Alternative Investments

Highlights Central banks globally have turned dovish, with the Fed virtually promising to cut rates in July. But this will be an “insurance” cut, like 1995 and 1998, not the beginning of a pre-recessionary easing cycle. The global expansion remains intact, with the fundamental drivers of U.S. consumption robust and China likely to ramp up its credit stimulus over the coming months. The Fed will cut once or twice, but not four times over the next 10 months as the futures markets imply. Underlying U.S. inflation – properly measured – is trending higher to above 2%. U.S. GDP growth this year will be around 2.5%. Inflation expectations will move higher as the crude oil price rises. Unemployment is at a 50-year low and the U.S. stock market at an historical peak. These factors suggest bond yields are more likely to rise than fall from current levels. The upside for U.S. equities is limited, but earnings growth should be better than the 3% the bottom-up consensus expects. The key for allocation will be when to shift in the second half into higher-beta China-related plays, such as Europe and Emerging Markets. For now, we remain overweight the lower-beta U.S. equity market, neutral on credit, and underweight government bonds. To hedge against the positive impact of China stimulus, we raise Australia to neutral, and re-emphasize our overweights on the Industrials and Energy sectors. Feature Overview Precautionary Dovishness – Or Looming Recession?   Recommendations Quarterly Portfolio Outlook: Precautionary Dovishness – Or Looming Recession? Quarterly Portfolio Outlook: Precautionary Dovishness – Or Looming Recession? Central banks everywhere have taken a decidedly dovish turn in recent weeks. June’s FOMC statement confirmed that “uncertainties about the outlook have increased….[We] will act as appropriate to sustain the expansion,” hinting broadly at a rate cut in July. The Bank of Japan’s Kuroda said he would “take additional easing action without hesitation,” and hinted at a Modern Monetary Theory-style combination of fiscal and monetary policy. European Central Bank President Draghi mentioned the possibility of restarting asset purchases. There are two possible explanations. Either the global economy is heading into recession, and central banks are preparing for a full-blown easing cycle. Or these are “insurance” cuts aimed at prolonging the expansion, as happened in 1995 and 1998, or similar to when the Fed went on hold for 12 months in 2016 (Chart 1). Our view is that it is most likely the latter. The reason for this is that the main drivers of the global economy, U.S. consumption ($14 trillion) and the Chinese economy ($13 trillion) are likely to be strong over the next 12 months. U.S. wage growth continues to accelerate, consumer sentiment is close to a 50-year high, and the savings rate is elevated (Chart 2); as a result core U.S. retail sales have begun to pick up momentum in recent months (Chart 3). Unless something exogenous severely damages consumer optimism, it is hard to see how the U.S. can go into recession in the near future, considering that consumption is 70% of GDP. Moreover, despite weaknesses in the manufacturing sector – infected by the China-led slowdown in the rest of the world – U.S. service sector growth and the labor market remain solid. This resembles 1998 and 2016, but is different from the pre-recessionary environments of 2000 and 2007 (Chart 4). There is also no sign on the horizon of the two factors that have historically triggered recessions: a sharp rise in private-sector debt, or accelerating inflation (Chart 5). Chart 1Insurance Cuts, Or Full Easing Cycle? Insurance Cuts, Or Full Easing Cycle? Insurance Cuts, Or Full Easing Cycle? Chart 2Consumption Fundamentals Are Strong... Consumption Fundamentals Are Strong... Consumption Fundamentals Are Strong... Chart 3...Leading To Rebound In Retail Sales ...Leading To Rebound In Retail Sales ...Leading To Rebound In Retail Sales Chart 4Manufacturing Weak, But Services Holding Up Manufacturing Weak, But Services Holding Up Manufacturing Weak, But Services Holding Up   Chart 5No Signs Of Usual Recession Triggers No Signs Of Usual Recession Triggers No Signs Of Usual Recession Triggers China’s efforts to reflate via credit creation have been somewhat half-hearted since the start of the year. Investment by state-owned companies has picked up, but the private sector has been spooked by the risk of a trade war and has slowed capex (Chart 6). China may have hesitated from full-blown stimulus because the authorities in April were confident of a successful outcome to trade talks with the U.S., and a bit concerned that the liquidity was going into speculation rather than the real economy. But we see little reason why they will not open the taps fully if growth remains sluggish and trade tensions heighten.1 Chinese credit creation clearly has a major impact on many components of global growth – in particular European exports, Emerging Markets earnings, and commodity prices – but the impact often takes 6-12 months to come through (Chart 7). A key question is when investors should position for this to happen. We think this decision is a little premature now, but will be a key call for the second half of the year. Chart 6China's Half-Hearted Reflation China's Half-Hearted Reflation China's Half-Hearted Reflation Chart 7China Credit Growth Affects The World China Credit Growth Affects The World China Credit Growth Affects The World Chart 8Fed Won't Cut As Much As Market Wants... Fed Won't Cut As Much As Market Wants... Fed Won't Cut As Much As Market Wants... The Fed has so clearly signaled rate cuts that we see it cutting by perhaps 50 basis points over the next few months (maybe all in one go in July if it wants to “shock and awe” the market). But the futures market is pricing in four 25 bps cuts by April next year. With GDP growth likely to be around 2.5% this year, unemployment at a 50-year low, trend inflation above 2%,2 and the stock market at an historical high, we find this improbable. Two cuts would be similar to what happened in 1995, 1998 and (to a degree) 2016 (Chart 8). In this environment, we think it likely that equities will outperform bonds over the next 12 months. When the Fed cuts by less than the market is expecting, long-term rates tend to rise (Chart 9). BCA’s U.S. bond strategists have shown that after mid-cycle rate cuts, yields typically rise: by 59 bps in 1995-6, 58 bps in 1998, and 19 bps in 2002.3 A combination of rising inflation, stronger growth ex-U.S., a less dovish Fed that the market expects, and a rising oil price (which will push up inflation expectations) makes it unlikely – absent an outright recession – that global risk-free yields will fall much below current levels. Moreover, June’s BOA Merrill Lynch survey cited long government bonds as the most crowded trade at the moment, and surveys of investor positioning suggest duration among active investors is as long as at any time since the Global Financial Crisis (Chart 10). Chart 9...So Bond Yields Are Likely To Rise ...So Bond Yields Are Likely To Rise ...So Bond Yields Are Likely To Rise Chart 10Investors Betting On Further Rate Decline Investors Betting On Further Rate Decline Investors Betting On Further Rate Decline The outlook for U.S. equities is not that exciting. Valuations are not cheap (with forward PE of 16.5x), but earnings should be revised up from the currently very cautious level: the bottom-up consensus forecasts S&P 500 EPS growth at only 3% in 2019 (and -3% YoY in Q2). We have sympathy for the view that there are three put options that will prop up stock prices in the event of external shocks: the Fed put, the Xi put, and the Trump put. Relating to the last of these, it is notable that President Trump tends to turn more aggressive in trade talks with China whenever the U.S. stock market is strong, but more conciliatory when it falls (Chart 11). For now, therefore, we remain overweight U.S. equities, as a lower beta way to play an environment that continues to be positive – but uncertain – for stocks. But we continue to watch for the timing to move into higher-beta China-related markets as the effects of China’s stimulus start to come through. Chart 11Trump Turns Softer When Market Falls Trump Turns Softer When Market Falls Trump Turns Softer When Market Falls   Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com   What Our Clients Are Asking Chart 12Temporary Forces Drove Inflation Downturn Temporary Forces Drove Inflation Downturn Temporary Forces Drove Inflation Downturn Why Is Inflation So Low? After reaching 2% in July 2018, U.S. core PCE currently stands at 1.6%, close to 18 month lows. This plunge in inflation, along with increased worries about the trade war and continued economic weakness, has led the market to believe that the Fed Funds Rate is currently above the neutral rate, and that several rate cuts are warranted in order to move policy away from restrictive territory. We believe that the recent bout of low inflation is temporary. The main contributor to the fall in core PCE has been financial services prices, which shaved off up to 40 basis points from core PCE (Chart 12, panel 1). However, assets under management are a big determinant of financial services prices, making this measure very sensitive to the stock market (panel 2). Therefore, we expect this component of core PCE to stabilize as equity prices continue to rise. The effect of higher equity prices, and the stabilization of other goods that were affected by the slowdown of global growth in late 2018 and early 2019, may already have started to push inflation higher. Month-on-month core PCE grew at an annualized rate of 3% in April, the highest pace since the end of 2017. Meanwhile, trimmed mean PCE, a measure that has historically been a more stable and reliable gauge of inflationary pressures, is at a near seven-year high (panel 3). The above implies that the market might be overestimating how much the Fed is going to ease. We believe that the Fed will likely cut once this year to soothe the pain caused by the trade war on financial markets. However, with unemployment at 50-year lows, and inflation set to rise again, the Fed is unlikely to deliver the 92 basis points of cuts currently priced by the OIS curve for the next 12 months. This implies that investors should continue to underweight bonds. Chart 13Turning On The Taps Turning On The Taps Turning On The Taps Will China Really Ramp Up Its Stimulus? The direction of markets over the next 12 months (a bottoming of euro area and Emerging Markets growth, commodity prices, the direction of the USD) are highly dependent on whether China further increases monetary stimulus in the event of a breakdown in trade negotiations with the U.S. But we hear much skepticism from clients: aren’t the Chinese authorities, rather, focused on reducing debt and clamping down on shadow banking? Aren’t they worried that liquidity will simply flow into speculation and have little impact on the real economy? Now the government has someone to blame for a slowdown (President Trump), won’t they use that as an excuse – and, to that end, are preparing the population for a period of pain by quoting as analogies the Long March in the 1930s and the Korea War (when China ground down U.S. willingness to prolong the conflict)? We think it unlikely that the Chinese government would be prepared to allow growth to slump. Every time in the past 10 years that growth has slowed (with, for example, the manufacturing PMI falling significantly below 50) they have always accelerated credit growth – on the basis of the worst-case scenario (Chart 13, panel 1). Why would they react differently this time, particularly since 2019 is a politically sensitive year, with the 70th anniversary of the founding of the People’s Republic in October and several other important anniversaries? Moreover, the government is slipping behind in its target to double per capita income in the 10 years to end-2020 (panel 2). GDP growth needs to be 6.5-7% over the next 18 months to achieve the target. The government’s biggest worry is employment, where prospects are slipping rapidly (panel 3). This also makes it difficult for the authorities to retaliate against U.S. companies that have large operations, such as Apple or General Motors, since such measures would hurt their Chinese employees. Besides a significant revaluation of the RMB (which we think likely), China has few cards to play in the event of a full-blown trade war other than fully turning on the liquidity tap again. Chart 14 Aren’t There Signs Of Bubbliness In Equity Markets? Clients have asked whether the current market environment has been showing any classic signs of euphoria. These usually appear with lots of initial public offerings (IPO), irrational M&A activity, and excess investor optimism. The IPO market has some similarities to the years leading up to the dot-com bubble, but it is important to look below the surface. The percentage of IPOs with negative earnings in 2018 was similar to the previous peak in 1999. However, the average first-day return of IPOs in 2019, while still above the historical average, has been much lower than that during the dot-com bubble period (Chart 14, panel 1). There is also a difference in the composition of firms going public. There are now many IPOs for biotech firms that have heavily invested in R&D, and so have relatively low sales currently but await a breakthrough in their products; by their nature, these are loss-making (panel 2). Cross-sector, unrelated M&A activity has also often been a sign of bubble peaks. It is a consequence of firms stretching to find inorganic growth late in the cycle. Such deals are characterized by high deal premiums, and are usually conducted through stock purchases rather than in cash. The current average deal premium is below its historical average (panel 3). Additionally, 2018 and 2019-to-date M&A deals conducted using cash represented 60% and 90% of the total respectively, compared to only 17% between 1996 and 2000. Investor sentiment is also moderately pessimistic despite the rally in the S&P 500 since the beginning of the year (panel 4). This caution suggests that investors are fearful of the risk of recession rather than overly positive about market prospects, despite the U.S. market being at an historical high. Given the above, we do not see any signals of the sort of euphoria and bubbliness that typically accompanies stock market tops. Will Japan Benefit From Chinese Reflation? Japan has been one of the worst-performing developed equity markets since March 2009, when global equities hit their post-crisis bottom in both USD (Chart 15) and local currency terms. Now with increasing market confidence in China’s reflationary policies, clients are asking if Japan is a good China play given its close ties with the Chinese economy. Our answer is No. Chart 15 Chart 16Downgrade Japan To Underweight Downgrade Japan To Underweight Downgrade Japan To Underweight   It’s true that Japanese equities did respond to past Chinese reflationary efforts, but the outperformances were muted and short-lived (Chart 16, panel 1). Even though Japanese exports to China will benefit from Chinese reflationary policy (panel 5), MSCI Japan index earnings growth does not have strong correlation with Japanese exports to China, as shown in panel 4. This is not surprising given that exports to China account for only about 3% of nominal GDP in Japan (compared to almost 6% for Australia, for example). The MSCI Japan index is dominated by Industrials (21%) and Consumer Discretionary (18%). Financials, Info Tech, Communication Services and Healthcare each accounts for about 8-10%. Other than the Communication Services sector, all other major sectors in Japan have underperformed their global peers since the Global Financial Crisis (panels 2 and 3). The key culprit for such poor performance is Japan’s structural deflationary environment. Wage growth has been poor despite a tight labor market. This October’s consumption tax increase will put further downward pressure on domestic consumers. There is no sign of the two factors that have historically triggered recessions: a sharp rise in private-sector debt, or accelerating inflation. As such, we are downgrading Japan to a slight underweight in order to close our underweight in Australia (see page 16). This also aligns our recommendation with the output from our DM Country Allocation Quant Model, which has structurally underweighted Japan since its inception in January 2016. Global Economy Chart 17Is Consumption Enough To Prop Up U.S. Growth? Is Consumption Enough To Prop Up U.S. Growth? Is Consumption Enough To Prop Up U.S. Growth? Overview: The tight monetary policy of last year (with the Fed raising rates and China slowing credit growth) has caused a slowdown in the global manufacturing sector, which is now threatening to damage worldwide consumption and the relatively closed U.S. economy too. The key to a rebound will be whether China ramps up the monetary stimulus it began in January but which has so far been rather half-hearted. Meanwhile, central banks everywhere are moving to cut rates as an “insurance” against further slowdown. U.S.: Growth data has been mixed in recent months. The manufacturing sector has been affected by the slowdown in EM and Europe, with the manufacturing ISM falling to 52.1 in May and threatening to dip below 50 (Chart 17, panel 2). However, consumption remains resilient, with no signs of stress in the labor market, average hourly earnings growing at 3.1% year-on-year, and consumer confidence at a high level. As a result, retail sales surprised to the upside in May, growing 3.2% YoY. The trade war may be having some negative impact on business sentiment, however, with capex intentions and durable goods orders weakening in recent months. Euro Area: Current conditions in manufacturing continue to look dire. The manufacturing PMI is below 50 and continues to decline (Chart 18, panel 1). In export-focused markets like Germany, the situation looks even worse: Germany’s manufacturing PMI is at 45.4, and expectations as measured by the ZEW survey have deteriorated again recently. Solid wage growth and some positive fiscal thrust (in Italy, France, and even Germany) have kept consumption stable, but the recent tick-up in German unemployment raises the question of how sustainable this is. Recovery will be dependent on Chinese stimulus triggering a rebound in global trade. Chart 18Few Signs Of Recovery In Global Ex-U.S. Growth Few Signs Of Recovery In Global Ex-U.S. Growth Few Signs Of Recovery In Global Ex-U.S. Growth Japan: The slowdown in China continues to depress industrial production and leading indicators (panel 2). But maybe the first “green shoots” are appearing thanks to China’s stimulus: in April, manufacturing orders rose by 16.3% month-on-month, compared to -11.4% in March. Nonetheless, consumption looks vulnerable, with wage growth negative YoY each month so far this year, and the consumption tax rise in October likely to hit consumption further. The Bank of Japan’s six-year campaign of maximum monetary easing is having little effect, with core core inflation stuck at 0.5% YoY, despite a small pickup in recent months – no doubt because the easy monetary policy has been offset by a steady tightening of fiscal policy. Emerging Markets: China’s growth has slipped since the pickup in February and March caused by a sharp increase in credit creation. Seemingly, the authorities became more confident about a trade agreement with the U.S., and worried about how much of the extra credit was going into speculation, rather than the real economy. The manufacturing PMI, having jumped to almost 51 in March, has slipped back to 50.2. A breakdown of trade talks would undoubtedly force the government to inject more liquidity. Elsewhere in EM, growth has generally been weak, because of the softness in Chinese demand. In Q1, GDP growth was -3.2% QoQ annualized in South Africa, -1.7% in Korea, and -0.8% in both Brazil and Mexico. Only less China-sensitive markets such as Russia (3.3%) and India (6.5%) held up. Interest rates: U.S. inflation has softened on the surface, with the core PCE measure slipping to 1.6% in April. However, some of the softness was driven by transitory factors, notably the decline in financial advisor fees (which tend to move in line with the stock market) which deducted 0.5 points from core PCE inflation. A less volatile measure, the trimmed mean PCE deflator, however, continues to trend up and is above the Fed’s 2% target. Partly because of the weaker historical inflation data, inflation expectations have also fallen (panel 4). As a result, central banks everywhere have become more dovish, with the Australian and New Zealand reserve banks cutting rates and the Fed and ECB raising the possibility they may ease too. The consequence has been a big fall in 10-year government bonds yields: in the U.S. to only 2% from 3.1% as recently as last September. Global Equities Chart 19Worrisome Earnings Prospects Worrisome Earnings Prospects Worrisome Earnings Prospects Remain Cautiously Optimistic, Adding Another China Hedge: Global equities managed to eke out a small gain of 3.3% in Q2 despite a sharp loss of 5.9% in May. Within equities, our defensive country allocation worked well as DM equities outperformed EM by 2.9% in Q2. Our cyclical tilt in global sector positioning, however, did not pan out, largely due to the 2% underperformance in global Energy as the oil price dropped by 2% in Q2. Going forward, BCA’s House View remains that global economic growth will pick up sometime in the second half thanks to accommodative monetary policies globally and the increasing likelihood of a large stimulus from China to counter the negative effect from trade tensions. This implies that equities are likely to rally again after a period of congestion within a trading range, supporting a cautiously optimistic portfolio allocation for the next 9-12 months. The “optimistic” side of our allocation is reflected in two aspects: 1) overweight equities vs. bonds at the asset class level; and 2) overweight cyclicals vs. defensives at the global sector level. However, corporate profit margins are rolling over and earnings growth revisions have been negative (Chart 19). Therefore, the “cautious” side of our allocation remains a defensive country allocation, reflected by overweighting DM vs. EM. Our macro view hinges largely on what happens to China. There is an increasing likelihood that China may be on a reflationary path to stimulate economic growth. We upgraded global Industrials in March to hedge against China’s re-acceleration. Now we upgrade Australia to neutral from a long-term underweight, by downgrading Japan to a slight underweight from neutral, because Australia will benefit more from China’s reflationary policies (see next page). Chart 20Australian Equities: Close The Underweight Australian Equities: Close The Underweight Australian Equities: Close The Underweight Upgrade Australian Equities To Neutral The relative performance of MSCI Australian equities to global equities has been closely correlated with the CRB metal price most of the time. Since the end of 2015, however, the CRB metals index has increased by more than 40%, yet Australian equities did not outperform (Chart 20, panel 1). Why? The MSCI Australian index is concentrated in Financials (mostly banks) and Materials (mostly mining), as shown in panel 2. Aussie Materials have outperformed their global peers, but the banks have not (panel 3). The banks are a major source of financing for the mining companies (hence the positive correlation with metal prices). They are also the source of financing for the Aussie housing markets, which have weighed down on the banks’ performance over the past few years due to concerns about stretched valuations. We have been structurally underweight Australian equities because of our unfavorable view on industrial commodities, and also our concerns on the Australian housing market and the problems of the banks. This has served us well, as Australian equities have done poorly relative to the global aggregate since late 2012. Now interest rates in Australia have come down significantly. Lower mortgage rates should help stabilize house prices, which suffered in Q1 their worst year-on-year decline, 7.7%, in over three decades. Australian equity earnings growth is still slowing relative to the global earnings, but the speed of slowing down has decreased significantly. With 6% of GDP coming from exports to China, Aussie profit growth should benefit from reflationary policies from China (panel 4). Relative valuation, however, is not cheap (panel 5). All considered, we are closing our underweight in Australian equities as another hedge against a Chinese-led re-acceleration in economic growth. This is financed by downgrading Japan to a slight underweight (for more on Japan, see What Our Clients Are Asking, on page 11). Government Bonds Chart 21Limited Downside In Yields Limited Downside In Yields Limited Downside In Yields Maintain Slight Underweight On Duration: After the Fed signaled at its June meeting that rates cuts were likely on the way, the U.S. 10-year Treasury yield dropped to 1.97% overnight on June 20, the lowest since November 2016. Overall, the 10-year yield dropped by 40 bps in Q2 to end the quarter at 2%. BCA’s Fed Monitor is now indicating that easier monetary policy is required. But that is already more than discounted in the 92 bps of rate cuts over the next 12 months priced in at the front end of the yield curve, and by the current low level of Treasury yields. (Chart 21). We see the likelihood of one or two “insurance” cuts by the Fed, but the current environment (with a record-high stock market, tight corporate spreads, 50-year low unemployment rate, and 2019 GDP on track to reach 2.5%) is not compatible with a full-out cutting campaign. In addition, the latest Merrill Lynch survey indicated that long duration is the most crowded global trade. Given BCA’s House View that the U.S. economy is not heading into a recession but rather experiencing a manufacturing slowdown mainly due to external shocks, the path of least resistance for Treasury yields is higher rather than lower. Investors should maintain a slight underweight on duration over the next 9-12 months. Chart 22Favor Linkers Over Nominal Bonds Favor Linkers Over Nominal Bonds Favor Linkers Over Nominal Bonds Favor Linkers Vs. Nominal Bonds: Global inflation expectations have dropped anew in the second quarter, with the 10-year CPI swap rate now sitting at 1.55%, 41 bps lower than its 2018 high of 1.96%. However, historically, the change in the crude oil price tends to have a good correlation with inflation expectations. BCA’s Commodity & Energy Strategy service revised down its 2019 Brent crude forecast to an average of US$73 per barrel from US$75, but this implies an average of US$79 in H2. (Chart 22). This would cause a significant rise in inflation expectations in the second half, supporting our preference for inflation-linked over nominal bonds. We also favor linkers in Japan and Australia over their respective nominal bonds. Corporate Bonds Chart 23Profit Growth Should Still Outpace Debt Growth Profit Growth Should Still Outpace Debt Growth Profit Growth Should Still Outpace Debt Growth We turned cyclically overweight on credit within a fixed-income portfolio in February. Since then, corporate bonds have produced 120 basis points of excess return over duration-matched Treasuries. We believe this bullish stance on credit will continue to pay dividends. The global leading economic indicators have started to stabilize while multiple credit impulses have started to perk up all over the world. Historically, improving global growth has been positive for corporate bonds (Chart 23, panel 1). A valid concern is the deceleration in profit growth in the U.S., as the yearly growth of pre-tax profits has fallen from 15% in 2018 Q4 to 7% in the first quarter of this year. In general, corporate bonds suffer when profit growth lags debt growth, as defaults tends to rise in this environment. Is this scenario likely over the coming year? We do not believe so. While weak global growth at the end of 2018 and beginning of 2019 is likely to weigh on revenues, the current contraction in unit labor costs should bolster profit margins and keep profit growth robust (panel 2). Additionally, the Fed’s Senior Loan Officer Survey shows that C&I loan demand has decreased significantly this year, suggesting that the pace of U.S. corporate debt growth is set to slow (panel 3). How long will we remain overweight? We expect that the Federal Reserve will do little to no tightening over the next 12 months. This will open a window for credit to outperform Treasuries in a fixed-income portfolio. We have also reduced our double underweight in EM debt, since an acceleration of Chinese monetary stimulus would be positive for this asset class. Commodities Chart 24Watch Oil And Be Wary Of Gold Watch Oil And Be Wary Of Gold Watch Oil And Be Wary Of Gold Energy (Overweight): Supply/demand fundamentals continue to be the main driver of crude oil prices. However, it seems as though the market is discounting something else. President Trump’s tweets, OPEC+ coalition statements, and concerns about future demand growth are contributing to price swings (Chart 24, panel 1). According to the Oxford Institute for Energy Studies, weak demand has reduced oil prices by $2/barrel this year. That should be offset, however, by a much larger contribution from supply cuts, speculative demand, and a deteriorating geopolitical environment. We see crude prices tilted to the upside, as OPEC’s ability to offset any supply disruptions (besides Iran and Venezuela) is limited (panel 2). We expect Brent to average $73 in 2019 and $75 in 2020. Industrial Metals (Neutral): A stronger USD accompanied by weakening global growth since 2018 has put downward pressure on industrial metal prices, which are down about 20% since January 2018. However, we now have renewed belief that the Chinese authorities will counter with a reflationary response though credit and fiscal stimulus. That should push industrial metal prices higher over the coming 12 months (panel 3). Precious Metals (Neutral): Allocators to gold are benefiting from the current environment of rising geopolitical risk, dovish central banks, a weaker USD, and the market’s flight to safety. Escalated trade tensions, falling global yields, and lower growth prospects are some of the factors that have supported the bullion’s 18% return