks, with USD/SEK falling by roughly 2% over this period. At the moment we continue to be bullish USD/SEK, as the krona is the most sensitive currency to the dollar's strength. However, on a longer term basis, we believe that inflationary pressures in Sweden will ultimately force the Riskbank to hike more than the market expects, providing support for the SEK. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Highlights In an environment where both interest rates and inflation are low but rising at a time of stretched equity valuations, what can investors do to enhance risk-adjusted portfolio returns? In this report, we investigate the roles of three types of popular instruments in a portfolio context: 1) Floating-Rate Notes, 2) Leveraged Loans and 3) Danish Mortgage Bonds. Floating-rate notes benefit from rising interest rates, but they are not a free lunch. Leveraged loans also benefit from rising interest rates; their very high correlation with high-yield bonds make them a good substitute for a portion of high-yield exposure in a rising-rate environment. Danish mortgage bonds have attracted foreign investors in recent years, but foreign ownership already accounts for about a quarter of the less than half a trillion USD market. Their positive correlation with aggregate bonds and negative correlation with equities in both Japan and the euro area make them a possible substitute for a portion of the bond basket in a balanced portfolio. Feature BCA has upgraded cash to overweight in the current environment, where inflation and interest rates are both low but rising, and equity valuations are stretched.1 For U.S. investors, holding cash is quite attractive as the cash yield is now higher than the equity dividend yield. For investors in the euro area, Switzerland, Sweden, Denmark and Japan, however, holding cash actually is a sure way to eat into portfolio returns, given the negative yields in these countries (Table 1). Table 1Current Yields* (%) Some clients, particularly those in Europe, have asked where to put cash to get higher returns. Unfortunately, it's hard to increase return without assuming additional risk. As shown in Table 1, investors could pick up some yield by putting money in 3-month deposits instead of 3-month Treasury bills, but even 3-month deposit rates are still negative in some European countries. In this report, we investigate the roles of three types of popular instruments in a low but rising rate environment: 1) Floating-Rate Notes (FRNs), 2) Leveraged Loans (LLs) and 3) Danish Mortgage Bonds (DMBs). 1. Floating-Rate Notes An FRN offers coupon payments that float or adjust periodically based on a predetermined benchmark rate. Typical benchmarks in the U.S. are Treasury bills, LIBOR, the prime rate or some other short-term interest rate. Once the benchmark is chosen, the issuer will establish an additional spread that it is willing to pay over the chosen benchmark rate. The spread mainly reflects an issuer's credit quality and the time to maturity of the note. Even though coupon reset frequency can vary between daily, weekly, monthly, quarterly and yearly, the average coupon rate has responded quickly to the fed funds rate, as shown in Chart 1. Issuers can be both government-sponsored enterprises and investment-grade corporations. Before the 2008 Great Financial Crisis, FRNs were mostly issued by corporations. Some of the notes, however, performed badly during the financial crisis, causing a drop in both total issuance and the share of corporate issuance (Chart 2). FRNs can be either callable or non-callable with or without caps and floors, so FRNs carry credit risk - and callable ones also carry call risk. In terms of interest rate risk, it applies mostly to the income received. Chart 1Rising Rate Environment Benefits FRNs Chart 2Corporate Dominance In FRN Market Because of the nature of floating rates, FRNs can benefit from rising interest rates and have limited price sensitivity to interest rates. As shown in Chart 3, the Bloomberg/Barclays U.S. Floating-Rate Note index has lower duration than the cash index, as represented by the Bloomberg/Barclays Treasury (<1 year) index, while it offers a nice yield pickup. Since the inception of the index in December 2003 it has, in general, outperformed the cash index. This reward, however, has come at a cost: it does not provide cash-like protection when such protection is needed in times like the Great Financial Crisis and the euro debt crisis in 2011 (Chart 3, panels 3 and 4). This is because the majority of FRNs are offered by corporations that carry credit risk. Consequently, FRNs have higher correlations to high-yield bonds and equities than to the aggregate bond index, as shown in Chart 4. Chart 3FRNs: Not A Free Lunch Chart 4FRNs: A Lower Risk Alternative To Junk Bonds The ideal time to invest in FRNs is when rates are low and are expected to rise. This is essentially our view on rates now. Instead of thinking of it as a cash alternative with higher risk, however, we recommend clients take the funding from the high-yield bucket, in line with our downgrade of high yield to neutral from overweight, and also our call of reducing portfolio duration. So how to invest in FRNs? According to Bloomberg Barclays, the U.S. FRN market has a market value of US$505.8 billion, which is small compared to the US$1,267.5 billion high-yield bond market. As such, FRNs are relatively less liquid to trade than corporate bonds. Therefore, they