Corporate Bonds

  Highlights While the Caixin PMI is pointing to improving economic conditions, other data series still reflect weak growth. China’s business cycle is likely to bottom in Q1 of next year, rather than in Q4. The failure of Chinese stocks to significantly outperform the global benchmark and the continued underperformance of cyclical stocks underscore the near-term risks to equities if this month’s trade & manufacturing data disappoint. We continue to recommend a neutral tactical stance (0-3 months) towards Chinese equities versus global stocks, but expect them to outperform on a cyclical (6-12 month) time horizon after economic growth firmly bottoms. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, the data remains mixed: the strength in the October Caixin PMI and the September pickup in electricity production are positive signs, but other important datapoints still point to weak conditions. We continue to expect that China’s business cycle is likely to bottom in Q1 of next year, rather than in Q4. We continue to expect that growth will bottom in Q1 of next year, rather than in Q4. Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review Within financial markets, Chinese stocks have rallied in absolute terms over the past month in response to greatly increased odds of a trade truce between China and the US, but have failed to outperform the global benchmark. This, in combination with the continued underperformance of cyclical stocks, suggests that hard evidence of an economic improvement in China will be required before Chinese stocks begin to rise in relative terms. The risk of near-term underperformance is still present, especially if October’s hard trade and manufacturing data disappoint. We continue to recommend a neutral tactical stance (0-3 months) towards Chinese equities versus global stocks, but expect them to outperform on a cyclical (6-12 month) time horizon after economic growth firmly bottoms. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Chart 1Not Yet A Clear Change In Trend Not Yet A Clear Change In Trend Not Yet A Clear Change In Trend The Bloomberg Li Keqiang index (LKI) ticked up in September, led by an improvement in electricity production. An improvement in the LKI in lockstep with a rising Caixin manufacturing PMI (discussed below) raises the odds that the Chinese economy may be bottoming earlier than we expect, but for now only modestly so. Chinese economic data is highly volatile, and Chart 1 shows that the improvement in the LKI is very muted when shown as a 3-month moving average. In addition, a slight improvement also occurred earlier this year, but proved to be a false signal. All told, for now we continue to expect that growth will bottom in Q1 of next year, rather than in Q4. Our leading indicator for the LKI was essentially flat in September on a smoothed basis, with sequential declines in M3 growth and the credit components of the indicator offsetting improvements in monetary conditions and M2. From a big picture perspective, the story of our LKI leading indicator remains unchanged: it continues to trend higher, at a much shallower pace than has been the case during previous easing cycles. The uptrend is the basis of our forecast that China’s growth will soon bottom, but the uncharacteristically shallow nature of the rise suggests that the eventual recovery will be modest. On a smoothed basis, Chinese residential floor space sold improved again in September, following a very significant rise in August. Over the past 12-18 months, we had emphasized that the double-digit pace of growth in China’s housing starts was unsustainable because it had entirely decoupled from the trend in sales (which have reliably led construction activity over the past decade). This gap disappeared over the summer due to a significant slowdown in starts, which is what we predicted would occur. However, the recent acceleration in floor space sold represents a legitimate fundamental improvement in the housing market, that for now is difficult to attribute to the recent drivers of housing demand (Chart 2).1 Still, investors should continue to watch China’s housing demand data closely over the coming few months, for further signs of a potential re-acceleration in housing construction. Investors need to see meaningful sequential improvements in China’s October trade and manufacturing data. The October improvement in China’s Caixin PMI was quite notable, as it appears to confirm the full one-point rise in the index that occurred in September and suggests that manufacturing in China’s private-sector is now durably expanding. Still, conflicting signals remain: the official PMI fell in October and remains below 50, and the significant September improvement in the Caixin PMI was not corroborated by an improvement in producer prices or nominal import growth (Chart 3). As PMIs are simply timely coincident indicators that do not generally have leading properties, investors will need to see meaningful sequential improvements in China’s October trade and manufacturing data in order to have confidence that the Caixin PMI improvement is not a false signal. Chart 2It Is Not Yet Apparent What Is Driving A Pickup In Housing Demand It Is Not Yet Apparent What Is Driving A Pickup In Housing Demand It Is Not Yet Apparent What Is Driving A Pickup In Housing Demand Chart 3If The Caixin PMI Is Not A False Signal, A Hard Data Improvement Must Occur Soon If The Caixin PMI Is Not A False Signal, A Hard Data Improvement Must Occur Soon If The Caixin PMI Is Not A False Signal, A Hard Data Improvement Must Occur Soon Chinese stocks have rallied 6-7% over the past month in absolute terms, but have modestly underperformed global equities. The rally in global stock prices has occurred largely in response to the mid-October announcement of a trade truce between China and the US. The failure of Chinese stocks to outperform during this period suggests hard evidence of an economic improvement in China will be required before Chinese stocks begin to outpace their global peers. At the regional equity level, the other notable development over the past month has been the continued outperformance of the MSCI Taiwan Index versus the global benchmark. Taiwan’s outperformance has been boosted by a rising TWD versus the dollar, but Taiwanese stocks have also outperformed in local currency terms. Taiwan province is highly exposed to global trade, and it is not surprising that equities have reacted positively to the prospect of a trade truce between the US and China. Further meaningful outperformance, however, will likely require a re-acceleration in Taiwanese exports, as export growth has merely halted its contraction (Chart 4). Within China’s investable equity market, cyclicals have underperformed defensives over the past month after having rallied significantly from late-August to mid-September (Chart 5). We noted in our October 30 Special Report that these cyclical sectors have historically been positively correlated with pro-cyclical macroeconomic and equity market variables,2 and their underperformance versus defensives is thus consistent with the failure of Chinese stocks in the aggregate to outperform global equities over the past month. In both cases, outperformance likely requires hard evidence of an upturn in China’s business cycle. Chart 4Export Growth Needs To Improve In Order To Expect Further Taiwanese Relative Outperformance Export Growth Needs To Improve In Order To Expect Further Taiwanese Relative Outperformance Export Growth Needs To Improve In Order To Expect Further Taiwanese Relative Outperformance Chart 5Cyclical Underperformance Underscores The Near-Term Risks To Chinese Vs. Global Stocks Cyclical Underperformance Underscores The Near-Term Risks To Chinese Vs. Global Stocks Cyclical Underperformance Underscores The Near-Term Risks To Chinese Vs. Global Stocks We do not take the rise in Chinese government bond yields as necessarily indicative of an imminent breakout in relative equity performance. Chart 6Chinese Relative Equity Performance Leads Bond Yields, Not The Other Way Around Chinese Relative Equity Performance Leads Bond Yields, Not The Other Way Around Chinese Relative Equity Performance Leads Bond Yields, Not The Other Way Around Chinese 10-year government bond yields have risen roughly 15bps over the past month, and are now 30bps off of their mid-August low. Many market participants view Chinese government bond yields as a leading growth barometer, but 10-year yields have actually lagged Chinese investable stock performance over the past two years (Chart 6). As such, we do not take the rise in yields as necessarily indicative of an imminent breakout in relative equity performance. Chinese onshore corporate bond spreads have declined over the past month as government bond yields have been rising, continuing a pattern of negative correlation between the two that has prevailed since early-2018. A negative correlation between yields and corporate bond spreads is a normal relationship, and it suggests that spreads may narrow over the coming year if the Chinese economy bottoms in Q1, as we expect. Spreads remain elevated despite the substantial easing in monetary conditions that occurred last year, due to persistent concerns about rising onshore defaults. While we acknowledge that defaults are indeed occurring, we have argued on several occasions that the pace of defaults would have to be much faster in order for current spreads to be justified.3 We continue to recommend a long RMB-denominated position in China’s onshore corporate bond market. The RMB has appreciated over the past month in response to news of a likely trade truce between the US and China, with most of the rise having occurred versus the US dollar. USD-CNY is likely to sustainably trade below the 7 mark in a trade truce scenario, but how much further downside is possible in the near-term absent a re-acceleration in Chinese economic activity remains an open question. With the Fed very likely on hold for the next year, stronger than expected economic growth in China would likely catalyze a persistent selloff in USD-CNY barring a re-emergence of the Sino-US trade war. This, however, is not our base-case view, meaning that we expect modest post-deal strength in the RMB.   Jonathan LaBerge, CFA Vice President Special Reports jonathanl@bcaresearch.com Jing Sima China Strategist JingS@bcaresearch.com   Footnotes 1. Please see China Investment Strategy Special Report, “China’s Property Market: Where Will It Go From Here?” dated September 13, 2018. 2. Please see China Investment Strategy Weekly Report, “A Guide To Chinese Investable Equity Sector Performance,” dated October 30, 2019. 3. Please see China Investment Strategy Weekly Reports, “A Shaky Ladder,” dated June 13, 2018, "Investing In The Middle Of A Trade War,” dated September 19, 2018 and "2019 Key Views: Four Themes For China In The Coming Year,” dated December 5, 2018. Cyclical Investment Stance Equity Sector Recommendations

Highlights Chart 1The Fed Must Remain Dovish The Fed Must Remain Dovish The Fed Must Remain Dovish Many were quick to label last week’s FOMC decision a “hawkish cut”. This is somewhat true in the near-term. The Fed lowered rates by 25 basis points while signaling that it doesn’t expect to have to cut more. But this focus on the near-term rate path misses the big picture. In the post-meeting press conference, Chairman Powell mentioned inflation expectations several different times. At one point, he called them “central” to the Fed’s framework and said “we need them to be anchored at a level that’s consistent with our symmetric 2 percent inflation goal.” As of today, the 5-year/5-year forward TIPS breakeven inflation rate is 1.69%, well short of the 2.3%-2.5% range that is consistent with the Fed’s goal (Chart 1). The Fed will take care to maintain an accommodative policy stance until inflation expectations are re-anchored. This will provide strong support for risk assets, and we recommend overweight positions in spread product versus Treasuries. We also expect that global growth will improve enough in the coming months for the Fed to keep its promise to stand pat. With the market still priced for 29 bps of cuts during the next 12 months, investors should keep portfolio duration low. Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 60 basis points in October, bringing year-to-date excess returns up to +429 bps. We consider three main factors in our credit cycle analysis: (i) corporate balance sheet health, (ii) monetary conditions and (iii) valuation.1 On balance sheets, our top-down measure of gross leverage is elevated and rising (Chart 2). In contrast, interest coverage ratios remain solid, propped up by the Fed’s accommodative stance. With inflation expectations still depressed, the Fed can maintain its “easy money” policy for some time yet. The Fed’s Senior Loan Officer survey shows that C&I lending standards tightened in Q3 (bottom panel). We expect the Fed’s accommodative stance to push standards back into “net easing” territory in Q4. But if standards continue to tighten, it could indicate that monetary conditions are not as accommodative as we think. For now, we see valuation as the main headwind for investment grade credit spreads. Spreads for all credit tiers are now below our targets, with the Baa tier looking less expensive than the others (panels 2 & 3).2 As a result, we advise only a neutral allocation to investment grade corporate bonds, with a preference for the Baa credit tier. We also recommend increasing exposure to Agency MBS in place of corporate bonds rated A or higher. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Fed Will Stay Supportive The Fed Will Stay Supportive Table 3BCorporate Sector Risk Vs. Reward* The Fed Will Stay Supportive The Fed Will Stay Supportive High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield performed in line with the duration-equivalent Treasury index in October, keeping year-to-date excess returns steady at +621 bps. The junk index’s option-adjusted spread (OAS) has been fairly stable for most of the year, but the sector has become increasingly attractive from a risk/reward perspective.3 This is because the index’s negatively convex nature has caused its average duration to fall alongside declining Treasury yields. Chart 3 shows that while the index OAS has been rangebound, the 12-month breakeven spread has widened considerably.4 In other words, while junk expected returns have been stable, those expected returns now come with considerably less risk. As a result, the junk index OAS looks increasingly attractive relative to our spread target.5 Specifically, we now view the junk index OAS as 141 bps cheap (panel 3). Falling index duration also explains the divergence between quality spreads and the index OAS. Many have observed that the spread differential between Caa and Ba-rated junk bonds has widened in recent months, while the overall index OAS has been stable (panel 4). However, the divergence evaporates when we look at 12-month breakeven spreads instead of OAS (bottom panel). MBS: Overweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in October, bringing year-to-date excess returns up to +3 bps. The conventional 30-year zero-volatility spread widened 4 bps on the month, as a 5 bps widening of the option-adjusted spread (OAS) was partially offset by a 1 bp decline in option cost (i.e. the expected losses from prepayments). This week we recommend upgrading Agency MBS from neutral to overweight, and in particular, we recommend favoring Agency MBS over corporate bonds rated A or higher. We have three main reasons for this recommendation.6 First, expected compensation is competitive. The conventional 30-year MBS OAS is now 53 bps. This is above its pre-crisis average (Chart 4), and only 4 bps below the spread offered by a Aa-rated corporate bond. All investment grade corporate bond credit tiers also look expensive relative to our spread targets. Second, risk-adjusted compensation heavily favors MBS. The Excess Return Bond Map in Appendix C shows that Agency MBS plot well to the right of investment grade corporates. This means that the sector is less likely to see losses versus Treasuries on a 12-month horizon. Finally, the macro environment for MBS remains supportive. Mortgage lending standards have barely eased since the financial crisis (bottom panel), and most people have already had at least one opportunity to refinance their mortgages. This burnout will keep refi activity low, and MBS spreads tight (panel 2). Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 20 basis points in October, bringing year-to-date excess returns up to +183 bps. Sovereign debt outperformed duration-equivalent Treasuries by 38 bps on the month, bringing year-to-date excess returns up to +475 bps. Local Authorities outperformed the Treasury benchmark by 9 bps, bringing year-to-date excess returns up to +220 bps. Meanwhile, Foreign Agencies outperformed by 63 bps, bringing year-to-date excess returns up to +261 bps. Domestic Agencies underperformed by 2 bps in October, dragging year-to-date excess returns down to +40 bps. Supranationals underperformed by 8 bps on the month, dragging year-to-date excess returns down to +31 bps. We continue to recommend an underweight allocation to USD-denominated sovereign bonds, given that spreads remain expensive compared to U.S. corporate credit (Chart 5). However, we noted in a recent report that Mexican and Saudi Arabian sovereigns look attractive on a risk/reward basis.7 This is also true for Foreign Agencies and Local Authorities, as shown in the Bond Map in Appendix C. Our Emerging Markets Strategy service also thinks that worries about Mexico’s fiscal position are overblown, and that bond yields embed too high of a risk premium (bottom panel).8  Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 7 basis points in October, dragging year-to-date excess returns down to -64 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio fell almost 2% in October, and currently sits at 85% (Chart 6). We recently upgraded municipal bonds from neutral to overweight.9 The decision was based on the fact that yield ratios had jumped significantly. Yield ratios continue to look attractive relative to average pre-crisis levels, especially at the long-end of the Aaa curve (panel 2). Specifically, 2-year and 5-year M/T yield ratios are close to average pre-crisis levels at 73% and 77%, respectively. Meanwhile, M/T yield ratios for longer maturities are all above average pre-crisis levels. M/T yield ratios for 10-year, 20-year and 30-year maturities are 86%, 94% and 97%, respectively.   Fundamentally, state & local government balance sheets remain solid. Our Municipal Health Monitor remains in “improving health” territory and state & local government interest coverage has improved considerably in recent quarters (bottom panel). Both of these trends are consistent with muni ratings upgrades continuing to outnumber downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve steepened considerably in October, as short-dated yields came under downward pressure even as long-maturity yields edged higher. The 2/10 Treasury slope steepened 12 bps on the month, and currently sits at 17 bps. The 5/30 slope steepened 9 bps on the month, and currently sits at 66 bps (Chart 7). Last week’s report discussed the outlook for the 2/10 Treasury slope on a 6-12 month horizon.10 We considered the main macro factors that influence the slope of the yield curve: Fed policy, wage growth, inflation expectations and the neutral fed funds rate. We concluded that the 2/10 slope has room to steepen during the next few months, as the Fed holds down the front-end of the curve in an effort to re-anchor inflation expectations. However, we see the 2/10 slope remaining in a range between 0 bps and 50 bps, owing to strong wage growth and downbeat neutral rate expectations. Despite the outlook for modest curve steepening, we continue to recommend holding a barbelled Treasury portfolio. Specifically, we favor holding a 2/30 barbell versus the 5-year bullet, in duration-matched terms. This position offers strong positive carry (bottom panel), due to the extreme overvaluation of the 5-year note, and looks attractive on our yield curve models (see Appendix B). TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 27 basis points in October, bringing year-to-date excess returns up to -64 bps. The 10-year TIPS breakeven inflation rate rose 1 bp on the month, and currently sits at 1.60%. The 5-year/5-year forward TIPS breakeven inflation rate fell 8 bps on the month, and currently sits at 1.69%. Both rates remain well below the 2.3%-2.5% range consistent with the Fed’s target. The divergence between the actual inflation data and inflation expectations is becoming increasingly stark. Trimmed mean PCE inflation has been fluctuating around the Fed’s target for most of the year (Chart 8). However, long-maturity TIPS breakeven inflation rates remain stubbornly low. As we have pointed out in prior research, it can take time for expectations to adapt to a changing macro environment.11 That being said, the 10-year TIPS breakeven rate is currently 32 bps too low according to our Adaptive Expectations Model, a model whose primary input is 10-year trailing core inflation (panel 4). It is highly likely that the Fed will have to tolerate some overshoot of its 2% inflation target in order to re-anchor inflation expectations near desired levels. We anticipate that the committee will do so, and maintain our view that long-dated TIPS breakevens will move above 2.3% before the end of the cycle. ABS: Underweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 5 basis points in October, dragging year-to-date excess returns down to +67 bps. The index option-adjusted spread for Aaa-rated ABS widened 5 bps on the month. It currently sits at 39 bps, 5 bps above its minimum pre-crisis level (Chart 9). Our Excess Return Bond Map (see Appendix C) shows that Aaa-rated consumer ABS rank among the most defensive U.S. spread products and also offer more expected return than other low-risk sectors such as Domestic Agency bonds and Supranationals. However, we remain wary of allocating too much to consumer ABS because credit trends continue to shift in the wrong direction. The consumer credit delinquency rate is still low, but has put in a clear bottom. The same is true for the household interest expense ratio (panel 3). Senior loan officers also continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). All in all, our favorable outlook for global growth causes us to shy away from defensive spread products, and deteriorating ABS credit metrics are also a cause for concern. Stay underweight. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in October, bringing year-to-date excess returns up to +233 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS was flat on the month. It currently sits at 73 bps, below its average pre-crisis level but somewhat above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate (CRE) is somewhat unfavorable, with lenders tightening loan standards (panel 4) in an environment of tepid demand. The Fed’s Senior Loan Officer survey shows that banks saw slightly stronger demand for nonfarm nonresidential CRE loans in Q3, after four consecutive quarters of falling demand (bottom panel). CRE prices have accelerated of late, but are still not keeping pace with CMBS spreads (panel 3). Despite the poor fundamental picture, our Excess Return Bond Map shows that CMBS offer a reasonably attractive risk/reward trade-off compared to other bond sectors (see Appendix C). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 10 basis points in October, bringing year-to-date excess returns up to +100 bps. The index option-adjusted spread was flat on the month, and currently sits at 57 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer a compelling risk/reward trade-off. An overweight allocation to this high-rated sector remains appropriate. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record At present, the market is priced for 29 basis points of cuts during the next 12 months. We anticipate a flat fed funds rate over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. The Fed Will Stay Supportive The Fed Will Stay Supportive The Fed Will Stay Supportive The Fed Will Stay Supportive Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuations: Raw Residuals In Basis Points (As Of November 1, 2019) The Fed Will Stay Supportive The Fed Will Stay Supportive Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of November 1, 2019) The Fed Will Stay Supportive The Fed Will Stay Supportive Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 48 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 48 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) The Fed Will Stay Supportive The Fed Will Stay Supportive Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of November 1, 2019) The Fed Will Stay Supportive The Fed Will Stay Supportive Ryan Swift U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso Research Analyst jeremiep@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 2 For details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Crisis Of Confidence”, dated October 22, 2019, available at usbs.bcaresearch.com 4 The 12-month breakeven spread is the spread widening required to break even with a duration-matched position in Treasuries on a 12-month horizon. It can be approximated by OAS divided by duration. 5 For details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 8 Please see Emerging Markets Strategy Weekly Report, “Country Insights: Malaysia, Mexico & Central Europe”, dated October 31, 2019, available at ems.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, “Two Themes and Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 11 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Rising recession risk, shaky economic fundamentals, and absence of positive yielding assets motivate us to reexamine which assets can be counted on to protect a portfolio in the future. We analyze 10 safe havens on four different dimensions: consistency, versatility, efficiency, and costs. Using this framework, we examine the historical performance of each safe haven and provide an outlook on their likely effectiveness over the next decade. We conclude that U.S. TIPS and farmland should provide the best portfolio protection. Cash, U.S. Treasuries and gold are other good alternatives. Meanwhile, U.S. investment-grade bonds, global ex-U.S. bonds, silver, and currency futures are likely to be poor protection choices. Feature For most investors, capital preservation is the most important goal when managing money. However, how to go about it remains a difficult question.  Investing in safe havens can be painful during bull markets, as their returns are usually lower than those of equities. Moreover, economic, political, and financial regimes change over time, which means that an asset that protected your portfolio in the past might not do so in the future. Therefore, it becomes good practice to review one’s safety measures periodically, even if one does not think that a crash is imminent. The current environment in particular, is a propitious time to review safe havens given that: Chart I-1A Great Time To Review Safety Measures A Great Time To Review Safety Measures A Great Time To Review Safety Measures A key recession signal is flashing red: The yield curve inverted in the United States in August (Chart I-1 – top panel). An inversion of the yield curve does not necessarily imply a recession, but historically it has been a very reliable signal of one, given that it indicates that monetary policy is too tight for the economy. Structural risks are rising: Rich equity valuations in the U.S. and high leverage levels elsewhere are signs that the pillars supporting this bull market might be fragile (Chart I-1 – middle panel). In addition, protectionism and populism, forces that BCA has long argued are here to stay, threaten to upend the regime of free trade that has benefited equities since the 1950s.1 Yields are near all-time lows: Historically, investors have been able to endure bear markets by hiding in safe assets with positive yield, as these assets will normally provide a reliable cash flow regardless of the economic situation. However, these type of assets are increasingly hard to find, particularly in the government bond space, where 50% of developed country bonds have negative yields (Chart I-1 – bottom panel). Considering these factors, how should investors protect their portfolios in the next decade? To answer this question, we analyze 10 safe havens divided into five broad asset classes: Nominal government bonds: U.S. Treasuries and global ex-U.S. government bonds. Other fixed income: U.S. investment-grade credit and U.S. TIPS.2 Currencies: yen futures and Swiss franc futures. Precious metals: gold futures and silver futures. Other assets: farmland and U.S. cash. We look at historical performance since 1973 for all safe havens except for global ex-U.S. bonds and farmland. For these assets, we look at performance since 1991 due to limited data availability. We mainly look at quarterly returns in order to compare illiquid assets to publicly traded ones. We do not consider each safe haven in isolation, but rather as an addition to equities within a portfolio. Specifically, we explore our safe haven universe relative to the MSCI All Country World equity index from the perspective of a U.S. investor. For our non-U.S. clients, we will release a report from the perspective of other countries if there is sufficient interest. Importantly, we do not look only at historical performance. We also examine whether there is a reason to believe that future returns will be different from past ones, by analyzing how the properties of each safe haven might have changed. When evaluating each safe haven, we focus on four properties: Consistency: a safe haven should generate consistent positive returns during periods of negative equity performance, with returns increasing with the severity of the equity drawdown. Versatility: safe havens should perform well across different types of crises. Efficiency: a safe haven should produce enough upside during crises, so only a small allocation to the safe haven is necessary to reduce losses. Costs: drag to portfolio overall performance (opportunity costs) should be as small as possible. Readers who wish to see just our overall conclusions should read our Summary Of Results section below. For our analysis of how safe havens have performed in the past, please see the Historical Performance section. Finally, for our analysis of how we expect the performance of safe havens to change, please see our Outlook section. Summary Of Results The Best Safe Havens U.S. TIPS should be an excellent safe haven to protect a portfolio in the next decade. While TIPS might not be as cheap to hold as they have been in the past, upside potential remains strong, which means that a moderate allocation can provide substantial protection to an equity portfolio. Moreover, U.S. TIPS are one of the best hedges against crises triggered by rising rates and inflation, which in our view are the biggest structural risks that asset allocators face. Farmland could also be a great safe haven for investors who have the ability to allocate to illiquid assets given that it is the cheapest safe haven in terms of portfolio drag. However, investors should be aware that the current low yield could potentially affect its performance during crises. Good Alternatives Cash can be a good alternative to protect an equity portfolio, given its outstanding performance during equity drawdowns caused by inflation. Moreover, its opportunity costs should decrease relative to the past. However, investors should take into account that the efficiency of cash at the current juncture is poor, which means that a relatively large allocation is needed in order to achieve meaningful portfolio protection. A portfolio with a 30% allocation to Treasuries historically provided the same downside protection as a portfolio with a 44% allocation to gold. We also like gold futures as a safe haven since they offer some of the most attractive opportunity costs. In addition, their upside is greater than that of most safe havens due to their negative correlations with real rates. However, gold’s volatility makes it an unreliable asset, which prevents us from placing it higher in the safe haven hierarchy. Historically, U.S. Treasuries have been one of the best safe havens to hedge an equity portfolio. Will this performance continue in the future? We do not think so. While yields are still high enough to provide plenty of upside potential, they have fallen to the point where they have increased the opportunity costs of U.S. Treasuries and reduced their consistency. The Rest Global ex-U.S. bonds have very limited upside due to their low yields. Meanwhile U.S. investment-grade credit remains at risk from poor corporate balance sheets, compounded by the fact that credit no longer has an attractive yield cushion. Currencies like the yen and the Swiss franc will continue to be unreliable and very expensive safe havens. Finally, while silver’s costs and reliability could improve, its high cyclicality relative to other safe havens will make silver a poor protection choice. Historical performance Consistency How did safe havens perform when equities lost money? To assess consistency, we plot the performance of each safe haven during all quarters when global equities had losses (Chart I-2). Cash and farmland were the only assets to have positive returns during every equity drawdown. U.S. Treasuries and U.S. TIPS were also very consistent, and had the additional advantage that their returns tended to increase as equity losses worsened. Global ex-U.S. bonds, while not as consistent, generated positive returns most of the time. Chart I-2Safe Haven Returns During Drawdowns In Global Equities Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s On the other hand, investment-grade bonds, the yen, the Swiss franc, gold, and silver were much more inconsistent. In general, even though these assets had larger positive returns than other assets, they were prone to deep selloffs concurrent with equity drawdowns. Silver was the worst of all safe havens, being mostly a negative return asset during quarters of negative equity performance. Versatility How did the type of crisis affect the performance of safe havens? We classify crises according to their catalyst into the following four categories: bursts of U.S. asset bubbles (tech bubble, 2008 housing crisis), ex-U.S. crises (1998 EM crisis, European debt crisis), flash crashes/political events (1987 Black Monday, 9/11 terrorist attack),  rate/inflation shocks (1974 oil crisis, 1980 Fed shock) and others (every other equity drawdown we could not classify).3  We look at the performance of seven safe havens since 1973 (Chart I-3A) and of all 10 since 19914 (Chart I-3B): Chart I-3ASafe Haven Return During Different Type Of Crisis (1973 - Present) Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Chart I-3BSafe Haven Return During Different Type Of Crisis (1991 - Present) Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s   During bursts of U.S. asset bubbles, U.S. Treasuries were the most effective hedge in both sample periods, followed by U.S. TIPS and farmland. Corporate bonds, cash, gold, and the Swiss franc also had positive returns, though they were small. Finally, the yen and silver had negative returns. During crises happening outside of the U.S., U.S. Treasuries were once again the best option. U.S. TIPS, yen futures, farmland, gold, and U.S. investment-grade bonds also provided strong returns.  Meanwhile, global ex-U.S. bonds and cash provided relatively weak returns, while both the Swiss franc and silver accrued losses. During flash crashes/political events, the Swiss franc had the best performance followed by global ex-U.S. bonds, though in general all safe havens but silver provided positive returns. Rate/inflation shocks were the most difficult type of crisis to hedge. Cash and U.S. TIPS were by far the best performers. Moreover, while U.S. Treasuries were able to eke out a small positive return, all other safe havens lost money during these crises. Efficiency How much allocation to each safe haven was needed to protect an equity portfolio? Chart I-4 show how adding incremental amounts of each safe haven5 to an equity portfolio reduced the overall portfolio’s 10% conditional VaR (the average of the bottom decile of returns).6 Since 1973, U.S. TIPS and U.S. nominal government bonds were the most efficient safe havens, providing the most protection per unit of allocation (Chart I-4 – top panel). Conditional VaR was reduced by almost half when allocating 40% to either Treasuries or TIPS. Cash, U.S. investment-grade, the yen, the Swiss franc, gold, and silver followed in that order. The difference between the safe havens was significant. As an example, a portfolio with a 30% allocation to U.S. Treasuries historically provided the same downside protection as a portfolio with a 36% allocation to U.S. IG credit, a 39% allocation to the yen or a 44% allocation to gold. Meanwhile, there was no allocation to silver which would have provided the same level of protection. When using a sample from 1991, the main difference was the reduced efficiency of cash – the result of lower average interest rates when using a more recent sample. Other than cash, the efficiency of most safe havens remained unchanged: U.S. Treasuries were the best option, followed by U.S. TIPS, farmland, U.S. investment-grade bonds, global ex-U.S. government bonds, cash, the yen, gold, the Swiss franc, and silver in that order (Chart I-4 – bottom panel). Chart I-4Historically, Fixed-Income Assets Were The Most Efficient Safe Havens Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Costs How do safe haven returns compare to equities? To evaluate opportunity costs, we compare the difference of the historical return of each safe haven versus global equities. Overall, hedging with currencies was extremely costly, as their return was well below that of equities in both samples (Chart I-5). Cash was also an expensive safe haven to hedge with, particularly in the most recent sample. On the other hand, fixed-income assets like U.S Treasuries, investment-grade credit, and U.S. TIPS had very low costs (global ex-U.S. bonds also had cost of around 2% in a limited sample).  Farmland had negative opportunity costs because it outperformed equities during the sample period.7 Chart I-5Historically Fixed Income Assets And Farmland Had The Lowest Opportunity Cost Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Outlook Chart I-6No More Yield Cushion Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Chart I-7Silver Has Become Less Cyclical Silver Has Become Less Cyclical Silver Has Become Less Cyclical For our outlook, we assess how the four traits under study have changed for all safe havens: Consistency: Will safe havens continue to be reliable in the absence of high coupons? Many of the safe havens in our sample were effective at hedging equities due to their high yield. Even if they had negative capital appreciation, total returns stayed positive thanks to the offsetting effect of the yield return. However, as rates have declined, yield return has also decreased substantially (Chart I-6). Therefore, safe havens, like cash, government bonds, and even farmland will not be as consistent as they were in the past. Credit could be even more vulnerable: the combination of a low yield, and unhealthy fundamentals will turn U.S. corporate bonds into a negative-return asset in the next crisis. Silver might be the lone safe haven to improve its consistency. Industrial use for silver has fallen substantially in the past 10 years, decreasing its cyclical nature (Chart I-7). Thus, while silver might still be an erratic safe haven, it should be more consistent in the future than its historical performance would suggest.   Versatility: What will the next crisis look like? Chart I-8Inflation and Political Crisis Will Plague The 2020s Inflation and Political Crisis Will Plague The 2020s Inflation and Political Crisis Will Plague The 2020s Determining what the next crisis will look like is crucial for safe haven selection. Below we rank the types of crises in order of how likely and severe we think they will be in the future: Inflation/rate shock: We expect inflation to be significantly higher over the next decade. This will be the highest risk for asset allocators in the future. As we explained in our May 2019 report, a change in monetary policy framework, procyclical fiscal policy, waning Fed independence, declining globalization, and demographic forces are all conspiring to lift inflation in the next decade.8 Importantly, we believe that the Fed will be dovish initially, as it cannot let inflation continue to underperform its target after missing the mark for the last 10 years (Chart I-8 – top panel). However, this will cause an inflationary cycle, which will eventually lead the Fed to raise rates significantly and trigger a recession. Political events/flash crashes: Political events will also pose a risk to the markets on a structural basis. The rise of China as a superpower has shifted the world into a paradigm of multipolarity, which historically has resulted in military conflict. Moreover, animus for conflict is not dependent on President Trump. The American public in general feels that the economic relationship with China is detrimental to the United States (Chart I-8 – bottom panel). This means that any president, Democrat or Republican will have a political incentive to jostle with China for economic and political supremacy for years to come. Ex-U.S. crises: We expect Emerging Markets in general, and China in particular, to be among the most vulnerable parts of the global economy as we enter the next decade. Over the last 10 years, China’s money supply has increased four-fold, becoming larger than the money supply of the U.S. and the euro area combined. In addition, corporate debt as a % of GDP stands at 155%, higher than Japan at the peak of its bubble and higher than any country in recorded history (Chart I-9). We rank this type of crisis slightly below the first two because Emerging Market assets are depressed already. Thus, while we believe that there is further downside to come for these economies, some weakness has already been priced in. U.S. asset bubble burst: We believe that there are no systemic excesses in the U.S. economy, making a U.S. asset bubble burst a lesser risk than other types of crises. Although it is true that U.S. corporate debt stands at all-time highs, it is still at a much lower level than in other countries. Moreover, weakness of corporate credit is not likely to have systemic consequences on the economy, given that leveraged institutions like banks and households hold only a small amount of outstanding corporate debt (Chart I-10). Chart I-9EM crises Are Also A Risk EM crises Are Also A Risk EM crises Are Also A Risk Chart I-10A U.S. Corporate Debt Deblacle Will Not Have Systemic Consequences A U.S. Corporate Debt Deblacle Will Not Have Systemic Consequences A U.S. Corporate Debt Deblacle Will Not Have Systemic Consequences What does this ranking mean in terms of safe haven performance? U.S. TIPS and cash should be held in high regard as they will be some of the only assets that will perform well during an inflation/rate shock. The Swiss franc and global ex-U.S. bonds should be best performers during political crises, although U.S. TIPS could also provide adequate protection. Efficiency: Is there any upside left for safe havens when interest rates are near zero? As yields go below the zero bound it becomes harder for bonds to generate large positive returns. European or Japanese government bonds in particular would need their yields to go deep into negative territory to counteract a large selloff in equities (Table I-1). But can interest rates go that low? We do not think so. The recent auction of German bunds, where a 0%-yielding 30-year bond attracted the weakest demand since 2011, suggests that interest rates in these countries might be close to their lower bound.  On the other hand, though U.S. yields are low, they are still high enough for U.S. Treasuries to provide high returns in case of a crisis. Table I-1No Room For Positive Returns In The Government Bond Space Outside Of The U.S. Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Low rates also have an effect on the efficiency of U.S. investment-grade bonds, cash, and farmland because their upside during crises does not come from capital appreciation but rather from their yield, (the price of IG credit actually declines during most crisis). As mentioned earlier, their yield has declined substantially compared to the past, which means that a larger allocation will be necessary to counteract a selloff. Chart I-11Switzerland Has A High Incentive To Prevent The Franc From Appreciating Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s The upside of the yen could also be compromised. The Bank of Japan is likely to intervene aggressively in the currency market to prevent the Japanese economy from falling into a deflationary spiral, since it is very difficult for it to lower Japanese rates further. The Swiss franc is even more vulnerable. In contrast to Japan, Switzerland is a small open economy that has to import most of its products (Chart I-11). This means that the Swiss National Bank has a very high incentive to intervene in currency markets during a crisis, given that a rally in the franc could depress inflation severely. What about U.S. TIPS? In contrast to nominal government bond yields or even yields on corporate debt, U.S. real rates are not limited by the zero bound (Chart I-12).  This makes TIPS a more attractive option than other fixed-income assets, since real rates can have much more room for further downside than nominal ones. To be clear, this will only be the case if our forecast of an inflationary crisis materializes. Likewise, since gold is heavily influenced by real rates, it should also offer significant upside during the next crisis.9 Chart I-12Real Rates Have More Downside Potential Than Nominal Ones Real Rates Have More Downside Potential Than Nominal Ones Real Rates Have More Downside Potential Than Nominal Ones Costs: Can I afford to hold safe havens in a world of low returns? To provide an outlook for the expected cost of each safe haven, we use the return assumptions from our June Special Report.10 We subtract the expected return on global equities from the expected return for each safe haven to reach an expected cost value. However, three of the safe havens (global ex-U.S. government bonds, the Swiss franc and silver) did not have a return estimate. We compute their expected returns as follows: For the Swiss franc we use the methodology we used for all other currencies in our report. We base the expected return on the current divergence from the IMF PPP value, as well as the IMF inflation estimates. In addition, we add the relative cash rate assumed return for both our yen and Swiss franc estimates, as futures take into account carry return. For global ex-U.S. bonds we take the weighted average of the expected return of the euro area, Japan, U.K., Canada, and Australia government bonds. We weight the returns according to their market capitalization in the Bloomberg/Barclays government bond index. Due to silver’s dual role as an inflation hedge and industrial metal, silver prices are a function of both gold prices and global growth. To obtain a return estimate we run a regression on silver against these two variables and use our growth and gold return estimate to arrive at an assumed return for silver. Chart I-13 shows our results: while their cost will improve, currency futures remain the most expensive hedge. The opportunity cost of precious metals and cash will decrease, making them more attractive options than in the past. Meanwhile, low yields will increase the opportunity costs of most fixed-income assets. Finally, farmland will remain the cheapest safe haven, even with decreased performance. Chart I-13Oportunity Cost For Fixed Income Safe Havens Will Be Higher Than In The Past Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Juan Manuel Correa Ossa Senior Analyst juanc@bcaresearch.com Appendix A Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Footnotes 1 Please see Geopolitical Strategy Special Report, "The Apex Of Globalization – All Downhill From Here, " dated November 12, 2014, available at gps.bcaresearch.com. 2 We use a synthetic TIPS series for data prior to 1997. For details on the methodology, please see: Kothari, S.P. and Shanken, Jay A., “Asset Allocation with Inflation-Protected Bonds,” Financial Analysts Journal, Vol. 60, No. 1, pp. 54-70, January/February 2004. 3 For a detailed list of how we classified each equity drawdown, please see Appendix A. 4 The only crises caused by a rate/inflation shock occurred in 1974 and 1980. Thus we have this type of drawdown only in Chart 3A and not in Chart 3B. 5 For yen, Swiss franc, silver and gold futures we assume an allocation to an ETF which follows their performance. Since futures have zero initial costs they cannot be directly compared to traditional assets in terms of percentage allocation. 6 We prefer this measure over VaR given that it captures the properties of the left tail of returns more accurately. 7  While the farmland index subtracts management fees, we recognize that there are costs involved in holding these illiquid assets which are not necessarily captured by the return indices. Thus, the real historical cost of holding farmland was not negative but likely close to zero. 8 Please see Global Asset Allocation Strategy Special Report "Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises," dated May 22, 2019, available at gaa.bcaresearch.com. 9 Please see Commodity & Energy Strategy Special Report "All that Glitters…And Then Some" dated July 25, 2019, available at ces.bcaresearch.com. 10 Please see Global Asset Allocation Strategy Special Report "Return Assumptions - Refreshed and Refined" dated June 25, 2019,  

Highlights Shifting Trends: The factors that have driven bond yields lower throughout 2019 – slowing growth, rising uncertainty, demand for safe assets and dovish monetary policy expectations – have all started to turn in a more bond-bearish direction. Duration & Country Allocation Strategy: Maintain a moderate below-benchmark stance on aggregate bond portfolio duration. Favor lower-beta countries with central banks that are more likely to stay relatively dovish as global yields drift higher, like core Europe, Australia and Japan. Credit Allocation Strategy: Stay overweight corporate bonds versus government debt in the U.S. and Europe, both for investment grade and high-yield. Maintain just a neutral stance on EM USD-denominated spread product, but look to upgrade if global growth improves further and the USD begins to weaken. Feature Chart of the WeekBond Yields Sniffing A Turn In Global Growth? Bond Yields Sniffing A Turn In Global Growth? Bond Yields Sniffing A Turn In Global Growth? It has been fifty days (and counting) since the 2019 low for the benchmark 10-year U.S. Treasury yield was reached on September 3. The year-to-date low for the benchmark 10-year German bund yield was seen six days before that on August 28. Yields have risen by a healthy amount since those dates, up +34bps and +37bps for the 10yr Treasury and Bund, respectively. This has occurred despite the significant degree of bond-bullish pessimism on global growth and inflation that can be found in financial media reporting and investor surveys. The fact that yields are now steadily moving away from the lows suggests that the 2019 narrative for financial markets – slowing global growth, triggered by political uncertainty and the lagged impact of previous Fed monetary tightening and China credit tightening, forcing central banks to turn increasingly more dovish – is no longer correct. If that is true, yields have more near-term upside as overbought government bond markets begin to “sniff out” a bottoming out of global growth momentum (Chart of the Week). In this Weekly Report, we take a look at the changing state of the factors that fueled the sharp decline in bond yields in 2019. We follow that up with a review of all our current recommended investment positions on duration, country allocation and spread product allocations in light of recent developments. We conclude that maintaining a below-benchmark duration exposure, while favoring lower-beta countries in sovereign debt and overweighting corporate debt in the U.S. and Europe, is the most appropriate fixed income strategy for the next 6-12 months. The timing of the bottoming of yields in the major developed markets (DM) should not be surprising, given the more bond-bearish turn of reliable leading directional yield indicators. Yields Are Rising At The Right Time, For The Right Reasons Chart 2Bond-Bullish Growth & Inflation Factors Are Turning Bond-Bullish Growth & Inflation Factors Are Turning Bond-Bullish Growth & Inflation Factors Are Turning The timing of the bottoming of yields in the major developed markets (DM) should not be surprising, given the more bond-bearish turn of reliable leading directional yield indicators. The diffusion index of our global leading economic indicator (LEI), which leads the real (ex-inflation expectations) component of DM bond yields by twelve months, is at an elevated level (Chart 2). At the same time, the slowing of the annual rate of growth in the trade-weighted U.S. dollar, which leads 10-year DM CPI swap rates by around six months, is signaling that bond yields have room to increase from the inflation expectations side. Finally, the rising trend of positive data surprises for the major DM countries is also pointing to higher yields. Breaking it down at the country level, the pickup in DM 10-year bond yields since the 2019 lows has been widespread (Charts 3 & 4). The range of yield increases is as low as +16bps in Japan, where the Bank of Japan (BoJ) is pursuing a yield target, to +46bps in Canada where the economy and inflation are both accelerating. Chart 3Pricing Out Some Expected Rate Cuts … Pricing Out Some Expected Rate Cuts ... Pricing Out Some Expected Rate Cuts ... Chart 4… Across All Developed Markets ... Across All Developed Markets ... Across All Developed Markets The increase in yields has also occurred alongside reduced expectations for easier monetary policy. Our 12-month discounters, which measure the expected change in short-term interest rates priced into Overnight Index Swap (OIS) curves, show that markets have partially priced out some (but not all) expected rate cuts in all major DM countries. The Three Things That Have Changed For Global Bond Markets So what has changed to trigger a reduction in rate cut expectations and an increase in global yields? The bond-bullish narrative that we refer to in the title of this report can be broken down into the following three elements, which have all turned recently: Slowing global growth (now potentially bottoming) Chart 5Global Growth Bottoming Out Global Growth Bottoming Out Global Growth Bottoming Out Current global growth is still trending lower, when looking at measures like manufacturing PMIs or sentiment surveys like the global ZEW index. Forward-looking measures like our global LEI, however, have been moving higher in recent months, suggesting that a bottom in the PMIs may soon unfold (Chart 5). We investigated that improvement in our global LEI in a recent report and concluded that the move higher was focused almost exclusively within the emerging market (EM) sub-components that are most sensitive to improving global growth.1 This fits with the improvement shown in the OECD LEI for China, a bottoming of the annual growth rate of world exports, and the general acceleration of global equity markets – the classic leading economic indicator. Rising political uncertainty (now potentially fading) The U.S.-China trade war (including the implications for the upcoming 2020 U.S. presidential election) and the U.K. Brexit saga have been the main sources of bond-bullish political uncertainty over the past several months. Yet recent developments have helped reduce the odds of the most negative tail risk outcomes, providing a bit of a boost to global bond yields. The U.S. and China have agreed (in principle) to a “phase one” trade deal that, at a minimum, lowers the chances of a further escalation of the trade dispute through higher tariffs. Meanwhile, the momentum has shifted towards a potential final Brexit agreement between the U.K. and European Union that can avoid an ugly no-deal outcome. Our colleagues at BCA Research Geopolitical Strategy believe that developments are likely to continue moving away from the worst-case scenarios, given the constraints faced by policymakers.2 U.S. President Donald Trump is now in full campaign mode for the 2020 elections and needs a deal (of any kind) to deflect criticism that his trade battle with China is dragging the U.S. economy into recession. Already, there has been a sharp decline in income growth for workers in swing states that could vote for either party’s candidate in next year’s election (Chart 6). Trump cannot afford to lose voters in those states, many of which are in the U.S. industrial heartland (i.e. Ohio, Michigan) that helped put him in the White House. In other words, he is highly incentivized to turn down the heat on the trade war or else face a potential loss next November. While these political uncertainties have not been fully resolved by these latest developments, the shift in momentum away from worst-case scenarios has likely been enough to reduce the safe-haven bid for DM government bonds, helping push yields higher. Meanwhile, China is facing a slowing economy and rising unemployment, but with reduced means to fight the downtrend given high private sector debt that has impaired the typical response between easier monetary conditions and economic activity (Chart 7). While the Chinese government does not want to be seen as caving in to U.S. pressure on trade policy, its desire to maintain social stability by preventing a further rise in unemployment from the trade war provides a powerful incentive to try and ratchet down tensions with the U.S. Chart 6Political Reasons For Trump To Retreat On Trade Political Reasons For Trump To Retreat On Trade Political Reasons For Trump To Retreat On Trade In the U.K., a no-deal Brexit is an economically painful and politically unpopular outcome that would severely damage the re-election chances of Prime Minister Boris Johnson and his Conservative party. Thus, even a hard-line Brexiteer like Johnson must respond to the political constraints forcing him to try and get a Brexit deal done (Chart 8). Chart 7Economic Reasons For China To Retreat On Trade Economic Reasons For China To Retreat On Trade Economic Reasons For China To Retreat On Trade Chart 8Political Reasons To Retreat On A No-Deal Brexit Political Reasons To Retreat On A No-Deal Brexit Political Reasons To Retreat On A No-Deal Brexit While these political uncertainties have not been fully resolved by these latest developments, the shift in momentum away from worst-case scenarios has likely been enough to reduce the safe-haven bid for DM government bonds, helping push yields higher. Bull-flattening pressure on yield curves (now turning into moderate bear-steepening) The final leg down in bond yields in August had a technical aspect to it, fueled by the demand for duration and convexity from asset-liability managers like European pension funds and insurance companies. Falling yields act to raise the value of liabilities for that group of investors, forcing them to rapidly increase the duration of their assets to match the duration of their liabilities (the technique used to limit the gap between the value of assets and liabilities). That duration increase is carried out by buying government bonds with longer maturities (and higher convexity), but also through the use of interest rate derivatives like long maturity swaps and swaptions. The end result is a bull flattening of yield curves (both for government bonds and swaps) and a rise in swaption volatility (i.e. the price of swaptions). Those dynamics were clearly in play in August after the shocking imposition of fresh U.S. tariffs on Chinese imports early in the month. Bond and swaption volatilities spiked, and bond/swap yield curves bull-flattened, in both Europe and the U.S. (Chart 9). That effect only lasted a few weeks, however, and volatilities have since declined and curves have steepened. This suggests that the “convexity-buying” effect has run its course and is now starting to work in the opposite direction, with asset-liability managers looking to reduce the duration of their assets as higher yields lower the value of their liabilities. This is putting some upward pressure on longer-maturity global bond yields. Chart 9Signs Of Reduced Convexity-Related Bond Buying Signs Of Reduced Convexity-Related Bond Buying Signs Of Reduced Convexity-Related Bond Buying Chart 10Bull-Flattening Yield Curve Pressures Easing Up A Bit Bull-Flattening Yield Curve Pressures Easing Up A Bit Bull-Flattening Yield Curve Pressures Easing Up A Bit Chart 11Fed & ECB Actions Should Help Steepen Up Curves Fed & ECB Actions Should Help Steepen Up Curves Fed & ECB Actions Should Help Steepen Up Curves The steepening seen so far must be put in context, however, as yield curves remain very flat across the DM world (Chart 10). Term premia on longer-term bonds remain very depressed, although those should start to increase as global growth stabilizes and the massive safe-haven demand for global government debt begins to dissipate. Some pickup in inflation expectations would also help impart additional bear-steepening momentum to yield curves – a more likely result now that the Fed and ECB have both cut interest rates and, more importantly, will start provide additional monetary easing by expanding their balance sheets (Chart 11). Bottom Line: The factors that have driven bond yields lower throughout 2019 – slowing growth, rising uncertainty, demand for safe assets and dovish monetary policy expectations – have all started to turn in a more bond-bearish direction. Reviewing Our Recommended Bond Allocations In light of these shifting global trends described above, the fixed income investment implications are fairly straightforward: Yields are rising around the world, suggesting that the current move is a shift higher driven by non-country-specific factors like more stable future global growth prospects. Duration: A moderate below-benchmark overall duration stance is warranted for global fixed income portfolios, with yields likely to continue drifting higher over at least the next six months. A big surge in yields is unlikely, as central banks will need to see decisive evidence that global growth is not only bottoming, but accelerating, before shifting away from the current dovish bias. Given the reporting lags in the economic data, such evidence is unlikely to appear until the first quarter of 2020 at the earliest. Yet given how flat yield curves are across the DM government bond markets, the trajectory of forward rates is quite stable relative to spot yield levels, making it much easier to beat the forwards by positioning for even a modest yield increase. Country Allocation: Yields are rising around the world, suggesting that the current move is a shift higher driven by non-country-specific factors like more stable future global growth prospects. In that case, using yield betas to the “global” bond yield is a good way to consider country allocation decisions within a fixed income portfolio. We looked at those yield betas in an August report, using Bloomberg Barclays government bond index data for the 7-10 year maturity buckets of individual countries and the Global Treasury aggregate (Chart 12).3 The rolling 3-year betas were highest in the U.S. and Canada, making them good countries to underweight within a global government bond portfolio in a rising yield environment. The yield betas were lowest in Japan, Germany and Australia, making them good overweight candidates. The U.K. was a unique case of having a relatively high historical yield beta prior to the 2016 Brexit referendum and a lower yield beta since then - making the U.K. allocation highly conditional on the resolution of the Brexit uncertainty. Spread Product Allocation: The backdrop described in this report, where global growth is bottoming out but where central banks maintain a dovish bias, is a perfect sweet spot for global spread product like corporate bonds and Peripheral European government debt. Thus, an overweight stance on overall global spread product versus governments is warranted. The backdrop described in this report, where global growth is bottoming out but where central banks maintain a dovish bias, is a perfect sweet spot for global spread product like corporate bonds and Peripheral European government debt. With regards to our current strategic fixed income recommendations and model bond portfolio allocations, we already have much of the positioning described above in place. We are below-benchmark on overall duration, underweight higher-beta U.S. Treasuries; overweight government bonds in lower-beta Germany, France, Japan and Australia (Chart 13); overweight investment grade corporate bonds in the U.S., euro area and U.K.; and overweight high-yield corporate bonds in the U.S. and euro area. Chart 12Favor Lower-Beta Government Bond Markets Favor Lower-Beta Government Bond Markets Favor Lower-Beta Government Bond Markets There are areas where our positioning could change, however. Chart 13Lower-Beta Laggards Should Start To Outperform Lower-Beta Laggards Should Start To Outperform Lower-Beta Laggards Should Start To Outperform In terms of government bonds, we are currently overweight the U.K. and neutral Canada. A final Brexit deal would justify a downgrade of Gilts to at least neutral, if not underweight, as the Bank of England has signaled that rate hikes would be justified if the Brexit uncertainty was resolved. A downgrade of higher-beta Canadian government debt to underweight could also be justified, although the Bank of Canada is not signaling that a change in monetary policy (in either direction) is warranted. For now, we will hold off on any change to our U.K. stance, as it is now likely that there will be another extension of the Brexit deadline beyond October 31. As for Canada, we remain neutral for now but will revisit that stance in an upcoming Weekly Report. With regards to spread product, we are only neutral EM USD-denominated sovereign and corporate debt, as well as Spanish sovereign bonds; and underweight Italian government debt. An EM upgrade to overweight would require two things that are not yet in place: a weaker U.S. dollar and accelerating Chinese economic growth. Chart 14Stay Overweight Corporates In The U.S. & Europe Stay Overweight Corporates In The U.S. & Europe Stay Overweight Corporates In The U.S. & Europe As for Peripheral governments, we have preferred to be overweight European corporate debt relative to sovereign bonds in Italy and Spain. The recent powerful rally in the Periphery, however, has driven the spreads over German bunds in those countries down to levels in line with corporate credit spreads (Chart 14). We will maintain these allocations for now, but will investigate the relative value proposition between euro area Peripheral sovereigns and corporates in an upcoming report. Bottom Line: Maintain a moderate below-benchmark stance on aggregate bond portfolio duration. Favor lower-beta countries with central banks that are more likely to stay relatively dovish as global yields drift higher, like core Europe, Australia and Japan. Stay overweight corporate bonds versus government debt in the U.S. and Europe, both for investment grade and high-yield. Maintain just a neutral stance on EM USD-denominated spread product, but look to upgrade if global growth improves further and the USD begins to weaken. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, “What Is Driving The Improvement In The BCA Global Leading Economic Indicator?”, dated October 2, 2019, available at gfis.bcaresearch.com. 2 Please see BCA Research Geopolitical Strategy Weekly Report, “Five Constraints For The Fourth Quarter”, dated October 11, 2019, available at gps.bcaresearch.com. 3 Please see BCA Research U.S. Bond Strategy/Global Fixed Income Strategy Weekly Report, “Where’s The Positive Carry In Bond Markets?", dated August 20, 2019, available at usbs.bcaresearch.com and gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Cracks Are Forming In The Bond-Bullish Narrative Cracks Are Forming In The Bond-Bullish Narrative Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: Trade uncertainty has depressed survey measures of economic sentiment, but the hard economic data have been relatively robust. If the trade war starts to calm down during the next two months, as we expect, then the survey data will rebound, causing bond yields to move higher. Fed: With inflation expectations low, the Fed must ensure that financial conditions stay accommodative and that the economic recovery remains on track. This means that the Fed will meet market expectations and cut rates next week. Beyond that, we expect growth to improve enough that further cuts are unnecessary. Negative Convexity: This year’s large decline in yields has increased the attractiveness of negatively convex assets, in risk-adjusted terms. Investors should favor high-yield over investment grade corporates. They should also favor Agency MBS over Aaa, Aa and A rated corporates. Feature Chart 1Positive Surprises Driven By The Hard Data Positive Surprises Driven By The Hard Data Positive Surprises Driven By The Hard Data The next two months are crucial for the U.S economy. Measures of sentiment, on both the business and consumer side, are sending recessionary signals. However, measures of actual economic activity paint a more benign picture (Chart 1). This divergence between the “hard” and “soft” data will likely resolve itself within the next couple of months, and the outcome of U.S./China trade negotiations will play a major part in determining whether that resolution is positive or negative. On the “Hard” And “Soft” Data There is a ton of economic data available to investors these days, but all of it can generally be classified as either “soft” or “hard”. We call measures of actual economic activity, such as housing starts or retail sales, “hard” data. These are the sorts of measures used to calculate a nation’s GDP. Alternatively, we use the term “soft” data to describe survey measures where firms or consumers are asked to describe whether activity is improving or deteriorating, or whether they are becoming more or less optimistic about the future. Some examples of soft data are PMI surveys and measures of consumer confidence. Both sorts of measures have value. Soft data are usually timelier and often lead the hard data. However, they are also more prone to whipsaws. The hard data tend to be more reliable, but don’t always provide enough lead time to be actionable. The soft and hard data are sending very different signals. At present, the soft and hard data are sending very different signals. On the consumer side, core retail sales are growing at the robust year-over-year pace of 4.8%, even though consumer confidence has declined during the past year (Chart 2). On the business side, the ISM manufacturing PMI survey came in at 47.8 in September, the lowest print since 2009. However, industrial production has fallen by only 0.1% during the past year. Industrial production growth got as low as -4% during the 2015/16 period, when the ISM was at a higher level (Chart 3). Similarly, actual orders for core durable goods have barely contracted, even though CEO confidence is at recessionary levels (Chart 3, panel 2). Capacity utilization also remains fairly strong, well above its 2016 low (Chart 3, bottom panel) Chart 2Hard Vs. Soft Data: On The Consumer Side Hard Vs. Soft Data: On The Consumer Side Hard Vs. Soft Data: On The Consumer Side Chart 3Hard Vs. Soft Data: On The Business Side Hard Vs. Soft Data: On The Business Side Hard Vs. Soft Data: On The Business Side Housing is the only sector of the economy that doesn’t currently display a dichotomy between the hard and soft data. All measures of housing activity are growing strongly, a rapid snapback following last year’s weakness (Chart 4). Chart 4Housing Activity Summary Housing Activity Summary Housing Activity Summary Trade Negotiations Are Pivotal The soft data started to lag the hard data at around the same time as the Global Economic Policy Uncertainty index shot higher last year (Chart 5). This leads us to conclude that worries about the trade war’s negative consequences have caused sharp declines in measures of sentiment and confidence, even though the trade war’s actual impact on the hard data has been minor. This is what makes the outcome of November’s U.S./China trade talks so important. If an agreement is reached that makes it clear that no new tariffs will be implemented, we expect that would remove enough uncertainty for the soft data to improve, converging with the hard data. However, if things fall apart, then we would expect the negative survey data to eventually drag the hard data lower. Housing is the only sector of the economy that doesn’t currently display a dichotomy between the hard and soft data. Our sense at the moment is that the looming 2020 U.S. election provides enough incentive for both sides to strike a deal, but the outcome could still go either way. Last Friday’s report from our Global Investment Strategy service discussed the outlook for trade negotiations in more detail.1 For bond investors, we are confident that a removal of trade uncertainty would lead to a rebound in important soft data measures such as the ISM manufacturing PMI and the CRB Raw Industrials index. Any increase in those measures would also send bond yields sharply higher. The ratio between the CRB Raw Industrials index and Gold continues to track the 10-year Treasury yield closely (Chart 6). Chart 5Trade War Worries Affecting ##br##Sentiment Trade War Worries Affecting Sentiment Trade War Worries Affecting Sentiment Chart 6Bond Yields Will Shoot Higher Once Trade Uncertainty Dissipates Bond Yields Will Shoot Higher Once Trade Uncertainty Dissipates Bond Yields Will Shoot Higher Once Trade Uncertainty Dissipates Bottom Line: Trade uncertainty has depressed survey measures of economic sentiment, but the hard economic data have been relatively robust. If the trade war starts to calm down during the next two months, as we expect, then the survey data will rebound, causing bond yields to move higher. The Fed Next Week The dichotomy between hard and soft data fits nicely with how the Fed has been describing the economic outlook for most of the year. That is, an economy who’s baseline outlook is favorable but that faces some downside risks. While that outlook doesn’t immediately suggest a policy response, low inflation expectations make it pretty clear what the Fed’s course of action will be during the next few months. The 5-year/5-year forward TIPS breakeven inflation rate is currently 1.68%, well below the 2.3%-2.5% range that is consistent with the Fed’s inflation target (Chart 7). What’s more, the median 3-year inflation forecast from the New York Fed’s Survey of Consumer Expectations just hit an all-time low (Chart 7, bottom panel). The Fed must take appropriate action to drive inflation expectations higher. At present, this means that it must ensure that financial conditions stay accommodative so that the economic recovery can continue. Eventually, continued economic recovery will lead to higher realized inflation (Chart 7, panel 2), and inflation expectations will follow realized inflation higher. Chart 7Low Inflation Expectations Equals Accommodative Fed Low Inflation Expectations Equals Accommodative Fed Low Inflation Expectations Equals Accommodative Fed In order to keep financial conditions accommodative, the Fed must at least match the market’s current rate cut expectations. An October rate cut is more or less fully priced, and it is therefore highly likely that the Fed will cut rates next week. After that, the market is pricing in roughly 50/50 odds of a fourth rate cut in December. But those expectations will certainly change as we learn the outcome of November’s trade talks and as the economic data roll in. Ultimately, we expect that enough good news will hit the wire between now and December that a fourth rate cut will be unnecessary. But the more important message is that, as long as inflation expectations are low, the Fed will not risk upsetting market expectations. Balance Sheet Update The Fed decided not to wait until next week to unveil its revamped balance sheet policy. It didn’t really have the luxury of time, given the turmoil in money markets that we discussed in a recent report.2 The main conclusion from our report is that the Fed must inject more bank reserves into the economy if it wants to maintain control of interest rates. This is exactly what the Fed will do going forward. It announced that it will purchase Treasury bills at least until the second quarter of 2020, starting at an initial pace of $60 billion per month. It will also continue to reinvest the proceeds from maturing Treasury notes/bonds and MBS into newly issued Treasury notes/bonds. Continued economic recovery will lead to higher realized inflation. Assuming the pace of $60 billion per month stays constant, and making some other assumptions about the growth rates of non-reserve liabilities, we project that the Fed’s actions will cause the supply of reserves to rise from $1.53 to $1.63 trillion by next June, and that its securities holdings will rise from $3.59  to $4.05 trillion (see Chart 8 and Table 1). Chart 8The Fed's Balance Sheet Over Time The Fed's Balance Sheet Over Time The Fed's Balance Sheet Over Time Table 1Fed's Balance Sheet: Projections Crisis Of Confidence Crisis Of Confidence As we have argued in the past, now that the link between the Fed’s balance sheet and its interest rate policy has been severed, we see no investment implications from the Fed’s new balance sheet strategy. As per our Golden Rule of Bond Investing, changes in the fed funds rate relative to expectations will continue to drive bond yields.3 Since the Fed’s balance sheet strategy tells us nothing about its future interest rate plans, it should mostly be ignored. Bottom Line: With inflation expectations low, the Fed must ensure that financial conditions stay accommodative and that the economic recovery remains on track. This means that the Fed will meet market expectations and cut rates next week. Beyond that, we expect growth to improve enough that further cuts are unnecessary. A Good Time To Buy Negative Convexity We have repeatedly mentioned the attractiveness of high-yield bonds and Agency MBS during the past few weeks. The one thing those sectors have in common is that they are negatively convex. That is, unlike most fixed income instruments, their durations are positively correlated with yields. As a result, this year’s big drop in yields has led to large declines in duration for both high-yield and agency MBS (Chart 9). But despite this lower duration, junk spreads have remained relatively flat while MBS spreads have actually widened. In other words, expected return has not fallen even as the risk embedded in negatively convex securities has declined markedly. Chart 9Negatively Convex Products Are Attractive Negatively Convex Products Are Attractive Negatively Convex Products Are Attractive Last week we unveiled a new way of measuring risk for U.S. spread products.4 The Risk Of Losing 100 bps can be thought of as the number of standard deviations of annual spread change necessary for a sector to underperform duration-matched Treasuries by more than 100 basis points. A higher value means the sector is at a lower risk of losing 100 bps, and vice-versa. Chart 10 shows our new risk measure plotted against expected return for the investment grade and high-yield credit tiers, as well as for conventional 30-year Agency MBS. The y-axis shows each sector’s 12-month expected excess return, which we calculate as OAS less an adjustment for expected default losses. The x-axis shows the Risk Of Losing 100 bps. To put recent market moves in context, we show how each sector has moved within Chart 10 since spreads last troughed, about one year ago. Notice that last October, Ba and B rated junk bonds offered more expected return than Baa-rated corporates, with similar risk. Now, Ba and B offer a similar return advantage, but with much less risk. Caa-rated junk now strictly dominates the Baa sector in terms of risk and reward. Chart 10Risk-Reward Tradeoff Favors Negatively Convex Securities Crisis Of Confidence Crisis Of Confidence Turning to Agency MBS, we see again that the large fall in duration has led to a substantial risk reduction since last October. This is why we recently recommended upgrading Agency MBS at the expense of Aaa, Aa, and A corporates.5 Bottom Line: This year’s large decline in yields has increased the attractiveness of negatively convex assets, in risk-adjusted terms. Investors should favor high-yield over investment grade corporates. They should also favor Agency MBS over Aaa, Aa and A rated corporates. Ryan Swift U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “Kumbaya”, dated October 18, 2019, available at gis.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “What’s Up In U.S. Money Markets?”, dated September 24, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The investors we met last week were ready to hear some good news: The constructive story we told across three days of client meetings is more sanguine than the consensus view, but clients were open to considering it. Global economic weakness and the elevated risk of a U.S. recession were primary concerns, … : As our Global Investment Strategy colleagues have suggested, it will take some time for investors to be convinced that global manufacturing really has seen the bottom and that the U.S. isn’t flirting with a recession. … followed by trade tensions and corporate indebtedness, … : Our small sample suggests that investors may have become de-sensitized to the daily ebb and flow of the U.S.-China conflict, though we continue to believe it looms large in the minds of corporate managements. … but nothing matches the anxiety provoked by Elizabeth Warren’s ascent: Every client asked about the potential consequences of a Warren White House. Feature We spent most of last week meeting with a subset of wealth management and family office clients. They are more focused on absolute returns than relative returns, but their primary concerns are nearly identical to their relative-return peers’. Our meetings touched on a broad constellation of questions about the fate of the expansion, the equity bull market, global growth and the U.S.-China trade negotiations. Clients also asked about the credit outlook and if inflation should be on their radar, but the topic that they raised with the most fervor, in every single one of our meetings, was the prospect of a Warren or Sanders presidency. Q: What is the bond market telling us? We think of the bond market as having two distinct components, rates (Treasuries) and credit (spread product). We have gotten used to regular retracements in the 10-year Treasury yield since it bottomed in July 2016, but watching it melt from 3.25% last November to 1.5% this August has challenged our constructive take on the U.S. economy. Falling yields are not necessarily signaling imminent economic trouble, however, so we continue to hold the view that a recession won’t occur before late 2021 or early 2022. We see this year’s falling Treasury yields as a coincident reflection of decelerating growth, not a harbinger of a recession. On a purely domestic basis, the principal driver of the decline in yields has been the shift in monetary policy expectations. The Fed’s dovish pivot did not occur in a vacuum, of course. Clear signs of decelerating growth set the stage for easier policy, both here and abroad. Whether or not the Fed was always calling the tune, all three step-function declines in 12-month forward fed funds rate expectations occurred as it was guiding markets to expect easier policy: ahead of the March FOMC meeting, when Fed speakers began warning of the danger of inflation expectations becoming unanchored on the downside; in May, when they were busily preparing the ground for a rate cut; and after the July meeting raised the prospect that the July cut would not be a one-off event (Chart 1). Chart 1The Fed's Dovish Pivot, ... The Fed's Dovish Pivot, ... The Fed's Dovish Pivot, ... Sovereign rates are not entirely determined domestically, and much of the softness in Treasury yields reflects the softness in yields in the rest of the world. So far this year, 10-year sovereign yields have moved in lockstep on either side of the Atlantic (Chart 2), preserving no-arbitrage conditions in currency-hedged Treasuries, gilts and bunds. Crude prices are another global variable, and their decline has weighed on inflation break-even rates (Chart 3), dampening the inflation compensation demanded by Treasury buyers. From a rates perspective, we think the bond market is telling us that global growth has slowed, central banks have taken monetary accommodation up a notch, and oil prices have slid. That’s not exactly an ideal growth backdrop, but it hardly spells the end of the expansion. Chart 2... And European Sovereigns' Gravitational Pull Have Dragged Treasury Yields Lower ... And European Sovereigns' Gravitational Pull Have Dragged Treasury Yields Lower ... And European Sovereigns' Gravitational Pull Have Dragged Treasury Yields Lower The credit market concurs. It doesn’t betray a whit of concern that the expansion is in trouble. Spreads quickly unwound last year’s fourth-quarter spike, and have since hung around their post-crisis lows (Chart 4). Non-financial corporations have become more indebted throughout the expansion, but servicing the debt is not at all onerous with yields at rock-bottom levels (Chart 5). Our U.S. Bond Strategy service’s proprietary corporate health monitor is signaling that corporate balance sheets have weakened (Chart 6, third panel), but the other elements required for a meaningful widening of spreads – a completed monetary tightening cycle1 (Chart 6, second panel), and a tightening of lending standards (Chart 6, bottom panel) – are not yet in place. Chart 3Falling Oil Prices Have Smothered Inflation Worries Falling Oil Prices Have Smothered Inflation Worries Falling Oil Prices Have Smothered Inflation Worries Chart 4Spreads Are Tight, ... Spreads Are Tight, ... Spreads Are Tight, ...   Chart 5... And Debt Service Is Easy ... And Debt Service Is Easy ... And Debt Service Is Easy Q: Isn’t it time to reduce credit exposures? Tight spreads may be a contrarian warning sign. Though it is sensible to shift some of a company’s financing burden to debt when it is so much cheaper than equity, combining a larger debt burden with degraded covenant protections is a concern. Low interest rates will keep debt service costs from chafing, and help keep defaults in check for now, but the bond market is increasingly vulnerable. Chart 6Spread Widening Conditions Aren't Yet In Place Spread Widening Conditions Aren't Yet In Place Spread Widening Conditions Aren't Yet In Place Chart 7Income Investors Need Not Apply Income Investors Need Not Apply Income Investors Need Not Apply Despite that vulnerability, when the next default cycle arrives, it will not have anywhere near the impact of the housing bust because it will deal no more than a glancing blow to the banks. Single-family homes collateralize the American banking system; corporate bonds are held by a diffuse assortment of unlevered players. It stinks for any unlevered investor when it loses money, but it doesn’t cause much of a ripple in the overall economy. Today’s buildup in corporate borrowing is not analogous to 2006-7’s residential mortgage Superfund site, and suggestions to the contrary are ill-founded. Elevated corporate leverage is a vulnerability, but it is not enough for an investor to identify a vulnerability; s/he also has to identify the catalyst that will cause it to snap. Nonfinancial corporate debt levels are a fissure that has been made longer by debauched covenants. Markets won’t suffer until the fissure lengthens and widens enough to turn into a crack that no investor can ignore. It is our view that easy monetary conditions will keep the fissure out of sight and out of mind for several months at least. Defaults only occur when a borrower is unable to refinance its maturing obligations. As long as there is at least one lender willing to extend new credit at manageable terms, the borrower won’t go bust. The current monetary policy backdrop, featuring zero/negative interest rate policy in much of the major economies, all but ensures a steady supply of willing lenders. Life insurers, pension funds and endowments with a need for income to offset fixed liabilities have been forced out the risk curve to source income sufficient to meet them (Chart 7). The net result has been to provide even wobbly credits offering an incremental 50 or 75 basis points with a line of would-be lenders out the door and around the corner. The global manufacturing sector has already succumbed to recession, but stout performance in the service sector has allowed developed economies to keep expanding. The weakest credits will not find lifelines, but plenty of dubious ones will. The current ultra-loose monetary policy environment is simply not a backdrop in which defaults pick up in earnest. Until central banks get a little less prodigal, the marginal lender won’t become more selective, the plates will keep spinning, and spread product will continue to generate excess returns over cash and Treasuries. Q: Things look worse outside the U.S. What’s your global growth outlook? Chart 8Manufacturing May Be Bottoming, ... Manufacturing May Be Bottoming, ... Manufacturing May Be Bottoming, ... The global manufacturing sector is in recession, but the overall global economy is not (Chart 8). A manufacturing recession does not necessarily lead to a full-blown recession, and the ongoing expansion in developed economies’ much larger service sector provides a formidable bulwark against manufacturing’s struggles (Chart 9). While it is too early to conclude if or when global activity will accelerate, our global leading economic indicator, and the diffusion index that leads it, suggest that it is in the process of bottoming (Chart 10). Chart 9... And Services May Have Stopped Decelerating ... ... And Services May Have Stopped Decelerating ... ... And Services May Have Stopped Decelerating ... Chart 10... If Leading Indicators Have Found A Footing ... If Leading Indicators Have Found A Footing ... If Leading Indicators Have Found A Footing Chart 11From Headwind To Tailwind From Headwind To Tailwind From Headwind To Tailwind Our China Investment Strategy team sees scope for Chinese growth to gather some steam in the first quarter of 2020, when local governments will be freed from the budget constraints imposed by Beijing through the end of this year. In the meantime, September money and credit growth topped expectations, and policymakers have been undertaking modest stimulus measures like trimming bank reserve requirement ratios. Changes in Chinese credit growth lead changes in global growth (Chart 11), via China’s credit-reliant import channel. Its imports are Europe’s, Japan’s, Asian EMs’, and Australia’s, Brazil’s and Chile’s exports. As their exports rise, so too does their aggregate demand, giving rise to a self-reinforcing virtuous circle. Q: What would President Warren mean for markets? Investors’ concerns about a Warren presidency are surely justified; Senator Warren has openly, and often gleefully, expressed hostility for banks, defense contractors, drug companies, oil companies engaged in fracking, and big tech. That’s quite a list, and it accounts for a considerable share of S&P 500 market capitalization. It is fair to say that a Warren administration would be unfriendly to equity investors, but there are several points to keep in mind before liquidating one’s portfolio and fleeing the country. It’s too early to award her the Democratic nomination. In October 2007, the smart money was certain that Hillary Clinton had already locked up a berth in the finals against the eventual Republican nominee. Very few Americans could have named the freshman senator from Illinois, known for little more than a well-received speech at the 2004 convention, but he became President Obama. A lot could still happen between now and the Iowa caucuses on February 3rd. Unseating an incumbent president is a tall order. As long as the economy does not enter a recession between now and next November, and the administration can achieve a policy victory without suffering a high-profile policy failure, our Geopolitical Strategy colleagues argue that Trump should be the presumed winner of the 2020 election. Their presumption applies no matter who captures the Democratic nomination, even as the U.S. electorate is shifting to the left over time (Chart 12). Transforming Washington is easier said than done. The framers designed the federal government to be fairly resistant to sweeping change. The Electoral College tamps down popular passions in the presidential election, and Congress and the courts limit the power of the executive branch. Administrations with majorities in the House and Senate routinely find themselves with less freedom than they would like, especially after they exhaust political capital achieving one major legislative initiative (as with the Obama Administration and the Affordable Care Act). Even if the Democrats ride President Warren’s coattails to control over Capitol Hill next November, legislators from conservative or swing districts and states will balk at her entire suite of proposals. Chart 12Democratic Voters Are Leaning More Left Questions From The Road Questions From The Road Investment Implications Our sunnier view of the global economic outlook translates into more constructive equity allocations across global regions and blocs. The BCA house view recommends equal weight allocations to Emerging Markets and the Eurozone within global equity portfolios across tactical (0-3-month) and cyclical (3-12-month) timeframes. We expect to upgrade EM and Eurozone equities to overweight, and downgrade U.S. equities from overweight, across those timeframes once global growth begins to accelerate. We would also favor higher-beta currencies versus the dollar, and limit or avoid exposure to lower-beta currencies like the yen or the Swiss franc, if the data are poised to validate our base-case growth scenario. BCA’s recommendations have become especially data dependent because global investors seem to be firmly ensconced in “show-me” mode. It has been our sense as a firm, supported by the impression we got from last week’s meetings, that investors are reluctant to give growth prospects, and risk assets, the benefit of the doubt. Ground down by trade-related tweets, and skeptical that the latest wave of extraordinary monetary policy measures will have a perceptible impact on growth or inflation, they want to see definitive evidence of a turn before they’ll adjust their portfolio positioning to accommodate it. The wariness is also a reflection of the conflicting signals issued late in the business cycle and the elevated levels of geopolitical uncertainty. If the global economy turns as we think it soon will, global investors should be prepared to add cyclical exposures to their portfolios, even if Elizabeth Warren solidifies her current status as the front-runner for the Democratic nomination. That sense of wariness keeps us recommending benchmark duration exposure in fixed income portfolios over the 0-to-3-month tactical timeframe, though we have little appetite for interest-rate exposure looking out beyond the near term, and are below-benchmark duration over the 3-to-12-month cyclical and greater-than-12-month strategic timeframes. We still like spread product over the full 12-month horizon, as we expect stronger growth will make viable U.S. corporations better credits and that ZIRP/NIRP will continue to protect some of the rest. We endorse the house view that relative U.S. equity returns may slow, but global growth should give a boost to absolute equity returns, and we continue to recommend that investors remain at least equal weight equities in balanced portfolios. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 We are in accord with Chair Powell’s stated view that the rate cuts are mid-cycle cuts, not the beginning of a new easing cycle.

Highlights Duration & Fed: Our late-1990s & 2015/16 roadmap for the economy still holds, but risks are mounting. Despite the risks, we expect that trade tensions will calm enough for the economic data to improve during the next few months. The result will be one more Fed rate cut this month, followed by an extended on-hold period. Investors should keep portfolio duration low in that environment. Junk Quality Spreads: This year’s divergence between the Caa/Ba quality spread and the high-yield index spread is highly unusual, but has more to do with movements in Treasury yields and changing index duration than with broader concerns about corporate credit quality. Investment Grade Risk & Reward: We present a novel approach for assessing the risk/reward trade-off among investment grade corporate bond sectors. We note that Saudi Arabian and Mexican Sovereign bonds, Foreign Agency bonds and Conventional 30-year Agency MBS look particularly attractive in risk-adjusted terms. Feature Contagion? This publication has repeatedly pointed to the late-1990s and the 2015/16 periods as appropriate comparables for today’s global growth slowdown. That is, we expect that the current spate of weakness will stay confined within the manufacturing sector and will not spread into the broader economy, leading the U.S. into recession. This call is important from an investment perspective because it implies that the Fed is not currently engaged in an easing cycle that will bring the funds rate back to zero. Rather, we anticipate only three rate cuts this year (we’ve already seen two), followed by the eventual resumption of hikes. Bond yields will not make new lows in that environment. Chart 1Manufacturing Weakness Spreading? Manufacturing Weakness Spreading? Manufacturing Weakness Spreading? Chart 2"Hard" Data Still Firm "Hard" Data Still Firm "Hard" Data Still Firm But some data received this month challenge our economic narrative. Specifically, September’s drop in the ISM Non-Manufacturing PMI from 56.4 to 52.6 and the year-over-year decline in the Conference Board’s survey of consumer confidence (Chart 1). Both are sending tentative signals that economic weakness might be spreading from the manufacturing sector into the broader U.S. economy. The Fed is worried about the same thing, as evidenced by this passage from the September FOMC minutes: One risk that the economy faced was that the softness recorded of late in firms’ capital formation, manufacturing, and exporting activities might spread to their hiring decisions, with adverse implications for household income and spending. Participants observed that such an eventuality was not embedded in their baseline outlook; however, a couple of them indicated that this was partly because they assumed that an appropriate adjustment to the policy rate path would help forestall that eventuality. This passage makes two important points. First, it stresses the risk of contagion from manufacturing into services and consumer spending as a precondition for recession. This risk has clearly increased, but we are not yet ready to abandon our base case outlook. For one thing, Chart 1 shows that the ISM Non-Manufacturing survey printed at 51.8 for one month in 2016, before rebounding sharply. Second, the “hard” economic data paint a much rosier picture that the “soft” survey data (Chart 2). Industrial production has already bounced off its lows and, unlike the ISM Manufacturing PMI, has not yet approached 2015/16 levels. Similarly, new orders for capital goods are much stronger than during the 2015/16 period. As for consumer spending, it continues to grow at a rapid pace despite the drop in confidence. Chart 3Expect One Rate Cut In October Expect One Rate Cut In October Expect One Rate Cut In October The most logical explanation for the divergence between “hard” and “soft” data is that business and consumer sentiment are being pulled down by concerns about the ongoing trade war. Our sense is that some positive news on that front is now required to bring the survey data back into line with the “hard” numbers. On that note, we anticipate that the looming 2020 election will provide enough incentive for President Trump to reach some sort of détente with China. In fact, as we go to press, optimism about a potential trade deal has pushed the 10-year Treasury yield up above 1.70%. If this optimism is not vindicated, then weak survey data will eventually drag the “hard” data lower. The economy is at a critical and highly uncertain juncture. Amidst so much uncertainty, and with so much hinging on near-term political decisions, how should we expect the Fed to respond? The above passage from the September FOMC minutes gives us a strong clue. It illustrates that the Fed believes that sufficiently accommodative monetary policy will help mitigate the risk of contagion from manufacturing into services and consumer spending. In other words, the Fed must help weather the current storm by ensuring that financial conditions remain supportive. This means refraining from delivering hawkish surprises to market expectations.1 The Fed believes that sufficiently accommodative monetary policy will help mitigate the risk of contagion from manufacturing into services and consumer spending. With that in mind, we note that the market has mostly priced-in an October rate cut (Chart 3), and we expect the Fed to deliver on that expectation. Assuming an October cut, the market is only pricing-in a 28% chance of another cut in December. Overall, the market is priced for 59 basis points of rate cuts during the next 12 months. We anticipate a 25 bps cut this month, followed by an improvement in the economic data that will make further cuts unnecessary. Bottom Line: Our late-1990s & 2015/16 roadmap for the economy still holds, but risks are mounting. Despite the risks, we expect that trade tensions will calm enough for the economic data to improve during the next few months. The result will be one more Fed rate cut this month, followed by an extended on-hold period. Investors should keep portfolio duration low in that environment. High-Yield Quality Spreads: Less Than Meets The Eye Corporate bonds have generally performed quite well this year, but oddly, the lowest tier of junk has not kept pace (Chart 4). Investment grade excess returns have followed a typical risk-on pattern. That is, the lowest rated / riskiest credit tiers have performed best in a bull market. However, in the high-yield space, Caa-rated debt has bucked the trend and actually underperformed the duration-matched Treasury index by 33 bps. Chart 4Caa-Rated Junk Is Not Keeping Pace Caa-Rated Junk Is Not Keeping Pace Caa-Rated Junk Is Not Keeping Pace Is this a potentially worrying sign for corporate spreads more generally? To consider the question, we looked at the historical relationships between quality spreads – the spread differential between low-rated and high-rated credit tiers – and the overall index spreads for both investment grade and high-yield. We found a strong positive correlation in both cases, but no leading or lagging properties. That is, quality spreads tend to follow the same trend as the overall index spread, but do not flag signs of trouble before the overall index. Nonetheless, the current divergence between the Caa/Ba quality spread and the high-yield index spread is highly unusual (Chart 5). Our sense, however, is that the divergence has less to do with concerns about credit quality and more to do with this year’s large moves in Treasury yields and changes to bond index duration. Chart 5De-Coupling In Quality Spreads... De-Coupling In Quality Spreads... De-Coupling In Quality Spreads... Chart 6...Is Due To Duration ...Is Due To Duration ...Is Due To Duration   Specifically, we note that this year’s large decline in Treasury yields has caused junk index duration to plunge, but the drop has been greater for the Ba credit tier than the Caa credit tier (Chart 6). Ba index duration has fallen by 0.8 this year (from 4.4 to 3.5), while Caa index duration has fallen by 0.6 (3.4 to 2.8). The result is that if we control for changes in duration by looking at a 12-month breakeven spread instead of the average index option-adjusted spread (OAS), we see that the quality spread widening is roughly consistent with the overall index (Chart 6, panel 3).2 In other words, the steep drop in Treasury yields has not led to the same reduction in risk in the Caa credit tier as it has in the other junk credit tiers. Caa spreads have widened on a relative basis, as a result. This year’s large decline in Treasury yields has caused junk index duration to plunge. It’s also interesting to note that the opposite dynamic is afoot within the investment grade corporate space. The Baa/Aa quality spread is more or less consistent with the overall index spread in OAS terms (Chart 5, top panel), but the quality spread widening is exacerbated when the impact of changing duration is considered (Chart 6, panels 1 & 2). That is, index duration has lengthened by more for the upper credit tiers than it has for the Baa credit tier. This makes Baa corporates look particularly attractive in risk-adjusted terms, as we have noted in prior research.3 From a big picture perspective, it is unusual for Treasury yields to fall so much without a concurrent widening in credit risk premiums. Eventually, this anomaly will be resolved by either: Higher Treasury yields in the event that recession is avoided, or Wider credit spreads in the event of a contraction in U.S. economic activity But in the meantime, negatively convex sectors such as high-yield corporates and Agency MBS look particularly attractive on a risk-adjusted basis. These sectors have benefited from the drop in Treasury yields by seeing their durations fall. They should perform well as long as the current environment of low Treasury yields and stable credit spreads persists. We take a more detailed look at the prospects for risk-adjusted performance within the different investment grade bond sectors in the next section. Risk And Reward In Investment Grade Bond Sectors As mentioned above, in this week’s report we present a novel approach for considering the risk/reward trade-off between different investment grade sectors of the U.S. bond market. We consider 23 sectors in total: 4 corporate credit tiers Conventional 30-year Agency MBS and Agency CMBS Aaa-rated non-Agency CMBS, credit card ABS and auto loan ABS Domestic and Foreign Agency bonds Supranationals Local Authority bonds (mostly taxable munis and USD-denominated Canadian provincial debt) USD-denominated Sovereign bonds for 10 different emerging markets Reward First, we consider the reward side of the equation. We do not impose any macro view, but instead, use the average index OAS as the best estimate for each sector’s 12-month expected excess returns relative to a duration-matched position in Treasuries. Chart 7 shows the expected excess returns for each sector. Right away, the attractiveness of Mexican sovereign debt is apparent. Mexico carries an A rating, but offers a greater spread than the Baa corporate index. Chart 7Expected Returns A Perspective On Risk And Reward A Perspective On Risk And Reward Risk We decided to assess risk using a breakeven spread framework. We calculate a 12-month breakeven spread for each sector. This spread represents the basis point spread widening required for each sector to break even with a duration-matched position in Treasury securities on a 12-month horizon. We calculate the breakeven spread using the following equation: 0 = OAS – D(B) + 0.5*CVXs*(dYs)2 - 0.5*CVXT*(dYT)2 Where: OAS = the sector’s option-adjusted spread D = the sector’s duration B = the breakeven spread CVXs = the sector’s convexity CVXT = the convexity of a duration-matched Treasury security dYs = trailing 1-year volatility of the sector’s yield dYT = trailing 1-year volatility of the duration-matched Treasury yield Chart 8 shows each sector’s 12-month breakeven spread, and it illustrates that the breakeven spread is a sub-optimal measure of risk. In theory, the highest breakeven spreads should be the least likely to see losses, but this is obviously not the case. Baa-rated South African Sovereign debt carries the largest breakeven spread, but it should be among the riskiest of the sectors. Chart 812-Month Breakeven Spreads A Perspective On Risk And Reward A Perspective On Risk And Reward The missing piece of the puzzle is spread volatility. South African sovereign spreads need to widen by 39 bps before losses are incurred, while Aaa-rated credit card ABS spreads only need to widen by 13 bps. However, if spread volatility is much higher for South African sovereigns than for credit card ABS, then the sovereign sector still might be more likely to see losses. To control for this difference we calculate the standard deviation of annual spread changes for each sector, starting from May 2014 when all sectors have available data. We then divide each sector’s breakeven spread by the result. This calculation gives us a volatility-adjusted 12-month breakeven spread. In other words, it is the number of standard deviations of spread widening required for each sector to see losses on a 12-month horizon (Chart 9). Chart 912-Month Volatility-Adjusted Breakeven Spreads A Perspective On Risk And Reward A Perspective On Risk And Reward Risk & Reward We bring risk and reward together in Charts 10-12. Chart 10 shows expected returns on the y-axis and the vol-adjusted 12-month breakeven spread on the x-axis. Sectors plotting near the top-right of the chart give the best returns and lowest risk of losses, while sectors plotting near the bottom-left provide low expected returns and high risk of losses. Immediately, Saudi Arabian sovereigns and Foreign Agency debt stand out as offering high expected returns for their risk levels. Note that South African sovereigns plot off the charts, toward the top-left of Charts 10-12, as indicated by the arrows. Chart 10Expected Returns Vs. Risk Of Negative Excess Returns A Perspective On Risk And Reward A Perspective On Risk And Reward Chart 11Expected Returns Vs. Risk Of Losing 100 BPs A Perspective On Risk And Reward A Perspective On Risk And Reward Chart 12Expected Returns Vs. Risk Of Losing 200 BPs A Perspective On Risk And Reward A Perspective On Risk And Reward In Charts 11 and 12 we make one further refinement to our risk measure. In these charts, instead of calculating 12-month breakeven spreads, we calculate the spread change necessary for each sector to underperform Treasuries by 100 bps and 200 bps, respectively. Saudi Arabian sovereigns and Foreign Agency debt stand out as offering high expected returns for their risk levels. This adjustment arguably gives a more useful perspective on risk. For example, because spreads are quite narrow in the Supranational and Domestic Agency sectors, the risk of negative returns versus Treasuries is quite elevated. However, these sectors also carry high credit ratings and low spread volatility, making it exceedingly unlikely that they would deliver losses of 100 bps or more. Considering Charts 11 and 12, we look for sectors that clearly dominate other ones, i.e. plotting both higher and further to the right. Once again, Foreign Agencies and Saudi Arabian sovereigns both look very appealing. Mexican sovereign debt also offers very high expected return, and less risk that the Baa corporate sector. We would also like to point out the attractiveness of Agency MBS. As we noted in a recent report, Agency MBS offer considerably less risk than high-rated corporate debt, and similar expected returns. Note that this analysis doesn’t impose any macroeconomic view, and our sense is that the macro back-drop is more favorable for MBS spreads than for corporates.4 All in all, we reiterate our recommendation to favor Agency MBS over Aaa-, Aa- and A-rated corporate bonds. We will continue to refine this approach to measuring the risk/reward trade-off in the coming weeks, including incorporating high-yield debt into our analysis. Stay tuned. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 For further discussion on this topic please see U.S. Bond Strategy Weekly Report, “Act As Appropriate”, dated August 27, 2019, available at usbs.bcaresearch.com 2 The 12-month breakeven spread is the spread widening required on a 12-month horizon to break even with a duration-matched position in Treasury securities. It can be approximated by dividing the option-adjusted spread by duration, as is done in Chart 6. 3 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Q3/2019 Performance Breakdown: Our recommended model bond portfolio underperformed the custom benchmark by -30bps during the third quarter of the year. Winners & Losers: The biggest underperformance came from underweight positions in U.S. Treasuries (-28bps) and Italian government bonds (-18bps) as yields plunged, dwarfing gains from overweights in corporate bonds in the U.S. (+11bps) and euro area (+4bps). Scenario Analysis For The Next Six Months: We are maintaining our current positioning, staying below-benchmark on duration while overweighting U.S. and euro area corporates vs. government debt. In our base case scenario, global growth will begin to stabilize but the Fed will deliver one more “insurance” rate cut by year-end, leading to corporate bond outperformance. Feature Global bond markets have enjoyed a powerful bull run throughout 2019, as yields have plummeted alongside weakening global growth and growing political uncertainty. Those two forces came to a head in the third quarter of the year, with U.S.-China trade tensions ratcheting up another notch after the imposition of higher U.S. tariffs in early August and global manufacturing PMI data moving into contraction territory – especially in the U.S. The result was a significant fall in government bond yields as markets discounted both lower inflation expectations and more aggressive monetary easing from global central banks, led by the Fed and ECB. The benchmark 10-year U.S. Treasury yield and 10-year German Bund yield plunged -40bps and -25bps, respectively, during the July-September period. Yet at the same time, global credit markets remained surprisingly stable, as the option-adjusted spread on the Bloomberg Barclays Global Corporates index was unchanged over the same three months. In this report, we review the performance of the BCA Global Fixed Income Strategy (GFIS) model bond portfolio during the eventful third quarter of 2019. We also present our updated scenario analysis, and total return projections, for the portfolio over the next six months. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. This is done by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q3/2019 Model Portfolio Performance Breakdown: Good News On Credit Trumped By Bad News On Duration Chart of the WeekDuration Losses Dwarf Credit Gains In Q3/19 Duration Losses Dwarf Credit Gains In Q3/19 Duration Losses Dwarf Credit Gains In Q3/19 The total return for the GFIS model portfolio (hedged into U.S. dollars) in the third quarter was 2.0%, lagging the custom benchmark index by -30 bps (Chart of the Week).1 This brings the cumulative year-to-date total return of the portfolio to +7.8%, which has underperformed the benchmark by a disappointing –67bps. The Q3 drag on relative returns came entirely from the government bond side of the portfolio; specifically, the underweight allocation to U.S. Treasuries and Italian government bonds (Table 1). Those allocations reflected our views on overall portfolio duration (below benchmark) and a relative value consideration within European spread product (preferring corporates to Italy). Both those recommendations went against us as global bond yields dropped during Q3, with Italian yields collapsing (the benchmark 10-year yield was down –126bps) as investors chased any positive yield denominated in euros after the ECB signaled a new round of policy easing. The total return for the GFIS model portfolio (hedged into U.S. dollars) in the third quarter was 2.0%, lagging the custom benchmark index by -30 bps  Table 1GFIS Model Bond Portfolio Q3/2019 Overall Return Attribution Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Providing some partial offset to the U.S. and Italy allocations were gains from overweight positions in government bonds in the U.K., Australia and Japan. More importantly, our overweights in corporate debt in the U.S. and euro area made a strong positive contribution to the performance of the portfolio. 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. The most significant movers were: Chart 2GFIS Model Bond Portfolio Q3/2019 Government Bond Performance Attribution Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Chart 3GFIS Model Bond Portfolio Q3/2019 Spread Product Performance Attribution By Sector Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Biggest outperformers Overweight U.S. high-yield Ba-rated (+4bps) Overweight U.S. high-yield B-rated (+3bps) Overweight U.S. investment grade industrials (+3bps) Overweight Japanese government bonds with maturity of 5-7 years (+2bps) Overweight euro area corporates, both investment grade (+2bps) and high-yield (+2bps) Biggest underperformers Underweight U.S. government bonds with maturity beyond 10+ years (-15bps) Underweight Italy government bonds with maturity beyond 10+ years (-10bps) Underweight U.S. government bonds with maturity of 7-10 years (-5bps) Underweight Japanese government bonds with maturity beyond 10+ years (-4bps) Underweight U.S. government bonds with maturity of 3-5 years (-4bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q3/2019. The returns are hedged into U.S. dollars (we do not take active currency risk in this portfolio) and are 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 Q3/2019 (red for underweight, blue for overweight, gray for neutral).2 Ideally, we would look to see more blue bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. Chart 4Ranking The Winners & Losers From The Model Bond Portfolio In Q3/2019 Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence One thing that stands out from Chart 4 is that every fixed income sector generated a positive return, except for EM USD-denominated corporates. This is a fascinating outcome given the sharp falls in risk-free government bond yields which typically would correlate to a selloff in risk assets and widening of credit spreads. The soothing balm of looser global monetary policy seems to have offset the impact of elevated uncertainty on trade and future economic growth, allowing both bond yields and credit spreads to stay low. The soothing balm of looser global monetary policy seems to have offset the impact of elevated uncertainty on trade and future economic growth, allowing both bond yields and credit spreads to stay low.  We maintained an overweight stance on global spread product throughout Q3, as we felt that the monetary policy effect would continue to overwhelm uncertainty. We did, however, make some tactical adjustments to our duration stance after the U.S. raised tariffs on Chinese imports, upgrading to neutral on August 6th.3 We had felt that higher tariffs were a sign that a potential end to the U.S.-China trade conflict was now even less likely, which raised the odds of a potential risk-off financial market event that would temporarily push bond yields lower. We shifted back to a below-benchmark duration stance on September 17th, given signs of de-escalation in the trade dispute and, more importantly, some improvement evident in global leading economic indicators.4 Bottom Line: Our recommended model bond portfolio underperformed the custom benchmark index during the third quarter of the year, with the drag on performance from an underweight stance on U.S. Treasuries and Italian BTPs overwhelming the gains from corporate credit overweights in the U.S. and euro area. Future Drivers Of Portfolio Returns Looking ahead, the performance of the model bond portfolio will continue to be driven by two main factors: our below-benchmark duration bias and our overweight stance on global corporate debt versus government bonds. Chart 5Overall Portfolio Allocation: Overweight Credit Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence In terms of the specific high-level weightings in the model portfolio, we currently have a moderate overweight, equal to eight percentage points, on spread product versus government debt (Chart 5). This reflects a more constructive view on future global growth. Early leading economic indicators are starting to bottom out and global central bankers are maintaining a dovish policy bias despite low unemployment rates – both factors that will continue to benefit growth-sensitive assets like corporate debt. Early leading economic indicators are starting to bottom out and global central bankers are maintaining a dovish policy bias despite low unemployment rates – both factors that will continue to benefit growth-sensitive assets like corporate debt. We are maintaining our below-benchmark duration tilt at 0.6 years short of the custom benchmark (Chart 6). We recognize, however, that the underperformance from duration in the model portfolio will not begin to be clawed back until there are signs of a bottoming in widely-followed cyclical economic indicators like the U.S. ISM index and the German ZEW. We think that will happen given the uptick in our global leading economic indicator (LEI), but that may take a few more months to develop based on the usual lead time from the LEI to the survey data like the ISM. The hook up in the global LEI does still gives us more confidence that the big decline in global bond yields seen this year is over, especially if a potential truce in the U.S.-China trade war is soon reached, as our political strategists believe to be increasingly likely. Chart 6Overall Portfolio Duration: Moderately Below Benchmark Overall Portfolio Duration: Moderately Below Benchmark Overall Portfolio Duration: Moderately Below Benchmark Turning to country allocation, we are sticking with overweights in countries where central banks are likely to be more dovish than the Fed over the next 6-12 months (Germany, France, the U.K., Japan, and Australia). We are staying underweight the U.S. where inflation expectations appear too low and Fed rate cut expectations look too extreme. The Italy underweight has become a trickier call. We have long viewed Italian debt as a growth-sensitive credit instrument rather than the yield-driven rates vehicle it became in Q3 as markets priced in fresh monetary easing measures from the ECB (including restarting government purchases). We will revisit our Italy views in an upcoming report but, until then, we will continue to view Italian BTPs within the context of our European spread product allocation. Thus, we are maintaining an overweight on euro area corporate debt (by 1% each in investment grade and high-yield) while having an equal-sized underweight (-2%) in Italian government bonds. Our combined positioning generates a portfolio that has “positive carry”, with a yield of 3.1% (hedged into U.S. dollars) that is +25bps over that of the custom benchmark index (Chart 7). That same portfolio, however, generates an estimated tracking error (excess volatility of the portfolio versus its benchmark) of 55bps - well below our self-imposed 100bps ceiling and still within the 40-60bps range we have targeted since the start of 2019 (Chart 8). Chart 7Portfolio Yield: Positive Carry From Credit Portfolio Yield: Positive Carry From Credit Portfolio Yield: Positive Carry From Credit Chart 8Portfolio Risk Budget Usage: Cautious Portfolio Risk Budget Usage: Cautious Portfolio Risk Budget Usage: Cautious Scenario Analysis & Return Forecasts In April 2018, we introduced a framework for estimating total returns for all government bond markets and spread product sectors, based on common risk factors.5 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). Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Table 2BEstimated Government Bond Yield Betas To U.S. Treasuries Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence This framework allows us to conduct scenario analysis of projected returns for each asset class in the model bond portfolio by making assumptions on those individual risk factors. In Tables 3A & 3B, we present our three main scenarios for the next six months, defined by changes in the risk factors, and the expected performance of the model bond portfolio in each case. The scenarios, described below, all revolve around our expectation that the most important drivers of future market returns will continue to be the momentum of global growth and the path of U.S. monetary policy. The scenario inputs for the four main risk factors (the fed funds rate, the price of oil, the U.S. dollar and the VIX index) are shown visually in Chart 9. Table 3AScenario Analysis For The GFIS Model Bond Portfolio For The Next Six Months Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Table 3BU.S. Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Chart 9Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Base Case (Global Growth Bottoms): The Fed delivers one more -25bp rate cut by the end of 2019, the U.S. dollar weakens by -3%, oil prices rise by +10%, the VIX hovers around 15, and there is a bear-steepening of the UST curve. This is a scenario where the U.S. economy ends up avoiding recession and grows at roughly a trend-like pace. The Fed, however, still delivers one more “insurance” rate cut to mitigate the risk of low inflation expectations becoming more entrenched. Global growth is expected to bottom out as heralded by the global leading indicators. A truce (but not a full deal) is expected on the U.S.-China trade front, helping to moderately soften the U.S. dollar through reduced risk aversion. The model bond portfolio is expected to beat the benchmark index by +91bps in this case. Global Growth Strongly Rebounds: The Fed stays on hold, the U.S. dollar weakens by -5%, oil prices rise by +20%, the VIX declines to 12, there is a modest bear-steepening of the UST curve. In this tail-risk scenario, global growth starts to reaccelerate in lagged response to the global monetary easing seen this year, combined with some fiscal stimulus in major countries (China, the U.S., perhaps even Germany). The U.S. dollar weakens as global capital flows shift to markets which are more sensitive to global growth. The model bond portfolio is expected to beat the benchmark index by +106bps in this case. U.S. Downturn Intensifies: The Fed cuts rates by -75bps, the U.S. dollar is flat, oil prices fall by -15%, the VIX rises to 30; there is a bull-steepening of the UST curve. Under this tail-risk scenario, the current slowing of U.S. growth momentum gains speed, pushing the economy towards recession. The Fed cuts rates aggressively in response, helping weaken the U.S. dollar, but not before global risk assets sell off sharply to discount a worldwide recession. The model portfolio will underperform the benchmark by -38bps in this scenario. In terms of our conviction level among the main drivers of the model portfolio returns – duration allocation (across yield curves and countries) and asset allocation (credit versus government bonds) – we are most confident that credit returns will exceed those of sovereign debt over the next six months. In terms of our conviction level among the main drivers of the model portfolio returns – duration allocation (across yield curves and countries) and asset allocation (credit versus government bonds) – we are most confident that credit returns will exceed those of sovereign debt over the next six months. The underweight duration position, however, will also eventually begin to pay off if the message from the budding improvement in global leading economic indicators turns out to be correct. A collapse of the U.S.-China trade negotiations is the biggest threat to our base case, which would make the “U.S. Downturn Intensifies” scenario a more likely outcome. Bottom Line: We are maintaining our current positioning, staying below-benchmark on duration while overweighting U.S. and euro area corporates governments. In our base case scenario, global growth will begin to stabilize but the Fed will deliver one more “insurance” rate cut by year-end, leading to spread product outperformance.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 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 Note that sectors where we made changes to our recommended weightings during Q3/2019 will have multiple colors in the respective bars in Chart 4. 3 Please see BCA Global Fixed Income Strategy Weekly Report, “Trade War Worries: Once More, With Feeling”, dated August 6, 2019, available at gfis.bcaresearch.com. 4 Please see BCA Global Fixed Income Strategy Weekly Report, “The World Is Not Ending: Return To Below-Benchmark Portfolio Duration”, dated September 17, 2019, available at gfis.bcaresearch.com. 5 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 The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns