Asset Allocation

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

Highlights Rising U.S. bond yields will continue to put downward pressure on global stocks in the near term, but will not trigger an equity bear market until rates reach restrictive territory. We are still at least 12 months away from that point. The blowout in Italian bond yields has further to go, which will also weigh on global risk assets. Nevertheless, we would buy BTPs for a tactical trade if the 10-year yield rose above 4%, because at that level EU policymakers will call out the fire engines. We downgraded global equities from overweight to neutral in June, while maintaining our bias for DM stocks over EM stocks. Barring any major new developments, we would turn bullish again if global stocks were to fall by 8% from current levels. Remain cyclically underweight interest rate duration. We would move to neutral on duration if the U.S. 10-year yield were to rise to 3.7%. We are still bullish on the dollar, but would shift to neutral if the DXY rose above 100. Feature Bond Yields: Up, Up, And Away Global risk assets remained on the back foot this week. The MSCI All-Country World stock market index has now fallen by 6.3% in dollar terms since last Wednesday. Even the mighty S&P 500 has finally buckled under the pressure. The vulnerability of U.S. stocks had been accumulating beneath the surface for some time, as evidenced by the fact that the advance-decline line has been deteriorating since the late summer. The small cap Russell 2000 is down 11.3% from its August 31st highs (Charts 1A& 1B). Chart 1ABreadth Deteriorated In The Lead-Up To The Correction Chart 1BStocks Under Pressure Bond yields usually fall when equities swoon. This time around, it is the increase in bond yields itself that has undermined stocks. In the U.S., yields have risen in response to better-than-expected growth, a wider budget deficit, rising oil prices, and an increasingly hawkish Fed. In Italy, worries about debt sustainability have been the primary driver of rising yields. Neither factor spells doom for global risk assets. However, a period of indigestion is likely over the coming weeks, which could see global equities go down before they go up again. The U.S. Economy: Too Much Winning? We have argued for much of this year that investors were underappreciating the extent to which the Federal Reserve can raise rates without choking off growth. The past few weeks have seen a growing recognition among investors that the Fed may be behind the curve in normalizing monetary policy. This has led to a steepening in the expected path of U.S. short-term rates, which, together with an increase in the term premium, have pushed up yields at the longer-dated maturities. Both better economic data and Fedspeak contributed to the bond sell-off. On the data front, the non-manufacturing ISM index clocked in at 61.6. The all-important employment component of the index hit a record high. Confirming the encouraging labor market signal from the ISM, the unemployment rate fell to a 48-year low of 3.68% in September. While average hourly earnings ticked down to 2.75% on a year-over-year basis, this was entirely due to base effects. On a month-over-month basis, average hourly earnings have risen by 0.3% for three straight months. If this trend continues, the year-over-year rate will rise to 3.2% by the end of this year. Tellingly, recent wage growth has been concentrated among workers at the bottom of the income distribution (Chart 2). This is important because not only do the wages of low-income workers correlate better with labor market slack than those of high-income workers, but low-income workers are also more likely to spend the bulk of their paychecks. Chart 2Wage Growth Has Accelerated At The Bottom Of The Income Distribution Higher wage growth will boost consumer spending. Indeed, it is probable that consumption will rise more than income, given that the personal savings rate has plenty of scope to fall from the current elevated level of 6.6%. Rising wages will incentivize companies to invest more in labor-saving technologies, translating into an increase in capital spending.1 Add in ongoing fiscal stimulus, and we have a recipe for an overheated economy. Starstruck No More As of today, the market has priced in one Fed rate hike in December but only two rate hikes in 2019 (Chart 3). Investors expect no rate hikes in 2020 and beyond. That still seems implausible to us, which suggests that the bond sell-off has further to go. Chart 3The Market Still Thinks The Fed Can't Raise Rates Above 3% In contrast to the past, the Fed no longer seems interested in talking down rate expectations. Speaking with Judy Woodruff at The Atlantic Festival, Chairman Powell stated the Fed "may go past neutral, but we are a long way from neutral at this point, probably."2 Even uber-dove Chicago Fed President Charles Evans appears to have jettisoned his worries about deflation, noting in a speech last Wednesday that "I am more comfortable with the inflation outlook today than I have been for the past several years."3 The Fed has also increasingly downplayed the importance of estimates of the neutral rate of interest, the concept on which the long-term "dots" in the Summary of Economic Projections are based. The Fed's new mantra is that economic data, rather than some theoretical model, should guide monetary policy. Ironically, it was New York Fed President John Williams, who developed one of the most widely used models of r-star, the eponymously named Holston-Laubach-Williams model, that best articulated the Fed's position. At a speech last Monday, Williams argued that the neutral rate of interest, or r-star, has "gotten too much attention in commentary about Fed policy." He went on to say that "Back when interest rates were well below neutral, r-star appropriately acted as a pole star for navigation. But, as we have gotten closer to the range of estimates of neutral, what appeared to be a bright point of light is really a fuzzy blur, reflecting the inherent uncertainty in measuring r-star."4 Trump And Bonds President Trump was quick to blame the Fed for this week's stock market sell-off. Within the span of 24 hours, he used the words "crazy," "loco," "ridiculous," "too cute," "too aggressive," and "big mistake" to describe recent Fed policy. We doubt Trump's rhetoric will have any immediate effect on Fed decision-making. But even if it did sway the Fed to slow the pace of rate hikes, the result will be higher bond yields, not lower yields. This is simply because any further delays in raising rates will lead to even more overheating, and ultimately, higher inflation and the need for higher rates down the road. Bond Sell-Off Will Produce A Correction In Stocks, Not A Bear Market At the height of this week's bond sell-off, the 10-year Treasury yield breached its 200-month moving average for the first time since ... October 1987 (Chart 4). While that sounds pretty ominous, keep in mind that the 10-year yield had reached almost 10% on the eve of the 1987 stock market crash, or about 6% in real terms. Chart 4Two Lines Meet After Three Decades As my colleague, Doug Peta, discussed two weeks ago, it is the level of interest rates that tends to matter more for stocks rather than the change in rates.5 Specifically, equity returns tend to be lowest at times when monetary policy is already in restrictive territory (Chart 5 and Tables 1 and 2). That was the case in 1987. It is not the case today. Chart 5The Fed Funds Rate Cycle Table 1Tight Policy Is Hazardous To Stocks' Health... Table 2...Especially In Real Terms The fact that stocks do worse in environments where monetary policy is tight makes perfect sense. A restrictive monetary policy is usually a prelude to a recession. As Chart 6 illustrates, bear markets and recessions almost always coincide, with the latter usually leading the former by about six-to-twelve months. None of our favorite leading recession indicators are flashing red now (Chart 7). Even the yield curve has steepened in recent weeks. Chart 6Recessions And Bear Markets Usually Overlap Still, higher long-term bond yields do reduce the long-term attractiveness of stocks compared with bonds. The S&P 500 earnings yield has risen modestly since 2016 due to the fact that earnings have grown somewhat more quickly than equity prices. However, the U.S. real 10-year yield has surged by almost 120 basis points over this period. On balance, this has caused the equity risk premium to decline (Chart 8).6 In order to bring the equity risk premium back down to mid-2016 levels, the S&P 500 would need to fall by about 15% from today's levels. We do not expect stocks to fall by that much, partly because the economic environment is more robust than back then, but a further drop of 5%-to-10% from current levels is certainly plausible. Chart 7A U.S. Recession Is Not Imminent Chart 8Stocks Versus Bonds Italy: Heading For A Debt Crisis? The rise in Treasury yields has reduced the attractiveness of other global government bond markets, causing them to sell off in sympathy. Notably, German bund yields have increased by 33 basis points since their May lows (Chart 9). Chart 9Global Bond Yields Moving Higher Rising German bund yields are bad news for Italy. All things equal, a higher "risk free" bund yield implies a higher Italian bond yield. To make matters worse, as Italian borrowing costs have risen, the perceived likelihood that Italy will be unable to repay its debt has increased. This has caused the spread between German bunds and Italian BTPs to widen, thereby magnifying the effect on Italian bond yields from the increase in risk-free yields. All this has happened at the worst possible moment. Italy's populist government and the European Commission are locked in a battle of wills over next year's budget. The Italian government is targeting a fiscal deficit of 2.4% of GDP for 2019, compared with a deficit of 0.8% that the outgoing caretaker