are mostly suitable for purchasing and holding to maturity. One can purchase individual floating-rate securities through a broker, or can invest in mutual funds that invest only in FRNs. Also, there are ETFs that only hold FRNs. Table 2 shows some basic information on three dedicated FRN ETFs. Table 2FRN ETFs* 2. Leveraged Loans Leveraged loans, also known as bank loans or senior secured loans, are a type of corporate debt that also have floating coupon rates, which, like the FRNs, adjust to changes in prevailing interest rates and hence benefit from rising rates. These loans tend to be senior to an issuer's traditional corporate bonds, and are collateralized by a pledge of the issuer's assets. However, secured does not mean safe. These loans are private investments which are generally held by funds or large institutional investors. Most of them carry sub-investment-grade ratings and can default. They also tend to be very illiquid to trade, because physical delivery to the buyer is often needed from a seller (by faxing the paperwork, for example). As such, during periods of market volatility, these loans can be subject to significant price declines. Even though bank loans share the same feature of having "floating coupon rates" as FRNs, they are higher risk securities. In the U.S., bank loans have been mostly inferior to FRNs on a risk-adjusted return basis, as their higher return is offset by much higher volatility (Chart 5A). In the euro area, however, these loans have become more favorable than FRNs since the start of 2018 (Chart 5B). Chart 5ALeveraged Loans Vs. FRNs: U.S. Chart 5BLeveraged Loans Vs. FRNs: Euro Area Historically, when interest rates have risen, bank loans have outperformed traditional fixed-income securities, and vice versa, because of their floating-rate feature, as shown in Charts 6A and 6B. This positive correlation with rates has been more consistent when the relative performance of bank loans is compared to government bonds and investment-grade corporate bonds. When compared to high-yield bonds, however, the correlation appears weak, as shown in the bottom panels of Charts 6A and 6B. This is not surprising given that these loans share similar "sub-investment grade" credit quality with junk bonds. In fact, as shown in Chart 7, bank loans have a highly positive correlation with junk bonds, yet a mostly negative correlation with the aggregate bond index both in the U.S. and the euro area. Chart 6ALLs Outperform When Rates Rise: U.S. Chart 6BLLs Outperform When Rates Rise: Euro Area Chart 7Bank Loan Correlations With Traditional Bonds This correlation feature has two very interesting implications: a) Adding bank loans to a standard aggregate bond portfolio could add diversification, and b) replacing some high-yield holdings with bank loans could generate a sub-investment grade basket with a better risk/reward profile compared to high-yield alone. Chart 8 and Table 3 show that historically there has existed an "optimal" combination of bank loans and high-yield bonds that somewhat improves the risk-adjusted return of the sub-investment grade basket. It's worth noting, however, that this historically "optimal" combination is subject to data frequency and time period, as is the case for the U.S. where the optimal weight for bank loans has been about 40% from 2002 to the present, but about 80% in the period from 1997 to the present. As such, in addition to thorough credit analysis to evaluate the suitability of bank loans, investors should also consider the variable nature of correlation when considering replacing part of their high-yield bond exposure with bank loans. Chart 8Junk Bonds - Leverage Loans Basket Profiles Table 3Risk Return Profiles Of Sub-Investment Grade Baskets 3. Danish Mortgage Bonds A Danish mortgage bond (DMB) is essentially a loan to a borrower who has taken out a mortgage on his or her home. Mortgage bonds are issued by mortgage credit institutions which often have high credit ratings. Some DMBs have fixed rates, while others have floating rates with a minimum of zero percent. Some of these bonds can also be callable, often at par (100). With a solid history of over 200 years, the DMB market has survived numerous occasions of economic and political turmoil, including the bankruptcy of the Kingdom of Denmark in 1813, the Great Depression of the 1930s and the Great Financial Crisis and ensuing recession in 2008. Over its entire history, every single issued bond has been repaid in full to investors, in large part due to the strong legislative framework that protects the bond investors (see Appendix 1). As of the end of July 2018, the DMB market consisted of kr. 2.672 trillion of AAA-rated covered bonds. Once largely dominated by local pensions and insurance companies, the DMB market has seen increasing interest from foreign investors in recent years. According to data from the Danish central bank, foreign ownership of fixed rate mortgage bonds stood at kr. 295 billion (29%) in July 2018 compared to kr. 154 billion (18%) in January 2016 (Chart 9). In terms of total holdings of all mortgage bonds (fixed rate, variable rate and bonds backing interest adjustment loans), foreigners held kr. 614 billion (23%), an increase of kr. 27 billion compared to the beginning of 2016. Japanese investors, who have suffered many years of extremely low yields domestically, have been quite active in the DMB market. According to data from the Bank of Japan, Japanese investors