Asset Allocation

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of October 31, 2018. The quant model downgraded U.S. and Italy to underweight from overweight while upgrading Canada to a slight overweight from underweight, largely due to changes in technical and valuation conditions. Now the model is overweight 5 countries (Netherland, Germany, Spain, Switzerland and Canada) and underweight 7 countries (Japan, U.S., U.K., France, Australia, Sweden and Italy), as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Chart 1, Chart 2 and Chart 3, both Level 1 and Level 2 of the model system outperformed in October by 6bps and 57 bps, respectively, resulting in an outperformance of 24 bps from the overall model. Since going live, the overall model has outperformed its benchmarks by 44 bps, driven by Level 2 outperformance of 121 bps and Level 1 outperformance of 2bps. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model Dear Client, As advised last month, we have suspended the GAA Equity Sector Selection Model due to the significant changes in the GICS sector classifications, implemented at the end of September. We will rebuild the model using the newly constituted sectors once full back data is available from MSCI, which we understand will be in December. We thank you for your understanding.

Dear Client, You will see in this Monthly Portfolio Update that we have expanded our table of Recommendations to include a wider range of the views that Global Asset Allocation (GAA) regularly discusses in its publications. Please see our most recent Quarterly Portfolio Outlook1 for a detailed explanation of those recommendations that we do not specifically touch on in this Monthly. A note on our publication schedule. We will not publish a Monthly for December, or a Q1 2019 Quarterly in mid-December. Instead, we will send you in late November the BCA 2019 Outlook (BCA's annual discussion with Mr. and Ms. X). This will be accompanied by a short GAA note, updating our recommendation tables with a brief commentary. Best Regards, Garry Evans A Correction, Not A Bear Market Investors have a tendency to forget that corrections are common in bull markets. The current equity run-up, which began in March 2009, has seen five corrections (defined as a 10-20% decline in the S&P500). We may now be experiencing the sixth, with the index already down 9.9% from its peak on September 20. Recommendations But we think the evidence is fairly strong that this is just a correction and not the beginning of a new bear market (using the common definition of a 20% or greater fall). It is highly unusual for bear markets to occur - and for bonds to outperform equities - except in the run-up to, and during, recessions (Chart 1). We see little to suggest that a recession in on the horizon over the next 12 months. Chart 1Corrections Are Not At All Rare What caused the correction? The immediate trigger was a seemingly concerted series of statements in early October from FOMC officials, including even doves such as Lael Brainard, that economic circumstances are "remarkably positive" and that rates remain "a long way from neutral" (to quote Fed Chair Jay Powell). In particular, New York Fed President John Williams argued that the neutral rate of interest (the r*) is very uncertain - even though he was joint creator of the main model that estimates it. The implication is that the Fed will keep on raising rates until the economy clearly slows. This pushed the 10-year Treasury yield above 3.2%. Markets are starting to worry that the Fed will make a policy mistake and that certain segments of the economy (housing, emerging markets?) may be too weak to withstand tighter monetary policy. Moreover, this is in a context in which global growth has been weakening (Chart 2), China appears to be slowing quite sharply (Chart 3), the trade war is escalating (with the U.S. now threatening to impose tariffs on all Chinese imports), and valuations for most assets are stretched. Chart 2Outside The U.S., Growth Is Slowing Chart 3Sharp Slowdown Ahead For China? So how worried should investors be? Most of the usual indicators of generalized risk aversion have not flashed strong warning signals during the equity market sell-off (Chart 4). The move up in bond yields came mostly from a rise in real yields, not inflation expectations, and the yield curve steepened, suggesting that markets are pricing in stronger growth not excessive Fed action. Safe haven assets, such as gold and the Swiss franc, did not perform particularly strongly. Credit spreads rose a little, by around 70 basis points, but do not yet signal stress. Chart 4No Signals Of Strong Risk Aversion Moreover U.S. growth, in particular, remains robust. Though the r* may be tricky to estimate, monetary policy is still clearly accommodative and is likely to remain so until at least mid-2019, even if the Fed hikes by 25bp a quarter (Chart 5). Fiscal policy will be stimulative until the end of 2019, adding 1.1 percentage points to growth this year and 0.5 next, according to IMF estimates. Earnings growth will slow from its current lick - Q3 U.S. earnings look like coming in at 23% year-on-year, compared to a forecast of 19% before the results season - but our models suggest that 2019 bottom-up estimates are about right, with growth slowing to around 10% in the U.S. and to somewhat less in the euro area and Japan (Chart 6).2 Chart 5Fed Policy Still Accomodative Chart 6Earnings Growth To Continue, Albeit More Slowly If we have a concern, it is that a few interest-rate sensitive elements of the U.S. economy are showing signs of softness. Housing starts have been weak for a while, but higher mortgage rates may now be having an effect, with residential investment subtracting from GDP growth in all three quarters so far this year (Chart 7). However, mortgage rates are unlikely to continue to rise at the same pace and so the effect should weaken in further quarters. Capex intentions and durable orders have also slipped, perhaps suggesting that corporations have reined back investment plans due to global uncertainties (Chart 8). But these signs point to slower growth next year, not recession, with the U.S. likely to continue to grow above trend. Historically, higher long-term rates have proved a drag on the economy only when they have risen above trend nominal GDP growth, currently around 3.8% (Chart 9). We have some way to go before we reach that tipping-point. Chart 7Housing Is Hurting Chart 8...And Capex Is Getting Cautious Chart 9Rates Matter When They Exceed Nominal Growth We moved to neutral on risk assets, including equities, at the beginning of July. Many of the worries we flagged then have come about. This is late in the cycle, and so volatility will probably remain elevated. However, we do not expect the next recession to come until 2020 at the earliest. Moreover, none of the warning signals on our bear market checklist (which includes the shape of the yield curve, profit margins, a peak in cyclical spending as a percentage of GDP, Fed policy becoming restrictive etc.) are yet flashing, though several may do by mid next year. Equity market valuations are no longer expensive after the recent sell-off (Chart 10). If the current correction were to continue and the drop in the S&P 500 extend to 15% and in global equities to 20% from their most recent peaks, we might be inclined tactically to move back overweight on risk assets. Chart 10Stocks Are No Longer Expensive Currencies: We expect further U.S. dollar appreciation. Divergences in growth and monetary policy between the U.S. and other developed markets will continue. While we expect the Fed to continue to hike once a quarter until end-2019, we could imagine the ECB turning more dovish if euro zone growth continues to slow