government had proposed in May. Strictly speaking, the new deficit target is still consistent with the 3% limit under the Maastricht Treaty. Nevertheless, it is still causing consternation in Brussels. There are at least three reasons for this: While the government's program has a lot of specifics about how it will increase the deficit - more public investment; a universal minimum income scheme; the ability to retire earlier than under current law; corporate tax cuts; no VAT hike in 2019, etc. - it does not specify which items in the budget will be cut. The program also provides few details on revenue measures, other than proposing a one-off tax amnesty, which will arguably reduce tax receipts over the long haul. The proposed budget assumes real GDP growth of 1.5% in 2019. This is higher than the May projection of 1.4%, and well above the IMF's most recent projection of 1%. The government's real GDP projections for 2020-21 are also about 0.7 percentage points above the IMF's estimates. While Italy's proposed fiscal deficit is below the Maastricht Treaty limit, its current debt-to-GDP ratio of 132% is well above the ceiling of 60% (Chart 10). This implies that Italy should be aiming for a smaller deficit target than what it is currently proposing. Chart 10Italy's Public Debt Mountain We expect the Italian government to ultimately acquiesce to the EU's demands, but not before the bond vigilantes have pushed them into a corner. For their part, the EU establishment would love nothing more than to embarrass the Five Star-Lega coalition in order to send a message to voters across Europe about the dangers of voting for populist parties. This means that the Italian 10-year yield may need to break above 4% - the level at which Italian banks would likely be technically insolvent based on the market value of their BTP holdings - before a compromise is reached. We would put on a tactical trade to buy 10-year BTPs at that level, but not before then. Investment Conclusions Goldilocks will survive, but the next couple of months will be challenging. Our soon-to-be-launched MacroQuant model is signaling a bearish outlook for stocks over the next 30 days (Chart 11). On the bond side, the model currently pegs the fair value for the U.S. 10-year yield at 3.7% (Chart 12). Bond sentiment is quite bearish at the moment, which makes a brief countertrend bond rally quite likely. However, the cyclical trend in yields remains to the upside. Chart 11MacroQuant* Recommends That Caution Is Warranted Towards Equities Chart 12MacroQuant Sees 10-Year Treasury Yields Still Below Fair Value We stated last week that investors should consider scaling back risk if they are currently overweight risk assets. We continue to favor this more cautious stance. For the first time in over a decade, short-term U.S. rates are above the dividend yield on the S&P 500 (Chart 13). Holding a bit more cash is finally an attractive option, at least for U.S.-based investors. Chart 13Cash Anyone? If the sell-off in global equities continues, it will present a buying opportunity, given that the next major global economic downturn is probably at least another two years away. Barring any major new developments, we would turn bullish on stocks again if the MSCI All-Country World Index were to fall by 12% 10% 8% from current levels.7 We would recommend that investors move from an underweight to a neutral interest rate duration position in global bond portfolios if the U.S. 10-year Treasury yield rose to 3.7%. We are still bullish on the dollar, but would shift to neutral if the DXY rose above 100. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 It is true that additional investment spending will raise aggregate supply, but normally it takes a while for that to happen. For example, it may take a few years to build an office tower or a new factory. Corporate R&D investment may not generate tangible benefits for a long time, especially in cases where the research is focused on something complicated (i.e., the design of new computer chips or pharmaceuticals). And even if investment spending could be transformed into additional productive capacity instantaneously, aggregate demand would still rise more than aggregate supply, at least temporarily. Here is the reason: The nonresidential private-sector capital stock is about 120% of GDP in the United States. As such, a one percent increase in investment spending would raise the capital stock by four-fifths of a percentage point. Assuming a capital share of income of 40% of national income, a one percent increase in the capital stock would lift output by 0.4%. Thus, a one-dollar increase in business investment would boost aggregate demand by one dollar in the year it is undertaken, while increasing supply by only 4/5*0.4 = roughly 32 cents. 2 Please see "WATCH: Powell says Fed is focused on 'controlling the controllable,' not politics," PBS News Hour, October 3, 2018; and Jeff Cox, "Powell says we're 'a long way' from neutral on interest rates, indicating more hike are coming," CNBC, October 3, 2018. 3 Charles Evans, "Monetary Policy 2.0?" OMFIF City Lecture on the U.S. Economic Outlook, London, England, October 3, 2018. 4 John C. Williams, "Remarks at the 42nd Annual Central Banking Seminar," Bank for International Settlements, October 1, 2018. 5 Please see U.S. Investment Strategy Special Report, "When Will Higher Rates Hurt Stocks?" dated September 24, 2018; and Special Report, "Revisiting The Fed Funds Rate Cycle," dated September 3, 2018. 6 For this exercise, we define the equity risk premium as the difference between the S&P 500 earnings yield (the inverse of the forward P/E ratio) and the real 10-year bond yield (using CPI swaps as our measure of expected inflation). 7 The perils of writing a report during a week when markets are moving fast. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Please note that a Special Alert titled "Brazil: A Regime Shift?" discussing investment implications of the weekend elections was published on Tuesday. Highlights The combination of rising U.S. bond yields and slumping growth in EM/China heralds further downside in EM risk assets and currencies. Watch for a breakdown in Asian risk assets and currencies. As a market-neutral trade for the next several months, we recommend going long Latin American and short emerging Asian stocks in common currency terms. We are downgrading Hong Kong stocks from neutral to underweight within an Asian or EM equity portfolio. Feature U.S. bond prices have broken down, and yields have broken out (Chart I-1). The bond selloff will continue as U.S. growth is very strong and inflationary pressures are accumulating. Chart I-1U.S. Bond Yields Have Broken Out, More Upside How will EM financial markets react to a further rise in U.S. bond yields? If EM growth were robust and fundamentals healthy, financial markets in developing countries would have no problem digesting higher U.S. interest rates. However, the fact is that EM fundamentals are poor and growth is weakening. Consequently, financial markets in the developing world are very vulnerable to higher U.S. bond yields. For now, U.S. bond yields will continue to rise, the U.S. dollar will strengthen further, and the EM bear market will endure. Stay short/underweight EM risk assets. Understanding The Nexus Between EM Assets And U.S. Bonds Rising U.S. bond yields pose a threat to EM risk assets if the former leads to a stronger U.S. dollar and by extension weaker EM currencies. Notably, risks to EM share prices will magnify if dollar borrowing costs for EM (corporate and sovereign bond yields) increase further (Chart I-2). In short, if rising U.S. bond yields are not offset by narrowing EM credit spreads, EM dollar bond yields will climb. This in turn will weigh on EM share prices. Chart I-2Rising Dollar Borrowing Costs: A Bad Omen For EM Stocks Chart I-3 highlights that the divergence between U.S. and EM share prices this year can be attributed to the decoupling in their credit spreads. Chart I-3Diverging Credit Spreads Between EM & U.S Credit spreads, meanwhile, are steered by EM exchange rates (Chart I-4). When EM currencies depreciate, debtors' ability to service U.S. dollar debt worsens, and credit spreads widen to reflect higher risk. The opposite also holds true. Chart I-4EM Credit Spreads Are A Function Of EM Currencies Overall, getting EM exchange rates right is of paramount importance. Hence, a vital question: Do EM currencies always depreciate when U.S. bond yields are rising or the Federal Reserve is tightening? Chart I-5 suggests not. Before 2013, EM currencies appreciated with rising U.S. bond yields. Since 2013, the correlation has been mixed. Chart I-5No Stable Relationship Between U.S. Bond Yields & EM Currencies The key difference between these periods is the performance of EM/Chinese economies. When EM/China growth is robust or accelerating, financial markets in developing economies have no trouble digesting higher U.S. interest rates and their currencies tend to appreciate. By contrast, when EM/China growth is weak or slumping, EM asset prices and currencies tumble regardless of the trajectory of U.S. interest rates. A pertinent question at the moment is why robust U.S. growth is not helping EM weather higher U.S. interest rates. The caveat is that EM as a whole is more exposed to the Chinese economy than the American one. Hence, barring a meaningful improvement in Chinese growth, higher U.S. bond yields will be overwhelming for EM financial markets. This is why we have been focusing on China's growth dynamics. Bottom Line: Desynchronization between the U.S. and Chinese economies will persist. The resulting combination of rising U.S. bond yields, a stronger greenback and depreciating EM currencies foreshadows further downside in EM risk assets. Emerging Asia: Do Not Catch A Falling Knife The latest export data from Korea and Taiwan point to a continued slowdown in their exports (Chart I-6). Corroborating the deepening slump