purchased some kr. 50 billion of long-term Danish non-government bonds in the period from 2016 to June 2018.3 In June 2018, Nykredit, the largest Danish mortgage bank with a market share of about 40%, even created a DMB index hedged to yen using one-month forward rates due to popular demand and corresponding requests from Japanese investors. As shown in Chart 10, since 2009, the DMB index hedged to yen has outperformed both JGBs and Japanese corporate bonds. Chart 9Foreign Ownership of Danish Fixed Rate Mortgage Bonds* Chart 10DMBs For Japanese Investors Even though interest rates in the U.S. are much higher than those in the euro area, investing in the U.S. after hedging the currency is not really attractive for euro investors. For example, U.S. bank loans have outperformed European bank loans in local currency terms; after being hedged into euro, however, the yield advantage disappears. In terms of government bonds, euro investors really have no incentive to invest in U.S. Treasurys, hedged or unhedged (Chart 11). Given the Danish krone's peg to the euro, it is natural for euro investors to look at the DMB market. Chart 12 shows that DMBs have indeed outperformed both government and corporate bonds in the euro area when 3-month deposit rate turns negative. During the 2008 financial crisis, DMBs also outperformed euro area corporate bonds. However, they did underperform both euro area corporate and government bonds when the European Central Bank started buying bonds after the euro debt crisis. So, how would the exposure of DMBs impact a portfolio's risk/return profile? We have two interesting observations from Chart 13: Chart 11Rate Advantage Vs. Currency Risk Chart 12DMBs For Euro Investors Chart 13DMBs As A Domestic Bond Substitute? In Japan, hedged DMBs have a very low correlation with equities, corporate bonds and JGBs, even though the correlation with equities has generally been negative, and with bonds generally positive. In the euro area, DMBs have a negative correlation with equities, but a highly positive correlation with both government and corporate bonds. And the correlation to government bonds is quite similar to that of corporate bonds. Therefore, in theory, replacing part of a standard bond portfolio with DMBs could improve a balanced portfolio's risk/return profile for both Japanese and euro area investors. Table 4 shows the risk/return profiles of hypothetical 60/40 standard domestic equity/bond portfolios for Japan and euro area that have a certain percentage of domestic bonds replaced with Danish mortgage bonds: for Japan, the DMBs are hedged to yen, and for the euro area they are unhedged but converted into euros. Table 460/40 Equity/Bond Portfolio Profile with DMB Exposures As expected, for Japan, substituting domestic aggregate bonds with hedged DMBs increases portfolio return more than volatility, thereby improving risk/adjusted returns. For the euro area, however, the story is not straightforward. Over a longer time frame, DMBs have not been a good substitute for euro area aggregate bonds. Since the 3-month euro rate turned negative in June 2015, however, DMBs have largely improved a balanced portfolio's risk/return profile. It is also worth noting that, unlike Japanese investors who benefit from a positive hedging gain since the Danish three-month rate has been lower than Japan's since 2015, euro area investors do not have such a benefit. Also, even though the DMB market is the largest covered bond market in the world, its market size is less than half a trillion USD. Given the fact that foreign investors already account for about a quarter of the market, it is not clear how euro area investors can significantly deploy more capital to enhance portfolio returns. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Appendix 1: The Danish Mortgage Act4 Danish mortgage bonds are issued under the Danish Mortgage Act. Two key features of the Act protect investors in DMBs. First, the central element in the Danish Mortgage Act is the "balancing principle." This principle requires that there is a match between the inflows and outflows of a mortgage-issuing bank, and limits the amount of risk (interest rate, FX, volatility and liquidity) that a Danish mortgage bank can undertake. In addition, Danish mortgage banks must meet minimum capital requirements of 8% of risk-weighted assets. Second, the "Danish title number and land registration systems and efficient compulsory sale procedure" ensures well-defined property rights through a general register of all properties in Denmark. Ownership and encumbrances on individual properties are easily identified, and that information is available to the public. If a borrower defaults on a payment, the mortgage bank can take over the property and the compulsory sale procedure ensures that a mortgage bank can sell the property in the real estate market or through a forced sale. The period from default to a forced sale to be completed can be as short as six months. 1 Please see Global Investment Strategy Special Report entitled, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. 2 Please see "Fixed Rate Mortgage Bonds Are Attractive For Foreigners," Portfolio Investment, Danmarks Nationalbank, dated August 28, 2018. 3 Please see "Fixed Rate Mortgage Bonds Are Attractive For Foreigners," Portfolio Investment, Danmarks Nationalbank, dated August 28, 2018. 4 Please see "Danish Covered Bond Handbook," Danske Bank, dated September 15, 2017.