since its September 2018 low. Until evidence of a bottom in global growth emerges, we expect the copper-to-gold ratio – another barometer for global growth – to continue falling (panel 4). The months ahead could see a correction, as investors take profits with gold in overbought territory. Nevertheless, we continue to recommend gold as both an inflation hedge as well as against any uncertain escalated political tensions. Currencies Chart 25Stronger Global Growth Will Weigh On The Dollar Stronger Global Growth Will Weigh On The Dollar Stronger Global Growth Will Weigh On The Dollar U.S. dollar: The trade-weighted dollar has been flat since we lowered our recommendation from positive to neutral in April. We expect that the Fed will cut rates at least once this year, easing financial conditions, and boosting economic activity. This will eventually prove negative for the dollar. However as long as the global economy is weak the greenback should hold up. Stay neutral for now. Euro: Since we turned bullish on the euro in April, EUR/USD has appreciated by 1.5%. Overall, we continue to be bullish on EUR/USD on a cyclical timeframe. Forward rate expectations continue to be near 2014 lows, suggesting that there is little room for U.S. monetary policy to tighten further vis-à-vis euro area monetary policy, creating a floor under the euro (Chart 25, panel 1). EM Currencies: We continue to be negative on emerging market currencies. However, some indicators suggest that Chinese weakness, the main engine behind the EM currency bear market might be reaching its end. Chinese marginal propensity to spend (proxied by M1 growth relative to M2 growth), has bottomed and seems to have stabilized (panel 2). The bond market has taken note of this development, as Chinese yields are now rising relative to U.S. ones (panel 3). Historically, both of these developments have resulted in a rally for emerging market currencies. Thus, while we expect the bear market to continue for the time being, the pace of decline is likely to ease, making EM currencies an attractive buy by the end of the year. Accordingly, we are reducing our underweight in EM currencies from double underweight to a smaller underweight position. Alternatives Chart 26 Return Enhancers: Hedge funds historically display a negative correlation with global growth momentum. Despite growth slowing over the past year, hedge funds underperformed the overall GAA Alternatives Index as well as private equity. Hedge funds usually outperform other risky alternatives during recessions or periods of high credit market stress. Credit spreads have been slow to rise in response to the slowing economy and worsening political environment. A pickup in spreads should support hedge fund outperformance (Chart 26, panel 2). Inflation Hedges: As we approach the end of the cycle, we continue to recommend investors reduce their real estate exposure and increase allocations towards commodity futures. Our May 2019 Special Report4 analyzed how different asset classes perform in periods of rising inflation. Our expectation is that inflation will pick up by the end of the year. An allocation to commodity futures, particularly energy, historically achieved excess returns of nearly 40% during periods of mild inflation (panel 3). Volatility Dampeners: Realized volatility in the catastrophe bond market is generally low. In fact, absent any catastrophe losses, catastrophe bonds provide stable returns, with volatility that is comparable to global bonds (panel 4). In a December 2017 Special Report,5 we tested for how the inclusion of catastrophe bonds in a traditional 60/40 equity-bond portfolio would have impacted portfolio risk-return characteristics. Replacing global equities with catastrophe bonds reduced annualized volatility by more than 1.5%. Risks To Our View Chart 27What Risk Of Recession? What Risk Of Recession? What Risk Of Recession? Our main scenario is sanguine on global growth, which means we argue that bond yields will not fall much below current levels. The risks to this view are mostly to the downside. There could be a full-blown recession. Most likely this would be caused either by China failing to do stimulus, or by U.S. rates being more restrictive than the Fed believes. Both of these explanations seem implausible. As we argue elsewhere, we think it unlikely that China would simply allow growth to slow without reacting with monetary and fiscal stimulus. If current Fed policy is too tight for the economy to withstand, it would imply that the neutral rate of interest is zero or below, something that seems improbable given how strong U.S. growth has been despite rising rates. Formal models of recession do not indicate an elevated risk currently (Chart 27). We continue to watch for the timing to move into higher-beta China-related markets as the effects of China’s stimulus start to come through. Even if growth is as strong as we forecast, is there a possibility that bond yields fall further. This could come about – for a while, at least – if the Fed is aggressively dovish, oil prices fall (perhaps because of a positive supply shock), inflation softens further, and global growth remains sluggish. Absent a recession, we find those outcomes unlikely. The copper-to-gold ratio has been a good indicator of U.S. bond yields (Chart 28). It suggests that, at 2%, the 10-year Treasury yield has slightly overshot. In fact, in June copper prices started to rebound, as the market began to price in growing Chinese demand. Chart 28Can Bond Yields Fall Any Further? Can Bond Yields Fall Any Further? Can Bond Yields Fall Any Further? Chart 29Are Analysts Right To Be So Gloomy? Are Analysts Right To Be So Gloomy? Are Analysts Right To Be So Gloomy?   For U.S. equities to rise much further, multiple expansion will not be enough; the earnings outlook needs to improve. Analysts are still cautious with their bottom-up forecasts, expecting only 3% EPS growth for the S&P500 this year (Chart 29). This seems easy to beat. But a combination of further dollar strength, worsening trade war, further slowdown in Europe and Emerging Markets, and higher U.S. wages would put it at risk. Footnotes 1 Please see What Our Clients Are Asking on page 9 of this Quarterly for further discussion on why we are confident China will ramp up stimulus if necessary. 2 Trimmed Mean PCE inflation, a better indicator of underlying inflation than the Core PCE deflator, is above 2%. Please see What Our Clients Are Asking on page 8 of this Quarterly for details. 3 Please see U.S. Bond Strategy Weekly Report, “Track Records,” dated June 18, available at usb.bcaresearch.com. 4 Please see Global Asset Allocation Special Report “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019 available at gaa.bcaresearch.com 5 Please see Global Asset Allocation Special Report “A Primer On Catastrophe Bonds,” dated December 12, 2017 available at gaa.bcaresearch.com   GAA Asset Allocation

Highlights We update our long-range forecasts of returns from a range of asset classes – equities, bonds, alternatives, and currencies – and make some refinements to the methodologies we used in our last report in November 2017. We add coverage of U.K., Australian, and Canadian assets, and include Emerging Markets debt, gold, and global Real Estate in our analysis for the first time. Generally, our forecasts are slightly higher than 18 months ago: we expect an annual return in nominal terms over the next 10-year years of 1.7% from global bonds, and 5.9% from global equities – up from 1.5% and 4.6% respectively in the last edition. Cheaper valuations in a number of equity markets, especially Japan, the euro zone, and Emerging Markets explain the higher return assumptions. Nonetheless, a balanced global portfolio is likely to return only 4.7% a year in the long run, compared to 6.3% over the past 20 years. That is lower than many investors are banking on. Feature Since we published our first attempt at projecting long-term returns for a range of asset classes in November 2017, clients have shown enormous interest in this work. They have also made numerous suggestions on how we could improve our methodologies and asked us to include additional asset classes. This Special Report updates the data, refines some of our assumptions, and adds coverage of U.K., Australian, and Canadian assets, as well as gold, global Real Estate, and global REITs. Our basic philosophy has not changed. Many of the methodologies are carried over from the November 2017 edition, and clients interested in more detailed explanations should also refer to that report.1 Our forecast time horizon is 10-15 years. We deliberately keep this vague, and avoid trying to forecast over a 3-7 year time horizon, as is common in many capital market assumptions reports. The reason is that we want to avoid predicting the timing and gravity of the next recession, but rather aim to forecast long-term trend growth irrespective of cycles. This type of analysis is, by nature, as much art as science. We start from the basis that historical returns, at least those from the past 10 or 20 years, are not very useful. Asset allocators should not use historical returns data in mean variance optimizers and other portfolio-construction models. For example, over the past 20 years global bonds have returned 5.3% a year. With many long-term government bonds currently yielding zero or less, it is mathematically almost impossible that returns will be this high over the coming decade or so. Our analysis points to a likely annual return from global bonds of only 1.7%. Our approach is based on building-blocks. There are some factors we know with a high degree of certainly: such as the return on U.S. 10-year Treasury yields over the next 10 years (to all intents and purposes, it is the current yield). Many fundamental drivers of return (credit spreads, the small-cap premium, the shape of the yield curve, profit margins, stock price multiples etc.) are either steady on average over the cycle, or mean revert. For less certain factors, such as economic growth, inflation, or equilibrium short-term interest rates, we can make sensible assumptions. Most of the analysis in this report is based on the 20-year history of these factors. We used 20 years because data is available for almost all the asset classes we cover for this length of time (there are some exceptions, for example corporate bond data for Australia and Emerging Markets go back only to 2004-5, and global REITs start only in 2008). The period from May 1999 to April 2019 is also reasonable since it covers two recessions and two expansions, and started at a point in the cycle that is arguably similar to where we are today. Some will argue that it includes the Technology bubble of 1999-2000, when stock valuations were high, and that we should use a longer period. But the lack of data for many assets classes before the 1990s (though admittedly not for equities) makes this problematic. Also, note that the historical returns data for the 20 years starting in May 1999 are quite low – 5.8% for U.S. equities, for example. This is because the starting-point was quite late in the cycle, as we probably also are now.   We make the following additions and refinements to our analysis: Add coverage of the U.K., Australia, and Canada for both fixed income and equities. Add coverage of Emerging Markets debt: U.S. dollar and local-currency sovereign bonds, and dollar-denominated corporate credit. Among alternative assets, add coverage of gold, global Direct Real Estate, and global REITs. Improve the methodology for many alt asset classes, shifting from reliance on historical returns to an approach based on building blocks – for example, current yield plus an estimation of future capital appreciation – similar to our analysis of other asset classes. In our discussion of currencies, add for easy reference of readers a table of assumed returns for all the main asset classes expressed in USD, EUR, JPY, GBP, AUD, and CAD (using our forecasts of long-run movements in these currencies). Added Sharpe ratios to our main table of assumptions. The summary of our results is shown in Table 1. The results are all average annual nominal total returns, in local currency terms (except for global indexes, which are in U.S. dollars). Table 1BCA Assumed Returns Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined Unsurprisingly, given the long-term nature of this exercise, our return projections have in general not moved much compared to those in November 2017. Indeed, markets look rather similar today to 18 months ago: the U.S. 10-year Treasury yield was 2.4% at end-April (our data cut-off point), compared to 2.3%, and the trailing PE for U.S. stocks 21.0, compared to 21.6. If anything, the overall assumption for a balanced portfolio (of 50% equities, 30% bonds, and 20% equal-weighted alts) has risen slightly compared to the 2017 edition: to 4.7% from 4.1% for a global portfolio, and to 4.9% from 4.6% for a purely U.S. one. That is partly because we include specific forecasts for the U.K., Australia, and Canada, where returns are expected to be slightly higher than for the markets we limited our forecasts to previously, the U.S, euro zone, Japan, and Emerging Markets (EM). Equity returns are also forecast to be higher than 18 months ago, mainly because several markets now are cheaper: trailing PE for Japan has fallen to 13.1x from 17.6x, for the euro zone to 15.5x from 18.0x, and for Emerging Markets to 13.6x from 15.4x (and more sophisticated valuation measures show the same trend). The long-term picture for global growth remains poor, based on our analysis, but valuation at the starting-point, as we have often argued, is a powerful indicator of future returns. We include Sharpe ratios in Table 1 for the first time. We calculate them as expected return/expected volatility to allow for comparison between different asset classes, rather than as excess return over cash/volatility as is strictly correct, and as should be used in mean variance optimizers. Chart 1Volatility Is Easier To Forecast Than Returns Volatility Is Easier To Forecast Than Returns Volatility Is Easier To Forecast Than Returns For volatility assumptions, we mostly use the 20-year average volatility of each asset class. As discussed above, historical returns should not be used to forecast future returns. But volatility does not trend much over the long-term (Chart 1). We looked carefully at volatility trends for all the asset classes we cover, but did not find a strong example of a trend decline or rise in any. We do, however, adjust the historic volatility of the illiquid, appraisal-based alternative assets, such as Private Equity, Real Estate, and Farmland. The reported volatility is too low, for example 2.6% in the case of U.S. Direct Real Estate. Even using statistical techniques to desmooth the return produces a volatility of only around 7%. We choose, therefore, to be conservative, and use the historic volatility on REITs (21%) and apply this to Direct Real Estate too. For Private Equity (historic volatility 5.9%), we use the volatility on U.S. listed small-cap stocks (18.6%). Looking at the forecast Sharpe ratios, the risk-adjusted return on global bonds (0.55) is somewhat higher than that of global equities (0.33). Credit continues to look better than equities: Sharpe ratio of 0.70 for U.S. investment grade debt and 0.62 for high-yield bonds. Nonetheless, our overall conclusion is that future returns are still likely to be below those of the past decade or two, and below many investors’ expectations. Over the past 20 years a global balanced portfolio (defined as above) returned 6.3% and a similar U.S. portfolio 7.0%. We expect 4.7% and 4.9% respectively in future. Investors working on the assumption of a 7-8% nominal return – as is typical among U.S. pension funds, for example – need to become realistic. Below follow detailed descriptions of how we came up with our assumptions for each asset class (fixed income, equities, and alternatives), followed by our forecasts of long-term currency movements, and a brief discussion of correlations. 1. Fixed Income We carry over from the previous edition our building-block approach to estimating returns from fixed income. One element we know with a relatively high degree of certainty is the return over the next 10 years from 10-year government bonds in developed economies: one can safely assume that it will be the same as the current 10-year yield. It is not mathematical identical, of course, since this calculation does not take into account reinvestment of coupons, or default risk, but it is a fair assumption. We can make some reasonable assumptions for returns from cash, based on likely inflation and the real equilibrium cash rate in different countries. After this, our methodology is to assume that other historic relationships (corporate bond spreads, default and recovery rates, the shape of the yield curve etc.) hold over the long run and that, therefore, the current level reverts to its historic mean. The results of our analysis, and the assumptions we use, are shown in Table 2. Full details of the methodology follow below. Table 2Fixed Income Return Calculations Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined Projected returns have not changed significantly from the 2017 edition of this report. In the U.S., for the current 10-year Treasury bond yield we used 2.4% (the three-month average to end-April), very similar to the 2.3% on which we based our analysis in 2017. In the euro zone and Japan, yields have fallen a little since then, with the 10-year German Bund now yielding roughly 0%, compared to 0.5% in 2017, and the Japanese Government Bond -0.1% compared to zero. Overall, we expect the Bloomberg Barclays Global Index to give an annual nominal return of 1.7% over the coming 10-15 years, slightly up from the assumption of 1.5% in the previous edition. This small rise is due to the slight increase in the U.S. long-term risk-free rate, and to the inclusion for the first time of specific estimates for returns in the U.K., Australia, and Canada. Fixed Income Methodologies Cash. We forecast the long-run rate on 3-month government bills by generating assumptions for inflation and the real equilibrium cash rate. For inflation, in most countries we use the 20-year average of CPI inflation, for example 2.2% in the U.S. and 1.7% in the euro zone. This suggests that both the Fed and the ECB will slightly miss their inflation targets on the downside over the coming decade (the Fed targets 2% PCE inflation, but the PCE measure is on average about 0.5% below CPI inflation). Of course, this assumes that the current inflation environment will continue. BCA’s view is that inflation risks are significantly higher than this, driven by structural factors such as demographics, populism, and the advent of ultra-unorthodox monetary policy.2 But we see this as an alternative scenario rather than one that we should use in our return assumptions for now. Japan’s inflation has averaged 0.1% over the past 20 years, but we used 1% on the grounds that the Bank of Japan (BoJ) should eventually see some success from its quantitative easing. For the equilibrium real rate we use the New York Fed’s calculation based on the Laubach-Williams model for the U.S., euro zone, U.K., and Canada. For Japan, we use the BoJ’s estimate, and for Australia (in the absence of an official forecast of the equilibrium rate) we take the average real cash rate over the past 20 years. Finally, we assume that the cash yield will move from its current level to the equilibrium over 10 years. Government Bonds. Using the 10-year bond yield as an anchor, we calculate the return for the government bond index by assuming that the spread between 7- and 10-year bonds, and between 3-month bills and 10-year bonds will average the same over the next 10 years as over the past 20. While the shape of the yield curve swings around significantly over the cycle, there is no sign that is has trended in either direction (Chart 2). The average maturity of government bonds included in the index varies between countries: we use the five-year historic average for each, for example, 5.8 years for the U.S., and 10.2 years for Japan. Spread Product. Like government bonds, spreads and default rates are highly cyclical, but fairly stable in the long run (Chart 3). We use the 20-year average of these to derive the returns for investment-grade bonds, high-yield (HY) bonds, government-related securities (e.g. bonds issued by state-owned entities, or provincial governments), and securitized bonds (e.g. asset-backed or mortgage-backed securities). For example, for U.S. high-yield we use the average spread of 550 basis points over Treasuries, default rate of 3.8%, and recovery rate of 45%. For many countries, default and recovery rates are not available and so we, for example, use the data from the U.S. (but local spreads) to calculate the return for high-yield bonds in the euro zone and the U.K. Inflation-Linked Bonds. We use the average yield over the past 10 years (not 20, since for many countries data does not go back that far and, moreover, TIPs and their equivalents have been widely used for only a relatively short period.) We calculate the return as the average real yield plus forecast inflation. Chart 2Yield Curves Yield Curves Yield Curves Chart 3Credit Spreads & Default Rates Credit Spreads & Defaykt Rates Credit Spreads & Defaykt Rates     Bloomberg Barclays Aggregate Bond Indexes. We use the weights of each category and country (from among those we forecast) to derive the likely return from the index. The composition of each country’s index varies widely: for example, in the euro zone (27% of the global bond index), government bonds comprise 66% of the index, but in the U.S. only 37%. Only the U.S. and Canada have significant weightings in corporate bonds: 29% and 50% respectively. This can influence the overall return for each country’s index. Table 3Emerging Market Debt Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined Emerging Market Debt. We add coverage of EMD: sovereign bonds in both local currency and U.S. dollars, and USD-denominated EM corporate debt. Again, we take the 20-year average spread over 10-year U.S. Treasuries for each category. A detailed history of default and recovery is not available, so for EM corporate debt we assume similar rates to those for U.S. HY bonds. For sovereign bonds, we make a simple assumption of 0.5% of losses per year – although in practice this is likely to be very lumpy, with few defaults for years, followed by a rush during an EM crisis. For EM local currency debt, we assume that EM currencies will depreciate on average each year in line with the difference between U.S. inflation and EM inflation (using the IMF forecast for both – please see the Currency section below for further discussion on this). After these calculations, we conclude that EM USD sovereign bonds will produce an annual return of 4.7%, and EM USD corporate bonds 4.5% – in both cases a little below the 5.6% return assumption we have for U.S. high-yield debt (Table 3).   2. Equities Our equity methodologies are largely unchanged from the previous edition. We continue to use the return forecast from six different methodologies to produce an average assumed return. Table 4 shows the results and a summary of the calculation for each methodology. The explanation for the six methodologies follows below. Table 4Equity Return Calculations Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined The results suggest slightly higher returns than our projections in 2017. We forecast global equities to produce a nominal annual total return in USD of 5.9%, compared to 4.6% previously. The difference is partly due to the inclusion for the first time of specific forecasts for the U.K., Australia and Canada, which are projected to see 8.0%, 7.4% and 6.0% returns respectively. The projection for the U.S. is fairly similar to 2017, rising slightly to 5.6% from 5.0% (mainly due to a slightly higher assumption for productivity growth in future, which boosts the nominal GDP growth assumption). Japan, however, does come out looking significantly more attractive than previously, with an assumed return of 6.2%, compared to 3.5% previously. This is mostly due to cheaper valuations, since the growth outlook has not improved meaningfully. Japan now trades on a trailing PE of 13.1x, compared to 17.6x in 2017. This helps improve the return indicated by a number of the methodologies, including earnings yield and Shiller PE. The forecast for euro zone equities remains stable at 4.7%. EM assumptions range more widely, depending on the methodology used, than do those for DM. On valuation-based measures (Shiller PE, earnings yield etc.), EM generally shows strong return assumptions. However, on a growth-based model it looks less attractive. We continue to use two different assumptions for GDP growth in EM. Growth Model (1) is based on structural reform taking place in Emerging Markets, which would allow productivity growth to rebound from its current level of 3.2% to the 20-year average of 4.1%; Growth Model (2) assumes no reform and that productivity growth will continue to decline, converging with the DM average, 1.1%, over the next 10 years. In both cases, the return assumption is dragged down by net issuance, which we assume will continue at the 10-year average of 4.9% a year. Our composite projection for EM equity returns (in local currencies) comes out at 6.6%, a touch higher than 6.0% in 2017. Equity Methodologies Equity Risk Premium (ERP). This is the simplest methodology, based on the concept that equities in the long run outperform the long-term risk-free rate (we use the 10-year U.S. Treasury yield) by a margin that is fairly stable over time. We continue to use 3.5% as the ERP for the U.S., based on analysis by Dimson, Marsh and Staunton of the average ERP for developed markets since 1900. We have, however, tweaked the methodology this time to take into account the differing volatility of equity markets, which should translate into higher returns over time. Thus we use a beta of 1.2 for the euro zone, 0.8 for Japan, 0.9 for the U.K., 1.1 for both Australia and Canada, and 1.3 for Emerging Markets. The long-term picture for global growth remains poor, but valuation at the starting-point, as we have often argued, is a powerful indicator of future returns. Growth Model. This is based on a Gordon growth model framework that postulates that equity returns are a function of dividend yield at the starting point, plus the growth of earnings in future (we assume that the dividend payout ratio stays constant). We base earnings growth off assumptions of nominal GDP growth (see Box 1 for how we calculate these). But historically there is strong evidence that large listed company earnings underperform nominal GDP growth by around 1 percentage point a year (largely because small, unlisted companies tend to show stronger growth than the mature companies that dominate the index) and so we deduct this 1% to reach the earnings growth forecast. We also need to adjust dividend yield for share buybacks which in the U.S., for tax reasons, have added 0.5% to shareholder returns over the past 10 years (net of new share issuance). In other countries, however, equity issuance is significantly larger than buybacks; this directly impacts shareholders’ returns via dilution. For developed markets, the impact of net equity issuance deducts 0.7%-2.7% from shareholder returns annually. But the impact is much bigger in Emerging Markets, where dilution has reduced returns by an average of 4.9% over the past 10 years. Table 5 shows that China is by far the biggest culprit, especially Chinese banks. Table 5Dilution In Emerging Markets Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined BOX 1 Estimating GDP Growth We estimate nominal GDP growth for the countries and regions in our analysis as the sum of: annual growth in the working-age population, productivity growth, and inflation (we assume that capital deepening remains stable over the period). Results are shown in Table 6. Table 6Calculations Of Trend GDP Growth Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined For population growth, we use the United Nations’ median scenario for annual growth in the population aged 25-64 between 2015 and 2030. This shows that the euro zone and Japan will see significant declines in the working population. The U.S. and U.K. look slightly better, with the working population projected to grow by 0.3% and 0.1% respectively. There are some uncertainties in these estimates. Stricter immigration policies would reduce the growth. Conversely, greater female participation, a later retirement age, longer working hours, or a rise in the participation rate would increase it. For emerging markets we used the UN estimate for “less developed regions, excluding least developed countries”. These countries have, on average, better demographics. However, the average number hides the decline in the working-age population in a number of important EM countries, for example China (where the working-age population is set to shrink by 0.2% a year), Korea (-0.4%), and Russia (-1.1%). By contrast, working population will grow by 1.7% a year in Mexico and 1.6% in India. For productivity growth, we assume – perhaps somewhat optimistically – that the decline in productivity since the Global Financial Crisis will reverse and that each country will return to the average annual productivity growth of the past 20 years (Chart 4). Our argument is that the cyclical factors that depressed productivity since the GFC (for example, companies’ reluctance to spend on capex, and shareholders’ preference for companies to pay out profits rather than to invest) should eventually fade, and that structural and technical factors (tight labor markets, increasing automation, technological breakthroughs in fields such as artificial intelligence, big data, and robotics) should boost productivity. Based on this assumption, U.S. productivity growth would average 2.0% over the next 10-15 years, compared to 0.5% since 1999. Note that this is a little higher than the Congressional Budgetary Office’s assumption for labor productivity growth of 1.8% a year. Chart 4AProductivity Growth (I) Productivity Growth (I) Productivity Growth (I) Chart 4BProductivity Growth (II) Productivity Growth (II) Productivity Growth (II) Our assumptions for inflation are as described above in the section on Fixed Income. The overall results suggest that Japan will see the lowest nominal GDP growth, at 0.9% a year, with the U.S. growing at 4.4%. The U.K. and Australia come out only a little lower than the U.S. For emerging markets, as described in the main text, we use two scenarios: one where productivity grow continues to slow in the absence of reforms, especially in China, from the current 3.2% to converge with the average in DM (1.1%) over the next 10-15 years; and an alternative scenario where reforms boost productivity back to the 20-year average of 4.1%.   Growth Plus Reversion To Mean For Margins And Profits. There is logic in arguing that profit margins and multiples tend to revert to the mean over the long term. If margins are particularly high currently, profit growth will be significantly lower than the above methodology would suggest; multiple contraction would also lower returns. Here we add to the Growth Model above an assumption that net profit margin and trailing PE will steadily revert to the 20-year average for each country over the 10-15 years. For most countries, margins are quite high currently compared to history: 9.2% in the U.S., for example, compared to a 20-year average of 7.7%. Multiples, however, are not especially high. Even in the U.S. the trailing PE of 21.0x, compares to a 20-year average of 20.8x (although that admittedly is skewed by the ultra-high valuations in 1999-2000, and coming out of the 2007-9 recession – we would get a rather lower number if we used the 40-year average). Indeed, in all the other countries and regions, the PE is currently lower than the 20-year average. Note that for Japan, we assumed that the PE would revert to the 20-year average of the U.S. and the euro zone (19.2), rather than that of Japan itself (distorted by long periods of negative earnings, and periods of PE above 50x in the 1990s and 2000s).  Earnings Yield. This is intuitively a neat way of thinking about future returns. Investors are rewarded for owning equity, either by the company paying a dividend, or by reinvesting its earnings and paying a dividend in future. If one assumes that future return on capital will be similar to ROC today (admittedly a rash assumption in the case of fast-growing companies which might be tempted to invest too aggressively in the belief that they can continue to generate rapid growth) it should be immaterial to the investor which the company chooses. Historically, there has been a strong correlation between the earnings yield (the inverse of the trailing PE) and subsequent equity returns, although in the past two decades the return has been somewhat higher that the EY suggested, and so in future might be somewhat lower. This methodology produces an assumed return for U.S. equities of 4.8% a year. Shiller PE. BCA’s longstanding view is that valuation is not a good timing tool for equity investment, but that it is crucial to forecasting long-term returns. Chart 5 shows that there is a good correlation in most markets between the Shiller PE (current share price divided by 10-year average inflation-adjusted earnings) and subsequent 10-year equity returns. We use a regression of these two series to derive the assumptions. This points to returns ranging from 5.4% in the case of the U.S. to 12.5% for the U.K. Composite Valuation Indicator. There are some issues that make the Shiller PE problematical. It uses a fixed 10-year period, whereas cycles vary in length. It tends to make countries look cheap when they have experienced a trend decline in earnings (which may continue, and not mean revert) and vice versa. So we also use a proprietary valuation indicator comprising a range of standard parameters (including price/book, price/cash, market cap/GDP, Tobin’s Q etc.), and regress this against 10-year returns. The results are generally similar to those using the Shiller PE, except that Japan shows significantly higher assumed returns, and the U.K. and EM significantly lower ones (Chart 6). Chart 5Shiller PE Vs. 10-Year Return Shiller PE Vs. 10-Year Return Shiller PE Vs. 10-Year Return Chart 6Composite Valuation Vs. 10-Year Return Composite Valuation Vs. 10-Year Return Composite Valuation Vs. 10-Year Return     3. Alternative Investments We continue to forecast each illiquid alternative investment separately, but we have made a number of changes to our methodologies. Mostly these involve moving away from using historical returns as a basis for our forecasts, and shifting to an approach based on current yield plus projected future capital appreciation. In direct real estate, for example, in 2017 we relied on a regression of historical returns against U.S. nominal GDP growth. We move in this edition to an approach based on the current cap rate, plus capital appreciation (based on forecasts of nominal GDP growth), and taking into account maintenance costs (details below). We also add coverage of some additional asset classes: global ex-U.S. direct real estate, global ex-U.S. REITs, and gold. Table 7 summarizes our assumptions, and provides details of historic returns and volatility. Table 7Alternatives Return Calculations Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined It is worth emphasizing here that manager selection is far more important for many alternative investment classes than it is for public securities (Chart 7). There is likely to be, therefore, much greater dispersion of returns around our assumptions than would be the case for, say, large-cap U.S. equities. Chart 7For Alts, Manager Selection Is Key For Alts, Manager Selection Is Key For Alts, Manager Selection Is Key Hedge Funds Chart 8Hedge Fund Return Over Cash Hedge Fund Return Over Cash Hedge Fund Return Over Cash Hedge fund returns have trended down over time (Chart 8). Long gone is the period when hedge funds returned over 20% per year (as they did in the early 1990s). Over the past 10 years, the Composite Hedge Fund Index has returned annually 3.3% more than 3-month U.S. Treasury bills. But that was entirely during an economic expansion and so we think it is prudent to cut last edition’s assumption of future returns of cash-plus-3.5%, to cash-plus-3% going forward. Direct Real Estate Our new methodology for real estate breaks down the return, in a similar way to equities, into the current cash yield (cap rate) plus an assumption of future capital growth. For the cap rate, we use the average, weighted by transaction volumes, of the cap rates for apartments, office buildings, retail, industrial real estate, and hotels in major cities (for example, Chicago, Los Angeles, Manhattan, and San Francisco for the U.S., or Osaka and Tokyo for Japan). We assume that capital values grow in line with each’s country’s nominal GDP growth (using the IMF’s five-year forecasts for this). We deduct a 0.5% annual charge for maintenance, in line with industry practice. Results are shown in Table 8. Our assumptions point to better returns from real estate in the U.S. than in the rest of the world. Not only is the cap rate in the U.S. higher, but nominal GDP growth is projected to be higher too. Table 8Direct Real Estate Return Calculations Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined REITs We switch to a similar approach for REITs. Previously we used a regression of REITs against U.S. equity returns (since REITs tend to be more closely correlated with equities than with direct real estate). This produced a rather high assumption for U.S. REITs of 10.1%. We now use the current dividend yield on REITs plus an assumption that capital values will grow in line with nominal GDP growth forecasts. REITs’ dividend yields range fairly narrowly from 2.9% in Japan to 4.7% in Canada. We do not exclude maintenance costs since these should already be subtracted from dividends. The result of using this methodology is that the assumed return for U.S. REITs falls to a more plausible 8.5%, and for global REITs is 6.2%. Private Equity & Venture Capital Chart 9Private Equity Premium Has Shrunk Around Private Equity Premium Has Shrunk Around Private Equity Premium Has Shrunk Around It makes sense that Private Equity returns are correlated with returns from listed equities. Most academic studies have shown a premium over time for PE of 5-6 percentage points (due to leverage, a tilt towards small-cap stocks, management intervention, and other factors). However, this premium has swung around dramatically over time (Chart 9). Over the past 10 years, for example, annual returns from Private Equity and listed U.S. equities have been identical: 12%. However, there appears to be no constant downtrend and so we think it advisable to use the 30-year average premium: 3.4%. This produces a return assumption for U.S. Private Equity of 8.9% per year. Over the same period, Venture Capital has returned around 0.5% more than PE (albeit with much higher volatility) and we assume the same will happen going forward.   Structured Products In the context of alternative asset classes, Structured Products refers to mortgage-backed and other asset-backed securities. We use the projected return on U.S. Treasuries plus the average 20-year spread of 60 basis points. Assumed return is 2.7%. Farmland & Timberland Chart 10Farm Prices Grow More Slowly Than GDP Farm Prices Grow More Slowly Than GDP Farm Prices Grow More Slowly Than GDP As with Real Estate and REITs, we move to a methodology using current cash yield (after costs) plus an assumption for capital appreciation linked to nominal GDP forecasts. The yield on U.S. Farmland is currently 4.4% and on Timberland 3.2%. Both have seen long-run prices grow significantly more slowly than nominal GDP growth. Since 1980, for example, farm prices have risen at a compound rate of 3.9% per acre, compared to U.S. nominal GDP growth of 5.2% and global GDP growth of 5.5% (Chart 10). We assume that this trend will continue, and so project farm prices to grow 1.5 percentage points a year more slowly than global GDP (using global, not U.S., economic growth makes sense since demand for food is driven by global factors). This produces a total return assumption of 6%. For timberland, we did not find a consistent relationship with nominal GDP growth and so assumed that prices would continue to grow at their historic rate over the past 20 years (the longest period for which data is available). We project timberland to produce an annual return of 4.8%. Commodities & Gold For commodities we use a very different methodology (which we also used in the previous edition): the concept that commodities prices consistently over time have gone through supercycles, lasting around 10 years, followed by bear markets that have lasted an average of 17 years (Chart 11). The most recent super-cycle was 2002-2012. In the period since the supercycle ended, the CRB Index has fallen by 42%. Comparing that to the average drop in the past three bear markets, we conclude that there is about 8% left to fall over the next nine years, implying an annual decline of about 1%. Our overall conclusion is that future returns are still likely to be below those of the past decade or two, and below many investors’ expectations. We add gold to our assumptions, since it is an asset often held by investors. However, it is not easy to project long-term returns for the metal. Since the U.S. dollar was depegged from gold in 1968, gold too has gone through supercycles, in the 1970s and 2002-11 (Chart 12). We find that change in real long-term interest rates negatively affects gold (logically since higher rates increase the opportunity cost of owning a non-income-generating asset). We use, therefore, a regression incorporating global nominal GDP growth and a projection of the annual change in real 10-year U.S. Treasury yields (based on the equilibrium cash rate plus the average spread between 10-year yields and cash). This produces an assumption of an annual return from gold of 4.7% a year. We continue to see this asset class more as a hedge in a portfolio (it has historically had a correlation of only 0.1 with global equities and 0.24 with global bonds) rather than a source of return per se.  Chart 11Commodities Still In A Bear Market Commodities Still In A Bear Market Commodities Still In A Bear Market Chart 12Gold Also Has Supercycles Gold Also Has Supercycles Gold Also Has Supercycles   4. Currencies Chart 13Currencies Tend To Revert To PPP Currencies Tend To Revert To PPP Currencies Tend To Revert To PPP All the return projections in this report are in local currency terms. That is a problem for investors who need an assumption for returns in their home currency. It is also close to impossible to hedge FX exposure over as long a period as 10-15 years. Even for investors capable of putting in place rolling currency hedges, GAA has shown previously that the optimal hedge ratio varies enormously depending on the home currency, and that dynamic hedges (i.e. using a simple currency forecasting model) produce better risk-adjust returns than a static hedge.3  Fortunately, there is an answer: it turns out that long-term currency forecasting is relatively easy due to the consistent tendency of currencies, in developed economies at least, to revert to Purchasing Power Parity (PPP) over the long-run, even though they can diverge from it for periods as long as five years or more (Chart 13). We calculate likely currency movements relative to the U.S. dollar based on: 1) the current divergence of the currency from PPP, using IMF estimates of the latter; 2) the likely change in PPP over the next 10 years, based on inflation differentials between the country and the U.S. going forward (using IMF estimates of average CPI inflation for 2019-2024 and assuming the same for the rest of the period). The results are shown in Table 9. All DM currencies, except the Australian dollar, look cheap relative to the U.S. dollar, and all of them, again excluding Australia, are forecast to run lower inflation that the U.S. implying that their PPPs will rise further. This means that both the euro and Japanese yen would be expected to appreciate by a little more than 1% a year against the U.S. dollar over the next 10 years or so. Table 9Currency Return Calculations Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined PPP does not work, however, for EM currencies. They are all very cheap relative to PPP, but show no clear trend of moving towards it. The example of Japan in the 1970s and 1980s suggests that reversion to PPP happens only when an economy becomes fully developed (and is pressured by trading partners to allow its currency to appreciate). One could imagine that happening to China over the next 10-20 years, but the RMB is currently 48% undervalued relative to PPP, not so different from its undervaluation 15 years ago. For EM currencies, therefore, we use a different methodology: a regression of inflation relative to the U.S. against historic currency movements. This implies that EM currencies are driven by the relative inflation, but that they do not trend towards PPP. Based on IMF inflation forecasts, many Emerging Markets are expected to experience higher inflation than the U.S. (Table 10). On this basis, the Turkish lira would be expected to decline by 7% a year against the U.S. dollar and the Brazilian real by 2% a year. However, the average for EM, which we calculated based on weights in the MSCI EM equity index, is pulled down by China (29% of that index), Korea (15%) and Taiwan (12%). China’s inflation is forecast to be barely above that in the U.S, and Korean and Taiwanese inflation significantly below it. MSCI-weighted EM currencies, consequently, are forecast to move roughly in line with the USD over the forecast horizon. One warning, though: the IMF’s inflation forecasts in some Emerging Markets look rather optimistic compared to history: will Mexico, for example, see only 3.2% inflation in future, compared to an average of 5.7% over the past 20 years? Higher inflation than the IMF forecasts would translate into weaker currency performance. Table 10EM Currencies Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined In Table 11, we have restated the main return assumptions from this report in USD, EUR, JPY, GBP, AUD, and CAD terms for the convenience of clients with different home currencies. As one would expect from covered interest-rate parity theory, the returns cluster more closely together when expressed in the individual currencies. For example, U.S. government bonds are expected to return only 0.8% a year in EUR terms (versus 2.1% in USD terms) bringing their return closer to that expected from euro zone government bonds, -0.4%. Convergence to PPP does not, however, explain all the difference between the yields in different countries. Table 11Returns In Different Base Currencies Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined 5. Correlations Chart 14Correlations Are Hard To Forecast Correlations Are Hard To Forecast Correlations Are Hard To Forecast We have not tried to forecast correlations in this Special Report. As discussed, historical returns from different asset classes are not a reliable guide to future returns, but it is possible to come up with sensible assumptions about the likely long-run returns going forward. Volatility does not trend much over the long term, so we think it is not unreasonable to use historic volatility data in an optimizer. But correlation is a different matter. As is well known, the correlation of equities and bonds has moved from positive to negative over the past 40 years (mainly driven by a shift in the inflation environment). But the correlation between major equity markets has also swung around (Chart 14). Asset allocators should preferably use rough, conservative assumptions for correlations – for example, 0.1 or 0.2 for the equity/bond correlation, rather than the average -0.1 of the past 20 years. We plan to do further work to forecast correlations in a future edition of this report.  But for readers who would like to see – and perhaps use – historic correlation data, we publish below a simplified correlation matrix of the main asset classes that we cover in this report (Table 12). We would be happy to provide any client with the full spreadsheet of all asset classes . Table 12Correlation Matrix Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1      Please see Global Asset Allocation Special Report, “What Returns Can You Expect?”, dated 15 November 2017, available at gaa.bcaresearch.com 2      Please see Global Asset Allocation Special Report, “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated 22 May 2019, available at gaa.bcaresearch.com 3      Please see GAA Special Report, “Currency Hedging: Dynamic Or Static? A Practical Guide For Global Equity Investors,” dated 29 September 2017, available at gaa.bcaresearch.com  

Highlights MLPs’ one-of-a-kind legal structure offers investors gaudy distribution yields and tax-saving advantages. They boomed alongside fracking, enjoying spectacular growth between 2009 and 2014. MLPs used to exhibit a high correlation with utilities, but since the 2014 oil bust, they have performed in step with the rest of the energy sector. Improved valuations have recently put MLPs back on investors’ radar. However, structural impediments and heterogeneous balance-sheet quality argue against broad index exposure. Investors would be better served by concentrating their efforts on picking individual stocks. Opportunities reside within smaller-cap MLPs and MLPs exposed to the Permian basin. Feature Dear Client, In place of a Weekly Report written from South Africa, where I have been meeting with clients, we are sending you this Special Report on Master Limited Partnerships (MLPs), written by my colleague Jennifer Lacombe.* Like mortgage REITs, which U.S. Investment Strategy followed from 2011 to 2013, MLPs are a yield play that investors might find to be an appealing bond alternative. We trust that you will find this report interesting and informative. Best regards, Doug Peta, Senior Vice President U.S. Investment Strategy * This report was initially published by our Global ETF Strategy service on November 15, 2018. It has been lightly revised to update charts and reflect subsequent market developments.   Q: What are MLPs and their tax benefits? Master Limited Partnerships (MLPs) are publicly listed partnerships involving two classes of partners. A General Partner (GP) controls the assets and manages the daily operations of the business. Limited Partners (LPs) - and public investors - provide the capital and collect cash flow distributions. Unlike corporations, which pay corporate taxes on their income, MLPs have the ability to pass through all of their income to their owners, along with deductible items like amortization and depreciation expenses. MLP investors, in turn pay income tax at their own individual marginal tax rates. MLP owners are thereby shielded from the double taxation that would otherwise apply when the corporation paid taxes on its income, and the shareholder paid taxes on the dividend distributed from the corporation’s income. Q: Why are they predominantly found in the energy sector? Concerns about the potential loss of federal income led Congress to limit MLP eligibility to companies in the energy and real estate sectors when it overhauled the tax code in 1986. Since the 1986 Act took effect, MLPs have had to generate at least 90% of “qualifying income” from their energy or real estate operations. Section 7704 of the Internal Revenue Code defines “qualifying income” as income derived from exploration, development, mining or production, processing, refining, transportation or marketing of any mineral or natural resource, as well as certain passive-type income including interest, dividends and real property rents. Over the years, the shale revolution and the rise of new technologies, such as horizontal drilling and fracturing, created elevated demand for energy infrastructure. Today, MLPs almost exclusively operate in the natural resources space (Chart 1). Chart 1 Q: Why did MLPs outperform assets of all stripes following the Great Financial Crisis? A combination of several factors led MLPs to record stunning returns between 2009 and 2014. The Alerian MLP Total Return Index grew by a whopping annualized rate of 38% during that time. Decreasing interest-rate environments are typically supportive of yield plays’ outperformance. Powered by high single-digit to double-digit distribution yields, MLPs led Treasuries, utilities stocks, high-yield bonds and even the S&P 500 over that six-year stretch (Chart 2). With the shale revolution in full swing, sustaining strong demand for pipelines and other energy infrastructure, investors’ funds flowed abundantly into the energy MLP space (Chart 3). Prices - a mathematical function of multiples and earnings - soared as money kept pouring in and P/E tripled in the first 7 years following the Great Financial Crisis (Chart 4). Chart 2Decreasing Interest Rates Are A Boon To Yield Plays Decreasing Interest Rates Are A Boon To Yield Plays Decreasing Interest Rates Are A Boon To Yield Plays   Chart 3Horizontal Drilling Attracted A Lot Of Money... Horizontal Drilling Attracted A Lot Of Money... Horizontal Drilling Attracted A Lot Of Money...   Chart 4...Sending Multiples Soaring ...Sending Multiples Soaring ...Sending Multiples Soaring Q: Why has such outperformance not attracted more institutional and foreign investors? Because of U.S. tax rules, MLPs are relatively unattractive to tax-exempt investors and non-U.S. investors. The tax rule for U.S. tax-exempt investors – institutional investors such as pension funds, university endowments, charities and IRAs – treats MLP earnings as unrelated business taxable income (UBTI), making them subject to income tax. Moreover, to retain their own pass-through status and tax shield, open-ended funds – like many mutual funds and ETFs – can allocate no more than 25% of their total holdings to MLPs, and no more than 10% to a single MLP. U.S. tax rules consider foreign owners of MLPs to be engaged in a business in the U.S., and require them to file and pay U.S. federal income tax. Therefore, only U.S. individuals can truly reap the full benefits of the MLP structure. Though they easily access these securities on public exchanges, the tax shield comes at the price of convoluted accounting treatments. Unitholders receive Schedule K-1 tax forms that can be complicated enough to result in significant accounting costs. They are most suited for high net worth investors’ portfolios, although smaller investors who are not daunted by accounting burdens have also embraced the vehicle. Q: Why are MLP yields so high? The typical MLP partnership agreement incentivizes a GP to distribute all available cash to unitholders, after retaining reserves for business operations and liabilities. Not only does the corporate tax exemption increase the amount of available cash, but the General Partner also has wide discretion over the amount of retained reserves. Because distributions are the main determinant of any yield play’s performance, GPs have historically emphasized distribution yields – sometimes at the expense of retained earnings. The more assurance investors have that they will receive reliable cash flows, the better the MLP will perform in the market. Q: Do MLPs trade like other bond proxies? The distribution model worked beautifully during the shale-oil boom. Low retained reserves never became an issue because MLPs collected steady revenues – a function of prices and volumes of oil or gas processed - and could fund distributions in excess of operating cash flow by issuing new debt or equity. Investors were so eager to invest that GPs found themselves at the controls of a positive feedback loop in which the more cash they distributed to investors, the more capital flowed in to fund even higher distributions. The infrastructure-heavy business model and high payout ratios echoed companies in the utilities sector and, indeed, MLP returns correlated strongly with utilities stocks. However, the discretion embedded in the MLP model reached a breaking point soon after the oil bust arrived in mid-2014. The price-led decline in revenues necessitated distribution cuts and severed the correlation with utilities (Chart 5). Chart 5A Utilities Proxy No More... A Utilities Proxy No More... A Utilities Proxy No More... Q: Were MLPs immune to energy price swings before the 2014 bust? Conventional investor wisdom maintains that MLPs are immune to commodity price swings in the aggregate because of their utility-like characteristics and because long-term contracts lock in selling prices. Actually, however, MLP revenue structures differ greatly from one line of activity to the other. Natural gas pipeline transportation accounts for a quarter of aggregate MLP activity. Prices per unit of volume transited are contractually locked in 5-to-20-year contracts, providing immunity to spot price moves during the entire duration of the contract. Storage (natural gas not immediately needed, or crude oil waiting to be refined) accounts for another quarter of aggregate activity and is subject to a similar pricing model as natural gas pipelines. Only the contract lengths are much shorter, ranging from 1 to 5 years. Petroleum pipeline transportation accounts for 44% of MLP activity. Contracts locking prices over the long run are not typical in this line of business. The Federal Energy Regulatory Commission (FERC) also imposes a yearly price increase amounting to the Producer Price Index for Finished Goods, plus a 1.23% adjustment. MLP revenue structures are therefore varied, and only natural gas pipeline transportation’s revenue streams - a quarter of the sector – are truly immune to fluctuations in spot prices, thanks to their long-term contracts. It follows that MLPs in aggregate are indeed correlated with energy price swings and trade closely in line with energy stocks (Chart 6). Chart 6...An Energy Proxy Instead ...An Energy Proxy Instead ...An Energy Proxy Instead Up until recently, their correlation to spot oil prices in particular was even more striking. However, they failed to match the 2017-18 recovery in oil markets (Chart 8). Because cash flow reliability is a key driver of the investment decision for any yield play, distribution cuts are bound to make any MLP investors skittish, and oil prices may have to enter an extended bull market before they overcome their fears (Chart 7). Chart 7   Chart 8...Kept MLPs Depressed In Spite Of Oil Price Recovery ...Kept MLPs Depressed In Spite Of Oil Price Recovery ...Kept MLPs Depressed In Spite Of Oil Price Recovery Q: So, how cheap are they now? Since its peak in the summer of 2014, the Alerian MLP Total Return index has declined by 38% and is now flirting with the two-standard-deviation-cheap zone (Chart 9). Their profit margins have also strongly recovered (Chart 10). Chart 9Cheap Valuations... Cheap Valuations... Cheap Valuations...   Chart 10...Amid Recovering Profit Margins ...Amid Recovering Profit Margins ...Amid Recovering Profit Margins Because of the infrastructure-heavy nature of MLPs, traditional valuation metrics such as price-to-earnings can be misleading. High depreciation charges have significant impacts on earnings. Cash flows are an appropriate measure as they best inform a firm’s ability to maintain its distributions. Q: Great! So which ETF should I buy? The Alerian MLP index’s low multiples and recovering profit margins are not sufficient endorsements in themselves. An index is not an investible vehicle and even the best of index-tracking instruments can only imperfectly replicate an exposure. In the MLP space in particular, structural impediments reduce the attractiveness of exchange-traded products. Because ETFs are subject to the previously mentioned 25% cap on MLP holdings, many supplement their portfolios with regular pipeline or infrastructure stocks. Although the overall fund provides a decent exposure to the energy infrastructure sector, the diluted MLP exposure does not offer distribution yields anywhere comparable to the yields direct MLP owners receive. An alternative is to opt for a C-corporation structure. The flagship Alerian MLP ETF (ticker: AMLP) falls into this category. This structure allows for an undiluted exposure to MLPs, all the while relieving an ETF shareholder from having to deal with the complicated and costly accounting treatment that direct MLP ownership involves. However, C-corporations are subject to corporate income taxes, which cancels out the tax benefits of investing in MLPs in the first place. The resulting cumulative tax drag on returns can become substantial over time (Chart 11). Chart 11 Investors seek MLP exposure for the high distribution yields made possible by tax advantages. A fund will indeed provide diversification and accounting relief, but at the cost of surrendering either some yield or some of the tax advantages. This is not to mention that the bulk of the exchange-traded vehicles are Exchange Traded Notes (ETNs). Unlike ETFs, they do not own any underlying shares or units of securities. Instead, they are instruments issued and backed by financial institutions. Even in the case of well-established lending institutions, we shy away from these types of products, as we are not keen on taking unnecessary counterparty risk. Many MLP exchange-traded products are also illiquid, or have not gathered a significant mass of assets under management. The expense ratios are also high in the MLP exchange-traded product space, a result of the complicated accounting treatment of K-1 forms that are borne by the ETF or ETN sponsor (Table 1). Table 1ETNs Constitute Two Thirds Of A Relatively Illiquid Universe MLPs: Not Your Typical Yield Play MLPs: Not Your Typical Yield Play Q: What about the flagship Alerian MLP ETF? It’s clearly well-established. The flagship Alerian MLP ETF (ticker: AMLP) tracks the Alerian MLP Infrastructure Index and has gathered close to USD 10bn of AUM under its belt since its inception in 2010. Amid all the above limitations, it is the only viable option. However, it comes with its own set of yellow flags. Because it tracks a market-capitalization weighted index, half of the fund’s assets under management are concentrated in its five largest holdings. As we go to press, these are Magellan Midstream Partners LP, Enterprise Products Partners LP, Energy Transfer LP, Plains All American Pipeline LP and MPLX LP. These companies’ distribution yields have recovered since the 2014 oil crash, but the question of the sustainability of these cash flows is of utmost importance. Although retained earnings are at all-time highs, so is the level of debt (Chart 12). The fact that 50% of the fund is concentrated in these top 5 constituents dilutes the diversification benefits of index investing. Chart 12Distributions Are Financed By Cash Flows...And A Lot Of Debt Distributions Are Financed By Cash Flows...And A Lot Of Debt Distributions Are Financed By Cash Flows...And A Lot Of Debt Q: So, what are my options? The MLP universe is heterogeneous. Wide disparity in valuation (Chart 13), debt levels (Chart 14) and performance (Chart 15) indicate that opportunities reside further down the capitalization scale. Chart 13   Chart 14   Chart 15 Because an index is a weighted average, a heterogeneous market does not warrant broad-index exposure, especially when the smallest constituents offer the best opportunities. Amalgamation is always a process of blending wheat and chaff together, but in this case it disproportionately favors the chaff. Stock picking thrives against this backdrop. Our expertise does not extend to evaluating individual energy MLPs. We leave the honor of recommending the best-in-class opportunities to the professional bottom-up analysts, backed by thorough and diligent review of company fundamentals and management capabilities. Where we can add value is in the analysis of economic cycles and secular macroeconomic forces. Despite the sharp fall in prices over the past two months, brought about by the surprise eleventh-hour waivers granted to Iranian oil importers, BCA’s Commodity & Energy Strategy service believes the global oil market remains tight. Our strategists expect that oil prices will recover in 2019 as OPEC producers, Russia, and Canada reduce output by an aggregate 1.4 million barrels a day, and the Iran-driven supply glut is worked off. While a 2019 oil spike would be a tailwind to petroleum pipeline MLPs, surging production in U.S. shales – led by the Permian Basin in West Texas – means the new pipeline capacity being built to accommodate higher output will find a ready market. Regardless of what happens with prices, our energy strategists foresee a localized surge in demand for transportation and other midstream services in the U.S. shales. In line with IEA projections, they expect U.S. crude oil production to grow by approximately 1.3 million barrels a day in 2019 once the constraints imposed by a lack of pipeline capacity in the fecund Permian basin ease. MLPs positioned to resolve the transportation bottleneck should be able to count on a bright near-term future. “Location, location, location” applies to pipelines as well as real estate, and reinforces a bottom-up focus when selecting MLPs.   Jennifer Lacombe, Senior Analyst jenniferl@bcaresearch.com

Highlights As investors increasingly look at allocating assets based on environmental, social, and governance (ESG) considerations, these strategies are becoming less niche. We look at different ESG investing strategies, in both equities and bonds, and analyze their historical risk-adjusted returns and performance in bear markets and recessions. We find that ESG indices have at least performed in line with, and often outperformed, aggregate indices, with lower volatility. However, performance varies from region to region and between asset classes. Markets with the worst ESG standards tend to see the biggest improvement in performance when ESG factors are considered Feature Increasing investor interest in environmental, social, and governance (ESG) investing poses a big question for money managers: how does an allocation to ESG investments affect the return and volatility profile of a traditional portfolio? This Special Report addresses the following issues: What are the risk-return characteristics of ESG investments from a top-down perspective? Do ESG investments provide recession/bear market protection? What are the unique challenges that money managers using an ESG strategy need to account for? A Brief Overview Of ESG To begin, we need to define what exactly ESG investing means. We see it as any investment activity that recognizes a certain set of principles to screen for environmental, social, and governance standards. ESG investing, as a term, is relatively new. However, the core concept can be traced back several decades. During the 20th century, ethical investing (EI) emerged, as investors applied faith-based criteria to their investments. From the 1980s, socially responsible investing (SRI) allowed investors to focus on social and environmental goals, in addition to their ethical beliefs. This was mainly due to an increased global awareness of environmentalism that emerged in this period, following events such as the Exxon Valdez oil spill in 1989 and claims of labor-rights abuses in various industries. In the early 2000s, ESG investing arose from investors' increasing awareness of the need to include corporate governance as an additional screening to SRI investing. The inclusion of the governance factor was also due to numerous corporate scandals, such as Enron's bankruptcy in 2001. Simply put, ESG is a broader concept than the previous incarnations of ethical investing. Throughout the early 2000s, various global initiatives started supporting the cause of ESG investing. The United Nations launched the Principles for Responsible Investing (PRI) in 2006 to promote ESG investing among institutional investors.1 Based upon six pillars, the PRI aims to encourage the use of ESG factors by investors in their investment process. Currently, most of the demand for ESG investing comes from larger financial institutions, particularly pension funds, whereas smaller investment institutions and retail investors lag in their interest. The Global Sustainable Investment Alliance (GSIA) has released a global standard classification to distinguish between the different ESG strategies as summarized in Table 1. Negative screening, positive screening, and corporate engagement are the most used strategies, while themed investing and targeted-situation investing have relatively less allocation. Figure 1 illustrates various examples of which types of investments might fall under ESG.2 Table 1Global Standard ESG Classification* ESG Investing: No Harm, Some Benefit ESG Investing: No Harm, Some Benefit Figure 1Types Of Investments That Fall Under ESG* ESG Investing: No Harm, Some Benefit ESG Investing: No Harm, Some Benefit The total market size of "sustainable investing" is difficult to quantify, due to the wide range of securities that could fall under this ambiguous label. According to the 2016 Global Sustainable Investment Review, published bi-annually by the GSIA, global ESG assets under management (using a very broad definition of ESG) totaled $22.9 trillion dollars as of 2016, a 25% increase from 2014.3 The development of cleaner energy sources, changing social norms, interest by millennials in environmental and social issues, and regulation are among the drivers of this growth. The increasing number of ETFs and mutual funds that define themselves as "socially conscious", standing at 279 as of Q3 2018, also demonstrates the growing interest in ESG investing.4 Additionally, the number of active managers integrating ESG factors in their investment strategy has grown (Chart 1). Chart 1Growing Interest... ESG Investing: No Harm, Some Benefit ESG Investing: No Harm, Some Benefit Increasing investor demand has translated into further transparency from companies. According to the Governance & Accountability Institute, the number of S&P 500 firms that disclose their sustainability, corporate governance and social responsibility performance more than quadrupled between 2011 and 2017 (Chart 2).5 Chart 2...More Transparency ESG Investing: No Harm, Some Benefit ESG Investing: No Harm, Some Benefit However, transparency is not the only barrier to the growth of ESG investing. The term ESG is still utilized and defined in different ways, confusing investors. A joint survey by the UN and the CFA Institute showed that 43% of U.S. equity and fixed income investors cited a lack of historical data, and 41% limited understanding and knowledge of ESG issues as the top barriers to incorporating ESG.6 Additionally, due to the lack of a standardized reporting system, investors cannot properly assess and compare ESG metrics across firms.7 ESG factors tend to be hard to quantify. Inconsistent ESG ratings due to differences in data analysis and reporting contribute to the lack of comparability. Investors should do their own thorough due diligence before investing. Various funds that screen for "socially responsible" criteria do sometimes include controversial stocks. For example, Vanguard's SRI European Stock Fund includes Royal Dutch Shell and British American Tobacco plc amongst its top 10 holdings.8 Risk-Return Characteristics9 To compare returns across regions, we use the MSCI ESG Leaders Index, which MSCI describes as using a best-in-class strategy and excluding companies involved in the alcohol, gambling, tobacco, nuclear power, and weapons businesses. It also minimizes sector-based tracking error by targeting 50% of the market capitalization within each GICS sector.10 MSCI assigns companies an ESG rating ranging from AAA to CCC; companies must maintain a rating above BB to be eligible for inclusion. We use the Bloomberg Barclays MSCI Socially Responsible Indices for our fixed-income comparisons. These indices use a negative screening process to exclude issuers involved in businesses that are in conflict with social and environmental values. Historical data for ESG indices tend to be limited; the earliest data-point for the MSCI ESG Leaders Index is September 2007. We analyze historical metrics for two periods: one starting September 2007, and the other starting July 2009 to show returns after the negative impact of the Global Financial Crisis (GFC). Tables 2 and 3 show that equity investors have enjoyed higher risk-adjusted returns on equity ESG indices thanon standard equity indices. However, this is not the case across all regions. The global ESG equity index outperformed in both periods, with lower volatility (Chart 3). In the U.S. and U.K., ESG indices underperformed their conventional counterparts, but in the euro area, China and Canada they significantly outperformed, while achieving lower volatility (charts for all countries shown in the Appendix). Emerging markets are perhaps the biggest surprise, since here the ESG index outperformed by over 3.5% annually in both periods. However, EM outperformance was mainly driven by China (Chart 4). Table 2Equities: Risk-Return Profile (September 2007 - October 2018) ESG Investing: No Harm, Some Benefit ESG Investing: No Harm, Some Benefit Table 3Equities: Risk-Return Profile (July 2009 - October 2018) ESG Investing: No Harm, Some Benefit ESG Investing: No Harm, Some Benefit Chart 3ESG Equities: Global Outperformance ESG Equities: Global Outperformance ESG Equities: Global Outperformance Chart 4China Drove EM Outperformance China Drove EM Outperformance China Drove EM Outperformance A study conducted by MSCI ESG Research showed that stock selection had the biggest contribution to the excess return of the emerging markets ESG equity indices, followed by sector-selection tilts. In fact, stock-selection added value in most regions, except the U.S. The MSCI ESG Leaders Index excludes firms such as Amazon (for its labor practices), Apple (supply-chain issues), and Facebook (privacy and data security) from both the U.S. and the global ESG indices, which resulted in its relative poor performance during the strong technology market of the past few years. Some argue that the regions with the worst ESG standards tend to see the biggest improvement in performance when ESG factors are considered. However, a debate then arises as to whether ESG ratings can be taken at face value, or should simply be an input into a broader analysis.11 One of the most surprising results from Tables 2 and 3 is the finding that the global ESG index has lower volatility, given the more idiosyncratic risk of ESG indices, which have on average only about half the number of constituents of aggregate market indices. The concentration - based on a Herfindahl-Hirschman Index (HHI) - of the top 10 ESG constituents is about four times that of the broad indices. ESG equity indices trade at lower PE multiples than traditional indices. Chart 5 shows that, on average, ESG equities' outperformance has been mainly driven by stronger relative earnings growth rather than relative multiple expansion. Earnings contributed 48% to total return growth for the ACWI ESG index, compared to 41% for its counterpart. PE expansion contributed 21% of the ESG index's total return, compared to over 30% for the ACWI index. Chart 5Drivers Of Return Drivers Of Return Drivers Of Return The conclusions are not very different for fixed income (Table 4). There is little difference between returns for corporate SRI bonds and investment grade bonds. Despite the slight sector tilts towards financials and banks in SRI Bond Indices, the indices have largely tracked each other (Chart 6). Table 4Bonds: Risk-Return Profile (July 2009 - October 2018) ESG Investing: No Harm, Some Benefit ESG Investing: No Harm, Some Benefit Chart 6ESG Bonds: No Difference In Performance ESG Bonds: No Difference In Performance ESG Bonds: No Difference In Performance Only a limited amount of research has been conducted into the importance of ESG factors for credit portfolios, but several papers concluded that ESG scores do not significantly impact performance, though there was some evidence that bonds of companies with higher ESG scores actually trade at wider spreads.12 Recession/Bear Market Protection Despite the efforts of ESG providers to limit sector-based tracking error, ESG equity indices still tend to have sector tilts due to over- and under-weighting firms based on their ESG scores. Sectors such as Information Technology, Financials, Communication Services, and Healthcare usually are favored relative to Materials, Industrials, and Energy. However, the magnitude of these tilts differs from region to region, and understanding the scope of these tilts is important when considering an ESG allocation. For example, the Chinese MSCI ESG Leaders Index is heavily skewed towards Communication Services (one stock, Tencent, in particular). Simply put, the sector composition/index construction of ESG indices alters their cyclicality and, therefore, performance. To understand this, it is important to observe this behavior over as many cycles as possible. To analyze this, we looked at the U.S. MSCI KLD 400 Index, one of the oldest ESG indices, with data starting in 1990. In 2001-2002 (the aftermath of the tech bubble), the KLD 400 underperformed the S&P 500 due to the former's larger exposure to tech. On the other hand, during the 2007-2008 GFC, the KLD 400 had a smaller drawdown than the S&P 500 (Chart 7). Chart 7Sector Tilts Matter Sector Tilts Matter Sector Tilts Matter Additionally, Table 5 shows that an ESG allocation has tended to at least perform in line with equities overall, if not slightly outperform them, during bear markets. The MSCI KLD 400 outperformed the S&P 500 by an annualized average of 1% in the past five bear markets.13 Table 5Bear Market Protection? ESG Investing: No Harm, Some Benefit ESG Investing: No Harm, Some Benefit We performed a risk-return analysis of a portfolio consisting of 60% conventional equities and 40% investment-grade bonds, compared to similarly weighted ESG-focused equity and fixed income indices. The results for the three regions for the period July 2009 and October 2018 are shown in Chart 8. Chart 8Portfolio Performance (Jul 2009 - Oct 2018) ESG Investing: No Harm, Some Benefit ESG Investing: No Harm, Some Benefit The global and the euro area multi-asset ESG portfolios outperformed the conventional portfolios by 2 and 10 bps a year respectively while achieving slightly lower volatility. The U.S. ESG portfolio, on the other hand, slightly underperformed due to the underperformance of the ESG equity index in a strong tech market of the past nine years. Conclusion From the above analysis, we would draw the following conclusions: There is little evidence that ESG investing detracts from performance. In fact, there is some evidence that it can provide some outperformance and bear-market protection depending on the ESG index composition. Consideration of ESG factors in taking investment decisions needs to go beyond simply looking at ESG scores. Incorporating ESG analysis will increasingly become a core step in assessing risk for both equity and fixed-income investors. Index methodology and construction, as well as sector composition, play a big role in evaluating expected performance. ESG indices are growing. As of end of 2017, there were 42 ESG-focused equity indices by the major three providers as shown in Appendix Table 1. We expect to see more as ESG becomes increasingly acknowledged. Amr Hanafy, Research Associate amrh@bcaresearch.com Footnotes 1 Please see https://www.unpri.org/pri/about-the-pri 2 Please see https://www.ussif.org/files/Publications/Retail_Investor_Guide.pdf 3 Please see http://www.gsi-alliance.org/wp-content/uploads/2017/03/GSIR_Review2016.F.pdf 4 Please see Charles Schwab, Socially Conscious Funds List https://www.schwab.com/public/file/P-9561751/. Based on data from Morningstar, Inc. 5 Please see https://www.ga-institute.com/press-releases/article/flash-report-85-of-sp-500-indexR-companies-publish-sustainability-reports-in-2017.html 6 Please see ESG Integration In The Americas: Markets, Practices, And Data https://www.unpri.org/download?ac=5397 7 Please see CFA Financial Analysts Journal, Third Quarter 2018, Volume 74, Issue 3 https://www.cfapubs.org/doi/pdf/10.2469/faj.v74.n3.full 8 Please see https://global.vanguard.com/portal/site/loadPDF?country=ch&docId=14053 9 It is important to note that, in this report, we make no assumptions regarding the methodology or ESG ranking scores of the indices discussed, but rather take them as given by their providers (MSCI and Bloomberg Barclays). 10 Please see https://www.msci.com/eqb/methodology/meth_docs/MSCI_ESG_Leaders_Indexes_Methodology_June_2017.pdf 11 Please see http://www.whebgroup.com/what-do-esg-ratings-actually-tell-us/#_edn4 12 Please see https://static.macquarie.com/dafiles/Internet/mgl/global/shared/sf/images/corporate/asset-management/investment-management/understanding-esg-in-credit-portfolios.pdf?v=3 13 Bear markets defined as a drawdown of 15% lasting more than three months. Appendix Appendix Table 1ESG Equity Indices ESG Investing: No Harm, Some Benefit ESG Investing: No Harm, Some Benefit Appendix Chart 1ESG Equities: U.S. ESG Equities: U.S. ESG Equities: U.S. Appendix Chart 2ESG Equities: Euro Area ESG Equities: Euro Area ESG Equities: Euro Area Appendix Chart 3ESG Equities: Emerging Markets ESG Equities: Emerging Markets ESG Equities: Emerging Markets Appendix Chart 4ESG Equities: Canada ESG Equities: Canada ESG Equities: Canada Appendix Chart 5ESG Equities: U.K. ESG Equities: U.K. ESG Equities: U.K. Appendix Chart 6ESG Bonds: U.S. ESG Bonds: U.S. ESG Bonds: U.S. Appendix Chart 7ESG Bonds: Euro Area ESG Bonds: Euro Area ESG Bonds: Euro Area

Highlights Investors looking for equity upside, along with fixed-income-like downside protection, coupled with a hedge against rising rates, should consider convertible bonds. As we near the end of the business cycle, the attractions of convertibles are becoming clearer: investors will benefit from more upside capture in case of a last run-up in stocks, but at the same time suffer less downside in a recession. Moreover, in periods of rising rates, convertible bonds perform well compared to other traditional fixed-income securities. However, multi-asset portfolio managers should note that the risk-return profile of convertible bonds is more like equities than bonds, and so convertibles have no place in a conservative fixed-income portfolio. Investors have a number of options to choose from when customizing equity-versus-fixed-income exposure in their convertible allocations. Feature Introduction An ideal financial instrument would have large equity exposure in an equity bull market, and increased fixed-income exposure in a bear market. Financial engineering can create synthetic positions using derivatives to replicate just this sort of hybrid exposure - or an investor can just buy convertible bonds. In this current, late, phase of the business cycle - with increased volatility, rising interest rates, and a pickup in inflation - where can investors find shelter, but without sacrificing returns in the event of a last blow-out run-up in stocks? In this report, we discuss how convertible bonds - despite their somewhat complex structure1 - could be the answer. Issuers prefer convertibles to traditional corporate bonds because of: 1) a lower coupon rate and fewer covenants, 2) the opportunity to sell equity at a premium to the current price, 3) a faster process for raising capital, compared to a secondary equity issue, and 4) easier access to capital markets for non-investment grade firms. On the demand side, the composition of convertible investors has evolved over time. Prior to the 2007-9 Global Financial Crisis (GFC), proprietary trading desks and leveraged hedge funds were the most important players, since convertible arbitrage2 was very profitable. But the liquidity freeze in 2008 and 2009 forced these short-term investors out of the market and brought back long-term buy-and-hold investors. Currently 65% of U.S. convertible bonds are held by long-only investors. This change in market structure has had important implications for arbitrage opportunities (Chart 1). Chart 1Fewer Short-Term Investors Should Investors Convert To Convertibles? Should Investors Convert To Convertibles? In the first half of 2018, issuance of global convertible securities topped $57 billion, the largest amount for a six-month period since 2008. The U.S. led the way, with issuance of $34 billion (Chart 2), followed by Asia ex-Japan at $12 billion, and Europe, $10 billion. The U.S. total includes $13.4 billion in convertible bond issuance by tech companies, the highest amount in the post-GFC period (Chart 2, panel 2). Bank of America Merrill Lynch estimates that full-year global issuance could be the highest in 12 years. The macro-backdrop for convertibles remains favorable: Chart 2Issuance Similar To Pre-Crisis Levels Should Investors Convert To Convertibles? Should Investors Convert To Convertibles? The hybrid equity/fixed-income exposure offers protection against rising rates because of its shorter duration; The new U.S. tax code limits interest deductibility, which strengthens the relative appeal of issuing a convertible security instead of a traditional bond; The return of volatility means investors benefit from holding a security with an embedded option; The flexibility of the asset class gives investors room to customize their exposure in terms of coupon rate, premium, and maturity. In this report, we start with the market structure and mechanics of convertible bonds. Next, we look at the four types of convertible bonds, which provide different risk-return profiles. In the following section, we analyze historical returns and performance in different market environments. Finally, we discuss the key asset allocation decisions involved in investing in convertible bonds. Our main findings are: Investors can customize their risk-return profile by choosing between high-volatility equity exposure (equity-sensitive convertibles), or more stable fixed-income exposure (credit-sensitive convertibles); Convertible bonds historically have generated an annualized return of 9.5% compared to 9.8% from equities, but with 2% lower volatility; Convertible bonds have a risk-return profile more like that of equities and junk bonds than that of investment-grade credit; In periods of rising rates and inflation, convertible bonds have outperformed their traditional fixed-income counterparts; In comparison to equities, convertibles capture more upside in bull markets than downside in bear markets; Investing in convertible bonds requires active management because of their varying degree of equity- and fixed-income sensitivity that changes over time. The Convertibles Market Convertible securities can be broken into three key groups: 1) convertible bonds (cash-pay3 and zero-coupon), 2) convertible preferred shares, and 3) mandatory convertibles. Cash-pay convertible bonds make up almost 80% of the outstanding market (Chart 3), while zero-coupon convertible bonds are almost non-existent. Mandatories and convertible preferred equities make up 15% and 7% respectively. Chart 3Convertibles Bonds Are 80% Of Convertibles Market... Convertibles Bonds Are 80% Of Convertibles Market... Convertibles Bonds Are 80% Of Convertibles Market... Before we delve deeper into the convertible bond markets, here are few key characteristics (Chart 4) of the other two groups: Chart 4...And Have The Best Risk-Adjusted Returns ...And Have The Best Risk-Adjusted Returns ...And Have The Best Risk-Adjusted Returns Convertible Preferred Equities are issued with a specific dividend rate that is generally higher than the dividend on common shares. They include an embedded option to convert to a specified number of common shares. Additionally, preferred dividends usually accumulate in arrears should the firm be unable to make a payment. The conversion rate increases with any increase in the common-share dividend. After the call protection expires, the company has the option of redeeming the issue at the stated par value. Mandatory Convertibles. These bonds automatically convert to common shares at a specified time. However, they do not offer downside protection since conversion can be into shares worth less than the original issue price. Rating agencies view these securities more as equities than bonds, giving firms an incentive to issue them from a balance-sheet perspective. Table 1 shows us that cash-pay (coupon paying convertible bonds) generated the highest return with the lowest volatility, thereby providing investors with the best risk-adjusted returns. Mandatory convertibles have a large excess kurtosis - driven by the forced conversion into equities at inopportune times. In bull and bear markets, it is clear convertible bonds did not enjoy the full upside provided by preferred shares and mandatories, but had 50% less downside in bear markets. Also, in periods of rising rates convertible bonds produced positive returns, but lagged both preferred shares and mandatory convertibles. Table 1Convertible Bonds' Risk-Return Profile Should Investors Convert To Convertibles? Should Investors Convert To Convertibles? A niche market exists for contingent convertibles (CoCos) - or, as they are sometimes called, anti-convertibles. Banks in the euro area issue CoCos to meet capital requirements and provide a cushion should they find themselves in a serious predicament. These typically pay a higher coupon than the bank's straight bonds to compensate for the possibility of a complete wipeout. In short, if all goes well you receive your fixed coupons and principal back at maturity. But, if things turn sour, the bonds convert to equity and the investor potentially loses everything. Mechanics Of Convertible Bonds Convertible bonds are a hybrid security issued as a senior unsecured bond with a fixed maturity (normally five years) with optionality to convert to a fixed number of shares. In exchange for the equity kicker, these bonds typically yield less and carry a lower coupon rate (Chart 5) than the issuer's comparable non-convertible debt. We describe the basics of convertible bonds in the Appendix. Chart 5The Cost Of An Embedded Option The Cost Of An Embedded Option The Cost Of An Embedded Option An investor considering an allocation to convertibles has four groups to choose from depending on his or her risk-return tolerance. The trade-off is between high volatility equity exposure versus more stable credit exposure. If the underlying stock does well, the convertible increases in value even without the investor exercising the option to convert into shares. If the stock does not appreciate, the investor retains the bond and collects regular coupons and par value at maturity. The interaction of market price with investment value and conversion price creates convertible bonds with different risk-return profiles: Credit Sensitive: A large decrease in the stock price has pushed the convertibles to trade close to their investment value (bond floor). These are out-of-the money convertibles, with a delta ranging from 10% to 40%, and also with large premium over investment value. The main factors affecting the pricing of such instruments are the level of interest rates and credit spreads. An investor has a small probability of generating large unexpected gains from underlying stock appreciation. Balanced: The stock price is close to the conversion price, making these at-the-money convertibles. They have a moderate premium to conversion value, and deltas in the range of 40-80%. Rising stock prices make the embedded call option more valuable, pushing the convertible price closer to the stock price. Long-term buy-and-hold investors looking to maintain a core allocation to convertibles should invest in balanced convertibles. Equity Sensitive: Convertibles that are deep in-the-money, trading near parity, with high deltas of over 80%, and generating returns that closely track equities. They still retain some downside protection due to seniority and par value at maturity even if they have most of the common share's upside potential. Distressed: As a company threatens to default or goes bankrupt, the value of the straight bond component declines to trade significantly below par. These bonds tend to have high degree of price volatility and low probability of return of capital. Risk & Return Convertible bond returns are driven by: 1) the bond component that is a function of rates, credit spreads, and curve effects; 2) the equity component, supported by the delta to the underlying stock price; and 3) the option component, that is a function of the underlying stock price and time to maturity. Convertibles combine characteristics of stocks and bonds (Chart 6), so they represent either lower-volatility equity exposure or enhanced fixed-income exposure. Over the past 24 years (Table 2), U.S. convertible bonds generated returns similar to U.S. equities, but with a lower volatility. However, relative to traditional corporate bonds, convertibles outperformed massively, but with much higher volatility. Looking at risk-adjusted returns, we see that convertible bonds have more similarity to equities and high-yield credit than to investment-grade credit (Chart 7). However, defaults in the convertible bond space have been close to 1%, which is significantly lower than the 4% in the high-yield credit market (Chart 8). This is because convertible bonds include a smaller proportion of issuers with high operating leverage, such as energy producers, and have a high representation of mature healthcare and technology companies. Chart 6Convertibles Vs. Traditional Convertibles Vs. Traditional Convertibles Vs. Traditional Table 2Better Than Equities, But More Volatile Than Traditional Bonds Should Investors Convert To Convertibles? Should Investors Convert To Convertibles? Chart 7Close To Equities & Junk Close To Equities & Junk Close To Equities & Junk Chart 8Lower Defaults Than Junk Bonds Should Investors Convert To Convertibles? Should Investors Convert To Convertibles? Short-term performance of the convertible bond market is driven by the composition of issuers, but long-term performance is driven by the performance of the different variables described above. In 1Q 2018, convertible bonds outperformed equities, largely due to technology and consumer staples convertibles. Technology convertibles saw a 11% gain, while the S&P technology sector was up only 3.5%. This was because technology convertible issuers were concentrated in the mid-cap growth segment, whereas the large-cap equity names are more heavily weighted in semiconductors. BCA has for two or three years been warning about the return of inflation and rising interest rates. Convertible bonds outperform traditional fixed income in periods of rising interest rates because: 1) rising rates are often coupled with periods of positive equity momentum, which benefits convertibles; 2) convertibles have lower duration than straight bonds. Since 1994, there have been 10 instances when the 10-year U.S. Treasury yield rose by more than 100 bps: convertible bonds outperformed in every instance. Additionally, convertible bonds enjoy a yield advantage: the average income return (coupon rate) on a convertible is greater than the dividend yield on the underlying stock. When investors allocate to convertible bonds from either their equity or fixed-income portfolio, the key consideration is upside versus downside exposure. When the underlying stock price rises, convertibles will capture a portion of the capital appreciation but, on the downside, convertibles continue to provide a consistent income flow and principal repayment at maturity. History tells us that convertibles capture more upside in bull markets than downside in bear markets. If the share price falls sharply below the conversion price, the convertible will react less and less to fluctuations in the underlying stock price. In short, convertible bonds provide more downside protection than stocks as market value will not drop below the investment value (bond floor). Convertibles also have a mechanism to offset rising equity volatility and rising rates. The embedded equity option in a convertible bond rises in value when volatility rises, providing a meaningful offset in contrast to equities that may suffer a drawdown. Over the long-run, convexity enables this asset to make the most of favorable stock market conditions, whilst suffering less in difficult conditions. As mentioned earlier, the risk-return profile of convertible bonds tends to have a closer relation with equities than with fixed income. Within fixed income, high-yield credit, which tends to have a return profile closely aligned with equities, has a strong correlation with convertible bonds. The greatest diversification potential is when convertible bonds are added to a portfolio of government bonds. However, investors should realize the risk-return profiles for convertibles and government bonds are very different, and an allocation to the former is only a possibility for an investor with a higher risk tolerance. What To Choose From? Equity Sensitive Versus Credit Sensitive Investors need to choose the right type of convertible bond depending on their risk tolerance. Equity-sensitive convertibles made up over 60% of the market prior to the GFC, but this proportion fell to around 20% during the recession (Chart 9). As stock prices tumble, the market price of convertibles get closer to the investment value (bond floor), and convertibles start behaving more like pure credit-sensitive bonds. Looking at total returns (Chart 10 & Table 3), it is clear that aggressive investors with a higher risk tolerance should invest exclusively in equity-sensitive convertibles. But investors looking to maintain a core long-term allocation to convertibles should focus on the balanced group. Despite being a small piece of the market, distressed convertibles are attractive return enhancers immediately after a recession. Investors looking for income return should prefer credit-sensitive or distressed convertibles over equity-sensitive ones. Equity-sensitive convertibles have the highest delta, making them the most vulnerable to underperformance in a downturn. Balanced convertibles have the highest vega, which means they are most impacted by increasing volatility - driven by both equity and rate volatility. In times of rising interest rates, equity-sensitive convertibles provide their best protection given their short duration. Credit- and rate-sensitive convertibles have almost double the duration, making them more vulnerable to rising rates. Chart 9Equity Vs. Fixed Income Exposure Equity Vs. Fixed Income Exposure Equity Vs. Fixed Income Exposure Chart 10Massive Outperformance By Equity Sensitive Massive Outperformance By Equity Sensitive Massive Outperformance By Equity Sensitive Table 3Equity Sensitive For The Aggressive, Credit Sensitive For The Conservative, Balanced For Everyone Should Investors Convert To Convertibles? Should Investors Convert To Convertibles? Small Cap Versus Large Cap Issues Investors can choose between convertible issues from companies of different size. Since the middle of the financial crisis, large-cap issues have grown to over 50% of the market (Chart 11), up from below 30%. The increase in market share was taken from small-cap issues, with mid-cap issues stable at 20% of the market. In terms of total returns (Chart 12 & Table 4), small cap outperformed both mid and, particularly, large caps. Part of this outperformance was due to the higher yield offered by small-cap issuers compared to their larger counterparts. In terms of equity sensitivity, small-cap issues currently have significantly lower delta than large caps. However, in times of rising volatility, small-cap issues lose more, driven by their higher vega. In terms of interest-rate sensitivity, all three sizes are roughly equally exposed given similar durations. Chart 11Bigger Is Not Always Better Bigger Is Not Always Better Bigger Is Not Always Better Chart 12Small Cap Outperforms Small Cap Outperforms Small Cap Outperforms Table 4Small Cap Provides The Best Value Should Investors Convert To Convertibles? Should Investors Convert To Convertibles? Investment Grade Versus The Rest A credit investor has one particularly important call: investment-grade versus high-yield. The situation is trickier for convertibles as over 60% of the bonds are unrated (Chart 13), thereby giving managers amply opportunity for alpha generation. Historical performance (Chart 14 & Table 5) shows that non-rated convertible bonds have a close relationship with non-investment-grade issues. Moreover, the relative performance of non-investment-grade and non-rated issues with investment grade issues follows a similar path. From an income-return perspective, both non-rated and non-investment-grade issues have lost their yield advantage since 2016. Investors are not receiving adequate yield for the additional risk they are taking with riskier issues. The return of volatility will have a smaller impact on investment-grade issues compared to the rest of the market because the former have a lower effective duration. Additionally, implied volatility is lower for investment-grade issues. Chart 13Over 60% Has No Credit Rating Over 60% Has No Credit Rating Over 60% Has No Credit Rating Chart 14Similar Return, But Different Risk Similar Return, But Different Risk Similar Return, But Different Risk Table 5No Rating = Source Of Alpha Should Investors Convert To Convertibles? Should Investors Convert To Convertibles? The Asset Allocation Decision The key question here is: are investors looking at convertible bonds (Chart 15) as part of an equity or a fixed-income allocation? Investors considering convertibles as part of their equity allocation are looking for a more defensive exposure and yield pick-up, and so should focus on balanced convertibles and not equity-sensitive ones. On the other hand, considering convertibles as part of fixed-income allocation will deliver equity exposure, and so investors should focus on credit-sensitive or balanced convertibles. Chart 15Somewhere Between Equities & Junk Somewhere Between Equities & Junk Somewhere Between Equities & Junk Another major factor is the investment horizon of the convertible allocation. A core strategic allocation to convertibles will require a hybrid exposure, providing lower-volatility equity exposure over multiple full market cycles. Such investors are looking for long-term equity upside, but are concerned about shorter-term downside equity volatility and should consider balanced convertibles. On the other hand, investors using convertibles as part of a tactical allocation, to make a short-term bet in order to diversify away from traditional fixed-income or equity exposure, should consider either equity-sensitive or credit-sensitive convertibles. The bottom-line is that convertible investing requires active management because these securities have varying degrees of equity and fixed-income sensitivity that change over time. In periods of rising equity markets, an investor with passive exposure to convertibles would automatically have a large holding in equity-sensitive convertibles with a high delta, thereby increasing his or her exposure to equity downside risk. For example, in February 2009, when markets troughed after the GFC, more than two-thirds of convertibles were trading as credit-sensitive instruments. An investor following a passive index in this situation would have had minimal exposure to equity-sensitive convertibles, and would thereby have had limited participation in the equity upside. Finally, the convertible universe is constantly evolving. The typical convertible bond is issued with a five-year life by a company in the early to mid stage of its corporate life cycle, seeking capital to grow. As time passes, the issuer matures to a point where it no longer needs convertibles in its capital structure. Nearly two-thirds of the current issuers of convertible were not in the market 10 years ago, while two-thirds of the S&P 500 members remain unchanged over this time. Aditya Kurian, Senior Analyst Global Asset Allocation adityak@bcaresearch.com 1 Despite the complexities, the first convertible bond was issued as long ago as 1874 by Rome, Watertown and Ogdensburg Railroad to finance a project. The bond was never converted since the underlying shares failed to rise enough and the company refinanced the bond in 1904. 2 For an explanation of convertible arbitrage, please see A Note On Convertible Arbitrage at the end of this report. 3 Convertible bonds that make regular coupon payments. A Note On Convertible Arbitrage A market-neutral hedge fund strategy where the manager goes long the convertible bond and short the underlying stock. The short position in the underlying stock creates a delta-neutral position, but maintaining this position requires dynamic hedging which is expensive. There is a possibility of large mispricing because of the over-the-counter nature of the market and uncertainty regarding call or redemption features of convertibles. Often, the embedded equity option is a source of cheap volatility compared to the underlying stock's listed options. A quick measure for convertible valuations is comparing the volatility of options in the market to the volatility priced in the embedded option in the convertible. If market volatility rises, but the price of convertible stays the same, the security could be cheap and attractive. Looking at historical performance (Table 6), convertible arbitrage generated almost 3% less than equities, but with less than half the volatility. However, all of the outperformance was during recessions or equity bear markets. Additionally, convertible arbitrage funds have large negative skew and kurtosis relative to both equities and the hedge-fund composite. We recommend investors allocate to convertible arbitrage hedge funds in preparation for a downturn. Table 6Convertible Arbitrage Versus Traditionals Should Investors Convert To Convertibles? Should Investors Convert To Convertibles? Appendix: The Basics Of Convertible Bonds Investment Value (Bond Floor): The fixed-income component of the convertible bond, or in other words, the value of the bond without the conversion feature (equity kicker). This remains stable over a wide range of stock prices but, when creditworthiness deteriorates, consequent stock price movements will have an impact on the investment value (IV). Holding creditworthiness constant, the IV provides the bond floor, below which the convertible should not trade. The IV fluctuates in tandem with the price of a straight corporate bond of similar quality. A convertible that is trading close to its IV will be more affected by changes in rates than one that is well above it. Investment Premium: The market price minus IV expressed as a percentage of IV. Premium over IV indicates the level of downside risk. A higher premium means the bond price is more sensitive to the price of underlying stock, which means less downside protection because the bond market price would have to decline significantly before reaching the IV. Higher premium is a result of rising underlying stock value, whereas a smaller premium is when the convertible is more interest-rate sensitive and behaves like a pure bond. Conversion Value (CV): The equity portion of the convertible bond. Conversion ratio is set at the time of issuance and it is the number of shares a bondholder will receive upon conversion. Conversion price is the price at which the number of converted shares is equal to the par value of the bond. At issuance, the underlying stock price is usually below conversion price. Conversion Premium: The market price minus CV expressed as a percentage of CV. As market price rises above CV, fixed-income attributes are lost and equity features take over, consequently decreasing conversion premium. Declining stock prices mean convertible market price approaches fixed-income value (bond floor) and conversion premium increases. Appendix Chart 1Preferred Shares & Mandatory Convertibles Have Higher Income Returns Preferred Shares & Mandatory Convertibles Have Higher Income Returns Preferred Shares & Mandatory Convertibles Have Higher Income Returns Appendix Chart 2Convertible Bonds' Delta & Vega Reduces In A Recession Convertible Bonds' Delta & Vega Reduces In A Recession Convertible Bonds' Delta & Vega Reduces In A Recession Appendix Chart 3Conversion Premium Far From Recessionary Levels Conversion Premium Far From Recessionary Levels Conversion Premium Far From Recessionary Levels Appendix Chart 4Average Duration Less Than 2.5 Average Duration Less Than 2.5 Average Duration Less Than 2.5 Appendix Chart 5U.S. Is 60% Of Global U.S. Is 60% Of Global U.S. Is 60% Of Global Appendix Chart 6U.S. Is Clearly The Best Performer U.S. Is Clearly The Best Performer U.S. Is Clearly The Best Performer Appendix Chart 7U.S. Also Provides The Best Income Return U.S. Also Provides The Best Income Return U.S. Also Provides The Best Income Return Appendix Chart 8But, U.S. Is The Most Equity Sensitive But, U.S. Is The Most Equity Sensitive But, U.S. Is The Most Equity Sensitive Appendix Chart 9U.S. Has A Higher Implied Volatility U.S. Has A Higher Implied Volatility U.S. Has A Higher Implied Volatility Appendix Chart 10Distressed Is The Best Solution Immediately After A Recession Distressed Is The Best Solution Immediately After A Recession Distressed Is The Best Solution Immediately After A Recession Appendix Chart 11Balanced Has The Lowest Coupon Balanced Has The Lowest Coupon Balanced Has The Lowest Coupon Appendix Chart 12Balanced Has Moderate Delta, But Highest Vega Balanced Has Moderate Delta, But Highest Vega Balanced Has Moderate Delta, But Highest Vega Appendix Chart 13Equity Sensitive Are The Best Rate Hedge Equity Sensitive Are The Best Rate Hedge Equity Sensitive Are The Best Rate Hedge Appendix Chart 14Premiums Are Stable Premiums Are Stable Premiums Are Stable Appendix Chart 15Mid-Cap Provides Low Income Return Mid-Cap Provides Low Income Return Mid-Cap Provides Low Income Return Appendix Chart 16Massive Delta & Vega Divergence Massive Delta & Vega Divergence Massive Delta & Vega Divergence Appendix Chart 17Large Cap Premium Has Risen The Most Large Cap Premium Has Risen The Most Large Cap Premium Has Risen The Most Appendix Chart 18Implied Volatility Is Similar Across The Board Implied Volatility Is Similar Across The Board Implied Volatility Is Similar Across The Board Appendix Chart 19ALl Coupon Rates Have Fallen ALl Coupon Rates Have Fallen ALl Coupon Rates Have Fallen Appendix Chart 20Investment Grade Has The Highest Delta Investment Grade Has The Highest Delta Investment Grade Has The Highest Delta Appendix Chart 21Underweight Duration = Investment Grade Convertibles Underweight Duration = Investment Grade Convertibles Underweight Duration = Investment Grade Convertibles Appendix Chart 22Premiums Stable Premiums Stable Premiums Stable

Highlights Recommended Allocation Quarterly - October 2018 Quarterly - October 2018 We don't see any change over the next six to 12 months to the current trends of strong U.S. growth, continuing Fed hikes, rising long-term interest rates, and an appreciating dollar. We stay neutral on global equities and continue to favor the U.S. and, to a degree, Japan. Given rising rates, a strengthening dollar, ongoing trade war and moderate slowdown in China, we expect EM assets to sell off further. We forecast the 10-year U.S. Treasuries yield to rise to 3.5% by H1 2019, and so we stay underweight fixed income, short duration, and continue to prefer TIPs. We are only neutral on credit within the (underweight) fixed-income bucket. We shift our equity sector weightings to reflect the GICS recategorization. We recommend a neutral on the new internet-heavy Communication sector, and underweight on Real Estate. We have a somewhat defensive sector bias, with overweights in Consumer Staples and Healthcare. Alternative risk assets, such as private equity and real estate, look increasingly overheated. We prefer hedge funds and farmland at this stage of the cycle. Overview More Of The Same When there's been a strong trend, it's always tempting to be contrarian and argue for a reversal. Tempting but, at the moment, we think wrong. This year has been characterized by a strong U.S. economy but slowing growth elsewhere, the outperformance of U.S. equities (up 10% year-to-date, compared to a 4% decline in the rest of the world), rising U.S. interest rates, dollar appreciation, and a big sell-off in emerging markets. While a short-term correction is always possible, we don't see a fundamental end to these trends over the next 6 to 12 months. Chart 1U.S. Growth Still Looks Strong U.S. Growth Still Looks Strong U.S. Growth Still Looks Strong Chart 2Growth In Europe And Japan Has Slipped Growth In Europe And Japan Has Slipped Growth In Europe And Japan Has Slipped U.S. growth is likely to remain strong. Consumer and business sentiment are both close to record highs; wage growth is beginning (finally) to accelerate; capex intentions are buoyant; and fiscal stimulus will add 0.7% to GDP growth this year and 0.8% next, as the budget deficit widens to close to 6% of GDP (Chart 1). Europe and Japan, by contrast, have slowed this year: both are more exposed to emerging markets than is the U.S.; fiscal policy in neither is particularly accommodative; and European banks suffer from weak loan growth and their EM exposure (Chart 2). The one trigger that would cause global ex-U.S. growth to accelerate relative to U.S. growth is a massive stimulus in China similar to 2009 and 2015. We think this unlikely because the authorities have reiterated their commitment to deleveraging and structural reform. Chinese credit growth and money supply data have as yet shown no signs of picking up, but they should be monitored carefully (Chart 3). Chart 3Chinese Stimilus, What Stimilus? Chinese Stimilus, What Stimilus? Chinese Stimilus, What Stimilus? Chart 4Republicans Like Trump's Tough Trade Talk Quarterly - October 2018 Quarterly - October 2018 An end to the trade war might also reverse the trends. U.S. markets have shrugged off the risk of escalating retaliatory tariffs on the (reasonable) grounds that trade has relatively little impact on the U.S. It is hard to see an end-game to the tariff war. President Trump's popularity has risen since he got tough on trade (Chart 4). He has changed his mind on many areas of policy during his career, but he's always consistently argued that the U.S. deficit shows that its trading partners treat it unfairly. The probability is high that the 10% tariff on $200 billion of Chinese goods will rise to 25% in January, and is eventually extended to all Chinese imports. It is equally unlikely that Xi Jinping will make concessions, since he can't be seen to bend to U.S. pressure and won't put at risk the crucial "Made in China 2025" plan. Chart 5Phillips Curve Working Again Phillips Curve Working Again Phillips Curve Working Again Although tariffs may not hurt U.S. growth much, they could be inflationary. The price of washing machines, the subject of the earliest tariffs in January, rose by 18% over the next four months. This is just another reason why it's unlikely that the Fed will slow its pace of rate hikes. With the labor market now clearly tight, there are signs that the Phillips curve is beginning to reassert itself (Chart 5), and wage growth is accelerating. With core PCE inflation at its 2% target and the impact of fiscal stimulus still coming through, the Fed will feel comfortable about maintaining its current schedule of one 25 basis point hike a quarter until there are signs that the economy is slowing.1 Could the sell-off in emerging markets cause the Fed to move to hold? In the 1990s Asia Crisis, only when the fall in Asian stocks started to affect the U.S. economy (with, for example, the manufacturing ISM going below 50) and the U.S. stock market, did the Fed ease policy (Chart 6). Eventually, the slowdown in the rest of the world might start to hurt the U.S. In the past, when the global ex-U.S. Leading Economic Indicator has fallen below zero, it has usually been followed by U.S. growth also faltering (Chart 7). Chart 6In 1998, Fed Cut Only When EM Hurt The U.S. In 1998, Fed Cut Only When EM Hurt The U.S. In 1998, Fed Cut Only When EM Hurt The U.S. Chart 7When The World Slows, Often U.S. Does Too When The World Slows, Often U.S. Does Too When The World Slows, Often U.S. Does Too Table 1What To Watch For Quarterly - October 2018 Quarterly - October 2018 Having in June lowered our recommendation on global equities to neutral (but keeping our overweight on U.S. stocks), we continue to monitor the factors that would make us turn negative on risk assets (Table 1 and Chart 8). None of them is yet flashing a warning signal, but it seems likely that we will need to move to an outright defensive stance sometime in H1 2019. One final key thing to watch: any signs that U.S. earnings growth is slipping. Much of the outperformance of U.S. equities this year is simply explained by better earnings growth, partly due to the tax cuts. Analysts' forecasts for 2019 have so far been very stable. If they start to be revised down, perhaps because of higher wages and export sales being dampened by the strong dollar, that would also be a signal to switch out of U.S. equities (Chart 9). Chart 8What To Watch For? What To Watch For? What To Watch For? Chart 9Will Analysts Revise Down EPS Forecasts? Will Analysts Revise Down EPS Forecasts? Will Analysts Revise Down EPS Forecasts? Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking Is The Fed Turning Dovish? Chart 10Fed Policy Still Accomodative Fed Policy Still Accomodative Fed Policy Still Accomodative Many investors interpreted Fed Chair Powell's speech at Jackson Hole in August dovishly. Powell questioned whether "policymakers should navigate by [the] stars": r* (the neutral rate of interest) and u* (the natural rate of unemployment), since these are uncertain. He emphasized that policy will be data dependent. We read it differently. Powell also pointed out that "inflation is near our 2 percent objective, and most people who want a job are finding one", and concluded that a "gradual process of normalization remains appropriate". A speech in September by Lael Brainard, a dovish FOMC member, reinforced this. She separated the long-run neutral rate (the terminal rate in the Fed dot plot) from the short-term neutral rate (Chart 10, panel 1). Her conclusion was that "with fiscal stimulus in the pipeline and financial conditions supportive of growth, the shorter-run neutral interest rate is likely to move up somewhat further, and it may well surpass the long-run equilibrium rate." In other words, the Fed needs to continue its gradual pace of hikes. The market does not see it that way. Futures markets have priced in that the Fed will raise rates until June (when the Fed Funds Rate will be 2.75-3% in nominal terms) and then stop (panel 2). But this implies that the Fed will halt once the FFR is at the (current estimate of the) neutral rate. But inflation is likely to pick up further over the next 12 months. And the Fed is worried that, despite rate hikes, financial conditions haven't tightened much (panel 3). So we expect the Fed to keep tightening until there are signs that growth is slowing. Is The Worst Over For Emerging Markets? Chart 11Excess Debt Is Underlying Cause Of EM Sell-Off Excess Debt Is Underlying Cause Of EM Sell-Off Excess Debt Is Underlying Cause Of EM Sell-Off Since the plunge in the Argentinian peso and Turkish lira, currencies in most emerging markets have fallen sharply. Does this present a buying opportunity for investors, or is there more contagion to come? While a short-term rebound is not impossible, we remain very negative on the outlook for most emerging market assets. Fed policy and rising U.S. interest rates can be seen as the trigger for, but not the underlying cause of, the recent sell-off. Since 1980 (Chart 11), there have been only two instances where EM stock prices collapsed amid rising U.S. rates: the 1982 Latin American debt crisis and the 1994 Mexican Tequila crisis. But both occurred because of poor EM fundamentals. We see similar underlying problems today. EM dollar-denominated debt as a share of GDP and exports is as high as it was during the Asia Crisis in the late 1990s. In addition, the EM business cycle will continue to decelerate in the medium term, as evidenced by falling manufacturing PMIs. Consequently, EM corporate earnings growth is slowing, and we expect it to fall meaningfully in this downturn. EM economies have become increasingly dependent on Chinese growth for their export demand. China is slowing, but we expect limited credit and fiscal stimulus from the authorities given their shift in focus towards de-leveraging and reforming the financial sector. Additionally, global trade is also weakening as seen by falling Asian exports and sluggish container freight movements. EM central banks have responded to currency weakness by raising rates, which in turn will lead to rising local currency bond yields and tightening financial conditions. A tightening of liquidity will slow money and credit creation, ultimately weighing on domestic demand. Moreover, with an accelerating U.S. economy, the U.S. dollar will continue to strengthen, eventually tightening global liquidity. We continue to advocate an underweight position in EM assets. Share prices will not bottom until EM interest rates fall on a sustainable basis, or until valuations reach clearly over-sold levels, which they have not yet. Chart 12The New Sectors Look Very Different Quarterly - October 2018 Quarterly - October 2018 What Just Happened To GICS? Following Real Estate's 2016 separation from Financials to become the 11th sector within GICS, September 28 2018 marked an even more disruptive change to equity classification. The change, aimed at keeping up with innovation and the current market structure, affects three of the 11 sectors: Telecommunication Services, Consumer Discretionary, and Information Technology (Chart 12). In short, the Telecommunication Services sector, once a value, low-weight, low-beta, high-yield, defensive sector is broadened and renamed Communication Services, offering broad-based coverage of content on various internet and media platforms. It includes the Media group, as well as selected companies from Internet & Direct Marketing Retail, taken out of Consumer Discretionary. Additionally, selected companies from the Internet Software & Services, as well as Application and Home Entertainment Software move into the new sector from IT. The E-commerce group also grows, with selected companies moving out of IT into Consumer Discretionary. Telecom/Communication, which previously behaved like Utilities, has turned into a high-growth, low-dividend sector. It is also a cyclical rather than defensive. It should trade at much higher multiples than its previous incarnation. IT is also no longer be the same. The sector, which once represented nearly 20% of the ACWI index, has shrunk to 13%, now mostly comprises hardware and software companies, after losing constituents such as Alphabet, Facebook, and Tencent. Chart 13Three Ideas To Enhance Risk-Adjusted Return Three Ideas To Enhance Risk-Adjusted Return Three Ideas To Enhance Risk-Adjusted Return Where To Find Yield In A Low-Return Environment? BCA's House View in June downgraded equities to neutral and moved cash to overweight. For U.S. investors, holding cash is quite attractive, as the yield on three-month Treasury bills is above 2%, higher than the 1.8% dividend yield on equities. But investors in Europe and Japan face negative yields on cash. Our recent Special Report analyzed three investment instruments that could enhance a balanced portfolio's risk-adjusted returns (Chart 13).2 Floating-Rate Notes. FRNs tend to be issued by government-sponsored enterprises and investment-grade corporations. They offer a nice yield pick-up over short-term U.S. Treasuries with significantly shorter duration. However, they do carry credit risk and so performed poorly in the 2007-9 recession. We, therefore, recommend investors fund these positions from their high-yield bucket. Leveraged Loans. These are floating-rate senior-secured bank loans. However, secured does not mean safe. Most are sub-investment grade and can be very illiquid, because physical delivery is often needed. They tend to be positively correlated with junk bonds but negatively correlated with the aggregate bond index. This suggests that adding bank loans to a portfolio can add diversification, and that replacing some high-yield holdings with bank loans can generate a sub-investment grade basket with a better risk/reward profile. Danish Mortgage Bonds. DMBs are covered mortgage bonds, with an average duration of five years and offering a yield to maturity of around 2% in Danish Krone. They have a strong track record: not a single bond has defaulted in the 200-year history of the market. This makes the market very attractive to euro zone and Japanese investors struggling with low bond yields. We find that adding DMBs to a standard bond portfolio significantly improves its risk/return profile. The main snags are that this is a fairly small market with a total outstanding market value of DKR2.7 trillion (around USD400 billion) - and is already 23% owned by foreigners. Global Economy Overview: The global economy will continue to be characterized by significant divergences. U.S. growth remains robust, pushing up inflation to the Fed's 2% target. By contrast, European and Japanese growth has weakened so far this year, meaning that central banks there remain cautious about tightening. Meanwhile, emerging markets will continue to deteriorate, faced with an appreciating dollar, rising U.S. interest rates, and lack of a big stimulus in China. U.S.: The ISM manufacturing index hit a 14-year high, above 60, in September before falling back slightly, to 59.8, in October. Core PCE inflation has reached 2%, the Fed's target. Wage growth, as measured by average hourly earnings, has finally begun to accelerate, reaching 2.9% YoY. With consumption and capex likely to remain robust, and the effect of fiscal stimulus not peaking until early next year, the U.S. economy will continue to grow strongly through 2019 (Chart 14). Only the recent slowdown in housing (probably caused by higher interest rates) remains a concern, but the sector is probably too small to derail overall economic growth. Chart 14Divergences Continue: U.S. Strong... Divergences Continue: U.S. Strong... Divergences Continue: U.S. Strong... Chart 15...Rest Of The World Weakening ...Rest Of The World Weakening ...Rest Of The World Weakening Euro Area: The decline in growth momentum seen since the start of the year has probably now bottomed. Both the PMI and ZEW indexes appear to have stabilized at a moderately positive level (Chart 15, panel 1). Core CPI inflation remains stable at about 1%, though headline inflation has been pushed up by higher oil prices. In this environment the ECB will be slow to raise rates, probably waiting until September next year and then hiking by only 10 basis points. Japan: The external sector has weakened, as shown by the industrial production data and leading economic indicators, probably because of slowing growth in China. However the domestic sector is showing signs of life, with corporate profits growing by more than 20% year-on-year, and capex rising at a rapid pace (6.4% YoY in Q2). However core inflation remains barely above zero, and therefore the Bank of Japan will continue its Yield Curve Control policy for the foreseeable future. Emerging Markets: Chinese growth continues to slow moderately, with the Caixin manufacturing PMI exactly at 50 (Chart 15, panel 3). The key question now is whether the authorities will implement massive stimulus, as they did in 2009 and 2015. The PBOC has cut rates and the government announced that it is bringing forward some fiscal spending. But the priority remains to deleverage and push ahead with structural reform. We do not expect, therefore, to see a significant acceleration of credit growth. Elsewhere in EM, central banks have significantly raised interest rates to defend their currencies, and this is likely to trigger recession in many countries within the next six months. Interest rates: Monetary policy divergences are likely to continue. The Fed will hike by 25 basis points a quarter until there are signs that growth is slowing and that tightness in the labor market is easing. Inflation is not showing signs of dramatic acceleration but, with the labor market so tight, the Fed will want to take out insurance against a future sharp rise. By contrast, the ECB and BOJ have no need to tighten (Chart 15, panel 4). Accordingly, we expect to see US long-term interest rates rise, with the 10-year Treasury bond yield reaching 3.5% in the first half of 2019. Chart 16When Will Earnings Turn Down? When Will Earnings Turn Down? When Will Earnings Turn Down? Global Equities Stay Cautious: We turned cautious on equities in the previous Quarterly Strategy Outlook,3 by upgrading the low-beta U.S. equity market to overweight at the expense of the high-beta euro area, by taking profit in our pro-cyclical tilt and moving to more defensive sectors, and by maintaining our core position of overweight DM relative to EM. Those moves proved to be effective as DM outperformed EM by 6%, the U.S. outperformed the euro area by 7.5%, and defensives outperformed cyclicals by 1.2%. Because of the sharp underperformance of EM equities relative to DM peers, it's tempting to bottom-fish EM equities. However, we suggest investors refrain from such an urge because we think it's too early to take such risk (see nexts section below). We therefore maintain our defensive tilts in both regional and country allocation and global sector allocation (see table at the end of the report). Equity valuations are less stretched than at the beginning of the year, due to strong earnings growth. However, BCA's global earnings model shows that earnings growth will slow significantly next year (Chart 16, panels 1 & 2). With earnings growth for every sector in positive territory, and the DM profit margin near a historical high, it would not take much for analysts to revise down earnings expectations (bottom 3 panels). Reflecting the GICS sector reclassification, we have initiated a neutral on the Communication sector and an underweight on the Real Estate sector. Chart 17EM Underperformance To Continue EM Underperformance To Continue EM Underperformance To Continue Continue To Underweight EM Vs. DM Equities Underweight EM equities vs. the DM counterparts has been a core position in GAA's global equity portfolio (in U.S. dollars and unhedged) this year. Despite the significant performance divergence over the past few months, we recommend investors continue to underweight EM equities, for the following reasons: First, BCA's House View is for the U.S. dollar to strengthen further, especially against EM currencies. This does not bode well for the EM equity performance relative to DM equities, given the close correlation of this with EM currencies (Chart 17, panel 1); Second, Chinese economic growth plays an important role in the EM economy. China's large weight in the EM equity index also makes the link prominent. With increasing concern from the trade war with the U.S., Chinese imports are likely to deteriorate, implying the sell-off in EM shares may have further to go (panel 2); Third, EM earnings growth is closely correlated with money supply as shown in panel 3. Forward earnings growth will have to be revised down given the slowing in money growth. Finally, even though EM equity valuations are now cheap on an absolute basis, EM equities have mostly traded in history at a discount to DM. Currently, the discount is still in line with historical averages (panel 4). Chart 18Real Estate Sector Looks Vulnerable Real Estate Sector Looks Vulnerable Real Estate Sector Looks Vulnerable Sector Allocation: Underweight on Real Estate and Neutral on Communication With the recently implemented GICS reclassification, involving the creation of a new Communication Services Sector by moving the media component in Consumer Discretionary and the internet companies in IT to the old Telecom Services sector (see section below for more details), we are reviewing our global sector allocations. Since we were already neutral on IT and Telecom Services, and since the new Communication sector is dominated by internet companies, it's natural to be neutral on the new Communication sector. Real Estate was lifted out of the Financials sector in 2016 to be a separate sector. But we did not include this sector previously in our recommendations because it mostly consists of commercial real estate (CRE) investment trusts. In our alternative asset coverage, we had preferred direct real estate due to its lower correlation with equities in general. In July this year, however, we downgraded exposure to direct real estate.4 It's much easier to reduce REITS holdings than direct CREs. As such, we take this opportunity to initiate an underweight on the Real Estate sector, mainly because of the less favorable conditions in both the macro backdrop and industry fundamentals. From a macro perspective, the tailwind from declining interest rates has turned into a headwind as interest rates rise. Over the past few years, the relative performance of Real Estate to the overall equity index has been closely correlated with the rise and fall of the long-term interest rates. BCA expects 10-year interest rates to trend higher. This does not bode well for the sector's equity performance going forward (Chart 18, panel 1). Industry fundamentals look vulnerable as well. The occupancy rate has already started to decline (panel 2). CRE prices have been making new highs on an inflation-adjusted basis, fueled by a historically high level of CRE loans and low level of loan delinquencies (Chart 18, panels 3 and 4). All these make the CRE sector extremely vulnerable. Government Bonds Maintain Slight Underweight On Duration. The U.S. 10-year government bond yield traded in a tight range in Q3 between 2.8% and 3.1%. With the current yield at 3.07% and the most recent inflation reading below expectations, it's tempting to take a less bearish view on duration, especially given the weakness in EM economies and EM asset prices. We agree that the spillover from weak global growth into the U.S. might cause the Fed to pause its gradual 25bps-per-quarter rate hike cycle at some point in 2019; however, markets currently have priced in only two rate hikes in the entire year of 2019, which means the risk is already priced in. With increasing pressure from rising supply, we still see rates rising over the next 9-12 months and so our short duration recommendation for government bonds is unchanged (Chart 19). Chart 19Rising Supply Will Push Up Rates Rising Supply Will Push Up Rates Rising Supply Will Push Up Rates Chart 20TIPS Breakevens Have A Little Further To Go TIPS Breakevens Have A Little Further To Go TIPS Breakevens Have A Little Further To Go Favor Linkers Vs. Nominal Bonds. BCA's U.S. Bond Strategy still believes that the U.S. TIPS break-evens will reach to our target range of 2.3%-2.5% because core inflation should remain close to the Fed's 2% target going forward. The latest NFIB survey supports this view as wage pressure is still on the rise, with reports of compensation increases near a record high (Chart 20). Compared to the current breakeven level of 2.1%, this means 10-year TIPS have upside of 20-40bp, an important source of return in the low-return fixed-income space. Maintain overweight TIPS vs. nominal bonds. However, TIPS are no longer cheap. For those who have not already moved to overweight TIPS, we suggest "buying TIPS on dips". Inflation-linked bonds (ILBs) in Australia and Japan are also still very attractive vs. their respective nominal bonds. Overweighting ILBs in those two markets also fits well with our macro themes. Corporate Bonds Chart 21Spreads Not Attractive Spreads Not Attractive Spreads Not Attractive After being overweight for over two years, last quarter we turned neutral on corporates, including high-yield credits, within a global bond portfolio. Developed market corporate bonds have performed poorly in 2018 led by weak returns in the Financials sector and steepening credit curves.5 On the positive side, global corporate health (Chart 21) has been improving, led by the resilience of the U.S. economy and tax cuts that have put corporations in a cyclically healthier position. However, this may not be sustainable as the tightening labor market is pushing up wage growth, which will pressure margins. Interest coverage has fallen in recent years despite strong profitability and low borrowing costs. The risk of downgrades will rise when the earnings outlook weakens or borrowing costs start to rise. An additional concern is that weaker global ex-U.S. growth and a stronger dollar will weigh on U.S. corporate revenues. In the euro area, interest coverage and liquidity continue to improve, supported by easy monetary policies that have lowered borrowing costs. However, with the ECB set to end its corporate bond purchase program along with purchases of sovereign bonds at the end of the year, euro area corporate bonds will lose a major support. In Japan, leverage has been steadily falling and return on capital rising, pushing up the interest coverage multiple to 9.6x, the highest in developed markets. With Japanese corporate profits at an all-time high, default risk is low. The BoJ's forward guidance suggests no tightening until 2020, giving corporates a low cost of borrowing and probably a weak currency. Excess spread from U.S. high-yield bonds after adjusting for expected default losses is 226 bps, slightly below the long-run mean of 247 bps. Most indicators suggest that default losses will remain low for the next 12 months, but it will be critical to track real-time indicators such as job cuts to see if there is any deterioration in growth which might start to push up default rates. With a global corporate bond portfolio, we prefer Japanese and U.S. credits to euro area corporates. Chart 22Prefer Oil Over Metals Prefer Oil Over Metals Prefer Oil Over Metals Commodities Energy (Overweight): Oil prices will continue to be driven by demand/supply fundamentals. We believe that that supply shocks will have more influence on the crude oil price over the coming months than will lower demand from EM (Chart 22, panel 2). U.S. sanctions on Iranian oil exports are estimated to take 800K-1M barrels a day out of global supply. We also factor in the risk of political collapse in Venezuela and outages in Iraqi and Libyan production, which would push oil prices higher. BCA's energy team forecasts that Brent crude will average $80 until year-end, and $95 by the end of the first half of next year.6 Industrial Metals (Neutral): An appreciating dollar along with weaker consumption of base metals in China, the world's largest consumer, are likely to keep industrial metals' prices depressed and to increase volatility over the next few months (panel 3). Additionally, the easing of U.S. sanctions on some Russian oligarchs connected with aluminum producer Rusal is likely to keep a lid on aluminum prices for now. Precious Metals (Neutral): Gold has been weak despite global uncertainties and political tensions arising from the U.S.-China trade spat, Middle East politics, and EM weakness. Since we see further upside in inflation in the coming months and remain concerned about global risk, gold remains an attractive hedge. However, rising real interest rates and the strong dollar will limit the upside (panel 4). Chart 23Further Upside For The Dollar Further Upside For The Dollar Further Upside For The Dollar Currencies U.S. Dollar: The dollar has continued its appreciation over the past couple of months, propelled by a moderately hawkish Fed and strong economic data. We see further upside to inflation, though the latest print fell short of expectations. Tighter financial conditions in the U.S. will add further upside to the currency on a broad trade-weighted basis, as well as against other majors (Chart 23, panels 1 and 2). EM Currencies: Dollar appreciation, higher interest rates, increasing trade tensions, and a slowdown in China, have put pressure on EM currencies. We expect these conditions to continue. Sharp interest rate hikes in Argentina and Turkey have not stopped the fall, probably because markets anticipate that the hikes will trigger recessions in these countries. Euro: Weak European economic data and downward growth revisions have put downward pressure on the currency. Additionally, looming political uncertainty in Italy, Europe's large exposure to EM, and continuing trade-war tensions make it likely that the euro will decline further (panel 4). The ECB confirmed its plan to end asset purchases by year-end, but is likely to raise rates only in late 2019. We maintain our view that EUR/USD will weaken to at least 1.12. GBP: Brexit issues continue to affect the pound: the only driver that could push GBP higher would be if both the European Union and the U.K. parliament agree to Theresa May's "Chequers plan". However, with strong opposition from both pro-Brexit Conservative MPs and the Labour Party, the chance of approval seem low. We remain bearish on the pound until there is more clarity on how Brexit will pan out and expect increasing volatility until then. Chart 24Signs Of Overheating In Alts? Signs Of Overheating In Alts? Signs Of Overheating In Alts? Alternatives Alternative assets under management continue to grow to record highs, driven by positive sentiment, the global search for yield, and the need for uncorrelated returns. However, there are increasing signs of overheating in the core areas of this market. We analyze our allocation recommendations using a framework of three buckets: 1) return enhancers, 2) inflation hedges, 3) volatility dampeners. Return Enhancers: In H1 2018, private equity (PE) outperformed hedge funds by 6.4% (Chart 24). However, last quarter we recommended investors pare back on their PE allocations and increase hedge funds. Rising competition in PE has pushed deal valuations to new highs, and we expect to see funds raised in 2018-2019 produce poor long-term returns because of higher entry valuations.7 Within the hedge fund space, we recommend investors shift to macro hedge funds, as the end of the business cycle approaches. Inflation Hedges: In H1 2018, commodity futures outperformed direct real estate by over 7%. We remain cautious on commercial real estate (CRE). Loans to CRE have reached a record $4.3 trillion, 11% higher than at the pre-crisis peak. As central banks tighten monetary policy, financial stress is likely to appear in CRE. CRE prices peaked in late 2016 and have subsequently moved sideways, partly due to the downturn in shopping malls and retail. Commodity futures, on the other hand, have performed well on the back of rising energy prices. However, we expect increased volatility in commodities due to supply disruptions in oil, and a further slowdown in EM demand. Volatility Dampeners: In H2 2018, farmland and timberland outperformed structured products by 3%. Timberland has a stronger correlation with economic growth via the U.S. housing market. This year, lumber prices have fallen from over $600 to $340, mostly due to speculative action in the futures market. However, this will ultimately impact income from timber sales. Farmland is more insulated from the economy since food demand is autonomous consumption. Structured products face pressures as rising rates push lower-quality tranches closer to default. Investors should favor farmland over timberland, and maintain only a minimum allocation to structured products. Risks To Our View Our main scenario, as outlined in the Overview, is that this year's trends will continue. What might cause them to change? Chart 25China Has Cut Rates A Bit China Has Cut Rates A Bit China Has Cut Rates A Bit Chart 26...But Fiscal Spending Not Yet Picking Up ...But Fiscal Spending Not Yet Picking Up ...But Fiscal Spending Not Yet Picking Up The biggest risk is Chinese policy. A big stimulus, in line with those in 2009 and 2015, would boost growth in emerging markets, Europe and Japan, push up commodity prices, and weaken the dollar. The PBoC has cut rates (Chart 25) and lowered the reserve requirement. The government has said it will bring this year's budget plans forward, though for now fiscal spending is slowing compared to last year (Chart 26). Faced with a major slowdown and devastating trade war, the Chinese authorities would doubtless throw everything at the problem. But, up until that point, their priority remains deleverage and reform, and so we expect them to do no more than moderately cushion the downside. Chart 27Are Speculators Too Long The Dollar? Quarterly - October 2018 Quarterly - October 2018 As always, a major factor is the U.S. dollar, which we expect to appreciate further, as the Fed tightens more than the market expects, and U.S. growth outpaces the rest of the world. What's the most likely reason we're wrong? Probably a situation like 2017, when speculators were very long the dollar just as growth in Europe started to accelerate relative to the U.S. Today, speculative positions are moderately long the dollar, but against the euro and yen not as much as in early 2017 (Chart 27). Aside from a Chinese reflation, it is hard to see what would propel an ex-U.S. growth spurt. True, Japanese capex and wages are showing some signs of life. But Japan worryingly intends to raise VAT in late 2019. And Europe faces considerable political risks - Brexit, Italy, troubled banks, contagion from Turkey - that make it unlikely that confidence will rebound. 1 For more details on this, please see section “What Our Clients Are Asking: Is The Fed Turning Dovish?” in this report. 2 Please see Global Asset Allocation Special Report, "Searching For Yield In A Low Return Environment," dated September 14, 2018 available at gaa.bcaresearch.com 3 Please see Global Asset Allocation "Quarterly - July 2018," dated July 2, 2018 available at gaa.bcaresearch.com 4 Please see Global Asset Allocation "Quarterly - July 2018," dated July 2, 2018 available at gaa.bcaresearch.com 5 Please see Global Fixed Income Strategy Weekly Report titled "A Performance Update On Global Corporate Bond Sectors," dated September 4, 2018 available at gfis.bcaresearch.com 6 Please see Commodity & Energy Strategy Weekly Report, "Odds of Oil-Price Spike in 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl," dated September 20, 2018. 7 Please see Global Asset Allocation Special Report on private equity, "Private Equity: Have We Reached The Top?," dated September 26, 2018 available at gaa.bcaresearch.com GAA Asset Allocation

Highlights Investors have piled into private equity (PE) in recent years, pushing assets under management (AUM) up to an all-time high of $3 trillion. However, there are increasing concerns about the outlook for the asset class over the next few years. In this report, we look at the fundraising and deal environment for PE, analyze historical risk-adjusted returns in comparison to traditional assets, and suggest how investors can optimize their PE allocation. Private equity and its two major sub-categories, buyouts and growth capital, have generated annualized returns of 13.4%, 13.7%, and 15.0% respectively over the past 32 years, significantly beating the returns from global equities and small-cap stocks of 8.4% and 9.1%. But the current environment is tougher. Dry powder (funds raised but not yet invested) exceeds $1 trillion. PE managers face increased competition from other investors and from companies with large cash balances looking to make acquisitions. Funds raised at the peak of bull markets have a higher probability of underperforming. The next two vintage years (2018 and 2019) face headwinds to making good returns, because of high entry valuations and a rising cost of borrowing. Manager selection is critical for a successful private-equity program. Top-quartile PE funds have outperformed second-quartile funds by as much as 8% a year over the past two decades. Feature Introduction The private equity (PE) market has grown more than five-fold since 2000, lifting assets under management from $577 billion to $2.97 trillion. However, its share of the private investment market has declined from 82% to 58% (Chart 1). Private equity and venture capital investing is said to date back to 1901 when J.P. Morgan purchased Carnegie Steel Co from Andrew Carnegie and Henry Philips for $480 million. The industry has evolved significantly over the years, and now encompasses a wide range of sub-strategies, offering investors a spectrum of exposures with very different risk/return profiles. Chart 1Private Equity Is A $3 Trillion Market Private Equity: Have We Reached The Top? Private Equity: Have We Reached The Top? Compared to public equity, private equity investing is harder because of: 1) long-term illiquidity, whereas public equities can be bought and sold quickly, 2) limited information on target companies, 3) the lack of a clear price discovery function, meaning that pricing in private markets depends heavily on negotiations, 4) less separation between ownership and control - finance providers in PE tend to be managers too. The PE space has matured over the years, and this is clearly seen in the compression of returns. However, many investors remain bullish on this asset class because of its historically attractive risk-adjusted return, and ability to diversify traditional portfolios. As of mid-2017, the median net return of the PE holdings of public pensions globally over the previous 10 years was 8.5% compared to 4.2% for public equities, 4.5% for real estate, and 5.2% for fixed income.1 In this report, we analyze in detail the PE market, with an overview of the fundraising cycle, deal environment, and exit channels. We include in-depth analysis of historical returns from the private equity market in aggregate, and from its two largest sub-categories, buyouts and growth capital. We end by listing the key risks for limited partners (LPs - the investors in PE funds), and include a brief note on private-equity secondary investing. Our key conclusions are: Private equity, including buyouts and growth capital, has had exceptionally good returns over the past three decades, but has been on a structural downtrend as competition has increased. Buyout funds generate a negative skew and moderate kurtosis, whereas growth capital tends to have a larger kurtosis and positive skew. Funds raised at the peak of bull markets have a greater probability of underperforming given their higher entry valuations. This is likely to be the case for funds raised over the next 18 months. The current economic cycle has produced fewer home-run deals - in 2002-2005, 35% of deals produced returns of 3x invested capital, but this fell to 20% in the 2010-2013 period. Megacap buyout funds produce the best returns, but this comes with significantly higher volatility pushing down the risk-adjusted return. These larger funds experience larger negative skew and kurtosis driven by greater use of leverage. Entry valuations of investments made by PE funds have been steadily rising, and so has leverage: the median debt/EBITDA has reached 5.5x. As multiples keep rising, general partners (GPs - the fund managers) have to make up the difference with equity infusion. Top-quartile managers have significantly outperformed. Third-quartile managers struggled even to outperform global equities, and fourth quartile managers failed to preserve their initial capital. The secondary PE market is growing. It provides access to mature portfolio assets deeper into their distributions phase, which reduces the duration of the LP's investment. Fundraising, Deals, And Exits Private equity investing consists of many different sub-categories (Chart 2) that differ in value creation techniques and the maturity of target companies. Buyouts and growth capital are over 90% of the total. Buyouts2 invest in established companies, usually with the intention of improving operations and financials. There is usually substantial use of leverage. Growth capital3 takes significant minority positions in profitable yet still maturing companies mostly without the use of leverage. Secondary funds acquire stakes in PE funds from other LPs. Co-investment funds make minority investments alongside a buyout, recapitalization, or any other non-controlling investment. Turnaround funds aim to revitalize companies that face operational difficulties. Chart 2Buyouts & Growth Capital Are 90% Of PE Private Equity: Have We Reached The Top? Private Equity: Have We Reached The Top? Private-equity firms raised $701 billion in 2017, making the past five years the strongest period for fundraising in history, with a total of $3.2 trillion (Chart 3). Additionally, more than two-thirds of the funds which closed in 2017 met or exceeded their target amounts, and 39% took less than a year to close. The last time fundraising peaked was in 2008, right in the middle of the last recession. However, since 2009, fundraising for buyouts has dropped from 85% to 70% of the aggregate for private equity, with growth capital picking up the slack, rising from 8% to 21%. As fundraising has gotten stronger, PE firms have been raising larger funds.4 These megafunds (with AUM greater than $5 billion) raised $174 billion in 2017, or 58% of that year's total buyout volume, a steep increase from $90 billion in 2016. For investment institutions with large amounts of capital to deploy, megafunds are an attractive and efficient outlet. Another reason for the very strong fundraising environment has been quick follow-up funds, where GPs race to launch new funds before predecessor funds have matured. Historically GPs have waited an average of 62 months between closing one fund and starting the next, but this has come down to 40 months in the past five years. With fundraising so strong, GPs are under pressure to deploy this capital wisely. Global PE deal volume increased by 14% in 2017, surpassing $1.2 trillion (Chart 4). But global deal count has been on the decline since 2015. Along with larger funds being raised, the average deal size in the private market has been rising steadily since the Global Financial Crisis (GFC). Despite increasing deal activity, the sheer volume of fundraising in recent years has led to massive accumulation of dry powder,5 which currently stands at $1.03 trillion. After 2008, dry powder as a percentage of AUM (Chart 5) was on a downward trend because of increased acquisition activity due to attractive valuations following the GFC. But this bottomed in 2012 at 29% and had risen to 35% at the end of 2017. If this level of dry powder accumulation continues, GPs will be forced to reduce hurdle rates and deploy capital into less attractive deals. Chart 3$3.2 Trillion Raised in 5 Years $3.2 Trillion Raised In 5 Years $3.2 Trillion Raised In 5 Years Chart 4Rising Deal Size Rising Deal Size Rising Deal Size Chart 5Harder To Find Attractive Deals Harder To Find Attractive Deals Harder To Find Attractive Deals Another reason for dry powder accumulation is increasing competition for deals both within the private equity market, and from external sources. The number of private equity funds is at an all-time high of 7,775.6 The external competition comes largely from corporate buyers with large cash balances looking for inorganic growth. Corporations have two advantages over PE firms: 1) potential built-in synergies when it comes to integrating the target, giving them the ability to pay a higher price, and 2) a lower cost of capital. An increasing number of corporations have been setting up corporate venture-capital units (Chart 6) to focus on acquisition-led growth. In 2017, there were 38,479 companies bought and sold globally for a total value of $3.3 trillion. But, private equity's share of this market was just 13% by deal value and 8% by deal count (Chart 7). Looking forward, PE funds are likely to act more aggressively and take a larger share of the market, as they did in 2006-2007. In order to increase their share of global deal activity, private-equity funds need to look at more strategic ways to pick up assets: Chart 6Corporations Setting Up VCs Corporations Setting Up VCs Corporations Setting Up VCs Chart 7Buyouts Only A Tiny Player In Global M&A Private Equity: Have We Reached The Top? Private Equity: Have We Reached The Top? Zombie Assets: Assets (portfolio companies) belonging to funds that last raised initial capital between 2003 and 2008 but have not executed a deal since 2015. Currently there are over 100 such companies that are possible targets for takeover in 2018-2019. Carve-Outs: Over the past few years, one in five deals in the U.S. has come from corporations disposing of non-core assets.7 This provides a steady deal flow for buyout and turnaround funds. Public To Private: As multiples in private markets converge with those in public markets, more and more publicly listed companies are being taken private, and this market has doubled since 2016 (Chart 8). Additionally, lenders have become more comfortable about financing these high-value transactions. Buy & Build/Add-Ons: Purchasing cheaper small assets and adding them to existing large established platform companies. This in turn transforms a group of smaller companies at lesser multiples into a larger corporation with a premium valuation. Add-ons made up one-third of deals a decade ago, but that has now reached 50%. But, since such deals are smaller in terms of dollar value, they make up less than 25% of the total deal volume. Finally, PE firms have also been increasing the holding period of the assets in their portfolio. The median holding period before the GFC was four years, and this has now increased to over five years (Chart 9). Additionally, private equity firms exited 40% of all deals in fewer than three years, but now these quick-flips have fallen to only 20%. This is partly a response to increased competition: GPs are skeptical about finding new attractive deals, and this forces them to hold onto assets for as long as possible. Additionally, the new U.S. tax code has increased from one to three years the threshold period for carry to be treated as capital gain with a lower tax rate, rather than taxed as ordinary income. With fundraising on fire but deal activity struggling to keep pace, the final pillar for a successful private equity program is the exit environment. Global PE-backed exits have been flat for the past two years at around $500 billion, with the deal count between 2,500 and 3,000 (Chart 10). The rise in exit activity in 2015 was fuelled by PE firms looking to exit portfolio companies acquired before the financial crisis. By 2017, the dynamic had changed since more than 80% of exits that year were companies acquired in 2009 or later. Finally, dividend recapitalizations8 reached $42 billion in 2017, but these are heavily dependent on an accommodative debt market and positive environment for high-yield bonds. With rising rates, dividend recapitalization, and other forms of special dividends or distributions that require borrowing, become harder to execute. Chart 8Public-To-Private Activity Public-To-Private Activity Public-To-Private Activity Chart 9Longer Holding Periods Longer Holding Periods Longer Holding Periods Chart 10Global PE Exits Are Healthy Global PE Exits Are Healthy Global PE Exits Are Healthy Historical Returns Before we look at the past risk-return profile of investing in this asset class, a note on the data used in this report. All return data are based on the Cambridge Associates Private Investment Benchmarks.9 We are satisfied with the methodology used and the format in which the returns are presented. The provider has taken sufficient steps to minimize survivorship bias. For more details on the data methodology, please see the Appendix. What can investors expect in terms of risk-return exposure from this asset class? Looking at Table 1, private equity and its sub-strategies have comfortably outperformed global equities, with lower volatility, over the past 32 years. Even after statistically adjusting returns for stale pricing,10 volatility for aggregate private equity and buyouts remains lower than for global equities and small-cap stocks. On the other hand, growth capital has had realized volatility greater than that of global equities, but with a significantly higher return; it is still the more attractive investment on a risk-adjusted basis. However, the significantly lower realized volatility of PE in aggregate, and buyout funds in particular, compared to growth capital makes them more attractive investments. Additionally, venture capital experienced volatility of close to 42%, more than double that of small-cap stocks, making it very unattractive from a risk-adjusted perspective. Table 1Risk-Return Spectrum Private Equity: Have We Reached The Top? Private Equity: Have We Reached The Top? However, comparing the performance of PE with that of publicly traded assets could be misleading given the uncertain timing of cash inflows and outflows from private equity programs. Therefore, we also show the Public Market Equivalent11 (PME) to adjust public-market indices for uncertain cash flow streams. Looking at Tables 2-4, we can see that private equity still outperforms equity indices on a PME basis over different time frames. Table 2Private Equity PME Analysis Private Equity: Have We Reached The Top? Private Equity: Have We Reached The Top? Table 3Buyout PME Analysis Private Equity: Have We Reached The Top? Private Equity: Have We Reached The Top? Table 4Growth Capital PME Analysis Private Equity: Have We Reached The Top? Private Equity: Have We Reached The Top? Another unique characteristic of private-market returns is the J-curve effect where investments in private markets take time to bear fruit, and fees are initially based on committed capital rather than invested capital. In addition, the biggest cash flows will be received towards the end, so the returns for the first few years can be misleading. IRR will remain negative until the point when distributions at least match contributions (the payback point). Given the non-linear return distribution of alternative assets such as PE and venture capital, risk analysis is not complete without skewness and kurtosis. Investing in buyout funds generates a negative skew and a moderate level of kurtosis, which means that investors can expect more stable, predictable returns, closer to a normal distribution. However, growth capital tends to have larger kurtosis and positive skew, thereby a higher probability of large upside gains. Since buyout capital structures tend to be more heavily geared, there is a higher skew towards negative returns driven by the leverage effect. Venture capital exhibits a return distribution similar to growth capital, where a few portfolio companies produce large positive returns given the start-up nature of its targets. PE returns remain attractive but, as with other alternative asset classes, performance has been on a downward trend (Chart 11) driven by increased competition. In the 1980s and 1990s, buyout firms exploited the poor performance of large U.S. conglomerates by acquiring underperforming divisions and using leverage. In the early 2000s, funds took advantage of the stock market rise, fuelled by low rates and levered returns. Within the structural downtrend in returns, PE has had a cyclical profile just like public equities. During bull markets there are more exits at higher valuations, and larger distributions to LPs. However, funds raised in bull markets have a higher probability of underperforming given their higher entry valuations. Looking forward, funds from recent vintages that are halfway through their life are likely to be able to take advantage of current tailwinds to build value and exit at the top. However, funds raised in the next two years will have to deal with high entry valuations and a possible increase in the cost of borrowing. There have been fewer write-offs and deals with capital impairments in the post-2009 period than in the years after the 2001 recession. However, the current economic cycle has produced fewer of the home-run deals that really drive PE performance. For example, in 2002-2005, 35% of deals produced returns of 3x invested capital or better, and more than 50% generated multiples of 2x or better. For the period 2010-2013, the equivalent percentages were 20% and 42% respectively. Looking at Chart 12, we can see that PE, buyout, and growth capital funds outperformed global equities and small-cap equities during recessions and equity bear markets. Chart 11Private Vs. Public Equity Private Vs. Public Equity Private Vs. Public Equity Chart 12Recession & Bear Markets Private Equity: Have We Reached The Top? Private Equity: Have We Reached The Top? Return persistence is the ability of top-performing manager to repeat the strong performance in their follow-up funds. In the PE industry, some large firms have proved able to repeat top-ranked performance time after time across multiple funds. We believe this is likely a function of their network of contacts that gives them access to proprietary deal flows. However, there are three factors that may be creating a spurious correlation here: 1) GPs tend to raise new funds 2-5 years into the life of an existing fund, thus creating overlapping structures of successive funds that are exposed to similar market environments, 2) investments in some portfolio companies are split between successive funds which induces a spurious patterns of performance persistence, 3) much of the top-quartile performance persistence came during periods of low competition. There is also a relationship between holding period and performance, whereby funds that hold onto portfolio companies for longer have lower performance, while quick-flips perform better. Funds have an incentive to exit successful investments earlier to show a good track record, and to extend the holding period of unsuccessful ones hoping for a better outcome. There is an intrinsic cyclicality in this relationship: in bear markets when valuations are low, funds will hold off from selling their assets in the hope of a better time to sell. Table 5 show the average returns LPs can expect from investing in companies with a specific sector focus. But, this comes with a large amount of idiosyncratic firm- and sector-specific risk; this tends to have a larger impact on buyouts than on venture capital which is already very industry focused. Geographic diversification gives investors access to different economic cycles and levels of market maturity across the globe. In the last recession, PE performance was very poor in some regions, while not that bad in others. There has been a clear cyclical pattern for U.S. versus ex-U.S. performance over the past 30 years, closely linked to the relative growth rates in the underlying economies (Chart 13). Table 5Returns By Sector Exposure Private Equity: Have We Reached The Top? Private Equity: Have We Reached The Top? Chart 14 shows that from Q3 1998 to Q4 2000 relative performance between buyout and growth capital funds tended to move along with the interest-rate trajectory - the former benefits from falling rates which lower the cost of borrowing. Additionally, looking at median net IRR for funds by vintage year, we see that buyouts outperformed growth capital in 17 out of the 21 years (Chart 15). This was driven by stronger distributions to buyout fund LPs. Additionally; it was achieved with a fairly similar standard deviation of fund performance across vintage years. Within the buyout space, the median U.S.-focused buyout fund outperformed its ex-U.S. counterpart only in 2004-2012. Chart 13U.S. Vs. Rest Of The World U.S. Vs. Rest Of The World U.S. Vs. Rest Of The World Chart 14Impact Of Rising Rates Impact Of Rising Rates Impact Of Rising Rates Chart 15Buyouts Vs Growth Capital Private Equity: Have We Reached The Top? Private Equity: Have We Reached The Top? Finally, when allocating to private-equity and especially buyout funds, investors have a choice between different deal sizes (small to megacap). Looking at Table 6, it is clear that megacap buyout funds have been able to produce the best returns, but this came with significantly higher volatility, pushing down risk-adjusted returns. Additionally, these megacap deals have a larger negative skew and kurtosis - investors should expect a higher probability of large negative returns. Looking at performance in recessions, one can find a relationship between the nature of the downturn and the performance of different buyout deal sizes. For example, during the 2001 recession, the smallest deal sizes produced the worst performance because smaller-cap tech stocks suffered in the aftermath of the dotcom bust. During the 2007-2009 recession, the worst hit were larger buyout deals because of the damage done to the credit market. An analysis of PE would not be complete without a discussion of valuations. The average deal size has risen by 25% since 2009: two-thirds of this increase is due to rising multiples, and the remaining one-third is organic (Chart 16). Median EV/EBITDA has risen from 5.6x in 2009 to 10.7x in 2017. Leverage levels have been rising alongside multiples, and so lenders will be more hesitant to offer debt financing for deals. GPs will have to to make up the funding shortage with equity infusion, and this leads to a decrease in IRR. Additionally, covenant-lite loans have been increasing since 2012 and are now 75% of overall loan volume in the U.S. The percentage of listed companies globally valued at more than 11x EV/EBITDA rose from 20% in 2012 to 54% in 2016. Table 6Size Matters Private Equity: Have We Reached The Top? Private Equity: Have We Reached The Top? Chart 16Private Equity Is Expensive Private Equity: Have We Reached The Top? Private Equity: Have We Reached The Top? Lastly, return dispersion is much larger for private-market investments compared to public markets, because of the more active nature of the investment process. If an LP had consistently picked only top-quartile managers from 2000, they would have outperformed second-quartile managers by an impressive 7.7% (Chart 17) a year. Top-quartile managers generated these higher returns with only a trivial increase in volatility, thereby producing far superior risk-adjusted returns. Additionally, skewness and kurtosis measures show no significant deterioration (Table 7). Third-quartile managers struggled even to outperform global equities, and fourth-quartile managers failed even to preserve initial capital. Therefore, manager selection is critical to building a successful private-equity program. Over the past decade, there has been clear compression in fees charged by private equity firms (Chart 18). Management fees tend to differ significantly between the smallest and largest funds; but they are fairly consistent at about 1.975% for funds with AUM between $100 million and $1.9 billion. Chart 17Manager Selection Is Critical Manager Selection Is Critical Manager Selection Is Critical Table 7Large Dispersion Private Equity: Have We Reached The Top? Private Equity: Have We Reached The Top? Chart 18Fee Compression? Private Equity: Have We Reached The Top? Private Equity: Have We Reached The Top? Risks In Private Equity Chart 19Strong Distributions Strong Distributions Strong Distributions The long-term investment horizon, illiquid nature, and unique structure of PE bring logistical challenges and unique risks. Given the erratic nature of capital draw-downs by GPs, some LPs might be unable to service capital calls which leads to their defaulting on their obligations. In this case, investors are exposed to funding risk and could lose their entire investment in the fund and all the capital already paid in. LPs tend to use distributions from a mature fund to finance capital calls of younger funds. But this may not be feasible in a slowdown when exits dry up and distributions slow, forcing LPs to raise additional capital from external sources12 for commitments. Many investors run an over-commitment strategy to avoid being under-exposed to their strategic allocation. The strong equity bull market has increased overall portfolio values, meaning that LPs have received large distributions, which have been double contributions since 2013 (Chart 19). Therefore, the net asset value (NAV) of PE holdings has not grown, and allocations even contracted in 2017, forcing LPs to keep plowing gains back into their programs to maintain the target allocation. Investors also face significant liquidity risk. GPs could be forced to sell portfolio companies in the secondary market at a discount to NAV, given the illiquid nature of the market. The secondary market tends to be very cyclical and is likely to experience a deal drought, as seen during the last financial crisis. Market risk is the impact of volatile markets on the quarterly changes in NAV of the portfolio. Capital risk relates to the realization value of the private-equity investments. There is a risk of a private-equity investment going bust and losing all its value. Holding a portfolio of funds exposed to many different companies can reduce this risk and generate a statistical distribution skewed towards positive returns. Additionally, diversification over multiple vintage years should create a right-skewed distribution that minimizes long-term capital risk. A Note On Private Equity Secondaries Chart 20Secondaries: Faster Return But Smaller Upside Private Equity: Have We Reached The Top? Private Equity: Have We Reached The Top? The secondary market for LPs' private-equity investments is growing. Direct secondaries are the sale of an interest in a direct PE investment or portfolio of direct PE investments to a new third-party investor. A secondaries fund is a PE fund raised by a fund-of-funds manager to acquire limited partnership interests in private equity from the original LPs. Secondary investing is no longer looked at as a source of liquidity for distressed investors, but as a differentiated investment strategy and a regular portfolio management tool to rebalance fund exposures and lock in realized gains. The secondary penetration rate (the percentage of total NAV across all PE strategies that trades in the secondary market) is still less than 2%13 but, as the secondary market continues to expand, investors may see a broader spectrum of assets on sale. Many investors look at the secondary market solely for opportunistic investments, making commitments only during or immediately following periods of market distress. Intuitively this makes sense, as secondary buyers should be able to negotiate steeper discounts during periods of elevated uncertainty and tight liquidity. However, there are many reasons to have a dedicated allocation: It Mitigates The J-Curve: Mature secondary investments cut off several years from the typical term of a PE fund because a good portion of the investment period is already completed. This generates immediate returns from the mature private-equity program. Many fund-of-funds managers will combine secondary interests with their primary portfolios to mitigate the J-curve. Less Blind Pool Risk: In private equity, LPs commit capital to a portfolio that is yet to be built. Secondary investing significantly reduces this risk because portfolios acquired are generally more than 50% invested and have less unfunded commitments. This provides investors with an actual portfolio of companies to evaluate. It Diversifies A Private-Equity Program: An allocation to secondaries can provide instant exposure to a highly diversified portfolio of mature private-equity interests. Lower Probability Of Poor Performance: The potential upside for secondary funds is not as high as that of primary funds, but the former produce poor returns much less frequently (Chart 20). Aditya Kurian, Senior Analyst Global Asset Allocation adityak@bcaresearch.com 1 Source: Bain Global Private Equity Report 2018. 2 Buyouts refers to deals in which a PE fund borrows a significant amount to acquire a target company or companies, which tend to be larger-cap private or publicly listed corporations. 3 Investments in mature companies with proven business models that are looking for capital to expand or restructure operations, enter new markets, or finance a major acquisition. 4 Apollo Investment Fund IX with an AUM of $24.7 billion raised in 2016-2017 is the largest buyout fund raised in history. 5 The amount of capital that has been committed to a private equity fund, but not yet deployed. 6 Source: Pitchbook. 7 The largest global buyout was the $17.9 billion carve-out of Toshiba Memory Corp in 2018. 8 Whereby a company owned by a private-equity fund issues debt in order to pay a dividend to the fund. 9https://www.cambridgeassociates.com/private-investment-benchmarks/ 10 To de-smooth returns, we used a first-order autoregressive model as shown by Rt = A0 + At Rt-1 + e, where At is the auto-regressive coefficient, and A0 is the intercept term. However, statistical methods do not always satisfactorily solve the problem of underestimated volatility for appraised asset values. 11 PME replicates the timing and size of private equity cash flows (purchases and sales) as if they had been invested in public equities. It is the dollar-weighted return that could have been achieved if funds had been invested in the index whenever a capital contribution was made and divested when the GP paid out a distribution. 12 In the Global Financial Crisis, Harvard Management Co issued a bond of more than $1 billion and considered selling a private equity stake of $1.5 billion at a 40%-50% discount to fund its capital calls. 13 Source: Preqin Ltd. Appendix: A Note On Data Sources And Definitions The performance indices all use quarterly unaudited, and annual audited fund financial statements produced by the GPs for their LPs. Partnership financial statements and narratives are the primary source of information concerning cash flows and ending residual/net asset values for both partnerships and portfolio company investments. The data providers' goal is to have a complete record of the quarterly cash flows and NAVs for all funds in the benchmark. All performance is calculated net of fees, expenses, and carried interest. Cambridge Associates (CA) uses two types of return calculation in its indices: Since Inception IRR: This calculates a discount rate which makes the NPV of an investment equal to zero. It is based on cash-on-cash returns over equal periods modified for the residual value of the partnership's equity or portfolio company's NAV. The residual value attributed to each respective group being measured is incorporated as its ending value. Transactions are accounted for on a quarterly basis, and annualized values are used for reporting purposes. End-To-End/Horizon IRR: A money-weighted return similar to the Since Inception IRR, except that it measures performance between two points in time. The calculation incorporates the beginning NAV, interim cash flows, and the ending NAV. All interim cash flows are recorded on the mid-period date of the quarter. With regards to avoiding survivorship bias, CA requires the complete set of financial statements from the fund's inception to the most current reporting date. When an active fund stops providing financial statements, CA reaches out to the manager to encourage them to continue to submit data. CA may, during this communication period, roll forward the fund's last reported quarter's NAV for several quarters. When CA is convinced that the manager will not resume reporting, the fund's entire performance history is removed from the database. Survivorship bias can affect all investment manager databases, including those of public asset managers. But the illiquid nature of private investments can actually help limit this impact, since the private investment partnerships owning illiquid assets will continue to exist and be legally required to report to the LPs even after the original manager ceases to exit. Over the past nine years the number of fund managers that stopped reporting to the database before liquidation averaged per year 0.7% of the total number of funds, and 0.6% of total NAV in the database. During that period the overall number of funds in the database increased by an average of 8% per year. Public Market Equivalent (PME): A private-to-public comparison that seeks to replicate private-investment performance under public-market conditions. The public index is recalculated as if shares were purchased and sold according to the private fund's cash flow schedule, with distributions calculated in the same proportion as the private fund. The PME NAV is a function of PME cash flows and public index returns. The PME attempts to evaluate the return that would have been earned had the dollars been deployed in the public markets instead of in private investments.

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* (%) Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment 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 Rising Rate Environment Benefits FRNs Rising Rate Environment Benefits FRNs Chart 2Corporate Dominance In FRN Market Corporate Dominance In FRN Market Corporate 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 FRNs: Not A Free Lunch FRNs: Not A Free Lunch Chart 4FRNs: A Lower Risk Alternative To Junk Bonds FRNs: A Lower Risk Alternative To Junk Bonds FRNs: 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* Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment 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. Leveraged Loans Vs. FRNs: U.S. Leveraged Loans Vs. FRNs: U.S. Chart 5BLeveraged Loans Vs. FRNs: Euro Area Leveraged Loans Vs. FRNs: Euro Area Leveraged 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. LLs Outperform Whe Rates Rise: U.S. LLs Outperform Whe Rates Rise: U.S. Chart 6BLLs Outperform When Rates Rise: Euro Area LLs Outperform When Rates Rise: Euro Area LLs Outperform When Rates Rise: Euro Area Chart 7Bank Loan Correlations With Traditional Bonds Bank Loan Correlations With Traditional Bonds Bank 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 Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment Table 3Risk Return Profiles Of Sub-Investment Grade Baskets Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment 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* Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment Chart 10DMBs For Japanese Investors DMBs For Japanese Investors DMBs 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 Rate Advantage Vs. Currency Risk Rate Advantage Vs. Currency Risk Chart 12DMBs For Euro Investors DMBs For Euro Investors DMBs For Euro Investors Chart 13DMBs As A Domestic Bond Substitute? DMBs As A Domestic Bond Substitute? DMBs 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 Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment 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.

Dear Client, I am travelling in Europe this week visiting clients. Instead of our Weekly Report, we are sending you a Special Report written by my colleague Xiaoli Tang of BCA's Global Asset Allocation. The report examines three types of instruments investors can look to in order to enhance risk-adjusted portfolio returns at a time when interest rates and inflation are low but rising: floating-rate notes, leveraged loans and Danish mortgage bonds. I trust you will find it informative. Best regards, Peter Berezin, Chief Global Strategist 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* (%) Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment 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 Rising Rate Environment Benefits FRNs Rising Rate Environment Benefits FRNs Chart 2Corporate Dominance In FRN Market Corporate Dominance In FRN Market Corporate 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 FRNs: Not A Free Lunch FRNs: Not A Free Lunch Chart 4FRNs: A Lower Risk Alternative To Junk Bonds FRNs: A Lower Risk Alternative To Junk Bonds FRNs: 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* Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment 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. Leveraged Loans Vs. FRNs: U.S. Leveraged Loans Vs. FRNs: U.S. Chart 5BLeveraged Loans Vs. FRNs: Euro Area Leveraged Loans Vs. FRNs: Euro Area Leveraged 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. LLs Outperform Whe Rates Rise: U.S. LLs Outperform Whe Rates Rise: U.S. Chart 6BLLs Outperform When Rates Rise: Euro Area LLs Outperform When Rates Rise: Euro Area LLs Outperform When Rates Rise: Euro Area Chart 7Bank Loan Correlations With Traditional Bonds Bank Loan Correlations With Traditional Bonds Bank 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 Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment Table 3Risk Return Profiles Of Sub-Investment Grade Baskets Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment 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* Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment Chart 10DMBs For Japanese Investors DMBs For Japanese Investors DMBs 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 Rate Advantage Vs. Currency Risk Rate Advantage Vs. Currency Risk Chart 12DMBs For Euro Investors DMBs For Euro Investors DMBs For Euro Investors Chart 13DMBs As A Domestic Bond Substitute? DMBs As A Domestic Bond Substitute? DMBs 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 Searching For Yield In A Low-Return Environment Searching For Yield In A Low-Return Environment 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. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Recommended Allocation Quarterly - July 2018 Quarterly - July 2018 Risks to equities and credit are now evenly balanced. We downgrade both to neutral. We are worried that desynchronized growth will further push up the dollar, damaging emerging markets, especially since U.S. inflation will remove the Fed "put". The trade war is nowhere near over, and China shows signs of slowing growth. To de-risk, we raise U.S. equities to overweight, cut the euro zone to neutral, and increase our underweight in EM. We move overweight in cash, rather than fixed income because, with inflation still rising, we see U.S. 10-year rates at 3.3% by year-end. We turn more cautious on equity sectors (reducing the pro-cyclicality of our recommendations by raising consumer staples and cutting materials) and suggest less pro-risk tilts for alternative assets, shifting to hedge funds and away from private equity. Overview Lowering Risk Assets To Neutral Since last December we have been advising risk-averse clients, who prioritize capital preservation, to turn cautious, but suggested that professional fund managers who need to maximize quarterly performance stay invested in risk assets. With U.S. equities returning 3% in the first half of the year and junk bonds 0% (versus -1% for U.S. Treasury bonds), that was probably a correct assessment. Now, however, our analysis indicates that the risk/reward trade-off has deteriorated. Although we still do not expect a global recession until 2020, risks to the global equity bull market have increased. The return outlook is asymmetrical: a last-year bull market "melt-up" could give 15-20% upside, but in bear markets over the past 50 years global equities have seen peak-to-trough declines of 25-60% (Table 1). We think it better to turn cautious too early. A key to successful asset allocation is missing the big drawdowns - but getting the timing of these right is a near impossibility. Table 1How Much Stocks Fall In Bear Markets Quarterly - July 2018 Quarterly - July 2018 Chart 1Growth Is Becoming More Desynchronized Growth Is Becoming More Desynchronized Growth Is Becoming More Desynchronized What are the risks we are talking about? Global growth is slowing and becoming less synchronized (Chart 1). Fiscal stimulus and a high level of confidence among businesses are keeping U.S. growth strong, with GDP set to grow by close to 3% this year and S&P 500 earnings by 20%. But the euro zone and Japan have weakened, and these growing divergences are likely to push the dollar up further, which will cause more trouble in emerging markets. EM central banks are reacting either by raising rates to defend their currencies (which will hurt growth) or by staying on hold (which risks significant inflation). With the U.S. on the verge of overheating, the Fed will need to prioritize the fight against inflation. Lead indicators of core inflation suggest it is likely to continue to rise (Chart 2). The FOMC's key projections seem incompatible with each other: it sees GDP growth at 2.7% this year (well above trend), but unemployment barely falling further, bottoming at 3.6% by end-2018 (from 3.8% now) and core PCE inflation peaking at 2.1% (now: 2.0%). A further rise in inflation means that the Fed "put option" will expire: even if there were a global risk-off event, the Fed might not be able to put tightening on hold. It will take only one or two more hikes for Fed policy to be restrictive - something we have previously flagged as a key warning signal (Chart 3). Chart 2U.S. Inflation Could Pick Up Further U.S. Inflation Could Pick Up Further U.S. Inflation Could Pick Up Further Chart 3Fed Policy Is Close To Being Restrictive Fed Policy Is Close To Being Restrictive Fed Policy Is Close To Being Restrictive There is no end in sight for the trade war. President Trump is unlikely to back down on imposing further tariffs on China, since the tough stance is proving popular with his support base. On the other hand, President Xi Jinping would lose face by giving in to U.S. demands. BCA's geopolitical strategists warn that we are not at peak pessimism, and do not rule out even a military dimension.1 China is unlikely to roll out stimulus, as it did in 2015. With the authorities focused on structural reform, for example debt deleveraging, the pain threshold for stimulus is higher than in the past. Recent moves such as reductions in banks' reserve requirement have had little impact on effective interest rates (Chart 4). More likely, China might engineer a weakening of the RMB, as it did in 2015. There are signs that it is already doing so (Chart 5). This would exacerbate political tensions. Chart 4China Has Not Eased Monetary Conditions... China Has Not Eased Monetary Conditions... China Has Not Eased Monetary Conditions... Chart 5...But It Might Be Depreciating The RMB ...But It Might Be Depreciating The RMB ...But It Might Be Depreciating The RMB As we explain in detail in the pages that follow, with risk now two-way, we cut our weighting in global equities to neutral. We are not going underweight since global economic growth remains above trend, and corporate earnings will continue to grow robustly (though no faster than analysts are already forecasting). We see upside risk if the Fed were to allow an overshoot of inflation amid strong growth. If the concerns highlighted above cause a 15% correction in equity markets - triggering the Fed to go on hold - we would be inclined to move back overweight (having in mind a scenario like 1987 or 1998, where a sell-off led to a last-year bull-market rally). More likely, however, we will move underweight at the end of the year, when recession signals, such as an inverted yield curve, appear. We have shifted our detailed recommendations to line up with this de-risking. We move overweight U.S. equities (which are lower beta, and where unhedged returns should benefit from a stronger dollar). We keep our overweight on Japan, since the Bank of Japan remains the last major central bank in fully accommodative mode. We increase our underweight in EM equities. Among sectors, we reduce pro-cyclicality by cutting materials to underweight and raising consumer staples to overweight. We remain underweight fixed income, since inflationary pressures point to the 10-year U.S. Treasury bond yield moving up to 3.3% before the end of this cycle. We remain short duration and continue to prefer inflation-linked securities over nominal bonds. Within fixed income, we cut corporate credit to neutral, in line with our de-risking. Finally, we recommend that investors move into cash rather than bonds, though we understand that, especially for European investors, this may mean accepting a small negative return.2 Still puzzled how markets may pan out over the next 12 months? Then join BCA's annual Conference in Toronto this September, where I will be chairing a panel on asset allocation, featuring two experienced Chief Investment Officers, Erin Browne of UBS Asset Management, and Norman Villamin of Union Bancaire Privée. Garry Evans, Senior Vice President garry@bcaresearch.com What Our Clients Are Asking How To Overweight Cash? Chart 6Sometimes Cas Is The Only Answer Sometimes Cas Is The Only Answer Sometimes Cas Is The Only Answer BCA's call to start to derisk portfolios includes a new overweight in cash. This is logical since, historically, cash often outperformed both equities and bonds early in a downturn, when growth was starting to falter (bad for equities) but inflation was still rising (bad for bonds) - though this last happened in 1994 (Chart 6, panel 1). Currently, a move to cash is easy for U.S. investors, who can invest in three-month Treasury bills yielding 1.9%, or USD money market funds, some of which offer just over 2%. But it is much harder for investors in the euro area, where three-month German government bills yield -0.55%. Also, in Japan cash yields -0.17% and in Switzerland -0.73%. Some European investors will be tempted to go into U.S. cash. Given our view of dollar appreciation over the next six months, this should pay off. But it clearly is risky, should we be wrong and the dollar decline. As theory predicts, the cost of hedging the U.S. dollar exposure wipes out any advantage (since three-month euro-dollar forwards are 2.7% lower on an annualized basis than EURUSD spot). Some investors will have to put up with a small negative return in nominal terms in order to (largely) protect their capital. More imaginative European fund managers might be able to come up with schemes to get cash-like returns but with a positive return. For example, Danish mortgage bonds yield 1.8% (in Danish krone, which is largely pegged to the euro) with little risk. U.S. mortgage-backed securities offer yields well over 3%, which should give a positive return after hedging costs (and relatively low risk, given the robust state of the U.S. housing market) - panel 3. Carefully-selected global macro hedge funds can give attractive Libor-plus returns.3 We still see attractiveness of catastrophe bonds,4 which have a high yield and no correlation to the economic cycle. How Seriously Should We Take The Risk Of A Trade War? Is this a full-blown trade war? The answer is not yet. However, the risk is rising that the current spat will turn into one. President Trump has escalated tensions further by indicating that a 10% tariff would be placed on $200 billion of Chinese imports, in addition to the 25% tariff on $50 billion of imports announced in March and to be implemented on July 6. Trump's incentive to escalate the conflict is that a tough trade policy plays well with his support base (Chart 7). Ever since the trade issue hit the headlines early this year, his approval ratings have been on the rise. This means that he is unlikely to back down at least until the mid-term elections in November. Xi Jinping is also unlikely, for his own political reasons, to give in to U.S. demands. But China's retaliation will most likely come through non-tariff actions, since its imports from the U.S. total only about $130 billion (compared to $500 billion of Chinese exports to the U.S.). It could look to restrict imports, for example via quotas, or cause extra bottlenecks for U.S. businesses operating in China. Additionally, it could threaten to sell some of its holdings of U.S. Treasuries, or devalue the RMB. As Chart 8 shows, the RMB has already weakened against the dollar this year (though this was mainly due to the dollar's overall strength). There are suggestions that China might adjust the currency basket that it targets for the RMB, for example by adding more Asian currencies, to allow further depreciation against the dollar. Chart 7 Quarterly - July 2018 Quarterly - July 2018 Chart 8Sharp Rise In RMB This Year Sharp Rise In RMB This Year Sharp Rise In RMB This Year It is hard, then, to see a smooth outcome to this standoff. A further escalation could even have a military dimension, with the U.S. having recently opened a new "embassy" in Taiwan, and sailing navy vessels close to Chinese "islands" in the South China Sea. It is also a complication that President Trump has recently raised tensions with other G7 trading partners, rather than engaging their help in combatting China's perceived unfair trading practices. Is It Time To Buy Chinese A-Shares? In Q2 2018, MSCI China A-shares lost 19% in absolute terms, compared to a 3.5% gain for MSCI U.S. Some investors attribute this performance divergence to trade tension between the U.S. and China, and take the view that the Chinese government may step in to stimulate the economy and support the equity market, similar to what happened in 2015. We have no doubt that China will stimulate again if the economy appears to be heading for a deep slowdown. Given elevated debt levels and excess capacity in some parts of the economy and worries about pollution, however, the bar for a fresh round of stimulus is a lot higher than in the past. With the incremental inclusion of MSCI on-shore A-Shares into the MSCI China investible universe, A-shares are gaining more attention from international investors. However, the A-Share Index is very different from the MSCI China Index. First, the sector compositions are very different, as shown in Chart 9. The MSCI China index is not only dominated by the tech sector (40%), it's also very concentrated, with the top 10 names accounting for 56% of the index, while the top 10 names in the A-shares account for only about 20%. Second, even in the same sectors, the performance of the two indexes has diverged as shown in Chart 10. We see the reason for these divergences being that domestic investors are more concerned about growth in China than foreign investors are. Instead of buying A-Shares, investors should be more cautious on the MSCI China Index, for which we have a neutral view within MSCI EM universe. Chart 9 Quarterly - July 2018 Quarterly - July 2018 Chart 10ONE CHINA, TWO DIFFERENT EQUITY INDEXES ONE CHINA, TWO DIFFERENT EQUITY INDEXES ONE CHINA, TWO DIFFERENT EQUITY INDEXES What Are The Characteristics Of The Private Debt Market? Chart 11Private Debt Market Quarterly - July 2018 Quarterly - July 2018 Private debt (Chart 11) raised a record $115 billion through 158 funds in 2017, pushing aggregate AUM from $244 billion in 2007 to $664 billion in 2017. This explosive growth was driven by bank consolidation in the U.S., increased financial sector regulation, and the global search for yield. Private debt has historically enjoyed a higher yield and return, along with fewer defaults, than traditional public-market corporate bonds. Below are some of the key points from our recent Special Report:5 Private debt has returned an average net IRR of 13% from 1989 to 2015. This compares to an annualized total return of 7% and 7.2% for equities and corporate bonds respectively. Investors can diversify their sources of risk and return by giving access to more esoteric exposures such as illiquidity and manager skill. The core risk exposure in private debt comes from idiosyncratic firm-specific sources, which is not the case with publicly traded corporate credit. Investors can gain more tailored exposure to different industries and customized duration horizons. Additionally, private debt was the only group in the private space that did not experience a contraction in AUM during the financial crisis. Direct lending and mezzanine debt are capital preservation strategies that offer more stable returns while minimizing downside. Distressed debt and venture debt are more return-maximizing strategies that offer larger gains, but with a higher probability of losses. In the late stages of an economic cycle, investors should deploy capital defensively through first-lien and other senior secured debt positions. In contrast, a recession would create opportunities for distressed strategies and within deeper parts of the capital structure. Global Economy Overview: Growing divergences are emerging in global growth, with the U.S. producing strong data, but a cyclical slowdown in the euro area and Japan, and the risk of significantly slower growth in China and other emerging markets. This means that monetary policy divergences are also likely to increase, exacerbating the rise in the U.S. dollar and putting further pressure on emerging markets. Eventually, however, tighter financial conditions could start to dampen growth in the U.S. too. U.S.: Data has been very strong for the past few months, with the Fed's two NowCasts pointing to 2.9% and 4.5% QoQ annualized GDP growth in Q2. Small businesses are confident (with the NFIB survey at a near record high), which suggests that the capex recovery is likely to continue. With unemployment at the lowest level since 1969, wages should pick up soon, boosting consumption. But it is possible the data might now start to weaken. The Surprise Index (Chart 12, panel 1) has turned down. And a combination of trade war and a stronger dollar (up 8% in trade-weighted terms since April) might start to dent business and consumer confidence. Chart 12U.S. Growth Remains Strong... U.S. Growth Remains Strong... U.S. Growth Remains Strong... Chart 13...While Europe, Japan And EMs Start To Slow ...While Europe, Japan And EMs Start To Slow ...While Europe, Japan And EMs Start To Slow Euro Area: Euro area data, by contrast to the U.S., have turned down since the start of the year, with both the PMI and IFO slipping significantly (Chart 13, panel 1). This is most likely because the 6% appreciation of the euro last year has affected export growth, which has slowed to 3.1% YoY, from 8.3% at the start of the year. However, the PMI remains strong (around the same level as the U.S.) and, with a weaker euro since April, growth might pick up late in the year, as long as problems with trade and Italy do not deteriorate. Japan: Japan's growth has also slipped noticeably in recent months (Chart 13, panel 2), perhaps also because of currency strength, though question-marks over Prime Minister Abe's longevity and the slowdown in China may also be having an effect. The rise in inflation towards the Bank of Japan's 2% target has also faltered, with core CPI in April back to 0.3% YoY, though wages have seen a modest pickup to 1.2%. Emerging Markets: China is now showing clear signs of slowing, as the tightened monetary conditions and slower credit growth of the past 12 months have an effect. Fixed-asset investment, retail sales and industrial production all surprised to the downside in May. The authorities have responded to this (and to threat of trade disruptions) by slightly easing monetary policy, though this has not yet fed through to market rates, which have risen as a result of rising defaults. Elsewhere in EM, many central banks have responded to sharp declines in their currencies by raising rates, which is likely to dampen growth. Those, such as Brazil, which refrained from defensive rate hikes, are likely to see an acceleration in inflation Interest rates: The Fed has signaled that it plans to continue to hike once a quarter at least for the next 12 months. It may eventually have to accelerate that pace if core PCE inflation moves decisively above 2%. The ECB, by contrast, announced a "dovish tightening" last month, when it signaled the end of asset purchases in December, but no rate hike "through the summer" of next year. It can do this because euro zone core inflation remains around 1%, with fewer underlying inflationary pressures than in the U.S. The Bank of Japan is set to remain the last major central bank with accommodative policy, since it is unlikely to alter its yield-curve control any time soon. Global Equities Chart 14Neutral Global Equities Neutral Global Equities Neutral Global Equities A Bird In The Hand Is Worth Two In The Bush: After the initial strong recovery from the low in March 2009, global equity earnings have risen by only 20% from Q3 2011, and that rise mostly came after February 2016. In the same period, global equity prices, however, have gained over 80%, largely due to multiple expansion (Chart 14), supported by accommodative monetary and stimulative fiscal policies. Year-to-date, our pro-cyclical equity positioning has played out well with developed markets (DM) outperforming emerging markets (EM) by 8.8%, and cyclical equities outperforming defensives by 2.9%. As the year progresses, however, we are becoming more and more concerned about future prospects given the stage of the cycle, stretched valuations and the elevated profit margin.6 The three macro "policy puts", namely the Fed Put, the China Put and the Draghi Put, are all in jeopardy of disappearing or, at the very least, of weakening, in addition to the risk of rising protectionism. BCA's House View has downgraded global risk assets to neutral.7 Reflecting this change, within global equities we recommend investors to take a more defensive stance by reducing portfolio risk. We remain overweight DM and underweight EM; We upgrade U.S. equities to overweight at the expense of the euro area (see next page); Sector-wise, we suggest to take profits in the pro-cyclical tilts and become more defensive (see page 14). Please see page 21 for the complete portfolio allocation details. U.S. Vs. The Euro Area: Trading Places Chart 15Favor U.S. Vs. Euro Area Favor U.S. Vs. Euro Area Favor U.S. Vs. Euro Area In line with the BCA House View to reduce exposure in global risk assets, we are downgrading the euro area to neutral in order to fund an upgrade of the U.S. to overweight from neutral, for the following reasons: First, GAA's recommended equity portfolio has always been expressed in USD terms on an unhedged basis. Historically, the relative total return performance of euro area equities vs. the U.S. has been highly correlated with the euro/USD exchange rate. With BCA's House View calling for further strength of the USD versus the euro, we expect euro area total return in USD terms to underperform the U.S. (Chart 15, panel 1). Second, the euro area economy has been weakening vs. the U.S. as seen by the relative performance of PMIs in the two regions; this bodes ill for the euro area's relative profitability (Chart 15, Panel 2). Third, because euro area equities have a much higher beta to global equities than U.S. equities do, shifting towards the U.S. reduces the overall portfolio beta (Chart 15, Panel 3). Last, even though euro area equities are cheaper than the U.S. in absolute term, they have always traded at a discount to the U.S. On a relative basis, this discount is currently fair compared to the historical average. Sector Allocation: Become More Defensive Chart 16Sectors: Turn Defensive Sectors: Turn Defensive Sectors: Turn Defensive Year to date, our pro-cyclical sector positioning has worked very well, especially the underweights in telecoms, consumer staples and utilities, and the overweight of energy. The overweight in healthcare also has worked well, but the overweights in financials and industrials, as well as the underweight of consumer discretionary, have not panned out. Global economic growth has peaked, albeit at a high level. This does not bode well for the profitability of the economically sensitive sectors (industrials, consumer discretionary and materials) relative to the defensive sectors (healthcare, consumer staples and telecoms), as shown in Chart 16, top two panels. In addition, slowing Chinese growth will weigh on the materials sector, and rising tension in global trade will pressure the industrials sector. As such, we are upgrading consumer staples to overweight (from underweight) and telecoms to neutral, and downgrading materials to underweight (from neutral). Oil has gained 16% so far this year, driving energy equities to outperform the global benchmark by 6.2%. Going forward, however, the oil outlook is less certain as OPEC and Russia work to ease production controls, and demand is cloudy. This prompts us to close the overweight in the energy sector to stay on the sideline for now (Chart 16, bottom panel). We also suggest investors to reduce exposure in financials to a benchmark weighting due to our concerns on Europe and also the flattening of yield curves. After all these changes, we are now overweight healthcare and consumer staples while underweight consumer discretionary, utilities and materials. All other sectors are in line with benchmark weightings. Government Bonds Maintain Slight Underweight On Duration. BCA's house view has downgraded global risk assets to neutral and raised cash to overweight, while maintaining an underweight in fixed income.8 This prompts us to downgrade credit to neutral vs. government bonds (see next page). However, we still see rates rising over the next 9-12 months and so our short duration recommendation for the government bonds is unchanged. The U.S. Fed is on track to deliver a 25bps rate hike each quarter given robust business confidence and tight labor markets, and the ECB has announced it will stop new bond buying in its Asset Purchase Program after December this year. As such, bond yields are likely to move higher in both the U.S. and the euro area given the close relationship between 10-year term premium and net issuance (Chart 17). Chart 17Yields Will Rise Further Yields Will Rise Further Yields Will Rise Further Chart 18Favor Inflation-Linked Bonds Favor Inflation-Linked Bonds Favor Inflation-Linked Bonds Favor Linkers Vs. Nominal Bonds. The latest NFIB survey shows that wage pressure is on the rise, with reports of compensation increases hitting a record high (Chart 18, top panel). BCA's U.S. Bond Strategy still believes that the U.S. TIPS breakeven will rise to 2.4-2.5% around the time that U.S. core PCE inflation exceeds the Fed's 2% target rate (the Fed forecasts 2.1% by end-2018). Compared to the current breakeven level of 2.1%, this means 10-year TIPS has upside of 30-40bps, an important source of return in the low-return fixed income space (Chart 18, panel 2). Maintain overweight TIPS vs. nominal bonds. However, TIPS are no longer cheap. For those who have not already moved to overweight TIPS, we suggest "buying TIPS on dips". Inflation-linked bonds (ILBs) in Australia and Japan are also still very attractive vs. their respective nominal bonds (Chart 18, bottom panel). Overweight ILBs in those two markets also fits well with our macro themes. Corporate Bonds Chart 19Spreads Not Attractive Spreads Not Attractive Spreads Not Attractive We have favored both investment-grade and high-yield corporates (Chart 19) over government bonds for over two years. But, while monetary and credit conditions remain favorable, we think rising uncertainty and weakening corporate balance sheets in the coming quarters warrant a more cautious stance. We are moving to neutral on corporate credit. In Q1, outstanding U.S. corporate debt grew at an annualized rate of 4.4%, while pre-tax profits (on a national accounts basis) contracted by 5.7%, raising gross leverage from 6.9x to 7.1x. The benign default rates and tight credit spreads associated with robust economic growth are at risk now that leverage growth is soon poised to overtake cash flow growth, challenging companies' debt service capability. Finally, if labor costs accelerate, leverage will continue to rise in 2H18. Since February, our financial conditions index has tightened considerably driven by a combination of falling equity prices and a stronger dollar. As monetary policy shifts to an outright restrictive stance once inflation reaches the Fed's target later in 2018, corporates will suffer. The risk-adjusted returns to high yield (Chart 20) are no longer attractive relative to government bonds. Chart 20Junk Only Attractive If Defaults Stay Low Junk Only Attractive If Defaults Stay Low Junk Only Attractive If Defaults Stay Low Chart 21Rising Leverage Rising Leverage Rising Leverage Finally, valuations are expensive. Investment grade spreads have widened by 50bps from the start of the year, but junk spreads are still close to their post-crisis lows. As we are late in the credit cycle, we do not expect further contraction in spreads. For now monetary and credit quality indicators remain stable, but we are booking profits and moving both investment-grade and high-yield corporates to neutral. In the second half of the year, as corporate leverage (Chart 21) starts to deteriorate and monetary policy gets more restrictive, we will look to further review our allocations. Commodities Chart 22Strong Demand But Uncertain Supply In Oil Strong Demand But Uncertain Supply In Oil Strong Demand But Uncertain Supply In Oil Energy (Overweight): Underlying demand/supply fundamentals (Chart 22, panel 2) will continue to drive prices, as the correlation with the U.S. dollar breaks down. We expect the key OPEC countries to increase production by 800k b/d and over 210k b/d in 2H18 and 1H19 respectively. This will be offset by losses in the rest of OPEC of 530k b/d and 640k b/d in 2H18 and 1H19 respectively. Venezuelan production has dropped from a peak of 2.1m b/d to 1.4m b/d, and we expect it to reach 1.2m b/d by year end and 1.0m b/d by the end of 2019. Additionally, we expect Iranian exports to fall by 200k b/d to the end of 2018, and by another 300k b/d by the end of 1H19 as a result of sanctions. Demand seems to be holding up for now, but is conditional on developments in global trade. BCA's energy team forecasts Brent crude to average $70 in 2H18 and $77 in 2019. Industrial Metals (Neutral): China remains the largest consumer of metals, and so price action will react to underlying economic growth there and to the dynamics of its local metals markets. Additionally, a strengthening dollar will add downward pressure to prices and increase volatility. We expect a physical surplus in copper markets to emerge by year end, given slower demand growth and supply concerns due to restrictions on China's imports of scrap copper. Precious Metals (Neutral): Rising global uncertainties and geopolitical tensions driven by trade wars and divergent monetary policy will continue to keep market volatility high. During periods of equity market downturns, gold will continue to be an attractive hedge. Additionally, as inflationary pressures continue to rise, investors will continue to look for inflation protection in gold. However, rising interest rates and a strengthening dollar could limit price upside. We recommend gold as a safe-haven asset against unexpected volatility and inflation surprises. Currencies Chart 23Dollar Appreciation To Continue King Dollar Dollar Appreciation To Continue King Dollar Dollar Appreciation To Continue King Dollar U.S. Dollar: Following the recent strong economic data out of the U.S., the Fed is likely to maintain its moderately hawkish stance and follow its current dot plan of gradual rate hikes over the course of this year and next. For now the Fed is unlikely to accelerate the pace of hikes: it hinted that it could allow inflation to overshoot its target of 2% on core PCE. We expect the U.S. dollar to appreciate further over the coming months (Chart 23, panel 1). Euro: Disappointments in European economic data, in addition to political uncertainties in Italy, have led to a correction in the EUR/USD (Chart 23, panel 2). The ECB's indication that it will not raise rates through the summer of 2019 added further downward pressure on the currency. In addition, rising tension related to trade war and its impact on European growth is likely to dampen the euro's performance further. We look for EUR/USD to weaken to at least 1.12. JPY: The outlook for the yen is more mixed than for the euro. Japanese data over the past couple of months have been anemic, and interest rate differentials with the U.S. point to a weakening yen (Chart 23, panel 3). Moreover, the BoJ is still concerned with achieving its inflation target and so remains the last major central bank in full accommodative mode. However, escalating global tension is likely to be a positive factor for the JPY as a safe haven currency. It also looks far cheaper relative to PPP than does the euro. We see the yen trading fairly flat to the USD, but appreciating against the euro. EM Currencies: Tighter U.S. financial conditions, rising bond yields, and a strengthening dollar are all disastrous for EM currencies (Chart 23, panel 4). Additionally, the ongoing growth slowdown in China, and in EM as a whole, will add further downside pressures on most EM currencies. Alternatives Chart 24Turn Defensive On Alts Turn Defensive On Alts Turn Defensive On Alts Allocations to alternatives continue to rise as investors look for new avenues to preserve capital and generate attractive returns. We are turning more cautious on risk assets across all asset classes on the back of a possible growth slowdown and restrictive monetary policy. With intra-correlations between alternative assets reaching new lows (Chart 24), investors need to be especially careful picking the right category of alt investments. Return Enhancers: We have favored private equity over hedge funds since 1Q16, and this has generated an excess return of 20%. But, given our decision to scale back on risk assets on the back of a possible growth slowdown, we are turning cautious on private equity. Higher private-market multiples, stiff competition for buyouts from large corporates, and an uncertain macro outlook will make deal flow difficult. On the other hand, as volatility makes a comeback and markets move sideways, discretionary and systematic macro funds should fare better. We recommend investors pair back on their private equity allocations and increase hedge funds as we prepare for the next recession. Inflation Hedges: We have favored direct real estate over commodity futures since 1Q16; this position has generated a small loss of 1.4%. Total global commercial real-estate (CRE) loans outstanding have reached a record $4.3 trillion, 11% higher than at the pre-crisis peak. CRE prices peaked in late 2016, and are now flat-lining, partly due to the downturn of shopping malls and traditional retail. On the other hand, commodity futures have had a good run on the back of rising energy prices. We recommend investors reduce their real estate allocations, and put on modest positions in commodity futures as an inflation hedge. Volatility Dampeners: We have favored farmland and timberland over structured products since 1Q16, and this has generated an excess return of 6%. As noted in our Special Report,9 of the two, timberland assets tend to have a stronger correlation with growth, whereas farmland demand is relatively inelastic during times of a slowdown. Additionally, farmland returns tend to have lower volatility compared to timberland. Structured products will continue to suffer with rising rates. We recommend investors allocate more to farmland over timberland, and stay underweight structured products. Risks To Our View Chart 25What If China's Imports Weaken Sharply What If China's Imports Weaken Sharply What If China's Imports Weaken Sharply Our neutral view on risk assets implies that we see the upside and downside risks as evenly balanced. Could the macro environment turn out to be worse than we envisage? Clearly, there would be more downside for equities if the risks we highlighted in the Overview (slowing growth, U.S. inflation, trade war, Chinese policy) all come through. China and emerging markets are the key. China's import growth has been trending down for 12 months; could it turn significantly negative, as it did in 2015 (Chart 25)? Emerging markets look sensitive to further rises in U.S. interest rates and the dollar. The most vulnerable currencies have already fallen by up to 20% since the start of the year, but could fall further (Chart 26). We would not over-emphasize these risks, however. If growth were to slow drastically, China would roll out stimulus. Emerging markets are more resilient than they were in the 1990s, thanks to currencies that mostly are floating and generally healthier current account positions (though, note, their foreign-currency debt is bigger). Chart 26EM Currencies Could Fall Further EM Currencies Could Fall Further EM Currencies Could Fall Further Chart 27Is This An Excuse For The Fed To Be Dovish? Is This An Excuse For The Fed To Be Dovish? Is This An Excuse For The Fed To Be Dovish? On the positive side, the biggest upside risk comes from the Fed slowing the pace of rate hikes even though growth is robust. This might be because U.S. inflation remains subdued (perhaps for structural reasons) - or because the Fed allows an overshoot of inflation, either under political pressure, or because of arguments that its inflation target is "symmetrical" and that it has missed it on the downside ever since the target was introduced in 2012 (Chart 27). This would be likely to weaken the dollar, giving emerging markets a reprieve. It might lead to a 1999-like stock market rally, perhaps led again by tech - specifically, internet - stocks. 1 Please see What Our Clients Are Asking: How Seriously Should We Take The Risk Of A Trade War, on page 7 of this Quarterly for more analysis of this subject. 2 Please see What Our Clients Are Asking: How To Overweight Cash, on page 6 of this Quarterly for some suggestions on how to minimize this. 3 Please see Global Asset Allocation Special Report, "Hedge Funds: Still Worth Investing In?", dated June 16, 2017, available at gaa.bcaresearch.com 4 Please see Global Asset Allocation Special Report, "A Primer On Catastrophe Bonds", dated December 12, 2017, available at gaa.bcaresearch.com 5 Please see Global Asset Allocation Special Report, "Private Debt: An Investment Primer", dated June 6, 2018, available at gaa.bcaresearch.com 6 Please see Global Asset Allocation - Quarterly Portfolio Outlook, dated April 3, 2018, available at gaa.bcaresearch.com 7 Please see Global Investment Strategy - Special Report "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 20, 2018, available at gis.bcaresearch.com 8 Please see Global Investment Strategy - Special Report "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 20, 2018, available at gis.bcaresearch.com 9 Please see Global Asset Allocation - Special Report "U.S. Farmland & Timberland: An Investment Primer", dated October 24, 2017, available at gaa.bcaresearch.com GAA Asset Allocation