in Asian growth and global trade, emerging Asian equity and credit markets are plunging. In particular: Chart I-6Global Trade Is Slowing The relative performance of emerging Asian stocks versus the global equity benchmark failed to break above important technical long-term resistance lines earlier this year, and will likely breach below their early 2016 lows (Chart I-7). Chart I-7Emerging Asian Equities Vs. Global: Further Underperformance Ahead Both high-yield and investment-grade emerging Asian corporate dollar-denominated bond yields continue to climb - a worrisome development for emerging Asian share prices (high-yield corporate bond yields are shown inverted in Chart I-8). Chart I-8Rising Corporate Bond Yields In Emerging Asia = Lower Stock Prices The equity selloff in emerging Asia is broad-based. Chart I-9 shows that the emerging Asian small-cap equity index is in freefall. Chart I-9Emerging Asian Small Caps Are In Freefall Net earnings revisions in China, Korea and Taiwan have dropped into negative territory (Chart I-10). Chart I-10Net Earnings Revisions Are Negative In China, Korea And Taiwan The Chinese MSCI All-Share Index - all stocks listed on the mainland and offshore (worldwide) - has plunged close to its early 2016 lows (Chart I-11). Chart I-11Chinese Broad Equity Index Is Back To Its 2016 Lows In China, the property market and construction remain at substantial risk. The budding slump in the real estate market will likely offset the government spending stimulus on infrastructure investment. Plunging share prices of property developers listed in both onshore and in Hong Kong point to a looming major downtrend in real estate market (Chart I-12). Chart I-12An Imminent Slump In Chinese Real Estate? For Asian equity portfolio managers whose mandate is to make a decision on Hong Kong and Singapore stocks, we recommend downgrading Hong Kong equities from neutral to underweight while maintaining Singapore at neutral within an Asian and overall EM equity portfolio. Our basis is that rising interest rates in the U.S. will translate into higher borrowing costs in Hong Kong due to the currency peg (Chart I-13). Simultaneously, Hong Kong's economy will suffer from a slowdown in China. Hence, a combination of weaker growth and rising borrowing costs will spell trouble for this interest rate-sensitive bourse. Chart I-13Higher U.S. Rates = Higher Hong Kong Rates Bottom Line: Equity and credit markets in emerging Asia are trading extremely poorly, and further downside is very likely. This week, we are downgrading allocations to Hong Kong stocks from neutral to underweight within an Asian or EM equity portfolio. A Relative Equity Trade: Short Asia / Long Latin America Common currency relative performance of emerging Asian versus Latin American stocks has broken down (Chart I-14). We reckon emerging Asian equities are set to underperform their Latin American peers for the next several months. Chart I-14Long Latin American / Short Emerging Asian Stocks The main culprit will likely be further depreciation in the RMB and an intensifying economic downturn in Asia, which will propel emerging Asian currencies and share prices lower. In regard to Latin America, elections in Mexico and Colombia have produced governments that will on the margin be positive for their respective economies. In Brazil too, first round election results are pointing to a market friendly result. We have been shifting our country equity allocation in favor of Latin America at the expense of Asia since late last year. In particular, we downgraded Chinese stocks in December 2017, Indonesian equities this past May and the Indian bourse last week. At the same time, we have been raising our equity allocation to Latin America by upgrading Mexico to overweight in April 2018, Colombia last week and Brazil earlier this week.1 Given we are also overweight Chilean stocks, our fully invested EM equity model portfolio noticeably overweights Latin America versus Asia. Notwithstanding our broad underweight in emerging Asia, we are still overweight Korea, Taiwan and Thailand within an EM equity portfolio. However, these overweights are paltry relative to both the size of the Asian equity universe and our overweights in Latin America. Bottom Line: Go long Latin American and short emerging Asian stocks in common currency terms as a trade for the next several months. Our Fully-Invested Equity Model Portfolio Chart I-15 demonstrates the performance of our fully invested EM equity portfolio versus the EM MSCI benchmark. This portfolio is constructed based on our country recommendations. Hence, it is a measure of alpha that clients could derive from our country calls and geographical equity allocations. Chart I-15EMS's Fully-Invested Model Equity Portfolio Performance We make explicit country equity recommendations (overweight, underweight and neutral) based on qualitative assessments of all relevant variables - the business cycle, liquidity, currency risks, policy, politics, valuations, and the structural backdrop among other things - for each country. This model portfolio is not a quantitative black box, but rather a combination of several factors: macro themes on the overall EM space, in-depth research on each individual country and various quantitative indicators. The table with our recommended country equity allocation is published at the end of our weekly reports (please refer to page 11). This fully invested equity model portfolio has outperformed the MSCI EM equity benchmark by about 65% with very low volatility since its initiation in May 2008. This translates into 500-basis-points of compounded outperformance per year. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EM: Staring At A Grey Swan?" dated October 4, 2018 and Emerging Markets Strategy Special Alert "Brazil: A Regime Shift?" dated October 9, 2018; links are available on page 11. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Portfolio Strategy A playable sector rotation opportunity has emerged, as we first argued at the recent BCA investment conference: Financials, industrials and select tech subgroups will lead the next phase of the market advance, a result of the bond market selloff gaining steam into year-end and beyond. In contrast, rising interest rates, a vibrant U.S. economy, softening operating metrics and high indebtedness signal that it is time to shed utility stocks. Recent Changes Trim the S&P Utilities sector to underweight today. Table 1 Feature On the eve of earnings season, the SPX remains close to an all-time high. The most recent spate of investor optimism was driven by President Trump cementing another deal last week, this time with Canada. While the renaming of NAFTA to USMCA is a step in the right direction (i.e. a deal was struck), a deal with China remains the elephant in the room. On that front, U.S. hawkish trade rhetoric should remain in vogue and any deal will have to wait until at least after the election, if not until Q1/2019. Up to now Trump's trade hawkishness has not infiltrated U.S. profits, but we continue to closely monitor IBES reported profit growth expectations. Following up from last week, the rest of the world is bearing the brunt of the U.S. trade-related rhetoric according to our profit growth models, a message sell-side analysts' forecasts also corroborate (we use forward EBITDA in order to gauge trend profit growth and filter out the tax-induced jump in U.S. EPS, Chart 1). Meanwhile, at the margin, seasonality can prop up stocks. While September - a historically negative return month, but not this year - is behind us, stock market crash-prone October is upon us, and thus a pick-up in volatility would not come as a surprise. Beyond October's dreaded crash history, the Presidential cycle has piqued our interest, especially years two and three. Building on our sister Geopolitical Strategy publication's research,1 and given the upcoming midterm elections, we created a cycle-on-cycle profile of SPX returns during these two middle Presidential cycle years (Chart 2). Chart 1U.S. Has The Upper Hand Chart 2Seasonality Boost Until Midyear 2019? In more detail, we analyzed 17 cycles starting in 1950 using S&P 500 daily data (reconstructed S&P 500 prior to 1957). During these iterations, only two two-year periods ended in the red, 1974/75 and 2002/03. The first coincided with a recession and the second took place in the aftermath of the dotcom bust. In addition, two other cycles produced roughly 5% two-year returns, 1962/63 and 1966/67. Finally, 1954/55 was the outlier when the SPX went parabolic and nearly doubled. While every cycle is different, it is clear from Chart 2 that the Presidential cycle should continue to underpin the SPX, if history is an accurate guide, especially given our forecast of no recession in the coming 9-to-12 months. In fact, the S&P could rise another 10%, in line with our 2019 expectation, predicated upon a 10% increase in profits and a lateral multiple move. Interestingly, according to the median Presidential cycle-on-cycle roadmap, while the back half of 2019 is likely to prove more challenging, the first half of next year should enjoy most of the returns (Chart 2). An assessment of recent data releases in the U.S. and abroad is also revealing. Chart 3 shows that the domestic economy is firing on all cylinders. Consumer confidence and sentiment hit multi-decade highs recently. Similarly, the job market remains vibrant and small business euphoria reigns supreme. Not only are small business owners optimistic on all employment-related subcomponents of the NFIB survey, but SME capex intentions are also as good as they get. The ISM manufacturing survey ticked down from the August peak, but remains close to 60. Its close sibling, the ISM services survey, vaulted into uncharted territory. All of this is reflected in the still-growing U.S. leading economic indicator and signals that the U.S. equity market remains on a solid footing. Outside U.S. shores, the bearish narrative is well established with EMs, especially the U.S. dollar debt-saddled fragile five that have to contend with twin deficits, sinking in a bear market. China's debt load is also coming under intense scrutiny as U.S. tariffs are all but certain to weigh on Chinese output growth. Nonetheless, there is a chance that the EMs have depreciated their currencies by enough to engineer a modest rebound (bottom panel, Chart 4). In other words, absent the currency peg straightjacket that dominated the region in the late-1990s, free-floating FX devaluations may serve as a relief valve in order to boost exports. The latest Korean MARKIT manufacturing PMI spiked above the boom/bust line to a multi-year high signaling that already humming Korean factories (industrial production is accelerating) will likely remain busy in the coming months. Other hard economic data also confirm these greenshoots: Korean manufacturing exports are expanding smartly. In particular, exports to China are soaring. Reaccelerating manufacturing selling prices also corroborate this budding Korean recovery (third panel, Chart 4). Chart 3U.S. Is On Fire Chart 4Reflationary Impulse? While it is premature to call an end to the EM carnage, most of the bad news on global export volumes and prices may be nearing an end and the EMs may even export some of their inflation to the U.S. Play The Sector Rotation Into Financials And Industrials... In recent research, we have been highlighting that inflation is slowly rearing its ugly head and there are high odds that the selloff in the bond market gains steam into year-end and beyond2 (as a reminder BCA's fixed income publications continue to recommend below-benchmark portfolio duration). Against such a backdrop, sectors that benefit from rising interest rates and that serve as inflation hedges should outperform in the coming quarters. The "FIT" market refers to financials, industrials and select technology stocks. In more detail, we expect a sector rotation, especially into financials and industrials that have been laggards and remain compellingly valued (Chart 5). With regard to financials, Chart 6 shows that this early cyclical sector enjoys a positive correlation with interest rates and inflation expectations, and a catch up phase in relative share prices looms in the coming quarters. Chart 5Rotate Into Financials... Chart 6...And Industrials Industrials stocks also benefit from rising inflation and interest rates as large parts of this deep cyclical sector are levered to the commodity cycle (Chart 7). In other words, industrials stocks are an indirect inflation hedge and trouble surfaces only when capital goods producers cannot pass rising input costs down the supply chain or to the consumer. But, we are not there yet. Keep in mind that during the last cycle, relative (and absolute) industrials performance peaked prior to relative energy stock prices. Similarly, the relative industrials stock price ratio troughed in early 2009 before their deep cyclical brethren put in a (temporary) bottom a year later (Chart 8). Chart 7Industrials Lead Chart 8Undervalued True, energy stocks are also going to perform well if our thesis of higher interest rates/inflation pans out in the coming quarters and especially if BCA's Commodity & Energy Strategy service's view of a looming oil price spike materializes (Chart 9). Thus, we sustain the high-conviction overweight stance in the broad sector and reaffirm our recent upgrade to an above benchmark allocation in the S&P oil & gas exploration & production (E&P) subgroup.3 We also reiterate our recent market-neutral and intra-commodity pair trade: long S&P oil & gas E&P / short global gold miners.4 This trade is off to a great start up 10.3% since inception and will benefit further from an inflationary impulse. Chart 9Energy Remains A High-Conviction Overweight While tech stocks have really delivered and led the market advance year-to-date, a bifurcated tech market should remain in place with capex levered S&P software and S&P tech hardware, storage & peripherals indexes (both are high-conviction overweights) outperforming early cyclical tech groups, semi and semi equipment stocks (we remain underweight both semi subindexes). Bottom Line: A playable rotation into financials and industrials is in the offing especially if the selloff in the bond market accelerates on the back of an inflationary whim. We continue to recommend an overweight allocation to both the S&P financials and S&P industrials sectors. ...But Lights Are Out For Utilities Utilities stocks are the ultimate loser from a backup in interest rates as they serve as premier fixed income proxies in the equity space and we are compelled to trim exposure to below benchmark. The niche S&P utilities sector yields 3.5% and when the competing risk free asset is near 3.2% and rising, investors prefer to shed, at the margin, riskier high-yielding equities and park the proceeds in U.S. Treasurys (Chart 10). While arguably most of the bad news is already reflected in washed out technicals and bombed out short and even long-term profit expectations (Chart 11), the selling will only accelerate into yearend and 2019. Chart 10Higher Yields Bite Chart 11Oversold And Unloved... Apart from the tight inverse correlation utilities have with interest rates, they are also a defensive sector that outperforms the broad market when the economy is in retreat. Currently a plethora of recent economic releases are signaling that the U.S. economy is overheating. Chart 12 illustrates the safe haven status of utility stocks (ISM surveys shown inverted). On the operating front, despite the upbeat economic data, electricity capacity utilization remains anemic. Capacity growth is likely responsible for this weak resource utilization signal as utilities construction continues unabated (private construction shown inverted, top panel, Chart 13). Adding insult to injury, inventory accumulation is also weighing on the sector (turbine inventories shown inverted, middle panel, Chart 13). Chart 12...But More Pain Looms Chart 13Weak Operating Metrics Worrisomely, all these expansion plans have been financed with debt. While this is not typically an issue for stable cash flow generating utilities, the sector's net debt-to-EBITDA profile has gone parabolic, nearly doubling since the GFC and even overtaking the early 2000s when a California deregulation wave first led to exuberance and then an electricity crisis (Chart 14). Any letdown in cash flow growth will be disruptive, especially given that the sector has no valuation cushion (bottom panel, Chart 14). Nevertheless, there are some risks that could put our underweight position offside. Natural gas prices have spiked of late and given that they are the marginal price setter for the sector they could boost utility pricing power and thus profits (top & middle panels, Chart 15). As the U.S. economy is firing on all cylinders, electricity demand should remain brisk and provide an offset to the otherwise weakening utility operating backdrop (bottom panel, Chart 15). Chart 14Heavily Indebted And Pricey Chart 15Risks To Underweight View Netting it all out, rising interest rates, a vibrant U.S. economy, softening operating metrics and high indebtedness signal that the time is ripe to sell utility stocks. Bottom Line: Downgrade the S&P utilities sector to underweight. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Fade The Midterms, Not Iraq Or Brexit," dated September 12, 2018, available at gps.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Deflation - Reflation - Inflation," dated August 20, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Soldiering On," dated July 16, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Deflation - Reflation - Inflation," dated August 20, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Duration: Last week's bond market rout was driven by strong U.S. data. Global growth (ex. U.S.) continues to weaken. Weak foreign growth that migrates stateside via a stronger dollar remains the biggest risk to our below-benchmark duration stance. For now, we prefer to hedge that risk by owning curve steepeners and maintaining only a neutral allocation to spread product. High-Yield: A supply shock in the oil market would most likely lead to steep backwardation in the oil futures curve and an increase in implied oil volatility. An increase in implied oil volatility will translate into a higher risk premium embedded in junk spreads. Emerging Market Sovereigns: All of the recent widening in USD-denominated EM sovereign spreads has been concentrated in Turkey and Argentina, two nations that remain highly exposed to global growth divergences and a stronger U.S. dollar. Most other EM countries offer less attractive spreads than comparable U.S. corporate debt. Remain underweight USD-denominated EM sovereign bonds. Feature Bond Breakout Chart 1The Long End Breaks Out Bond markets sold off sharply last week and long-dated Treasury yields took out some noteworthy technical levels in the process. The 10-year Treasury yield broke above its May 2018 peak of 3.11% and settled at 3.23% as of last Friday. The next big test for the 10-year's cyclical uptrend is the 2011 peak of 3.75% (Chart 1). The 30-year yield similarly broke above its May 2018 peak of 3.25%, settling at 3.39% as of last Friday. The next resistance for the 30-year occurs at the early-2014 peak of 3.96%. Removing our, admittedly uncomfortable, technical analysis hat, it is instructive to note which macro factors were responsible for last week's large bear-steepening of the Treasury curve and which weren't. Strong U.S. economic data - the non-manufacturing ISM survey hit its highest level since 1997 (Chart 2) - and Fed Chairman Powell commenting that the fed funds rate is "a long way from neutral at this point, probably" were the key drivers of the move.1 Taken together, these two developments suggest that the Fed is further behind the curve than was previously thought. This is consistent with an upward revision to the market's assessment of the neutral fed funds rate, which explains why the yield curve steepened and the price of gold edged higher.2 But it's equally important to note the factors that didn't drive the increase in yields. In this case, yields weren't driven by a rebound in growth outside of the U.S., which continues to flag (Chart 2, panel 2). The Global Manufacturing PMI fell for the fifth consecutive month in September. While our diffusion index based on the number of countries with PMIs above versus below the 50 boom/bust line ticked higher (Chart 2, panel 3), our diffusion index based on the number of countries with rising versus falling PMIs remained deeply negative (Chart 2, bottom panel). Chart 2Growth Divergences Deepen Chart 3Global PMIs Taken together, our diffusion indexes are consistent with an environment where most countries are experiencing decelerating growth from high levels. This message is confirmed by looking at the PMIs from the five largest economic blocs (Chart 3). The Eurozone PMI continues to fall rapidly, though it remains well above 50. The Emerging Markets (ex. China) PMI is also trending lower from a relatively high level, while the Chinese PMI is threatening to break below 50. Only the U.S. and Japan have healthy looking PMIs. The precariousness of non-U.S. growth leads us to reiterate the biggest risk to our below-benchmark duration view. The risk is that weak foreign growth eventually migrates to the U.S. via a stronger dollar and forces the Fed to pause its +25 bps per quarter rate hike cycle. If current trends continue, it is highly likely that U.S. growth will slow in the first half of next year, though it is unclear whether such a slowdown would be severe enough for the Fed to pause rate hikes.3 In any event, the bond market is only priced for the Fed to maintain its quarterly rate hike pace until June of next year (3 more hikes) before going on hold (Chart 4). Essentially, the market already discounts a rate hike pause, even after last week's large increase in yields. Chart 4Market's Rate Expectations Still Too Low For this reason, we prefer to maintain our below-benchmark portfolio duration stance, and to hedge the risk of weakening foreign growth by owning curve steepeners,4 and maintaining only a neutral allocation to spread product. Bottom Line: Last week's bond market rout was driven by strong U.S. data. Global growth (ex. U.S.) continues to weaken. Weak foreign growth that migrates stateside via a stronger dollar remains the biggest risk to our below-benchmark duration stance. For now, we prefer to hedge that risk by owning curve steepeners and maintaining only a neutral allocation to spread product. In Case You Needed Another Reason To Be Nervous About Junk As Treasury yields broke higher last week, the average high-yield index option-adjusted spread tightened to a fresh cyclical low of 303 bps. It has since rebounded to 316 bps (Chart 5). Our measure of the excess spread available in the high-yield index after adjusting for expected default losses is now at 196 bps, well below its historical average of 247 bps (Chart 5, panel 2). We have previously pointed out that even this below-average excess spread embeds a very low 12-month default loss expectation of 1.07%.5 Rarely have default losses been below that level. With job cut announcements forming a tentative bottom (Chart 5, bottom panel), we see high odds that default losses surprise to the upside during the next 12 months. In the absence of further spread tightening, that would translate to 12-month excess junk returns of 196 bps or less. But this week we want to highlight an additional risk to junk spreads. That risk being our Commodity & Energy Strategy service's view that crude oil prices could experience a positive supply shock in the first quarter of next year. At present, our strategists see high odds of $100 per barrel Brent crude oil in the first quarter of next year, and are forecasting an average price of $95 per barrel for 2019. At publication time, the Brent crude oil price was $85.6 At first blush it isn't obvious why high oil prices would pose a risk to junk spreads, and in fact there is no consistent correlation between the level of oil prices and junk spreads. However, there is a correlation between implied volatility in the crude oil market and junk spreads, with higher implied vol coinciding with wider spreads and vice-versa (Chart 6). Chart 5Default Loss Expectations Too Low Chart 6Higher Oil Vol = Wider Junk Spreads Would higher oil prices necessarily induce a spike in implied volatility? Not necessarily. It turns out that what matters for implied oil volatility is the slope of the futures curve.7 A contangoed futures curve where long-dated futures trade at a higher price than short-dated futures tends to be associated with high implied volatility. A steeply backwardated futures curve where long-dated futures trade well below short-dated futures is equally associated with elevated implied vol (Chart 7). Implied volatility tends to be lowest when the futures curve is in mild backwardation. A mild backwardation is typical when crude prices are in a gradual uptrend, as is the case at present. All in all, the following features provide a reasonable description of the current environment: Gradual uptrend in crude oil price Mild oil futures curve backwardation Low implied crude volatility Tight junk spreads However, as we head into next year, our commodity strategists anticipate that supply constraints will bite in the oil market. The U.S. is poised to implement an oil embargo against Iran in November, and Venezuela - another important oil exporter - remains on the brink of collapse. With global oil inventories already tight, and the loss of further production from Venezuela and Iran looming, our strategists anticipate that the number of days of demand covered by crude oil inventories will decline sharply. This decline will lead to a steep backwardation of the futures curve (Chart 8). Chart 7Brent Crude Oil Volatility Vs. Forward Slope Chart 8Supply Shock Will Lead To Steep Backwardation The bottom line for junk investors is that a supply shock in the oil market would most likely lead to a steep backwardation in the futures curve and an increase in implied oil volatility. An increase in implied oil volatility will translate into a higher risk premium embedded in junk spreads. We continue to recommend only a neutral allocation to high-yield in U.S. bond portfolios. We will await a signal that profit growth is set to deteriorate before advocating for a further reduction in exposure. Still No Buying Opportunity In EM Sovereigns Chart 9EM Index Spread Looks Cheap As growth divergences between the U.S. and the rest of the world increase, we are on high alert for an opportunity to shift some allocation out of U.S. corporate credit and into USD-denominated emerging market (EM) sovereign debt. However, so far EM spreads are simply not wide enough to merit attention from U.S. bond investors. This is not apparent from the average index spreads. In fact, a quick glance at the indexes shows that EM sovereign spreads have widened a lot relative to duration- and quality-matched U.S. corporates, and actually offer a healthy spread pick-up (Chart 9). However, a more detailed look at the spreads from individual countries shows that the spread advantage in EM is only available in a select few markets (Charts 10A & 10B). At the lower-end of the credit spectrum: Turkey, Argentina, Ukraine and Lebanon all offer higher breakeven spreads than comparable U.S. corporates. In the upper credit tiers: Saudi Arabia, Qatar and United Arab Emirates (UAE) look attractive. All other EM countries off lower breakeven spreads than comparable U.S. corporates. Chart 10ABreakeven Spreads: USD EM Sovereigns Vs. U.S. Corporates Chart 10BBreakeven Spreads: USD EM Sovereigns Vs. U.S. Corporates We would be very reluctant to shift any allocation out of U.S. corporates and into either Turkey or Argentina. Both of those countries are highly exposed to the tightening in global liquidity conditions that occurs alongside a strengthening U.S. dollar. Our Foreign Exchange and Global Investment Strategy teams created a Vulnerability Heat Map to identify which EM countries are likely to struggle as the U.S. dollar appreciates (Chart 11).8 These tend to be countries with large current account deficits and high external debt balances, though several other factors are also considered. The results show that Argentina and Turkey are the two most exposed nations. Chart 11Vulnerability Heat Map For Key EM Markets At the upper-end of the credit spectrum, the USD bonds from Saudi Arabia, Qatar and UAE are more interesting. Our geopolitical strategists anticipate an escalation of tensions between the U.S. and Iran following the U.S. midterm elections, and such tensions could increase the political risk premium embedded in all Middle Eastern debt. But for longer-term U.S. fixed income investors, it is worth noting that extra spread is available in the hard currency sovereign debt of Saudi Arabia, Qatar and UAE compared to A-rated U.S. corporates. Bottom Line: All of the recent widening in USD-denominated EM sovereign spreads has been concentrated in Turkey and Argentina, two nations that remain highly exposed to global growth divergences and a stronger U.S. dollar. Most other EM countries offer less attractive spreads than comparable U.S. corporate debt. Remain underweight USD-denominated EM sovereign bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Powell's full interview can be viewed here: https://www.youtube.com/watch?v=-CqaBSSl6ok 2 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com, where we note that every time the Global (ex. US) LEI has dipped below zero since 1993, the U.S. LEI has eventually followed. 4 Please see U.S. Bond Strategy Weekly Report, "More Than One Reason To Own Steepeners", dated September 25, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 6 Please see Commodity & Energy Strategy Weekly Report, "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl", dated September 20, 2018, available at usbs.bcaresearch.com 7 Please see Commodity & Energy Strategy Weekly Report, "Calm Before The Storm In Oil Markets", dated August 2, 2018, available at ces.bcaresearch.com 8 Please see Foreign Exchange Strategy/Geopolitical Strategy Special Report, "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1Second Half Rebound The leveling-off of bullish sentiment toward the dollar and the perception of fading political risk have caused spread product to rally hard since the end of June. Indeed, corporate bonds are almost back into the black versus Treasuries for the year (Chart 1). We caution against buying into either of these trends. We have demonstrated that divergences between the U.S. and the rest of the world usually end with weaker U.S. growth,1 and our geopolitical strategists warn that American tensions with both Iran and China are poised to ramp up after the November midterms.2 Add in persistent monetary tightening and corporate profit growth that is barely keeping pace with debt growth, and it becomes clear that the corporate spread environment is turning more negative. Investors should maintain below-benchmark portfolio duration and only a neutral allocation to spread product versus Treasuries. Evidence of deteriorating profit growth is required before turning more negative on spread product. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 78 basis points in September, bringing year-to-date excess returns up to -16 bps. The index option-adjusted spread tightened 8 bps on the month, and currently sits at 114 bps. Corporate bonds remain expensive with 12-month breakeven spreads for both A and Baa-rated credit tiers below their 25th percentiles since 1989 (Chart 2). Further, with inflation now at the Fed's target, monetary policy will provide less and less support for corporate bond returns going forward. These are the two main reasons we downgraded our cyclical corporate bond exposure to neutral in June.3 Gross leverage for the nonfinancial corporate sector declined in Q2, for the third consecutive quarter (panel 4), though the declines have been quite modest. Dollar strength and accelerating wage growth will weigh on corporate profits in the second half of the year, and with corporate profit growth just barely keeping pace with debt growth (bottom panel), odds are that leverage will start to rise. Midstream and Independent Energy companies remain attractively valued after adjusting for duration and credit rating (Table 3). These two sectors stand to benefit from rising oil prices into next year, as is expected by our commodity strategists.4 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 104 basis points in September, bringing year-to-date excess returns up to +326 bps. The average index option-adjusted spread tightened 22 bps on the month, and currently sits at 316 bps. Our measure of the excess spread available in the High-Yield index after accounting for default losses is currently 209 bps, below the long-run mean of 247 bps (Chart 3). This tells us that if default losses are in line with our expectations during the next 12 months, we should expect high-yield returns of 209 bps in excess of duration-matched Treasuries, assuming also no capital gains/losses from spread tightening/widening. But the default loss expectations embedded in our calculation are also extremely low relative to history (panel 4). Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.07% during the next 12 months. Default losses have rarely come in below that level. While most indicators suggest that default losses will remain low for the next 12 months, historical context clearly demonstrates that the risks are to the upside. Meanwhile, with gross corporate leverage likely to rise in the second half of the year,5 and job cut announcements already trending higher (bottom panel), current default loss forecasts appear overly optimistic. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in September, bringing year-to-date excess returns up to -7 bps. The conventional 30-year zero-volatility MBS spread tightened 5 bps on the month, driven by a 4 bps decline in the compensation for prepayment risk (option cost) and a 1 bp tightening in the option-adjusted spread. The excess return Bond Map on page 15 shows that MBS offer a relatively poor risk/reward trade-off, particularly compared to Aaa-rated non-Agency CMBS, High-Yield and Sovereigns. However, our Bond Map does not account for the macro environment, which remains favorable for the sector. Refi activity is tepid, and continued Fed rate hikes will ensure that it stays that way (Chart 4). Meanwhile, lending standards have been slowly easing since 2014 (bottom panel). Despite the steady easing, the Fed's most recent Senior Loan Officer Survey reports that mortgage lending standards remain at the tighter end of the range since 2005. This suggests that further easing is likely going forward. In a recent report we noted that residential investment has decelerated in recent months, with the weakness mostly stemming from multi-family construction.6 Demand for single-family housing remains robust, and we see no potential negative impact on MBS spreads during the next 6-12 months. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 48 basis points in September, bringing year-to-date excess returns up to +38 bps. Sovereign debt outperformed the Treasury benchmark by 151 bps, bringing year-to-date excess returns up to +67 bps. Foreign Agencies outperformed by 70 bps on the month, bringing year-to-date excess returns up to +34 bps. Local Authorities outperformed by 50 bps, bringing year-to-date excess returns up to +91 bps. Supranationals outperformed Treasuries by 4 bps, bringing year-to-date excess returns up to +16 bps. Domestic Agency bonds outperformed by 6 bps, bringing year-to-date excess returns up to +10 bps. After adjusting for differences in credit rating and duration, the average spread available from the USD-denominated Sovereign index is unattractive compared to the U.S. corporate bond space (Chart 5). Dollar strength should also cause Sovereign debt to underperform U.S. corporates in the coming months (panel 3). But the outlook could be worse for the Sovereign index. Mexico, Colombia and the Philippines make up approximately 50% of the index's market cap, and our Emerging Markets Strategy team has found that none of those countries are particularly vulnerable to a slowdown in Chinese aggregate demand.7 Mexico and Columbia are particularly insulated. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 36 basis points in September, bringing year-to-date excess returns up to +153 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 2% in September, and currently sits at 87% (Chart 6). This is about one standard deviation below its post-crisis mean and only slightly above the average of 81% that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. In a recent report we demonstrated that while M/T yield ratios are low, municipal bonds offer attractive yields compared to corporate bonds.8 For example, we observe that a 5-year Aa-rated municipal bond carries a yield of 2.40% versus a yield of 3.42% for a comparable corporate bond index. This implies that an investor with an effective tax rate of 30% should be indifferent between the two bonds. Moving further out the curve, the breakeven tax rate falls to 23% at the 10-year maturity point and is even lower at the 20-year maturity point. The greater attractiveness of long-maturity munis is consistent across credit tiers, and investors should favor long-dated over short-dated municipal debt (bottom panel). Treasury Curve: Favor The 7-Year Bullet Over The 1/20 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve underwent a roughly parallel upward shift in September. While the 10-year Treasury yield rose 19 bps, the 2/10 slope was unchanged at 24 bps and the 5/30 slope flattened 3 bps to reach 25 bps. The yield curve is already quite flat, and our models suggest that a lot more flattening is discounted. For example, our 1/7/20 butterfly spread model shows that 32 bps of 1/20 flattening is priced into the 1/7/20 butterfly spread for the next six months (Chart 7).9 With the U.S. economy growing strongly and the Fed moving at a gradual +25 bps per quarter pace, the curve is likely to flatten by less than is currently discounted on a cyclical (6-12 month) horizon. This argues for positioning in curve steepeners. In a recent report we also made the case for owning steepeners as a hedge against the risk that weak foreign growth infiltrates the U.S. via a stronger dollar.10 We found that the yield pick-up is similar for the different steepener trades we considered, and also that the 7-year yield has the most downside in the event of a pause in the Fed's tightening cycle. This argues for maintaining our position long the 7-year bullet and short the 1/20 barbell, a position that has earned +37 bps since it was initiated in May. TIPS: Overweight Chart 8Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 16 basis points in September, bringing year-to-date excess returns up to +138 bps. The 10-year TIPS breakeven inflation rate rose 6 bps on the month and currently sits at 2.14%. The 5-year/5-year forward TIPS breakeven inflation rate rose 7 bps and currently sits at 2.25%. Both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates remain below the 2.3% to 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed's 2% target. TIPS breakeven rates have held firm in recent months, despite the sharp drop in commodity prices (Chart 8). This suggests that investors' inflation expectations are increasingly being swayed by U.S. core inflation, which is now more or less consistent with the Fed's target (bottom panel). In recent reports we showed that year-over-year core inflation (both CPI and PCE) is likely to flatten-off during the next six months.11 But continued inflation prints near the Fed's target should be sufficient to drive long-dated breakevens higher, into our target range. This will occur as persistent prints near target cause investors' fears of deflation to gradually ebb. ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in September, bringing year-to-date excess returns up to +29 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 4 bps on the month and now stands at 33 bps, just below its pre-crisis minimum. The excess return Bond Map on page 15 shows that consumer ABS offer attractive return potential compared to other high-rated spread products - such as Agency CMBS and Domestic Agencies - but also carry a greater risk of losses. The Bond Map also reveals that Aaa-rated credit card ABS offer a more attractive risk/reward trade-off than Aaa-rated auto loan ABS. We continue to recommend favoring the former over the latter. Credit quality trends have been slowly moving against the ABS sector and we think caution is warranted. The consumer credit delinquency rate bottomed in 2015, albeit from a very low level, and it should continue to head higher based on the trend in household interest coverage (Chart 9). Average consumer credit bank lending standards have also been tightening for nine consecutive quarters (bottom panel). Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 41 basis points in September, bringing year-to-date excess returns up to +167 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 6 bps on the month and currently sits at 83 bps (Chart 10). In a recent report we showed that the macro picture for CMBS is decidedly mixed.12 A typical negative environment for CMBS is characterized by tightening bank lending standards for commercial real estate loans and falling demand. At present, both lending standards and demand for nonresidential real estate loans are close to unchanged (bottom two panels). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 13 basis points in September, bringing year-to-date excess returns up to +54 bps. The index option-adjusted spread tightened 1 bp on the month and currently sits at 44 bps. The Bond Maps on page 15 show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this defensive sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of September 28, 2018) Chart 12Total Return Bond Map (As Of September 28, 2018) Table 4Butterfly Strategy Valuation (As Of September 28, 2018) Table 5Discounted Slope Change During Next 6 Months (BPs) Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "A Story Told Through Charts: The U.S. Midterm Election", dated September 19, 2018, available at gps.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 4 Please see Commodity & Energy Strategy Weekly Report, "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl", dated September 20, 2018, available at ces.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "More Than One Reason To Own Steepeners", dated September 25, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "More Than One Reason To Own Steepeners", dated September 25, 2018, available at usbs.bcaresearch.com 7 Please see Emerging Markets Strategy Special Report, "Deciphering Global Trade Linkages", dated September 27, 2018, available at ems.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 9 For further details on our yield curve models please see U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15, 2018, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "More Than One Reason To Own Steepeners", dated September 25, 2018, available at usbs.bcaresearch.com 11 Please see U.S. Bond Strategy Weekly Report, "No Excuses", dated September 18, 2018, available at usbs.bcaresearch.com 12 Please see U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem", dated July 17, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Q3/2018 Performance Breakdown: The Global Fixed Income Strategy (GFIS) recommended model bond portfolio outperformed its custom benchmark in the third quarter of 2018 by +9bps. This raised the overall 2018 year-to-date performance to +6bps. Winners & Losers: The outperformance came mostly from our defensive duration positioning, which benefitted as global bond yields rose during the quarter, but also from successful country selection (overweight Australia & New Zealand, underweight the U.S., Canada & Italy). Our underweight tilts on EM credit were the largest drag on performance after the sharp EM rally in September. Scenario Analysis: The combination of defensive overall duration positioning and underweight allocations to EM and European credit should allow the model bond portfolio to outperform its custom benchmark index over the next year. Feature This week, we present the performance numbers of the BCA Global Fixed Income Strategy (GFIS) model bond portfolio for the 3rd quarter of 2018. We also update our scenario analysis of the future expected performance of the portfolio based on the risk-factor based return forecasting framework we introduced earlier this year. As a reminder to existing readers (and for new clients), the portfolio is a part of our service that is meant to complement the usual macro analysis of global fixed income markets. The model portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors, by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Broadly speaking, the portfolio did slightly outperform its benchmark index over the past three months, driven mostly by defensive duration positioning during a period of rising developed market bond yields. The portfolio would have done considerably better if not for a September rally in emerging market (EM) credit that flew in the face of our maximum underweight position in EM. We still have strong conviction in those two main themes - higher global bond yields and EM underperformance - and we fully expect our model portfolio to generate larger outperformance over the next year. Q3/2018 Model Portfolio Performance Breakdown: Duration Underweights Pay Off The total return of the GFIS model bond portfolio was +0.12% (hedged into U.S. dollars) in the third quarter of the year, which outperformed the custom benchmark index by +9bps (Chart of the Week).1 The main driver of the outperformance was our structural below-benchmark portfolio duration stance, which benefited as the overall Bloomberg Barclays Global Treasury Index yield rose to 1.54% - the highest level since April 2014. The portfolio's excess return got as high as +19bps on September 4th, before seeing some pullback in recent weeks as our main spread product tilt - underweight EM hard currency sovereign and corporate debt - enjoyed a counter-trend rally in September from the bearish spread widening seen since the start of 2018. Chart of the WeekDefensive Duration Stance = Q3 Outperformance Table 1GFIS Model Bond Portfolio Q3/2018 Overall Return Attribution In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +17bps of outperformance versus our custom benchmark index while the latter lagged the benchmark by -8bps (Table 1). The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. Chart 2GFIS Model Bond Portfolio Q3/2018 Government##BR##Bond Performance Attribution By Country Chart 3GFIS Model Bond Portfolio Q3/2018 Spread##BR##Product Performance Attribution By Sector The main individual sectors of the portfolio that drove the excess returns were the following: Biggest outperformers Underweight Japanese government bonds (JGBs) with maturities beyond 10 years (+7bps) Underweight U.S. Treasuries with maturities beyond 7 years (+6bps) Underweight French government bonds with maturities beyond 7 years (+2bps) Underweight Italian government bonds (+2bps) Overweight JGBs with maturities up to 10 years (+1bp) Biggest underperformers Underweight EM USD-denominated sovereign debt (-3bps) Underweight EM USD-denominated corporate debt (-3bps) Underweight euro area investment grade corporate debt (-2bps) Underweight euro area high-yield corporate debt (-1bp) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio. The returns are hedged into U.S. dollars (we do not take active currency risk in this portfolio) and also adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during the third quarter (red for underweight, blue for overweight, gray for neutral weight). Chart 4Ranking The Winners & Losers From The Model Portfolio In Q3/2018 Spread product sectors dominate the left half of that chart, as credit spreads have tightened across the board since the early September peak. The best performing sector during Q3 in our model portfolio universe was EM hard currency sovereign debt, which has delivered a total return of +2.8% since September 4th (with spreads tightening by 50bps) after losing -0.7% in July and August. Similar performance stories occurred in corporate debt in the U.S. and Europe during the quarter. That credit outperformance comes after the sustained spread widening seen in virtually all global credit markets (excluding U.S. high-yield) since January of this year. The main drivers that prompted that widening - Fed tightening, a stronger U.S. dollar, diminishing asset purchases from the European Central Bank (ECB) and Bank of Japan (BoJ), some cyclical slowing of non-U.S. growth - are still in place. With our geopolitical strategists continuing to highlight the additional risks of U.S.-China and U.S.-Iran tensions intensifying after next month's U.S. Midterm elections, a cautious stance on global spread product - as we have maintained since downgrading our recommended overall credit exposure to neutral in late June - is still warranted.2 Outside of spread product, our model portfolio tilts generally lined up with the sector returns shown in Chart 4. We have overweights on two of the best performing government bond markets (Australia and New Zealand) and underweights on three of the worst performers (U.S., Canada, Italy). Interestingly, despite having overweights on two of the worst performing government bond markets - Japan and the U.K. - the excess return contribution from those countries did not hurt the model bond portfolio return in Q3 (+8bps and 0bps, respectively). This was due to the curve steepening bias embedded within our overweight country tilts (i.e. more duration allocated to shorter-maturity buckets, see the model portfolio details on Page 14), which benefitted as yield curves in those countries bear-steepened. Net-net, we are satisfied with the modest portfolio outperformance seen in Q3, given that the rally in global credit markets went against our more defensive posture on spread product exposure. Bottom Line: The GFIS recommended model bond portfolio outperformed its custom benchmark in the third quarter of 2018 by +9bps. This put the overall 2018 year-to-date performance into positive territory (+6bps). The outperformance came entirely from our defensive duration positioning, which benefitted as global bond yields rose during the quarter, and from successful country selection. Our underweight tilts on EM credit were the largest drag on performance after the sharp EM rally in September. Future Drivers Of Portfolio Returns Looking ahead, the performance of the model bond portfolio will continue to benefit from two primary trends: rising global bond yields and growth divergences that continue to favor the U.S. In terms of the specific weightings in the GFIS model bond portfolio, we still prefer owning U.S. corporate debt versus equivalents in Europe and EM. When we downgraded our recommended allocation to U.S. and investment grade corporates to neutral from overweight back in July, we also cut the portfolio exposure to euro area corporates, as well as to all EM hard currency debt, to underweight. The latter changes were necessary to maintain our desired higher exposure to U.S. corporate debt versus non-U.S. corporates, although it did leave the model portfolio with a small overall underweight stance on global spread product (Chart 5). Importantly, we are maintaining a below-benchmark stance on overall portfolio duration, which is now one full year shorter than our benchmark index duration (Chart 6), even as we have grown more cautious on credit exposure. This is because we still see potential medium-term upward pressure on bond yields coming from tightening monetary policies (Fed rate hikes, ECB tapering of bond purchases) and increasing inflation expectations. The majority of global central bankers are dealing with tight labor markets and slowly rising inflation rates. While global growth has cooled a bit from the rapid pace seen in 2017, it has not been by enough to force policymakers to shift to a more dovish bias. Chart 5Spread Product Allocation:##BR##Neutral U.S., Underweight Non-U.S. Chart 6Maintaining##BR##Below-Benchnmark Duration Our underweights on EM and euro area spread product have left the portfolio in a "negative carry" position where it yields 34bps less than the benchmark index (Chart 7). In a backdrop of stable markets and low volatility, being short carry will be a drag on the model bond portfolio performance as we saw over the past month. Yet we do not see the recent market calm as being sustainable, with all plausible outcomes pointing to more volatile markets, largely driven by U.S.-centric events (more Fed tightening, a stronger dollar, U.S. growth convergence to slower non-U.S. growth, increased trade protectionism, higher oil prices due to U.S.-Iran tensions). We continue to suggest a cautious allocation of investor risk budgets against this backdrop. We have been targeting a tracking error (relative volatility versus the benchmark) for our model bond portfolio in the 40-60bp range, well below our 100bps maximum. Our current allocations give us a tracking error right at the bottom of that range (Chart 8).3 Chart 7The Cost Of Being More Defensive On Credit Chart 8Maintaining A Cautious Allocation Of The Risk Budget Scenario Analysis & Return Forecasts Back in April of this year, we introduced a framework for estimating total returns for all government bond markets and spread product sectors, based on common risk factors.4 For credit, returns are estimated as a function of changes in the U.S. dollar, the Fed funds rate, oil prices and market volatility as proxied by the VIX index (Table 2A). For government bonds, non-U.S. yield changes are estimated using historical betas to changes in U.S. Treasury yields (Table 2B). This framework allows us to conduct scenario analysis based on projected returns for each asset class in the model bond portfolio universe by making assumptions on those individual risk factors. Table 2AFactor Regressions Used To Estimate##BR##Spread Product Yield Changes Table 2BEstimated Government Bond##BR##Yield Betas To U.S. Treasuries With these tools, we than can attempt to forecast returns for each bond sector under different scenarios. We can then use those forecasts to predict the expected return for our model bond portfolio under those same scenarios. In Tables 3A & 3B. we show three differing scenarios, with all the following changes occurring over a one-year horizon. Table 3AScenario Analysis For The GFIS Model Portfolio Table 3BU.S. Treasury Yield Assumptions For The Scenario Analysis Our Base Case: the Fed delivers another 100bps of rate hikes, the U.S. dollar rises +5%, oil prices rise by +10%, the VIX index increases by five points from current levels, and U.S. Treasury yields rise by 40bps across the curve. A Very Hawkish Fed: the Fed delivers 150bps of rate hikes, the U.S. dollar rises by +10%, oil prices rise by +10%, the VIX index increases by ten points from current levels and there is a sharp bear flattening of the U.S. Treasury curve (2yr yield +75bps, 10yr yield +40bps). A Very Dovish Fed: the Fed only hikes rates by 25bps, the U.S. dollar falls by -5%, oil prices fall by -20%, the VIX index increases by fifteen points from current levels and there is a modest bull steepening of the U.S. Treasury curve. In this scenario, the Fed puts the rate hiking cycle on hold in response to a sharp tightening of U.S. financial conditions. Table 3A shows the expected returns for all three scenarios based on our risk-factor framework. The model bond portfolio is expected to outperform the custom benchmark index in all three scenarios we have laid out. This occurs even with the negative carry coming from the credit underweights in EM and Europe, with losses from credit spread widening projected to be larger than the yield give-up from being underweight. The excess returns are modest, however, with only 6bps of outperformance expected in our base case scenario and 13bps expected in the "Very Hawkish Fed" and "Very Dovish Fed" scenarios. This return distribution, with better outcomes occurring in the "tails", is a desirable property to have as it relates to the VIX/volatility forecasts embedded in the scenarios. Both of the non-base case scenarios have a higher VIX (Chart 9), even in the case of the "Very Dovish Fed" outcome where a severe U.S. financial market selloff (coming complete with a higher VIX) would be the necessary trigger for the Fed to reverse course and begin cutting interest rates (Chart 10). Such a backdrop would obviously hurt our below-benchmark duration stance, but would help our underweight EM/Europe spread product recommendations. Chart 9Risk Factors For Scenario Analysis Chart 10UST Yield Moves For Scenario Analysis Of course, our recommendations will not be static at current levels throughout the next twelve months. We increasingly expect that our next major allocation move will be downgrade U.S. spread product exposure and raise U.S. Treasury allocations, especially after the Fed delivers a few more 25bps-per-quarter rate hikes and the U.S. dollar rises further. This will provide a boost to the portfolio's expected returns through renewed spread widening and, potentially, a reduction of our below-benchmark overall duration stance as Treasury yields reach likely cyclical peaks. Bottom Line: The combination of defensive overall duration positioning and underweight allocations to EM and European credit should allow the model bond portfolio to outperform its custom benchmark index over the next year. Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Time To Take Some Chips Off The Table: Downgrade Global Spread Product Exposure To Neutral", dated June 26th 2018, available at gfis.bcaresearch.com. 3 In general, we aim to target a tracking error no greater than 100bps. We think this is reasonable for a portfolio where currency exposure is fully hedged and less than 5% of the portfolio benchmark is in bonds with ratings below investment grade. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start", dated April 10th 2018, available at gfis.bcareseach.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Feature GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of September 30, 2018. The quant model has not made significant allocation changes as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, the overall model underperformed its benchmark by 53 bps in September, largely driven by Level 2 model which underperformed its benchmark by 156 bps. Japan was the largest underweight in the model, yet Japan was the best performing country in September, which contributed largely to the model's underperformance. Since going live, the overall model has outperformed its benchmarks by only 7 bps, driven by the Level 2 outperformance of 46 bps offset by the 8 bps of Level 1 underperformance. Even though the model underperformed significantly in both August and September, it's still within the back-tested range based on one-year and four-year changes. Table 1Model Allocation Vs. Benchmark Weights 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. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Aditya Kurian, Senior Analyst adityak@bcaresearch.com

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