and Italian BTP 10-year bond yields rise above 4%. The Bank of Japan will stick to its Yield Curve Control policy, which will prevent the yen rising. Emerging market currencies look vulnerable as their economies slow as a result of central bank rate hikes earlier in the year. Asian currencies might undertake competitive devaluations if the renminbi falls below 7, as a result of a worsening trade war. Fixed Income: Long-term rates are unlikely to have peaked for this cycle. Core inflation will stay at around 2% for a few more months because of a favorable base effect, but underlying inflation pressures (the result of rising wages and increases in import tariffs) will push up U.S. inflation by mid next year (Chart 11). A combination of higher inflation, steady Fed hikes, and deteriorating supply/demand conditions (which will raise the term premium) will move 10-year rates above 3.5% by mid-2019 (Chart 12). We accordingly recommend being short duration and overweight TIPs. U.S. high-yield bonds look somewhat attractive, with a default-adjusted spread of 270 bps, after their recent modest sell-off (Chart 13). But this is dependent on our assumption (based on Moody's model) of credit defaults of only 1.04% over the next 12 months.3 Given where we are in the cycle, and considering the elevated corporate leverage in the U.S., we do not consider this a risk worth taking, and so maintain our moderate underweight in credit. Chart 11Underlying Inflation Pressures Are Strong Chart 12Indicators Point To Treasury Yields Above 3.5% Chart 13Are Junk Bonds Attractive Again? Equities: We prefer DM equities over EM, and favor the U.S. and, to a degree, Japan. Emerging markets continue their deleveraging process and will be hurt by rising U.S. rates, a stronger dollar, and slowdown in China. Valuations for EM equities, though one standard deviation cheap relative to global equities, are not yet sufficiently attractively valued to permit investors to buy EM stocks irrespective of their poor fundamentals. Moreover, analysts are still far too optimistic on the outlook for EM earnings, flattering the valuation metric (Chart 14). Stronger growth and an appreciating currency point to an overweight in U.S. equities which, moreover, would be likely to outperform in the event of a deeper correction, given their low beta. Chart 14EM Equities Aren't As Cheap As They Seem Commodities: The crude oil price has fallen back a little in recent weeks, as a result of increases in OPEC production, a modest slowing of demand, and releases of the U.S. Strategic Petroleum Reserve. Our energy strategists have slightly lowered their 2019 Brent forecast to $92 a barrel, from $95 (Chart 15). However, they warn that geopolitical risks, such as widespread application of sanctions on Iran and a collapse in Venezuela, and limits to capacity in Saudi Arabia and U.S. shale production could easily cause spikes above $100.4 A 100% year-on-year rise in oil prices has historically been a clear warning of recession. That would equal Brent at $120 in 1H 2019. Metal prices will continue to be driven by China. At the moment we see no sign of China implementing a major stimulus, which would boost infrastructure spending and therefore demand for commodities (Chart 16), and so we expect further falls in industrial commodities prices. Chart 15Oil Prices Can Rise Further Chart 16No Sings Of Big China Stimilus Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see GAA Quarterly Portfolio Outlook - October 2018, available at gaa.bcaresearch.com 2 For details of these models and the assumptions behind them, please see The Bank Credit Analyst November 2018, available at bca.bcaresearch.com 3 For details please see BCA U.S. Bond Strategy Weekly Report, "What Kind Of Correction Is This?", dated October 30, 2018, available at usbs.bcaresearch.com 4 For details please see BCA Commodity & Energy Strategy & Bond Strategy Weekly Report, "Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity", dated October 25, 2018, available at ces.bcaresearch.com GAA Asset Allocation

Highlights Growth Scare: Despite the recent pickup in global equity market volatility, bond volatility remains subdued. Until there is more decisive evidence of a deeper pullback in global growth that is impacting the mighty U.S. economy, yields on government bonds - which remain overvalued in all major developed economies - will have difficulty falling much more even if equity markets continue to correct. Stay below benchmark on global duration exposure, while maintaining only a neutral allocation to global credit. Canada: The Bank of Canada remains on a hawkish path to a more neutral policy rate, even with the lingering concerns over household debt and global trade tensions. Stay underweight Canadian government bonds in hedged global bond portfolios. Feature Just like that other great October tradition, Halloween, market volatility has returned to spook investors. Both the MSCI All-Country World Index and S&P 500 index are officially in correction territory, down -10% from the highs reached in September. The causes for the pullback range from high-profile third quarter U.S. earnings disappointments to increased evidence that the U.S.-China tariff war is negatively impacting U.S. investment spending. Yet the reaction from global bond markets has been relatively muted for such a large pullback in stocks. Benchmark 10-year government bond yields for the major developed markets are down from their peaks, but the declines have been smaller in countries where central banks are in a rate hiking cycle (U.S. -14bps, Canada -19bps) relative to countries where central banks are on hold (Germany -20bps, U.K. -31bps). One possible reason for this discrepancy is that the downtrend in data surprises appears to have stabilized in the U.S. and, even more importantly, China, while European data continues to disappoint relative to expectations (Chart of the Week). Chart of the WeekNoisy Equities, Calm Bonds We still do not believe that global bond yields have peaked for the cycle. We continue to recommend a below-benchmark strategic bias on overall duration exposure, but with only a neutral allocation to global corporate bonds that favors U.S. credit. On a more shorter-term tactical basis, there is a risk that yields could decline further, with more credit spread widening than seen during the current risk-off episode, if economic data starts to disappoint in the U.S. where growth has so far been resilient. Staying up in credit quality within an allocation to U.S. corporates is one way to hedge against such an outcome. Bond Yields Are Normalizing, Bond Volatility Is Not The selloff in risk assets has resulted in a pickup in widely-followed market volatility measures like the U.S. VIX index. Yet when looking at the level of realized total return volatility across all major asset classes, the current bout of turbulence has been unimpressive outside of global equities. In Chart 2, we present an update of a chart from our 2018 global bond outlook report, showing the current levels of realized volatility across different asset class benchmarks compared to their historical ranges. The vertical lines in each chart represent the range between 1999 and 2017 of annualized monthly volatilities for global government bonds, credit, equities, currencies and commodities. The red triangles represent the most recent 13-week annualized volatilities for those same asset classes. What stands out in the chart is that volatilities are off the historical lows for global equities, Italian government bonds and industrial commodities, yet volatilities remain subdued for developed market government bonds, global corporate debt and currencies. Chart 2Bond Volatility Remains Subdued, Despite More Volatile Equities We have long argued that the shift to a structurally higher level of volatility across all asset classes will show up first with a rise in bond volatility. In the U.S., in particular, sustained periods of elevated volatility for both Treasuries (as measured by the MOVE index) and stocks (as measured by the VIX index) have occurred alongside episodes of greater variance in nominal GDP growth (Chart 3). When the latter rises, that also triggers more uncertainty about the future path of monetary policy which feeds into a rise in expected bond volatility. That, in turn, impacts volatility in growth sensitive assets like equities, credit and commodities. Chart 3Equity Vol Responding To Growth Uncertainty Right now, nominal GDP volatility has picked up in the U.S. but still remains low by historical standards (middle panel). Some of that increased growth volatility can be attributed to the Trump fiscal stimulus coming at a time of full employment, which has helped boost both real GDP growth and U.S. inflation. Interest rate markets have moved to discount more Fed hikes in response, but the Fed's steady pace of well-telegraphed, 25bps-per-quarter rate increases is likely acting to dampen Treasury market volatility. As we have written about extensively throughout the course of 2018, the hurdle for central banks (not just the Fed) to shift to a less hawkish or more dovish policy stance is much higher when unemployment is low and inflation is closer to central bank targets. In such an environment, the correlation between equity and bond returns should be weaker than during periods of excess capacity and low inflation when central banks can stay dovish. That can be seen in Chart 4, which plots the trailing 52-week correlation of total returns for equities and government bonds for the major developed markets (top panel), along with the 10-year market-based inflation expectations for each country (bottom panel). For almost all countries shown, the stock/bond correlation has risen to zero away from the negative correlations that dominated the post-crisis years. That move in correlations has occurred alongside a more stable backdrop for inflation expectations, which are much closer to central bank targets. The lone exception is, of course, Japan, where inflation remains disappointingly low and the Bank of Japan continues to keep a tight lid on interest rates. Chart 4More Stable Inflation Means Less Correlated Stock & Bond Returns Besides more stable inflation, another factor preventing yields from falling as much as implied by the declines in equity markets is that global bond yields remain overvalued relative to trend economic growth. One way to assess this is to look at the level of real bond yields relative to a moving average of actual GDP growth. We show this for the major developed economies in Charts 5 & 6, which plot rolling 3-year moving averages of real GDP growth (a proxy for "trend" or potential growth) versus real 5-year government bond yields, 5-years forward. For the latter, we take the nominal 5-year/5-year forward yield and subtract a five-year moving average of realized headline inflation for each country, rather than market-based inflation-linked instruments like CPI swaps or TIPS, to allow for a longer history of real yields in the charts. Chart 5Real Bond Yields Are Still Too Low ... Chart 6... Compared To Real Economic Growth For all countries show, real bond yields remain below the level of real growth. The gap between the two is smallest in the U.S. and Canada - unsurprising, as central bankers have been tightening monetary policy, and helping push up real interest rates, in both countries. Bonds look most overvalued in core Europe, Japan and Sweden where policymakers have been using negative interest rates and quantitative easing (QE) to hold down bond yields. Real yields in those countries are between 200-300bps below our proxy for trend real growth. With such a large gap between actual growth and interest rates, it becomes harder for policymakers to consider easing monetary policy, or at least slow the pace of policy normalization, in response to more volatile financial markets. It should not be a surprise that last week, during a period of global market turmoil, the European Central Bank and Sweden's Riksbank both signaled that they remain on pace to end QE and begin hiking interest rates within the next 6-12 months, while the Bank of Canada delivered another 25bp rate hike. In the absence of a VERY large global growth shock, global real yields should be expected to increase over at least the next year, and a defensive posture on global duration exposure should be maintained. One such shock could come from a deeper downturn in China than has already occurred in 2018, which would feed into a bigger slowdown in non-U.S. growth. Another shock could come from the U.S. if the recent pullback in core durable goods orders (Chart 7) is a sign that a) U.S. companies are becoming more worried about the impact of U.S.-China trade tariffs on global growth; and/or b) the impact of the Trump fiscal stimulus is already starting to fade. Such a move could be exacerbated by a larger downturn in housing activity than seen already in response to rising mortgage rates. Chart 7Treasuries Are Exposed To A U.S. Growth Scare These shocks, if large enough, could trigger a short-covering rally in U.S. Treasuries, where sentiment remains very depressed (bottom panel). However, with leading economic indicators still pointing to above trend U.S. growth, and with U.S. consumer spending holding firm alongside a tight labor market and faster wage growth, such a pullback in yields would likely be short-lived and difficult for investors to time successfully. Bottom Line: Despite the recent pickup in global equity market volatility, bond volatility remains subdued. Until there is more decisive evidence of a deeper pullback in global growth that is impacting the mighty U.S. economy, yields on government bonds - which remain overvalued in all major developed economies - will have difficulty falling much more even if equity markets continue to correct. Stay below benchmark on global duration exposure, while maintaining only a neutral allocation to global credit. Canada Update: The BoC Stays Hawkish The Bank of Canada (BoC) delivered another rate hike last week, lifting the policy rate by 25bps to 1.75%. The language used to explain the hike was surprisingly hawkish. In the press conference following the BoC meeting, Senior Deputy Governor Carolyn Wilkins noted that the policy rate remains negative in real terms and is still below the central bank's estimate of neutral (between 2.5% and 3.5%). She also noted that the term "gradual" was no longer used to describe the pace of monetary tightening, so as not to give the impression that policy was following a steady predetermined path similar to the Fed's tightening cycle - potentially, a sign that more hawkish surprises could be in the offing. The BoC also sounded more optimistic on the outlook for the Canadian economy, while sounding less concerned about the two factors that should cause the most worry - high consumer debt levels and uncertainty over global trade. The more upbeat tone is at odds with the current pace of economic growth in Canada, which has slowed. GDP growth has decelerated to 1.9% from 3.0% at the end of 2017, while the OECD's leading economic indicator for Canada is also in a downtrend (Chart 8). In the Monetary Policy Report (MPR) that was also released last week, the latest BoC forecasts for Canadian real GDP growth for 2019 and 2020 were essentially left unchanged. Chart 8Is The BoC's Growth Optimism Justified? The BoC noted that the composition of demand within the Canadian economy was shifting away from consumption and housing towards business investment and exports. That can be seen in the most recent data that shows sluggish consumer spending (middle panel) and rebounding export growth (bottom panel). The central bank attributes the softer path for consumption to its own interest rate increases and changes to housing market policies, both of which have forced households to adjust their spending patterns. That is evident in the sharp decline in house price growth, deceleration of household credit growth and the softening trends in housing starts and residential investment spending (Chart 9) Chart 9Canadian Housing Has Cooled Off The BoC is of the view, however, that consumer spending will rebound (but not overheat) on the back of strong household income growth and a pickup in net immigration inflows that is boosting population growth. The other area of diminished concern for the central bank is investment spending, which has been negatively impacted by the uncertainty over the renegotiation of the North America Free Trade Agreement (NAFTA). That smooth acronym is now gone, to be replaced by the more awkward "USMCA", or United States-Mexico-Canada Agreement. That new trade deal has reduced the immediate uncertainty over the impact of U.S. trade policy on Canada, although the BoC did note in the MPR that there was still the potential for lingering uncertainty based on previous U.S. trade actions (i.e. on steel and aluminum imports to the U.S.) and because the USMCA has not yet been ratified. The BoC did make an upward adjustment to its assumptions regarding the hit to Canadian growth from U.S. trade policy compared to the July MPR. The level of exports is now only expected to fall by -0.3% over the next two years (vs -0.7% in the July MPR) and business investment is expected to decline by -0.7% over the same period (vs -1.4% in the July MPR). The reduction in trade uncertainty should be expected to free up demand for capex in Canada. The Q3/2018 BoC Senior Loan Officers' Survey reported a further easing of lending standards from the Q2 survey (Chart 10). The central bank's Q3 Business Outlook Survey also noted that firms' investment intentions continued to strengthen to the highest level in eight years (middle panel). This was primarily due to increased expectations for future sales growth, coming at a time of high reported capacity pressures (bottom panel). Importantly, the Business Outlook Survey took place before the USMCA deal was reached, suggesting that the data may actually understate sales expectations. This bodes well for future gains to overall GDP growth from business investment spending. Chart 10Canadian Companies Need To Invest & Hire That same Business Outlook Survey also reported that firms are continuing to experience labor shortages, most notably in sectors such as construction, transportation and information technology. This is a sign that employment growth should remain firm in Canada. Coming at a time when the unemployment rate at 5.9% remains well below estimates of full employment, this suggests that there could be some upward pressure on inflation. Canadian headline CPI inflation currently sits at 2.2%, while core CPI inflation is at 1.8% (Chart 11). That is a sharp decline from the 3% inflation seen in July, which was the result of an unexpected surge in airline fares. Yet at current levels, Canadian inflation sits right at the midpoint of the BoC's 1-3% target range. Furthermore, the BoC's own assessment is that the output gap is in a range of -0.5% to +0.5%, in line with the estimates from the IMF and OECD (middle panel). Although headline wage growth has cooled in recent months, the BoC's preferred measure that incorporates several wage measures ("Wage-Common"), has been stable near the same 2% levels as seen for CPI inflation. Chart 11Canadian Inflation At BoC Target Expect More BoC Hikes With the Canadian economy operating at full employment and with inflation at target, the BoC seems determined to push the policy rate back up towards their estimated 2.5%-3.5% range for the neutral rate. This means another 75-175bps of additional rate increases. At the moment, there are only 49bps of hikes over the next year discounted in the Canadian Overnight Index Swap (OIS) curve (Chart 12). This leaves Canadian bond yields exposed to additional rate increases. This is especially true given our forecast of continued Fed interest rate increases in 2019, as the BoC has been playing a game of "Follow the Leader" with the Fed during the current tightening cycle (top panel). Chart 12Stay Underweight Canadian Government Bonds In terms of our recommended fixed income investment strategy, we continue to favor: an underweight stance on Canadian government bonds for global bond investors a below-benchmark duration stance within dedicated Canadian bond portfolios long positions in Canadian inflation protection (CPI swaps or inflation-linked bonds) While we expect the Canadian yield curve to flatten as the BoC delivers more rate hikes than currently discounted over the next year, we do not see the 2-year/10-year curve flattening by more than is currently priced in the forwards. This is not the case for an outright duration bet, where the forwards are currently priced for very little upward movement in Canadian bond yields over the next year. Therefore, we prefer to stick with directional bets on Canadian yields (higher) and Canadian relative bond performance versus global peers (worse). Bottom Line: The Bank of Canada remains on a hawkish path to a more neutral policy rate, even with the lingering concerns over household debt and global trade tensions. Stay underweight Canadian government bonds in hedged global bond portfolios. Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy Overbought technicals, pricey valuations, decelerating global growth, declining capex, rising indebtedness and softening operating metrics argue for hopping off the S&P railroads index. Rising refined product stocks, ebbing gasoline demand, and excessive analyst profit optimism underscore that more pain lies ahead for refiners. Recent Changes Book profits of 15% in the S&P railroads index and downgrade to neutral today. TABLE 1 FEATURE Equities continue to digest the recent healthy pullback, and should remain range-bound before building a base in order to resume their bull market run. As we highlighted in our October 9thWeekly Report, "stock market crash-prone October is upon us, and thus a pick-up in volatility would not come as a surprise".1 Simply put, the difference between perception and reality propagates as volatility. Volatility has indeed come roaring back. There are high odds that vol will settle at a higher level, and bouts of volatility will be more frequent. The most important determinant of vol is interest rates, as we first highlighted on March 5th this year.2 For almost a decade, the Fed kept the fed funds rate close to zero in order to suppress volatility. QE and excess liquidity injections into the financial system and in the economy also aided in bringing down volatility across assets classes. Now this process is working in reverse. Not only is the Fed tightening monetary policy by increasing the fed funds rate, but it is also allowing maturing bonds to fall off its balance sheet (what some market participants have defined as quantitative tightening). In other words, as the Fed is mopping up excess liquidity, volatility is making a comeback (Chart 1). Chart 1VIX The Comeback Kid A relatively flat yield curve also points to higher volatility in the months ahead. This relationship is intuitive, given that a flat curve signals that the cycle is long in the tooth and a recession may be approaching. While both of these interest rate relationships with vol have a long lead time, the message is clear: investors should get accustomed to higher volatility at this stage of the cycle (yield curve shown on inverted scale, Chart 2). Chart 2Yield Curve And Vol Joined At The Hip Following up from last week, our Economic Impulse Indicator (EII) caught the attention of a number of our clients, igniting a healthy exchange. One criticism is that this Indicator has had some big misses in the past. This is true, but the recent history (since mid-1990s) has enjoyed an extremely high correlation. Importantly, if we show SPX profits as an impulse, the fit with the EII increases considerably (bottom panel, Chart 3). In addition, the EII moves in lockstep with the impulse of S&P 500 momentum (second panel, Chart 3). Chart 3Economic Impulse Yellow Flag Nevertheless, our worry remains intact and the risk of modest economic disappointment sometime early next year is rising (Chart 4). On that front, another indicator that continues to show signs of stress is the credit card chargeoff rate of U.S. commercial banks, excluding the 100 largest outfits. According to the Fed, both delinquencies and chargeoffs are near recessionary levels, a message large banks do not corroborate, at least not yet (Chart 5). Chart 4Economic Growth Trouble Chart 5Watch Credit Quality True, we do not think the consumer is at the cusp of retrenching as a tight labor market and rising wage inflation should boost disposable income, but rising interest rates are a clear headwind. Importantly, the fact that regional banks are sniffing out some credit quality trouble is disconcerting especially given the recent anecdote of commercial real estate (CRE) chargeoffs at Bank OZK, a regional bank that epitomizes the CRE excesses of the current cycle. We will continue to monitor our Indicators for further evidence of deteriorating credit quality. While all these risks are worrisome, and a surge in the U.S. dollar is a key EPS risk for 2019, last Friday we triggered our "buy the dip" strategy for long-term oriented capital that we have been touting recently - as the SPX hit the 10% drawdown mark since the late-September peak - predicated on BCA's view of no recession in the coming 12 months.3 In fact, none of the boxes in the three signposts we track to call the end of the cycle have been checked yet (please refer to last week's report for a recap).4 In addition, the multiple has reset significantly lower (down 20% from the cyclical peak set in January) flirting with the late-2015/early-2016 lows (Chart 6), leaving the onus on EPS to do the heavy lifting. Chart 6Wholesale Liquidation Should Bring Out Bargain Hunters On that front, Q3 earnings season has been solid, despite the input cost inflation worries that MMM and CAT rekindled recently (please look forward to reading next week's pricing power update where we gauge if the U.S. corporate sector will be in a position to pass on input cost inflation down the supply chain or to the consumer). This week we downgrade a transportation sub-group that has been on fire, and update our view on an energy index we continue to dislike. Time To Get Off The Rails We have been riding the rails juggernaut for roughly 16 months, but the time has come to get off board. Chart 7 shows that technical conditions are overbought and relative valuations are pricey, hovering near previous extremes as investors are extrapolating good times far into the future. Such euphoric readings have historically been synonymous with a high relative performance mark for this key transportation sub-index and are a cause for concern. Chart 7Overvalued And Overbought We do not want to overstay our welcome on the S&P rails index for a number of reasons. First, its is quite perplexing why this capital intensive industry has been cutting capex as the rest of the non-financial corporate sector has been growing gross fixed capital formation at near double-digit rates (second panel, Chart 8). Chart 8Capex Blues Adding insult to injury, railroad CEOs have been changing the capital structure of their respective firms by borrowing extensively in order to retire equity (in order to satisfy shareholders) and thus artificially massaging EPS higher. Going through the recent history of the constituents' financial statements is worrying. Net debt-to-EBITDA is up 75% since early-2015 near 2.2x and higher than the overall market, largely driven by rising indebtedness (Chart 8). Taken together, lack of investment and a higher debt burden are painting a grim backdrop, especially if cash flow growth suffers a mishap. Second, the global manufacturing outlook has downshifted on the back of Trump's trade rhetoric and China's larger than anticipated slowdown. Tack on our souring margin proxy and relative EPS euphoria resting mostly on equity retirement is under attack (second panel, Chart 9). Chart 9Warning Signals... Third, two of our key industry Indicators have suddenly turned south. Our Railroad Indicator has dropped into the contraction zone and our Rail Shipment Diffusion Indicator has fallen off a cliff lately (Chart 10). The implication is that rail freight demand is likely on the verge of cresting. Chart 10...Abound... Fourth, industry operating metrics are deteriorating, at the margin. Intermodal rail shipments have rolled over. In fact, toppy consumer confidence alongside decreasing traffic at the Port of Los Angeles signal that the path of least resistance is lower for this key rail freight category, comprising 50% of total carloads (Chart 11). In addition, coal shipments are moribund, despite the recent slingshot recovery in natural gas prices that should have enticed utilities to switch out of nat gas and into coal for electricity generation (not shown). Chart 11...Even In Intermodel... However, there are some positive offsets that prevent us from turning outright bearish on the S&P rails index. This transportation sub group is an oligopoly and is in the driver's seat with regard to pricing power (middle panel, Chart 12). In other words, it has the ability to pass rising diesel costs through to its clients as a fuel surcharge. Alternative modes of transportation like air freight and trucking are available, at least for some rail categories, but the switching costs are typically prohibitive and the relative price advantages few and far between. Chart 12...But There Are Offsets Further, rail pricing power is a key input to our railroad EPS model and the message from our model is that EPS have more upside, at least until Q1/2019. Thus, we refrain from swinging all the way to a below benchmark allocation. Adding it up, overbought technicals, pricey valuations, declining capex rising indebtedness and softening operating metrics argue for hopping off the rails. Bottom Line: Lock in gains of 15% since inception in the S&P rails index and downgrade to neutral. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Refiners Crack Under Pressure Pure-play refiners remain our sole underweight within the energy space, and despite recent M&A activity, they have trailed the broad market by 9% since the early-July inception. More downside looms, and we continue to recommend a below benchmark allocation in the S&P oil & gas refining & marketing index. We remain puzzled with sell-side analysts' extreme long-term EPS euphoria in this niche energy space. Historically, when an index catapults to a 25%/annum 5-year forward EPS growth rate, it is time to run for cover: the tech sector in the late 1990s, biotech stocks in the early-2000s and in 2014 and, most recently, semi equipment stocks in late-2017 all painfully demonstrate that stocks hit a wall when profit euphoria is so elevated (bottom panel, Chart 13). Chart 13Too Good To Be True Refiners are currently trading at a 45%/annum long-term EPS growth rate. While at first we thought base effects were the culprit, a closer inspection reveals that those effects were filtered out late last year and the recent increase in expected growth rate from 20% to north of 45% defies logic (middle panel, Chart 13). We expect a sharp revision to a rate below the broad market in the coming months, as refining stocks also continue to correct lower. There are a few reasons why we anticipate such a gravitational pull back down to earth. Refined product consumption is falling and that exerts a downward pull on refining profitability. This letdown in demand is materializing at a time when gasoline inventories are rising at a high mid-single digit rate (gasoline inventories shown inverted, bottom panel, Chart 14). Chart 14Bearish Supply Demand Backdrop Not only have light vehicle sales crested, but also vehicle miles driven are flirting with the contraction zone, weighing heavily on gasoline demand prospects (second panel, Chart 15). Chart 15No Valuation Cushion Ultimately, pricing discovery resolves any supply/demand imbalances and most evidence currently points to at least an easing in crack spreads. Chart 16 highlights that crude oil inventories are trailing the buildup in refined products stocks and that is pressuring refining margins. Chart 16Mixed Signals... The implication is that refining industry profits will underwhelm, which will catch investors and analysts by surprise given their near and long-term optimistic EPS assessment. If our weak profit backdrop pans out, then a lack of a valuation cushion suggests that relative share prices will likely suffer a significant drawdown (bottom panel, Chart 15). Nevertheless, there are two related positive offsets. And, if they were to persist then our bearish view on refiners would be offside. The widening Brent-WTI crude oil spread suggests that crack spreads could reverse course if it stays stubbornly elevated. This wide oil price differential has pushed refining net exports close to all-time highs and represents a profit relief valve as the energy space has, up to now, escaped the trade wars unscathed (Chart 17). Chart 17...On Crack Spreads Netting it out, rising refined product stocks, softening gasoline demand, and excessive analyst profit optimism underscore that more pain lies ahead for refiners. Bottom Line: Continue to avoid the S&P oil & gas refining & marketing index. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC and HFC. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Report, "The "FIT" Market" dated October 9, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, "Top 10 Reasons We Still Like Banks" dated March 5, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Insight, "Time To Bargain Hunt" dated October 26, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Report, "Icarus Moment?" dated October 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

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

Highlights Asset allocation: overweight industrial commodities versus equities... ...and neutral equities versus bonds. The euro: neutral for a broad basket but stay long JPY/EUR. The pound: long-term upside, but a better entry point awaits for those who can fine tune. Italian assets: buy when the 10-year BTP yield moves closer to 3 percent. Feature Some people ascribe this year's market action to economics, others ascribe it to geopolitics, but we put it down to mathematics (Chart of the Week). Chart of the WeekEquities Are In 'No Man's Land' As my colleague Peter Berezin recently pointed out, economies and markets can undergo disruptive 'phase transitions' analogous to when water transitions to ice. For water, a 4 degree drop in temperature from 6 degrees to 2 degrees produces no discernible effect, but the same 4 degree drop from 2 degrees to minus 2 degrees produces major disruption, as roads freeze over, pipes burst, and so forth.1 Similarly, as economic or financial stresses build, nothing discernible happens until a phase transition is reached, at which point everything goes haywire. Our thesis is that markets may be near such a phase transition. To explain why, we first need to correct the great misunderstanding of finance, the misunderstanding of risk. The Evolutionary Basis Of Investment Risk One of the major breakthroughs in behavioural finance was the discovery that we care deeply about the asymmetry of an investment's potential returns. Rationally, this asymmetry shouldn't matter if the expected value of the gains equals or exceeds the expected value of the losses. But it does matter, and the reason is that we significantly overestimate the probabilities of extreme tail-events (Chart I-2). Chart I-2We Overestimate The Probability Of Tail-Events Evolutionary biologists argue that this bias originated tens of thousands of years ago, when our distant ancestors had to survive daily 'fight or flight' threats. Faced with constant mortal danger, there was no time for measured analysis. Survival depended on a quick processing of choices into simple chunks: no risk, low risk, high risk. Thereby, our brains evolved to process a one in thousand and, say, a one in hundred chance of danger simply into the 'low risk' chunk, meaning that the 0.1 percent risk is overestimated to 1 percent - or whatever we define as low risk. Fast forward to today's financial markets, and our brains still overestimate extreme tail-events. It follows that for investments whose return distributions are asymmetric, the more extreme tail dominates the perception of its risk. Put simply, investors assess the risk of an investment in terms of its most extreme potential loss versus its most extreme potential gain in a short space of time (Chart I-3). Chart I-3Investors Assess Risk As The Most Extreme Potential Loss Versus Gain Why in a short space of time? The answer is that while most professional investors have long-term objectives, they must report mark-to-market performances every quarter or half-year. Unfortunately, a fund manager who delivers a deep short-term loss is in grave danger of being fired - the modern day equivalent of our distant ancestors' daily fight for survival. And it is nominal losses that matter because even in a period of deflation, any decline in the price level is unlikely to boost real returns over a period of a few months. Correcting The Great Misunderstanding Of Finance So the great misunderstanding of finance is to equate risk with volatility. Risky assets, such as equities, are risky not because they are volatile in the conventional (root mean squared) sense. After all, nobody worries if the price goes up sharply! Also, it is a great misunderstanding to think that equities do not provide diversification benefits. They clearly do - witness the protection that equities provided to bondholders in the bond bloodbath that followed President Trump's surprise victory in 2016 (Chart I-4). Chart I-4Equities Protected Bondholders In The Post Trump Victory Bond Bloodbath The real reason that risky assets are risky is because they have the propensity to experience much larger short-term losses than short-term gains - captured in the saying: equities climb up the stairs on the way up, but they jump out of the window on the way down. But here's the key point. At very low bond yields, bond returns develop the same (or worse) asymmetry as equity returns. Given the lower bound to yields, bond prices have no more stairs to climb... only a window to jump out of! (Chart I-5) The upshot is that equities lose their excess riskiness versus bonds, meaning that their valuations experience a phase transition sharply upwards. The corollary is that when bond yields normalise, equities regain their excess riskiness versus bonds - and their valuations must suffer a phase transition sharply downwards. Chart I-5At A 2% Bond Yield, Bond Returns Have the Same Negative Asymmetry As Equity Returns According to our empirical and theoretical analysis, this phase transition sharply downwards is most pronounced when the global (10-year) bond yield rises through 2 percent. In rule of thumb terms, this is when the sum of the yields on the T-bond, German bund and JGB breaches and remains above 4 percent (Chart I-6). At such a phase transition, it would be prudent to de-risk portfolios and sit aside, at least for a while. Chart I-6When The Sum Of 10-Year Yields On The T-Bond, Bund, And JGB = 4%, The Global 10-Year Yield = 2% Just below this level, a sum in the 3-4 percent range defines a kind of 'no man's land' in which equities drift sideways, perfectly explaining the behaviour of the market through the past year. With the sum now at 3.75 percent, the current message is to remain at neutral allocation to equities versus bonds. Instead, our main asset allocation recommendation is a relative value position: long industrial commodities versus equities - and the position has already gained 4 percent in the past two weeks. The Main Risk For European Institutions Is Existential Sticking with this week's theme of risk, the main risk confronting Europe's major institutions such as the ECB, the EU Council, and the EU Commission is an existential risk. This is because the very existence of the pan-European project relies on the ongoing (largely) unanimous support of a collection of sovereign European nations. As these sponsoring nations often have conflicting claims and interests, Europe's major institutions have intentionally designed themselves as rules-based organisations. Adherence to the rules is essential to avoid the bias, exceptionalism, and moral hazard that could tear apart the pan-European project. And this simple unifying principle explains the current stance of the ECB towards monetary policy, the stance of the EU Council towards Brexit, and the stance of the EU Commission towards the Italian budget. For the ECB, its main policy tools - interest rates, forward guidance on interest rates, and asset purchases - are calibrated to deliver its single objective: aggregate euro area CPI inflation 'below but close to 2 percent'. After a recent wobble in euro area growth, the 6-month credit impulse has ticked up (Chart I-7). Hence, it would be hard for the ECB to conclude that the convergence of inflation to its medium-term target has been blown off course (Chart I-8) - so we expect no major changes to the ECB's forward guidance. Leaving our overall stance to the EUR as neutral, with a preferred long exposure to JPY/EUR. Chart I-7The Euro Area 6-Month Credit Impulse Has Ticked Up Chart I-8Euro Area Inflation Has Been Drifting Up To Target Turning to the EU Council's strategy for Brexit, it will be unyielding on the indivisibility of the EU's four freedoms: goods, services, capital, and people. To do otherwise would be to undermine the strength and integrity of one of the EU's greatest achievements: the largest single market in the world. To give the U.K. special favours would risk giving it an unfair competitive advantage, as well as setting a dangerous precedent for other EU countries that wanted out. Hence, to avoid a hard North/South or East/West border for Ireland, the U.K.'s only option will be to remain indefinitely in a customs union with the EU. Once this is recognised and accepted by the U.K. parliament, the pound will rally.2 Finally, relating to the Italian budget, the EU Commission will adhere to the broad principle of its fiscal rules - again, because it cannot set a dangerous precedent for others. However, there may be some 'give' on the 2019 deficit in return for some 'take' on the 2020 and 2021 deficits. Ultimately, we expect de-escalation and compromise in this battle - but we recommend remaining neutral towards Italian assets until the 10-year BTP yield moves closer to 3 percent (Chart I-9). Chart i-9Remain Neutral Italian Assets Until The 10-Year BTP Yield Moves Closer To 3% Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the Global Investment Strategy Weekly Report 'Phase Transitions In Financial Markets: Lessons For Today' October 19, 2018 available at gis.bcaresearch.com 2 Please see the European Investment Strategy Weekly Report 'Understanding Brexit, Scandinavian Markets, And Semiconductors' October 18, 2018 available at eis.bcaresearch.com Fractal Trading Model* This week we note that the sharp sell-off in the Portuguese stock market is technically exhausted and ripe for a countertrend move. We prefer to express this as a market neutral pair-trade: long Portugal/short Hungary. Set the profit target at 6% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

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

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

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

Highlights The long term direction for the pound is higher... ...but as the EU withdrawal bill passes through the U.K. parliament, expect a very hairy ride. The stock markets in Norway, Sweden and Denmark are driven by energy, industrials, and biotech respectively. Upgrade Sweden to neutral and downgrade Denmark to underweight. Think of semiconductors as twenty-first century commodities. Overweight the semiconductor sector versus broader technology indexes. Chart of the WeekBritish Public Opinion On Brexit Is Shifting Feature The Brexit drama is playing out exactly as scripted (Chart I-2). Chart I-2The Pound Is Following The Brexit Drama In July, we wrote: "The U.K. government's much hyped 'Chequers' proposal for Brexit risks getting a cold shower... the EU27 will almost instantaneously reject the proposed division between goods and services as 'cherry-picking' from its indivisible four freedoms - goods, services, capital, and people... the rejection will be based not just on the EU's founding principles, but also on the practical realities of a modern economy - specifically, the distinction between goods and services has become increasingly blurred." 1 Hence, the Chequers proposal to avoid a hard border between Northern Ireland and the Irish Republic is just wishful thinking: "The Irish border trilemma will remain unsolved, leaving a 'backstop' option of Northern Ireland remaining in the EU single market - an outcome that will be politically unpalatable." 2 What happens next? Understanding Brexit In a sense, Brexit is very simple. The EU27 sees only three options for the long-term political and economic relationship between the U.K. and the EU. Remain in the EU (no Brexit). Plug into an off-the-shelf setup, either the European Economic Area (EEA), European Free Trade Association (EFTA), or a permanent customs union, which already establish the EU relationship with Norway, Iceland, Liechtenstein, and Switzerland (soft Brexit). Become a 'third country' to the EU like, for example, Canada (hard Brexit). The first option, to stay in the EU, is politically impossible unless a new U.K. referendum overturned the original referendum's vote to leave. The second option, to join the EEA, EFTA, or permanent customs union is very difficult for Theresa May - because it is strongly opposed by many of the Conservative government's ministers and members of parliament who regard the option as 'Brino' (Brexit in name only). However, in a significant recent development, the opposition leader Jeremy Corbyn has committed the Labour party to a Brexit that keeps the U.K. in a permanent customs union.3 The third option, to become a 'third country', would very likely require some sort of border in Ireland. As already discussed, the only way to avoid a border would be a perfect alignment between the U.K and EU on tariffs and regulations for goods and services. But then, there would be little point in becoming a third country. Here's the crucial issue. The EU27 does not know which option the U.K. will eventually take, yet it must provide an 'all-weather' safeguard for the Good Friday peace agreement, requiring no border between Northern Ireland and the Irish Republic. Therefore, the EU27 will need the withdrawal agreement to commit: either the whole of the U.K. to a potentially permanent customs union with the EU; or Northern Ireland to a potentially permanent customs separation from the rest of the U.K. - in effect, breaking up the U.K by creating a border between Britain and Northern Ireland. Clearly, the hard Brexiters and/or Northern Ireland unionist MPs will vote down a withdrawal bill which contains either of these commitments, thereby wiping out Theresa May's slender majority. The intriguing question is: might Labour MPs - or enough of them - vote for a potentially permanent customs union to get the soft Brexit they want? Labour would be torn between the national interest and the party interest, as it would be missing a golden opportunity to topple the Conservative government. If the withdrawal bill musters a majority, it would remove the prospect of a 'no deal' Brexit and the pound would rally - because it would liberate the Bank of England to hike interest rates more aggressively (Chart I-3 and Chart I-4). If the bill failed, the government and specifically Theresa May would be badly wounded. She might call a general election there and then. Chart I-3Absent Brexit, U.K. Interest Rates Would Be Higher Chart I-4Absent Brexit, U.K. Interest Rates Would Be Higher If May limped on, parliament would nevertheless have the final say on whether to proceed with a no deal Brexit. And the parliamentary arithmetic indicates that a clear majority of MPs would vote against proceeding over the cliff-edge. At this point with the government paralysed, the only way to unlock the paralysis would be to go back to the people. Either in a general election or in a new referendum, the key issue for the public would be a choice between one of the three aforementioned options for the U.K./EU long-term relationship - because by then, it would be clear that those are the only options on offer. Based on a clear recent shift in British public opinion, the preference is more likely to be for a soft (or no) Brexit than to become a third country (Chart of the Week). Bottom Line: The long term direction for the pound is higher but, as the withdrawal bill passes through parliament, expect a very hairy ride. Understanding Scandinavian Stock Markets The Scandinavian countries - Norway, Sweden, and Denmark - have many things in common: their languages, cultures, and lifestyles, to name just a few. However, when it comes to their stock markets, the three countries could not be more different. Looking at the three bourses, each has a defining dominant sector (or sectors) whose market weighting swamps all others. In Norway, oil and gas accounts for over 40 percent of the market; in Sweden, industrials accounts for 30 percent of the market and financials accounts for another 30 percent; and in Denmark, healthcare accounts for 50 percent of the market (Table I-1). Table I-1The Scandinavian Stock Markets Could Not Be More Different! In a sense, the dominant equity market sectors in Norway and Sweden just reflect their economies. Norway has a large energy sector; Sweden specializes in advanced industrial equipment and machinery and it also has very high level of private sector indebtedness, explaining the outsized weighting in banks. However, Denmark's equity market - dominated as it is by Novo Nordisk, which is essentially a biotech company - has little connection with Denmark's economy. The important point is that the four dominant sectors - oil and gas, industrials, financials, and biotech - each outperform or underperform as global (or at least pan-regional) sectors. If oil and gas outperforms, it outperforms everywhere and not just locally. It follows that the relative performance of the four dominant equity sectors drives the relative stock market performances of Norway, Sweden, and Denmark. Norway versus Sweden = Energy versus Industrials (Chart I-5) Chart I-5Norway Vs. Sweden = Energy Vs. Industrials Norway versus Denmark = Energy versus Biotech (Chart I-6) Chart I-6Norway Vs. Denmark = Energy Vs. Biotech Sweden versus Denmark = Industrials and Financials versus Biotech (Chart I-7) Chart I-7Sweden Vs. Denmark = Industrials And Financials Vs. Biotech Last week, we upgraded some of the more classical cyclical sectors to a relative overweight. Our argument was that if an inflationary impulse is dominating, beaten-down cyclicals have more upside than the more richly-valued equity sectors; and if a disinflationary impulse from higher bond yields is dominating, its main casualty will be the more richly-valued equity sectors. On this basis, our ranking of the four sectors is: Industrials, Financials, Energy, Biotech. Which means the ranking of the Scandinavian stock markets is: Sweden, Norway, Denmark. Bottom Line: From a pan-European perspective, upgrade Sweden to neutral and downgrade Denmark to underweight. Understanding Semiconductors The best way to understand semiconductors is to think of them as twenty-first century commodities. In the twentieth century, many everyday goods and products contained a classical commodity such as copper. Today, the ubiquity of electronic gadgets, devices, and screens contains a twenty-first century equivalent: the microchip. Hence, semiconductors are to the tech world what classical commodities are to the non-tech world. They exhibit exactly the same cycle of relative performance. If, as we expect, beaten-down industrial commodities outperform, it follows that the beaten-down semiconductor sector will outperform broader technology indexes (Chart I-8). Chart I-8Semiconductors Follow The Commodity Cycle Bottom Line: Overweight the semiconductor sector versus technology. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 For example, the sale of a car is no longer the sale of just a good. As car companies often structure the financing of the car purchase, a car purchase can be a hybrid of a good - the car itself, and a service - the financing package. Therefore, a single market for cars requires a single market for both goods and services. 2 The Irish border trilemma comprises: 1. the U.K./EU land border between Northern Ireland and the Irish Republic; 2. the Good Friday peace agreement requiring the absence of any physical border within Ireland; 3.the Northern Ireland unionists' refusal to countenance a U.K./EU border at the Irish Sea, which would entail a customs border between Northern Ireland and the rest of the U.K. 3 At the Labour Party's just-held 2018 conference, Jeremy Corbyn made a commitment to joining a permanent U.K./EU customs union. Fractal Trading Model* This week's recommended trade comes from Down Under. The 25% outperformance of Australian telecoms (driven by Telstra) versus insurers (driven by IAG and AMP) over the past 3 months appears technically extended, with a 65-day fractal dimension at a level that has regularly indicated the start of a countertrend move. Therefore, the recommended trade is short Australian telecoms versus insurers, setting a profit target of 7% and a symmetrical stop-loss. In other trades, long CRB Industrial commodities versus MSCI World Index achieved its profit target very quickly, leaving four open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart I-1Indicators To Watch - Bond Yields Chart I-2Indicators To Watch - Bond Yields Chart I-3Indicators To Watch - Bond Yields Chart I-4Indicators To Watch - Bond Yields Interest Rate Chart I-5Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations