Corporate Bonds

As is tradition, during client visits in Europe last week, I had the pleasure of reconnecting with Ms. Mea, a long-term BCA client.1 It was our third encounter and, as always, Ms. Mea was eager to delve into our reasoning, challenge our views and strategy, as well as gauge our conviction level. We devote this week's report to key parts of our dialogue. I hope clients find it insightful and beneficial. Ms. Mea: Isn't the EM selloff and underperformance already overextended? I am afraid you will overstay your negative view on EM risk assets as happened in 2016. What are you watching to ensure you alter your stance as and when appropriate? Answer: I am very cognizant of not overstaying my negative stance on EM. I viewed the EM/China rally from their 2016 lows as a mid-cycle outperformance in a structural downtrend.2 Consequently, I argued the rally was not sustainable and that it was a matter of time before EMs and China-plays entered into a new bear market. Barring perfect timing, it was difficult to make money during that rally. Investors who averaged in EM stocks and local bonds over the past three years (including late 2015/early 2016 lows) and did not sell early this year have not made money. The current down-leg in EM financial markets may be the last phase of the bear market/underperformance that began in 2011, and it will eventually create a major buying opportunity. That said, this bear market will likely last much longer and be larger in magnitude than many investors expect. In the recent report titled EMs Are In A Bear Market, I elaborated on why this is a bear market and not just a correction. We also discussed how much further it might go.3 Big-picture macro themes - such as China/EM credit excesses and misallocation of capital - have informed my core views in recent years. Notwithstanding, I am watching various market signals that often lead economic data and are typically early in signaling a reversal in financial markets. Just a few examples of market signals and indicators I am following closely: Turns in EM corporate bond yields often coincide with reversals in EM stocks. For now, EM corporate bond yields are rising, and hence they do not signal a bottom in EM share prices (Chart I-1, top panel). Chart I-1EM/Asian Corporate Bonds Signal Downside Risks To Share Prices EM/Asian Corporate Bonds Signal Downside Risks To Share Prices EM/Asian Corporate Bonds Signal Downside Risks To Share Prices The same holds true for Emerging Asian markets: surging corporate bond yields are heralding further declines in Asian share prices (Chart I-1, bottom panel). Our Risk-on versus Safe-Haven (RSH) currency ratio positively correlates with EM equity prices. The RSH ratio has recently rebounded but has not broken above its 200-day moving average (Chart I-2). Hence, there is no meaningful buy signal as of yet. Chart I-2Our Market Risk Indicator bca.ems_wr_2018_11_08_s1_c2 bca.ems_wr_2018_11_08_s1_c2 The annual rate of change of this indicator leads the global trade cycles and entails further slowdown in global trade (Chart I-3). Chart I-3Global Trade Slowdown Is Not Over bca.ems_wr_2018_11_08_s1_c3 bca.ems_wr_2018_11_08_s1_c3 Finally, a number of EM equity indexes - small-caps and an equal-weighted index - have broken below their 3-year moving averages (Chart I-4). This entails that the selloff in EM stocks is very broad-based. It could also entail that the overall EM index will likely break below its 3-year moving average as well (Chart I-4, bottom panel). Chart I-4EM Equity Selloff Has Been Broad-Based EM Equity Selloff Has Been Broad-Based EM Equity Selloff Has Been Broad-Based Apart from market signals, I am also monitoring economic data, and so far, there are few signs of a revival in global trade or EM growth. The EM manufacturing PMI is falling (Chart I-5, top panel). Manufacturing output growth in Asia and Germany are decelerating sharply (Chart I-5, bottom panel). When global trade growth underwhelms, EM risk assets and currencies fare poorly. Chart I-5Global Growth And EM Credit Spreads Global Growth And EM Credit Spreads Global Growth And EM Credit Spreads Remarkably, both panels of Chart I-5 corroborate that the key reason for the EM selloff this year has not been the Federal Reserve tightening but the deceleration in global trade. We do not foresee a reversal in global trade and China/EM growth deceleration in the coming months. This heralds maintaining our negative view on EM risk assets and currencies for now. Ms. Mea: It is true that China is slowing, but policymakers are also stimulating and a lot of bad news may already be priced into China-related markets. Why do you believe there is more downside in China-related markets and EM risk assets from today's levels? Answer: Indeed, China is easing policy, but policy stimulus has so far been limited. It also works with a time lag. First, the bottoms in the money and the combined credit and fiscal spending impulses preceded the trough in EM and commodities by 6 months at the bottom in 2015 and by about 15 months at the top in 2017 (Chart I-6). Even if the money as well as credit and fiscal impulses bottom today it could take several more months before the selloff in EM financial markets and commodities prices abates. Chart I-6China: Money, Credit And Fiscal Impulses And Financial Markets bca.ems_wr_2018_11_08_s1_c6 bca.ems_wr_2018_11_08_s1_c6 Second, the stimulus has so far been limited. The recently increased issuance of special bonds by local governments was already part of this year's budget. Simply, it was delayed early this year and has been pushed into the third quarter. In addition, there are reports that 42% of this recent special bond issuance will be used for rural land purchases rather than infrastructure spending.4 The former will not boost economic activity and demand for raw materials and industrial goods. Additionally, the ongoing regulatory tightening of banks and non-bank financial institutions will hinder these institutions' willingness and ability to extend credit, despite lower interest rates. We discussed in a recent report5 that both the effectiveness of the monetary transmission mechanism and the time lag between policy easing and a bottom in the business cycle are contingent on the money multiplier (creditors' willingness to lend and borrowers' readiness to borrow) and the velocity of money (marginal propensity to spend among households and companies). On both accounts, odds are that the transmission mechanism will be slower and somewhat impaired this time around than in the past. Chart I-7 illustrates that the marginal propensity to spend/invest by companies is diminishing, and it has historically defined the primary trend in industrial metals prices. Chart I-7China: Companies Are Turning More Cautious On Capex China: Companies Are Turning More Cautious On Capex China: Companies Are Turning More Cautious On Capex Third, most of the fiscal stimulus - tax cuts and income tax deductions - are designed to raise household incomes. This will primarily help spending on some consumer goods and services. Yet, there will be little help for property sales, construction and infrastructure spending. These three types of spending drive most of the demand for commodities, materials and industrial goods. In turn, industrial goods, machinery, commodities and materials account for about 80% of total Chinese imports. Hence, the channels by which China affects the rest of the world are via imports of capital goods, materials and commodities. Overall, China's tax reforms will have little bearing on its imports from other countries. The latter are heavily exposed to the mainland's construction and infrastructure spending, which in turn are driven by the Chinese credit cycle. This is why we spend so much time analyzing mainland money and credit cycles. Finally, the significance of U.S. import tariffs for the Chinese economy should be put into perspective. China's exports to the U.S. make up only 3.6% of its GDP. This compares with the mainland's total exports of 20% and capital spending of 42% of GDP (Chart I-8). Chart I-8What Drives China's Growth What Drives China's Growth What Drives China's Growth Consequently, capital spending is much more important to the Middle Kingdom's growth than its shipments to the U.S. That said, the trade confrontation between the U.S. and China is likely already negatively affecting overall business and consumer confidence in China (Chart I-9). Chart I-9China: Service Sector Is Moderating China: Service Sector Is Moderating China: Service Sector Is Moderating In addition, Chart I-10 illustrates that China's manufacturing PMI for export orders have plunged, signifying an imminent slump in its exports. This could be due to its shipments not only to the U.S. but also to developing economies, which account for a larger share of total exports than shipments to the U.S. and EU combined. Considerable depreciation in EM currencies has made their imports more expensive, dampening their capacity to import. Chart I-10Chinese Exports Are At Risk Chinese Exports Are At Risk Chinese Exports Are At Risk In brief, China's growth will continue to disappoint, weighing on China plays in financial markets. Ms. Mea: Why has strong U.S. growth not helped global trade, China and EM in general? How do U.S. economic and financial markets enter into your analysis about the world and EM? Answer: One common mistake that many commentators make is to form a view on the U.S. growth outlook and then extrapolate it to the rest of the world. The U.S. economy is still the largest, but it is no longer the sole dominant force in the global economy. Chart I-11 shows that U.S. and EU annual imports are equal to $2.5 and $2.2 trillion, respectively. Combined annual imports of China and the rest of EM amount to $6 trillion - hence, they are much larger than the aggregate imports of U.S. and EU. This is why global trade can deviate from time to time from U.S. domestic demand cycles. Chart I-11EM Imports Are Larger Than U.S. And EU Imports Together EM Imports Are Larger Than U.S. And EU Imports Together EM Imports Are Larger Than U.S. And EU Imports Together That said, due to their sheer size, U.S. financial markets have a much larger impact on global markets than U.S. imports do on global trade. EM financial markets are greatly influenced by their counterparts in the U.S. In this respect, we have a few observations: U.S. growth is robust, the labor market is tight and core inflation is rising. Barring a major deflation shock from EM, the path of least resistance for U.S. bond yields and the fed funds rate is up. Continued rate hikes by the Fed constitute a major menace to EM risk assets. For now, the growth divergence between the U.S. and rest of the world will continue to be manifested in a stronger U.S. dollar. This is a bad omen for EMs. Chart I-12A Risk To U.S. Share Prices A Risk To U.S. Share Prices A Risk To U.S. Share Prices Rising U.S. corporate bond yields have historically been associated with lower U.S. share prices, and presently portend a further drop in American equities (Chart I-12). Finally, the surge in equity market leaders - specifically, new economy stocks - has been on par with previous bubbles, as shown in Chart I-13. Chart I-13History Of Financial Bubbles History Of Financial Bubbles History Of Financial Bubbles It is impossible to know whether or not this is a bubble that has already reached its top. But the magnitude and speed of the rally, at minimum, warrant a consolidation phase. On the whole, Fed tightening, rising corporate bond yields, a strong dollar and elevated valuations warrant further correction in U.S. share prices. This will reinforce the downtrend in EM risk assets. Ms. Mea: Are fundamentals in many EM countries not better today than they were amid the taper tantrum in 2013? Specifically, current account balances in many developing nations have improved and their currencies have cheapened. Answer: Your observation is correct - current account deficits have improved and currencies have become much cheaper than before. Nevertheless, these are necessary but not sufficient conditions to turn bullish: First, marginal shifts in balance of payments drive exchange rates. Even though current account deficits are currently smaller and currencies are moderately cheap in many EMs, a deterioration in their current accounts due to weakening exports in general and falling commodities prices in particular will depress their currencies. In this context, China's imports are critical. As they decelerate, EM ex-China's current account balances will deteriorate and their exchange rates will depreciate. Second, current account surpluses do not always preclude currency depreciation. Chart I-14 shows that the Korean won, the Taiwanese dollar and the Malaysian ringgit experienced bouts of depreciation, despite running current account surpluses. Chart I-14Current Account Surpluses And Exchange Rates Current Account Surpluses And Exchange Rates Current Account Surpluses And Exchange Rates Third, emerging Asian currencies are at a risk from another spell of RMB depreciation. Chart I-15 illustrates that CNY/USD exchange rate correlates with the interest rate differential between China and the U.S. As the Fed hikes rates further and the People's Bank of China (PBoC) keep interest rates stable, the yuan will likely depreciate against the greenback. Chart I-15CNY/USD And Interest Rates CNY/USD And Interest Rates CNY/USD And Interest Rates Despite capital controls, it seems the interest rate differential affects the exchange rate in China too. Given the ongoing growth slowdown and declining return on capital in China, there are rising pressures for capital to exit the country. If the authorities push up interest rates to make the yuan attractive to hold, it will hurt the already overleveraged and weak economy. If the PBoC reduces interest rates further to help the real economy, the RMB will come under depreciation pressure. Given the constraints Chinese policymakers are facing, reducing interest rates and allowing the yuan to depreciate further is the least-worst outcome for the nation. Yet, this will rattle Asian currencies and risk assets. Finally, EM currency valuations are but particularly cheap, except Argentina, Turkey and Mexico as depicted in Chart I-16A & Chart I-16B. When currency valuations are not at an extreme, they usually do not matter for the medium-term outlook. Chart I-16AEM Currency Valuations EM Currency Valuations EM Currency Valuations Chart I-16BEM Currency Valuations EM Currency Valuations EM Currency Valuations As to the EM fixed-income market, exchange rates are the key driver of their performance. Currencies depreciation causes a selloff in high-yielding local currency bonds and typically leads to credit spread widening. The latter occurs because U.S. dollar debt becomes more difficult to service when the value of local currency declines. Besides, EM currencies usually weaken amid a global trade slowdown and falling commodities prices. The latter two undermine issuers' revenues and their capacity to service debt, warranting wider credit spreads. Ms. Mea: What about equity valuations? Aren't they cheap? Chart I-17EM Equity Multiples bca.ems_wr_2018_11_08_s1_c17 bca.ems_wr_2018_11_08_s1_c17 Answer: EM stocks are not very cheap. Our composite valuation indicator based on a 20% trimmed mean of trailing and forward P/Es, PBV, price-to-cash earnings and price-to-dividend ratios denotes a slightly attractive valuation (Chart I-17). According to our cyclically-adjusted P/E ratio, EM equities are also moderately cheap (Chart I-18). Chart I-18EM Equities: Cyclically-Adjusted P/E Ratio EM Equities: Cyclically-Adjusted P/E Ratio EM Equities: Cyclically-Adjusted P/E Ratio In short, EM equity valuations are modestly cheap. As with currencies, however, unless valuations are at an extreme (say, one or two-standard deviations from their mean), they may not matter for a while. Barring extreme over- or undervaluation, share prices are typically driven by profit cycles. Importantly, EM corporate earnings are set to decelerate further and probably contract in the first half of 2019 (Chart I-19). If this scenario transpires, share prices will drop further, regardless of valuations. Chart I-19EM Corporate Earnings Are At Risk EM Corporate Earnings Are At Risk EM Corporate Earnings Are At Risk Ms. Mea: Why don't you write about risks to your view? And, I would like to use this opportunity to ask what are the risks to your view presently? Answer: The basis of why I do not write about the risks to my view is as follows: The risks to a view are often the cases when the key pillars of analysis do not play out. It follows that in these cases, the risks to the view are obvious and there is no need to write about them. To sum up our discussion today, the key pillars of my view are: China's policy stimulus has so far been moderate and the stimulus usually works with a time lag. Additionally, the combination of the regulatory tightening on banks and non-bank financial organizations and the lingering credit and property market excesses in China will generate a growth slowdown that will be longer and deeper than the markets currently expect. The Fed will continue ratcheting up rates as U.S. core inflation is grinding higher. The combination of the above three will produce weaker global growth, a stronger U.S. dollar, and lower commodities prices. All in all, these are bearish for EM risk assets. It is evident that if these themes and assumptions are incorrect, the view will be wrong. Hence, writing that the risks to my view are that my assumptions and themes are mistaken is nothing other than tautology. That said, there are seldom cases when the underlying economic themes and the assumptions are valid, yet the investment recommendations are amiss. These are, in fact, true risks to the view and they are worthy of discussion. Yet, identifying in advance what could go wrong when the analysis and assumption are accurate is very difficult. Presently, I can think of one reason why my investment recommendations could be erroneous even if my economic themes end up being largely valid: It is the shortage of investable assets worldwide relative to capital that is looking to be invested. Quantitative easing programs in the advanced economies have shrunk the size of investable assets. As a result, too much money is chasing too few assets. Consequently, the risk to my view is that EM assets never become sufficiently cheap and that fundamentals do not matter that much. In other words, investors could rush back into EM risk assets despite the poor growth backdrop and not-so-cheap valuations. This is akin to a game of musical chairs where the number of participants is greater than the number of chairs. To complicate things, some chairs are broken, i.e., some assets are of bad quality. As a result, game participants (i.e., investors) are now facing a tough choice between (1) being somewhat prudent and risking being left without a chair; or (2) rushing in and getting either a good chair or a broken chair (depending on luck). Applying this musical chairs analogy, buying EM risk assets at the current juncture is similar to rushing in and hoping to get a good chair. It is a very high-risk bet and success is contingent on luck. In my subjective assessment, there is about a 30% chance that this strategy - buying EM risk now - will be successful with 70% odds favoring being risk averse for the time being. The latter entails staying with a defensive strategy in EM and underweighting/shorting EM versus DM. Ms. Mea: What is your recommended country allocation currently? Answer: In the EM equity space, our overweights are Korea, Thailand, Brazil, Mexico, Colombia, Chile, Russia, and central Europe. Our underweights, on the other hand, are India, Indonesia, the Philippines, Hong Kong, South Africa and Peru. Chart I-20 demonstrates the performance of our fully invested EM equity portfolio versus the EM MSCI benchmark. This portfolio is constructed based on our country recommendations. Hence, it is a measure of alpha that clients could derive from our country calls and geographical equity allocations. Chart I-20EMS's Fully-Invested Model Equity Portfolio Performance EMS's Fully-Invested Model Equity Portfolio Performance EMS's Fully-Invested Model Equity Portfolio Performance This fully invested equity model portfolio has outperformed the MSCI EM equity benchmark by about 65% with very low volatility since its initiation in May 2008. This translates into 500-basis-points of compounded outperformance per year. In the currency space, we continue recommending shorting a basket of the following EM currencies versus the dollar: ZAR, IDR, MYR, KRW and CLP. The full list of our country recommendations for equity, local fixed-income, credit and currency markets are available below. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Reports, "Where Are EMs In The Cycle?" dated May 3, 2018 and "Ms. Mea Challenges The EMS View," dated October 19, 2018, available at ems.bcaresearch.com. 2 Please see Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," dated July 19, 2018, available at ems.bcaresearch.com. 3 Please see Emerging Markets Strategy Weekly Report, "EMs Are In A Bear Market," dated October 18, 2018, available at ems.bcaresearch.com. 4 Please see: https://www.bloomberg.com/news/articles/2018-10-21/china-s-195-billion-debt-splurge-has-less-bang-than-you-think 5 Please see Emerging Markets Strategy Weekly Report, "EMs Are In A Bear Market," dated October 25, 2018, available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Chart 12015 Repeat? 2015 Repeat? 2015 Repeat?   Credit spreads widened as Treasury yields rose in October, bringing to mind the experience of 2015 when tight monetary policy and flagging global growth combined to cause a large drawdown in spread product excess returns. Chart 1 shows the familiar pattern. The market's rate hike expectations held constant throughout most of 2015. Meanwhile, falling commodity prices signaled weakness in global demand. Eventually, the combination of tight money and slowing growth was too much for the market to bear. Junk sold off in late-2015 and didn't recover until after the Fed scaled back its rate hike plans. It's hard to ignore today's similar set-up. Commodity prices are once again falling and the Fed appears committed to lifting rates. Unless global demand rebounds, we could be in for a repeat of late-2015's ugly price performance. The best way to position U.S. bond portfolios for this risk is to maintain below-benchmark portfolio duration, and to scale back exposure to credit risk. We advocate nothing more than a neutral allocation to spread product, with an up-in-quality bias. Feature Investment Grade: Neutral Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 82 basis points in October, dragging year-to-date excess returns down to -98 bps. The index option-adjusted spread widened 12 bps on the month, and currently sits at 117 bps. Recent spread widening has returned some value to the corporate bond space. The 12-month breakeven spread for Baa-rated corporate bonds is back up to its 36th percentile relative to history, while the same spread for A-rated securities is at its 18th percentile (Chart 2). Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Though spreads are somewhat more attractive, caution remains warranted in the corporate bond space. Corporate profit growth has only just managed to keep pace with debt growth during the past few quarters (bottom panel). In other words, even a mild deceleration in profits will be enough for leverage to resume its uptrend (panel 4). As we observed in last week's report, Q3's sharp decline in non-residential investment spending might signal that weak foreign growth is finally starting to weigh on profits.1 The possibility of rising leverage in the coming quarters leads us to recommend an up-in-quality bias within our neutral allocation to corporate bonds. To pick up extra spread we prefer a strategy of favoring long-maturity credits over short maturities. In last week's report we showed that the long-end of the credit curve outperforms (in excess return terms) when Treasury yields rise. High-Yield: Neutral High-Yield underperformed the duration-equivalent Treasury index by 159 basis points in October, dragging year-to-date excess returns down to +161 bps. The average index option-adjusted spread widened 55 bps on the month, and currently sits at 363 bps. Our measure of the excess spread available in the High-Yield index after accounting for default losses is currently 259 bps, above the long-run mean of 247 bps (Chart 3). This tells us that if default losses are in line with our expectations during the next 12 months and junk spreads remain constant, we should expect high-yield returns of 259 bps in excess of duration-matched Treasuries. If we assume that spreads tighten enough to bring our default-adjusted spread back to its long-run average, we would expect an excess return of 306 bps. Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview The main reason for continued caution on junk bonds is that the default loss expectation embedded in our excess spread calculation is extremely low relative to history (panel 4). Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.04% during the next 12 months. Default losses have rarely come in below that level. Further, the recent trend in job cut announcements makes it even more likely that default losses surprise to the upside during the next 12 months. Job cut announcements are highly correlated with the default rate, and while they remain low relative to history, they have clearly formed a trough this year (bottom panel). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Toxic Combination Toxic Combination   Table 3BCorporate Sector Risk Vs. Reward* Toxic Combination Toxic Combination MBS: Neutral Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 37 basis points in October, dragging year-to-date excess returns down to -44 bps. The conventional 30-year zero-volatility MBS spread increased 2 bps on the month. A 4 bps widening of the option-adjusted spread (OAS) was partially offset by a 2 bps decline in the compensation for prepayment risk (option cost). The OAS has widened in recent months, though it remains tight compared to its average pre-crisis level (Chart 4). The overall nominal MBS spread remains very low, but for good reason (panel 4). Chart 4MBS Market Overview MBS Market Overview MBS Market Overview The two most important drivers of MBS excess returns are: (i) mortgage refinancing activity and (ii) bank lending standards. Refi activity is already depressed and will stay muted as interest rates rise. Bank lending standards eased in Q2 for the 17th consecutive quarter, but remain tight relative to history. In response to a special question from the Fed's July Senior Loan Officer Survey, respondents noted that mortgage lending standards are in the tighter end of the range since 2005. This suggests that further gradual easing is likely going forward. With lending standards easing and refi activity low, the macro environment is consistent with tight MBS spreads. We maintain only a neutral allocation to the sector for now, but will look to upgrade when it comes time to further pare exposure to corporate credit risk. Government-Related: Underweight The Government-Related index underperformed the duration-equivalent Treasury index by 55 basis points in October, dragging year-to-date excess returns down to -16 bps. Sovereign debt underperformed the Treasury benchmark by 184 bps, dragging year-to-date excess returns down to -118 bps. Foreign Agencies underperformed by 94 bps on the month, dragging year-to-date excess returns down to -60 bps. Local Authorities underperformed by 28 bps, dragging year-to-date excess returns down to +63 bps. Supranationals underperformed Treasuries by 3 bps, dragging year-to-date excess returns down to +13 bps. Domestic Agency bonds underperformed by 4 bps, dragging year-to-date excess returns down to +5 bps. Sovereign debt has underperformed this year, but spreads remain expensive compared to U.S. corporate credit. In a recent report we looked at USD-denominated Emerging Market Sovereign debt by country and found that only a few nations offer excess spread compared to equivalently-rated U.S. corporates.2 Those countries being Argentina, Turkey, Lebanon and Ukraine at the low-end of the credit spectrum and Saudi Arabia, Qatar and UAE at the upper-end. We continue to view the Local Authority sector as very attractive. Not only does the sector offer elevated spreads (Chart 5), but it is dominated by taxable municipal securities which are insulated from weak foreign growth and U.S. dollar strength. Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview Municipal Bonds: Overweight Municipal bonds underperformed the duration-equivalent Treasury index by 47 basis points in October, dragging year-to-date excess returns down to +105 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 1% in October, and currently sits at 87% (Chart 6). This is about one standard deviation below its post-crisis mean and only slightly above the average of 81% that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview But despite the low yield ratio, we see tax-exempt municipal yields as quite attractive, especially at the long-end of the curve. For example, we observe that a 5-year Aa-rated municipal bond carries a yield of 2.55% versus a yield of 3.62% for a comparable corporate bond index. This implies that an investor with an effective tax rate of 30% should be indifferent between the two bonds. Moving further out the curve, the breakeven tax rate falls to 23% at the 10-year maturity point and is even lower at the 20-year maturity point. Further, unlike the corporate sector, state & local government balance sheets are relatively insulated from weakening foreign economic growth and a rising U.S. dollar. While our Municipal Health Monitor has bounced in recent quarters, it remains below zero, consistent with ratings upgrades outpacing downgrades (bottom panel). Treasury Curve: Favor The 7-Year Bullet Over The 1/20 Barbell The Treasury curve bear-steepened in October. The 2/10 slope steepened 4 bps and the 5/30 slope steepened 16 bps. As a result of the large curve steepening, our position long the 7-year bullet and short the 1/20 barbell returned +67 bps on the month, and is now up +107 bps since inception. However, the curve steepening also means that steepener trades focused on the belly (5-7 year) of the curve are no longer attractive according to our models (see Tables 4 & 5). The 7-year bullet is now fairly valued relative to the 1/20 barbell, meaning that the butterfly spread is priced for an unchanged 1/20 slope during the next six months (Chart 7). Our baseline macro assessment is that the yield curve slope will remain near current levels during that timeframe. As such, we close our position long the 7-year bullet and short the 1/20 barbell. Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview Absent attractive value, the only reason to focus curve exposure on the 5-7 year maturity point is as a hedge against an unexpected pause in Fed rate hikes. In prior research we showed that the belly of the curve performs best when the 12-month discounter falls.3 But with our discounter priced for only 61 bps of rate hikes for the next 12 months, this risk may not be worth hedging. Instead, we prefer to go long the 2-year bullet and short a duration-matched 1/5 barbell. This trade is attractively priced on our model (bottom panel) and should outperform in a rising yield environment. The 1/5 slope tends to steepen when our 12-month discounter rises, and vice-versa. TIPS: Overweight TIPS underperformed the duration-equivalent nominal Treasury index by 61 basis points in October, dragging year-to-date excess returns down to +76 bps. The 10-year TIPS breakeven inflation rate fell 9 bps on the month and currently sits at 2.06%. The 5-year/5-year forward TIPS breakeven inflation rate also fell 9 bps on the month and currently sits at 2.21%. Both the 10-year and the 5-year/5-year forward TIPS breakeven inflation rates remain below the 2.3% to 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed's 2% target. We think it is only a matter of time before inflation expectations adjust higher into that range, and we therefore maintain an overweight position in TIPS versus nominal Treasuries. The catalyst for wider TIPS breakevens will be persistent inflation readings near the Fed's 2% target. Trimmed mean inflation has only just returned to the Fed's 2% target (Chart 8), but will probably remain close to that level for the next six months. While base effects will pose a higher hurdle for year-over-year inflation during this time, pipeline inflation pressures are also building, as evidenced by the prices paid component of the ISM Manufacturing survey (panel 4).4 Chart 8Inflation Compensation Inflation Compensation Inflation Compensation ABS: Neutral Asset-Backed Securities underperformed the duration-equivalent Treasury index by 6 basis points in October, dragging year-to-date excess returns down to +23 bps. The index option-adjusted spread for Aaa-rated ABS widened 5 bps on the month and now stands at 38 bps, 4 bps above its pre-crisis low. The excess return Bond Map on page 15 shows that consumer ABS offer attractive return potential compared to both Supranationals and Domestic Agencies, but carry a substantially higher risk of losses. Agency CMBS appear much more attractive than consumer ABS on a risk/reward basis, offering approximately the same expected return with less risk. From a credit quality perspective, the consumer credit delinquency rate remains low by historical standards but has clearly put in a bottom (Chart 9). The household interest coverage ratio has been rising for 10 consecutive quarters, suggesting that the delinquency rate will continue to increase. Chart 9ABS Market Overview ABS Market Overview ABS Market Overview We remain neutral on consumer ABS for now, but prefer Local Authorities, Municipal Bonds and Agency-backed CMBS when it comes to high-quality spread product. If consumer credit delinquencies continue to rise without a commensurate increase in ABS spreads, then our next move will likely be a reduction to underweight. Non-Agency CMBS: Underweight Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 47 basis points in October, dragging year-to-date excess returns down to +120 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 10 bps on the month and currently sits at 94 bps (Chart 10). Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview A typical negative environment for CMBS is characterized by tightening bank lending standards on commercial real estate loans as well as falling demand. The Fed's Q2 Senior Loan Officer Survey showed that both lending standards and demand are close to unchanged. In other words, the macro picture for CMBS is decidedly mixed. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 31 basis points in October, dragging year-to-date excess returns down to +23 bps. The index option-adjusted spread widened 7 bps on the month and currently sits at 51 bps. The Bond Maps on page 15 show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of November 2, 2018) Toxic Combination Toxic Combination   Chart 12Total Return Bond Map (As Of November 2, 2018) Toxic Combination Toxic Combination   Table 4Butterfly Strategy Valuation (As Of September 28, 2018) Toxic Combination Toxic Combination   Table 5Discounted Slope Change During Next 6 Months (BPs) Toxic Combination Toxic Combination Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "What Kind Of Correction Is This?", dated October 30, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Oil Supply Shock Is A Risk For Junk", dated October 9, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "More Than One Reason To Own Steepeners", dated September 25, 2018, available at usbs.bcaresearch.com 4 For details on our base effects indicator for PCE inflation, please see U.S. Bond Strategy Weekly Report, "The Powell Doctrine Emerges", dated September 4, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Duration: The current strength of the U.S. economy suggests that, as was the case in February, the sell-off in risk assets may not result in much of a drop in Treasury yields. Weak foreign economic growth still presents a risk, but it should be hedged by adopting a more defensive stance on credit, not by increasing portfolio duration. Corporate Bonds: Weak foreign economic growth will impact U.S. corporate profits and investment spending before hitting U.S. consumer spending and overall GDP. This means it is better to hedge the risk from weak foreign growth by scaling back exposure to corporate bonds, while maintaining below-benchmark duration. Credit Curve: Favoring the long-end of the credit curve is a way to increase the average spread of a bond portfolio without taking on extra credit risk. Rather, the long-end of the credit curve outperforms when Treasury yields rise and underperforms when they fall. In the current environment we prefer going after the extra spread at the long-end of the credit curve, while maintaining an up-in-quality bias and only a neutral allocation to corporate bonds. Feature We're not out of the woods yet. Risk assets continued their decline last week, the VIX remains elevated and the 10-year yield has fallen off its highs (Chart 1). In the context of our Fed Policy Loop, lower bond yields are a positive sign for risk assets. Chart 1How Much Worse Will It Get? How Much Worse Will It Get? How Much Worse Will It Get? In our Fed Policy Loop framework, higher yields and the perception of increasingly hawkish Fed policy cause credit spreads to widen and stock prices to fall. Then, tighter financial conditions eventually lead to perceptions of more dovish Fed policy and lower bond yields. At some point, yields fall far enough to put a floor under risk assets (Chart 2). Chart 2The Fed Policy Loop What Kind Of Correction Is This? What Kind Of Correction Is This? We are now at the stage of the loop where we must determine how large a decline in Treasury yields will be necessary to halt the slide in risk assets. To make that determination, it is helpful to think about why risk assets are falling. Is it a simple correction driven by investors re-assessing appropriate valuations? Or is the market sniffing out a future slowdown in economic growth? Chart 3 shows why the difference is meaningful. In February 2018, a sharp increase in Treasury yields caused the stock-to-bond total return ratio to decline. However, the ratio quickly recovered once investor sentiment toward the stock market became somewhat less bullish. Importantly, Treasury yields did not need to fall to support a rebound in risk assets, they only needed to level-off for a time. Chart 3Lower Yields Required? Lower Yields Required? Lower Yields Required? In contrast, a meaningful decline in Treasury yields was required to arrest the drop in the stock-bond ratio that occurred in late-2015/early-2016. The difference between that period and the February 2018 period is obvious. In late-2015/early-2016, the U.S. Manufacturing PMI had just dipped below the 50 boom/bust line. This year the PMI has been closer to 60 (Chart 3, bottom panel). The current strength of the U.S. economy suggests that, as was the case in February, the sell-off in risk assets may not result in much of a drop in Treasury yields. With the market only priced for 54 bps of rate hikes during the next 12 months, and no signs of softening in the U.S. economic data, we are reluctant to abandon our cyclical below-benchmark portfolio duration stance at this time. That is not to say there are no risks on the horizon. In past reports we flagged the risk that slowing foreign economic growth will eventually impact the U.S. economy, causing it to slow as we head into next year.1 However, we think it makes more sense to hedge this risk by adopting a more defensive allocation to corporate credit versus Treasuries, rather than by shifting portfolio duration to look for lower yields. Hedge Economic Risk In Credit, Not Duration As was stated above, U.S. economic growth remains strong and the biggest risk on the horizon is that weak foreign growth eventually migrates stateside via a stronger dollar. Last week's third quarter GDP report confirmed that overall growth is solid, but also showed some evidence of weak foreign growth impacting the U.S. figures. Overall, real GDP grew by a healthy 3.5% (annualized) in the third quarter, supported mostly by consumer spending which contributed 2.7% to overall growth, the most since Q4 2014 (Chart 4). However, weakness was found in nonresidential investment spending which contributed only 0.1% to real growth, down from 1.2% in the prior quarter (Chart 4, bottom panel). Chart 4Parallels With Early 2015 Parallels With Early 2015 Parallels With Early 2015 This distribution of growth between consumer spending and investment is identical to what occurred in 2015, the last time that weak foreign growth infiltrated the U.S. economy. The more globally-exposed investment sector contributed almost nothing to growth in the first two quarters of 2015, while overall GDP growth stayed elevated, driven by strong consumer spending. Eventually, consumer spending also weakened and GDP growth plunged in the second half of the year, but the warning sign that weak foreign growth was negatively impacting the U.S. economy came from investment spending in the first half of 2015. We draw the distinction between U.S. investment spending and U.S. consumer spending for two reasons. The first is that investment spending is more influenced by global factors than the U.S. consumer. The second is that investment spending is tightly linked to corporate profit growth (Chart 5). In other words, weak foreign economic growth is likely to negatively impact U.S. corporate profits before it hits overall U.S. GDP. This makes credit spreads more exposed to global weakness than Treasury yields, which take their cues from overall GDP growth. Chart 5Investment Spending And Profits Are Linked Investment Spending And Profits Are Linked Investment Spending And Profits Are Linked While we think that weak foreign growth will weigh on corporate profits in the coming quarters, presenting a clear negative for corporate bond spreads. We must also consider that spread widening during the past two weeks means that valuation has improved. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses now stands at 274 bps, up from 212 bps a month ago and slightly above the historical average (Chart 6). However, we must also point out that our calculation embeds expected default losses of only 1.04% for the next 12 months. This low default loss expectation, which is derived from Moody's baseline default rate forecast and our own forecast of the recovery rate, means that there is a high risk that default losses surprise investors to the upside during the next 12 months (Chart 6, bottom panel). Any moderation in profit growth would make such an upside surprise even more likely. Chart 6Junk Value Has Improved... Junk Value Has Improved... Junk Value Has Improved... Another way to think about our default-adjusted high-yield spread is that if we assume that default losses occur in line with our forecast and that junk spreads remain flat at current levels, then junk bonds will outperform duration-matched Treasuries by 274 bps during the next 12 months. If spreads tighten by enough to bring the default-adjusted spread back to its historical average of 247 bps, then junk will outperform duration-matched Treasuries by 380 bps. However, at the current juncture we are more worried about spread widening during the next 6-12 months than spread tightening. Chart 7 shows that junk spreads tend to predict changes in capacity utilization. At current spread levels, this means we should expect capacity utilization to rise back to the 80% level during the next six months. If weak foreign economic growth starts to weigh on U.S. corporate profits, then such a large gain is very much in doubt (Chart 7, bottom panel). Chart 7...But Spreads Embed Strong IP Growth ...But Spreads Embed Strong IP Growth ...But Spreads Embed Strong IP Growth Bottom Line: Weak foreign economic growth will impact U.S. corporate profits and investment spending before hitting U.S. consumer spending and overall GDP. This means it is better to hedge the risk from weak foreign growth by scaling back exposure to corporate bonds, while maintaining below-benchmark duration. Extend Maturity In Credit, Not Treasuries Given the risk to corporate profits that is posed by weak foreign economic growth, we recommend investors maintain only a neutral allocation to corporate bonds and also maintain an up-in-quality bias across credit tiers.2 In the current environment we think the best way to pick-up spread within a neutral allocation to corporate bonds is to favor the long-end of the maturity spectrum. This will need to be offset by maintaining very low duration within your Treasury allocation to ensure that overall portfolio duration stays below benchmark. The rationale for favoring the long-end of the corporate credit curve is twofold. First, there is extra spread available at the long-end of the credit curve compared to the short-end. In fact, the long-maturity investment grade corporate bond index carries an average option-adjusted spread that is 107 bps greater than that of the intermediate-maturity index (Chart 8). Second, the extra spread available at the long-end of the credit curve is purely compensation for the extra duration risk. The bottom panel of Chart 8 shows that there is no spread advantage at the long-end on a "per unit of duration" basis. Chart 8Favor The Long-End Of The Corporate Credit Curve Favor The Long-End Of The Corporate Credit Curve Favor The Long-End Of The Corporate Credit Curve The fact that the extra spread at the long-end of the credit curve is purely compensation for duration is important because it means that when Treasury yields rise and average index duration falls, investors should demand less compensation for the extra duration risk at the long-end of the curve. In other words, rising Treasury yield environments should coincide with spread compression at the long-end of the credit curve versus the short end. We tested this idea empirically by looking at monthly excess returns in long-maturity corporate bonds versus short-maturity corporate bonds. Using a sample of monthly returns going back to 2000, we divide the months based on whether the Treasury curve bear-steepened, bear-flattened, bull-steepened or bull-flattened (Table 1). The results show that while changes in the slope of the yield curve don't have much impact, the long-end of the credit curve outperforms when Treasury yields rise and underperforms when they fall. Table 1Monthly Excess Return In Long Maturity Vs. Short Maturity Corporate Bonds (2000-Present) What Kind Of Correction Is This? What Kind Of Correction Is This? Bottom Line: Favoring the long-end of the credit curve is a way to increase the average spread of a bond portfolio without taking on extra credit risk. Rather, the long-end of the credit curve outperforms when Treasury yields rise and underperforms when they fall. In the current environment we prefer going after the extra spread at the long-end of the credit curve, while maintaining an up-in-quality bias and only a neutral allocation to corporate bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Waiting For Peak Divergence", dated October 23, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

The Great Recession and financial crisis cast a long shadow that will affect economies, policymakers and investors for years to come. The roots of the crisis are already well known. The first of a two-part series looks forward by examining the areas where we believe structural change has occurred related to the economy or financial markets. First, the financial crisis transformed the corporate bond market in several ways that heighten the risk for quality spreads in the next downturn. Debt and market liquidity are two key concerns. Corporate leverage will not cause the next recession. Nonetheless, when one does occur, corporate spreads in the U.S. and (to a lesser extent) the Eurozone will widen by more for any given degree of recession. This reflects a low interest coverage ratio, poor market liquidity, the downward trend in credit quality and covenant erosion. Second, the shock of the Great Recession and its aftermath appears to have affected the relationship between economic slack and inflation. Firms have been extra reluctant to grant wage gains. However, we argue that the "shell shock" effect will wane. The fact that inflation has been depressed for so long may actually cultivate the risk that inflation will surprise on the upside in the coming years. Investors should hold inflation-protection in the inflation swaps market, or by overweighting inflation-linked bonds versus conventional issues. Third, the events of the last decade have left a lasting impression on monetary policymakers. They will err on the side of allowing the economy to overheat and inflation to modestly overshoot the target in the major economies, despite signs of financial froth. The Fed will respond only with a lag to the current fiscally-driven surge in U.S. growth, leading to a boom/bust economic scenario. Central bankers will have no trouble employing unorthodox policies again in the future, and will be willing to push the boundaries even further during the next recession. Expect aggressive manipulation of the long-end of the yield curve when the time arrives to ease policy. We may also observe more coordination between monetary and fiscal policies. Fourth, global bond yields fell to unprecedented levels, reflecting both structural and cyclical headwinds to demand growth. A dismal productivity performance is another culprit. Productivity growth is poised to recover to some extent, while some of the growth headwinds have reached an inflection point. We do not expect nominal bond yields to return to pre-Lehman norms, and yields could even fall back to previous lows in the case of a recession. Nonetheless, we expect a yield pattern of higher lows and higher highs over the coming business cycles. The 10-year anniversary of the Lehman shock this autumn sparked an avalanche of analysis on the events and underlying causes of the Great Recession and financial crisis. It is a woeful story of greed, a classic bubble, inadequate regulation, new-fangled financial instruments, and a globalized financial system that spread the shock around the world. The crisis cast a long shadow that will affect economies, policymakers and investors for many years to come. The roots of the crisis are well known, so we will not spend any time going over well-trodden ground. Rather, this Special Report looks forward by examining the areas where we believe structural change has occurred related to the economy or financial markets. In Part I, we cover the corporate bond market, the inflation outlook, central bank policymaking and equilibrium bond yields. Part II will look at the debt overhang, systemic risk in the financial sector, asset correlations, the cult of equity and the rise of populism. While not an exhaustive list, we believe these are the key areas of structural change. (1) Corporate Bond Market: Leverage And Downgrade Risk The financial crisis transformed the corporate bond market in several ways that heighten the risk for quality spreads in the next downturn. Debt and market liquidity are two key concerns. An extraordinarily long period of extremely low interest rates was too much for corporate CEOs to pass up. However, because the durability of the economic recovery was so uncertain, it seemed more attractive to hand over the borrowed cash to shareholders than to use it to aggressively expand productive capacity. The ongoing equity bull market rewarded CEOs for the financial engineering, serving to create a self-reinforcing feedback loop. And so far, corporate bondholders have not policed this activity. The result is that the U.S. corporate bond market has grown in leaps and bounds since 2009 (Chart II-1A and Chart II-1B). The average duration of the Bloomberg Barclays index has also risen as firms locked in attractive financing rates. The same is true, although to a lesser extent, in the Eurozone. Chart II-1AU.S. BBB-Rated Share Rising... U.S. BBB-Rated Share Rising... U.S. BBB-Rated Share Rising... Chart II-1B...Same In The Eurozone ...Same In The Eurozone ...Same In The Eurozone Balance sheet health is obviously not the key driver of corporate bond relative returns at the moment. Nonetheless, investors will begin to worry about the growth outlook if interest rates continue to rise. The U.S. national accounts data suggest that interest coverage remains relatively healthy, but this includes large companies such as some of the FAANGs that have little debt and a lot of cash. The national accounts data are unrepresentative of the companies that are included in the Bloomberg Barclays corporate bond index, which are heavy debt issuers. To gain a clearer picture, we calculated a bottom-up Corporate Health Monitor (CHM) for a sample of U.S. companies that provides a sector and credit-quality composition that roughly matches the Bloomberg Barclay's index. The CHM is the composite of six critical financial ratios. Chart II-2 highlights that the investment-grade (IG) CHM has improved over the past two years due to the profitability sub-components. However, the debt/equity ratio has been in a steep uptrend. Interest coverage does not appear alarming by historical standards at the moment, but one can argue that it should be much higher given the extremely low average coupon on corporate bonds, and given that profit margins are extraordinarily high in the U.S. The rapid accumulation of debt has overwhelmed these other factors. Evidence of rising leverage is broadly based across sectors and ratings. Chart II-2U.S. IG Corporate Health U.S. IG Corporate Health U.S. IG Corporate Health Unfortunately, the profit tailwind won't last forever. At some point, earnings growth will stall and this cycle's debt accumulation will start to bite in the context of rising interest rates. To gauge the risk, we estimate the change in the interest coverage ratio over the next three years for a 100 basis-point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt.1 For our universe of Investment-grade U.S. companies, the interest coverage ratio would drop from a little over 7 to under 6, which is close to the lows of the Great Recession (denoted as "x" in Chart II-3). Of course, the decline in interest coverage will be much worse if the Fed steps too far and monetary tightening sparks a recession. The "o" in Chart II-3 denotes the combination of a 100 basis-point interest rate shock and a mild recession in which the S&P 500 suffers a 25% peak-to-trough decline in EPS. The overall interest coverage ratio plunges close to all-time lows at 4½. Chart II-3Interest Coverage To Plunge... Interest Coverage To Plunge... Interest Coverage To Plunge... These simulations imply that, for any given size of recession, the next economic downturn will have a larger negative impact on corporate health than in the past. Rating agencies have undertaken some downgrading related to shareholder-friendly activity, but downgrades will proliferate when the agencies realize that the economy is turning and the profit boom is over (Chart II-4). Banks will belatedly tighten lending standards, adding to funding pressure for the corporate sector. Chart II-4...And Ratings To Be Slashed ...And Ratings To Be Slashed ...And Ratings To Be Slashed Fallen Angels The potential for a large wave of fallen angels means that downgrade activity will be particularly painful for corporate bond investors. The surge in lower-quality issuance has led to a downward trend in the average credit rating and has significantly raised the size of the BBB-rated bonds relative to the IG index and relative to the broader universe of corporate bonds including high yield (Chart II-5, and Chart II-1A).2 The downward trend in credit quality predates Lehman, but events since the Great Recession have likely reinforced the trend. Chart II-5Lower Ratings And Longer Duration Lower Ratings And Longer Duration Lower Ratings And Longer Duration Studies show that bonds that get downgraded into junk status can perform well for a period thereafter, suggesting that investors holding a fallen angel should not necessarily sell immediately. Nonetheless, the process of transitioning from investment-grade to high-yield involves return underperformance as the spread widens. Poor market liquidity and covenant erosion will intensify pressure for corporate spreads to widen when the bear market arrives. Market turnover has decreased substantially since the pre-Lehman years, especially for IG (Chart II-6). The poor liquidity backdrop appears to be structural, reflecting regulation that has curtailed banks' market-making activity and prop trading, among other factors. Chart II-6Poor Market Liquidity Poor Market Liquidity Poor Market Liquidity The Eurozone corporate bond market has also seen rapid growth and a deterioration in the average credit rating. Liquidity is an issue there as well. That said, the Eurozone corporate sector is less advanced in the leverage cycle than the U.S. Interest coverage ratios will fall during the next recession, but this will be concentrated among foreign issuers - domestic issuers are much less at risk to rising interest rates and/or an economic downturn.3 Bottom Line: Corporate leverage will not cause the next recession. Nonetheless, when one does occur, corporate spreads in the U.S. and (to a lesser extent) Eurozone will widen by more for any given degree of recession. Current spreads do not compensate for this risk. (2) Inflation Undershoot Breeds Overshoot Inflation in the U.S. and other developed economies has been sticky since the financial crisis. First, inflation did not fall as much in the recession and early years of the recovery as many had predicted, despite the worst economic contraction in the post-war period. Subsequently, central banks have had trouble raising inflation back to target. In the U.S., core PCE inflation has only recently returned to 2%. Several structural factors have been blamed, but continuing tepid wage growth in the face of a very tight labor market raises the possibility that the inflation-generating process has been fundamentally altered by the Great Recession. In other words, the relationship between slack in the labor market (or market for goods and services) and inflation has changed. In theory, inflation should rise when the economy's output is above its potential level or when the unemployment rate is below its full-employment level. Inflation should fall when the reverse is true. This means that the change (not the level) in inflation should be positively correlated with the level of the output gap or the labor market gap. Chart II-7 presents the change in U.S. core inflation with the output gap. Although inflation appears to have become less responsive to shifts in the output gap after 1990, it has been particularly insensitive in the post-Lehman period. Chart II-7The U.S. Phillips Curve: RIP? The U.S. Phillips Curve: RIP? The U.S. Phillips Curve: RIP? One reason may be that the business sector was shell-shocked by the Great Recession and financial crisis to such an extent that business leaders have been more reluctant to grant wage gains than in past cycles. Equally-unnerved workers felt lucky just to have a job, and have been less willing to demand raises. Dampened inflation expectations meant that low actual inflation became self-reinforcing. We have some sympathy with this view. Long-term inflation expectations have been sticky at levels that are inconsistent with the major central banks meeting their inflation targets over the long term. This suggests that people believe that central banks lack the tools necessary to overwhelm the deflationary forces. The lesson for investors and policymakers is that, while unorthodox monetary policies helped to limit the downside for inflation and inflation expectations during and just after the recession, these policies have had limited success in reversing even the modest decline that did occur. That said, readers should keep in mind a few important points: One should not expect inflation to rise much until economies break through their non-inflationary limits. The major advanced economies have only recently reached that point to varying degrees; Inflation lags the business cycle (Chart II-8). This is especially the case in long 'slow burn' economic expansions, as we have demonstrated in previous research; and The historical relationship between inflation and economic slack has been non-linear. As shown in Chart II-9, U.S. inflation has tended to accelerate quickly when unemployment drops below 4½%. Chart II-8U.S. Inflation Lags The Cycle November 2018 November 2018 Chart II-9A Kinked Phillips Curve November 2018 November 2018 Shell Shock Is Fading We believe that the "shell shock" effect of the Great Recession on inflation will wane over time. Indeed, my colleague Peter Berezin has made the case that the fact that inflation has been depressed for so long actually cultivates the risk that inflation will surprise on the upside in the coming years.4 Central bankers have been alarmed by the economic and financial events of the last decade. They also cast a wary eye on Japan's inability to generate inflation even in the face of massive and prolonged monetary stimulus. Policymakers at the FOMC are determined to boost inflation and inflation expectations before the next economic downturn strikes. They are also willing to not only tolerate, but actively encourage, an overshoot of the 2% inflation target in order to ensure that long-term inflation expectations return "sustainably" to a level consistent with meeting the 2% target over the long term. In other words, the Fed is going to err on the side of too much stimulus rather than too little. This is an important legacy of the last recession (see below). Meanwhile, other structural explanations for low inflation are less powerful than many believe. For example, globalization has leveled off and rising tariff and non-tariff barriers will hinder important global supply chains. Our research also suggests that the rising industrial use of robots and the e-commerce effect on retail prices have had only a small depressing effect on U.S. inflation. Bottom Line: The Phillips curve relationship has probably not changed in a permanent way since Lehman went down. It is quite flat when the labor market is not far away from full employment, but the relationship is probably non-linear. As the unemployment rate drops further, the business sector will have no choice but to lift wages as labor becomes increasingly scarce. The kinked nature of the Phillips curve augments the odds that the Fed will eventually find itself behind the curve, and inflation will rise more than the market is expecting. The same arguments apply to the Bank of England and possibly even the European Central Bank. Gold offers some protection against inflation risk, but the precious metal is still quite expensive in real terms. Investors would be better off simply buying inflation-protection in the inflation swaps market or overweighting inflation-linked bonds over conventional issues. (3) Monetary Policy: Destined To Fight The Last War There are several reasons to believe that the shocking events of the crisis and its aftermath have left a lasting impression on monetary policymakers. Several factors suggest that they will err on the side of allowing the economy to overheat and inflation to modestly overshoot the target: Inflation Persistence: As discussed above, there is a greater awareness that it is difficult to lift both actual inflation and inflation expectations once they have fallen. Some FOMC members believe that long-term inflation expectations are still too low to be consistent with the Fed meeting its 2% inflation target over the long term. A modest inflation overshoot in this cycle would be beneficial, according to this view, in the sense that it would boost inflation expectations and thereby raise the probability that the FOMC will indeed meet its goals over the long term. It might also encourage some discouraged workers to re-enter the labor market. Some policymakers also believe that the Fed is not taking much of a risk by pushing the economy hard, because the Phillips curve is so flat. Zero Bound: Low inflation expectations, among other factors, have combined to dramatically reduce the level of so-called r-star - the short-term rate of interest that is neither accommodative nor restrictive in terms of growth and inflation. R-star is thought to be rising now, at least for the U.S., but it is probably still low by historical standards across the major economies. This increases the risk that policy rates will again hit the lower bound during the next recession, making it difficult for central banks to engineer a real policy rate that is low enough to generate faster growth.5 Fighting the Last War: Memories of the crisis linger in the minds of policymakers. The global economy came dangerously close to a replay of the Great Depression, and policymakers want to ensure that it never happens again. Some monetary officials have argued that a risk-based approach means that it is better to take some inflation risks to limit the possibility of making a deflationary policy mistake down the road. Fears that the major economies are now more vulnerable to deflationary shocks seem destined to keep central banks too-easy-for-too-long. Central bankers will also be quicker and more aggressive in responding when negative shocks arrive in the future. This applies more to the U.S., the U.K. and Japan than the European Central Bank, but even for the latter there has been a clear change in the monetary committee's reaction function since Mario Draghi took over the reins. Financial Stability Concerns Policymakers are also more concerned about financial stability. Pre-crisis, the consensus among the monetary elite was that financial stability should play second fiddle to the inflation target. It was felt that central banks should focus on the latter, and pay attention to signs of financial froth only when they affect the inflation outlook. In practice, this meant paying only lip service to financial excess until it was too late. It was difficult to justify rate increases when inflation was not threatening. It was thought that macro-prudential regulation on its own was enough to contain financial excesses. Today, policymakers see financial stability as playing a key role in meeting the inflation target. It is abundantly clear that a burst bubble can be highly deflationary. Some policymakers still believe that aggressive macro-prudential policies can be effective in directly targeting financial excesses. However, others feel there is no substitute for higher interest rates; as ex-Governor Jeremy Stein stated, interest rates get "in all the cracks". Moreover, the Fed does not regulate the shadow banking sector. The Fed is thus balancing concerns over signs of financial froth against the zero-bound problem and fears of the next deflationary shock. We believe that the latter will dominate their policy choices, because it will still be difficult to justify rate hikes to the public when there is no obvious inflation problem. In the U.S., this implies that the economic risks are skewed toward a boom/bust scenario in which the FOMC is slow to respond to a fiscally-driven late cycle mini-boom. Inflation and inflation expectations react with a lag, but a subsequent acceleration in both forces the Fed to aggressively choke off growth. Policy Toolkit Central bankers will be quite willing to employ their new-found policy tools again in the next recession. The new toolbox includes asset purchases, aggressive forms of forward guidance, negative interest rates, and low-cost direct lending to banks and non-banks in some countries. Policymakers generally view these tools as being at least somewhat effective, although some have argued that the costs of using negative interest rates have outweighed the benefits in Europe and Japan. The debate on how to deal with the zero-bound problem in the U.S. has focused on lifting r-star, including raising the inflation target, adopting a price level target, policies to boost productivity, and traditional fiscal stimulus. Nonetheless, ex-Fed Chair Yellen's comments at the Jackson Hole conference in 2016 underscored that it will be more of the same in the event that the zero bound is again reached - quantitative easing and forward guidance.6 No doubt, the major central banks will rely heavily on both of these tools in order to manipulate yields far out the curve. Forward guidance may be threshold-based. For example, policymakers could promise to keep the policy rate frozen until unemployment or inflation reaches a given level. Now that central bankers have crossed the line into unorthodox monetary policy and inflation did not surge, future policymakers will be willing to stretch the boundaries even further in the event of a recession. For example, they may consider price-level targeting, which would institutionalize inflation overshoots to make up for past inflation undershoots. It is also possible that we will observe more coordination between monetary and fiscal policies in the next recession. The combination of fiscal stimulus and a cap on bond yields would be highly stimulative in theory, in part by driving the currency lower. Japan has gone half way in this direction by implementing a yield curve control (YCC) policy. However, it has failed so far to provide any meaningful fiscal stimulus since the yield cap has been in place. It also appears likely that central bank balance sheets will not return to levels as a percent of GDP that existed before the crisis. An abundance of bank deposits at the central bank will help to satisfy a structural increase in the demand for cash-like risk-free assets. Maintaining a bloated balance sheet will also allow central banks to provide substantial amounts of reverse repos (RRPs) into the market, which should improve the functioning of money markets that have been impaired to some degree by regulation. We do not expect that a structural increase in central bank balance sheets will have any material lasting impact on asset prices or inflation. We believe that inflation will surprise on the upside, but not because central banks will continue to hold significant amounts of government bonds on their balance sheets over the medium term. Bottom Line: The implication is that the monetary authorities will have a greater tolerance for an overshoot of the inflation target than in the past. The Fed will respond only with a lag to the fiscally-driven surge in U.S. growth, leading to a boom/bust economic scenario. During the next recession, policymakers will rely heavily on quantitative easing and forward guidance to manipulate the yield curve (after the policy rate reaches the lower bound). (4) Bond Prices: Structural Factors Turning Less Bullish Perhaps the most dramatic and lasting impact of the GFC has been evident in the global bond market. Government yields fell to levels never before observed across the developed countries and have remained extremely depressed, even as the expansion matured and economic slack was gradually absorbed. Real government bond yields are still negative even at the medium and long parts of the curve in the Eurozone and Japan (Chart II-10). It is tempting to conclude that there has been a permanent shift down in global bond yields. Chart II-10Real Yields Still Depressed Real Yields Still Depressed Real Yields Still Depressed Real Yields Still Depressed Real Yields Still Depressed Equilibrium bond yields are tied to the supply side of the economy. Potential GDP growth is the sum of trend productivity growth and the pace of expansion of the labor force. Equilibrium bond yields may fall below the potential growth rate for extended periods to the extent that aggregate demand faces persistent headwinds. The headwinds in place over the past decade include fiscal austerity, demographics, household deleveraging, increased regulation and lingering problems in the banking sector that limited the expansion of credit, among others. These headwinds either affect the desire to save or the desire to invest, the interplay of which affects equilibrium bond yields. Some of these economic headwinds predate 2007, but the financial crisis reinforced the desire to save more and invest less. Space limitations prevent a full review of the forces that depressed bond yields, but a summary is contained in Appendix 1 and we encourage interested readers to see our 2017 Special Report for full details.7 The Great Supply-Side Shortfall Falling potential output growth in the major advanced economies also helped to drag down equilibrium bond yields. The pace of expansion in the global labor force has plunged from 1¾% in 2005, to under 1% today (Chart II-11). The labor force has peaked in absolute terms in the G7, and is already shrinking in China. Chart II-11Slower Labor Force Expansion... Slower Labor Force Expansion... Slower Labor Force Expansion... Productivity growth took a dramatic turn for the worst after 2007 (Chart II-12). The dismal productivity performance is not fully understood, but likely reflected the peaking in globalization, increased regulation and the dramatic decline in capital spending relative to GDP. The latter was reflected in a collapse in the growth rate of the global capital stock (Chart II-13). In the U.S., for which we have a longer history of data, growth in the capital stocks has lead shifts in productivity growth with a 3-year lag. Firms have also been slower to adopt new technologies over the past decade. Chart II-12...And Lower Productivity November 2018 November 2018 Chart II-13Productivity And Investment Productivity And Investment Productivity And Investment The resulting impact on the level of GDP today has been nothing short of remarkable. The current IMF estimate for the level of potential GDP in 2018 is 10% lower than was projected by the IMF in 2008 (Chart II-14). There has been a similar downgrading of capacity in Europe, Japan and the U.K. Actual GDP has closed the gap with potential GDP to varying degrees in the major countries, but at a much lower level than was projected a decade ago. Paul Krugman has dubbed this the "Great Shortfall". Chart II-14A Permanent Loss Of Output A Permanent Loss Of Output A Permanent Loss Of Output The Great Shortfall was even greater with respect to capital spending. For 2017, the IMF estimates that global investment was more than 20% below the level implied by the pre-crisis trend (Chart II-15). Reduced credit intermediation, from a combination of supply and demand factors, was a significant factor behind the structural loss of economic capacity according to the IMF study.8 Chart II-15Permanent Scars On Capital Spending Permanent Scars On Capital Spending Permanent Scars On Capital Spending By curtailing the business investment relative to GDP for a prolonged period, major economic slumps can have a permanent effect on an economy's long-term prospects. The loss of output since the financial crisis will never be regained. That said, bond yields in theory are related to the growth rate of productivity, not its level. The IMF report noted that there may even be some long-lasting effects on the growth rate of productivity. The crisis left lingering scars on future growth due to both reduced global labor force migration and fertility rates. The latter rose in the decade before the crisis in several advanced economies, only to decline afterward. Households postponed births in the face of the economic and financial upheaval. The IMF argues that not all of the decline in fertility rates will be reversed. An Inflection Point In Global Bond Yields On a positive note, the pickup in business capital spending in the major countries in recent years implies an acceleration in the growth rate of the capital stock and, thus, productivity. In the U.S., this relationship suggests that productivity growth could rise by a percentage point over the coming few years (Chart II-13). This should correspond to a roughly equivalent rise in equilibrium bond yields. Moreover, some of the other structural factors behind ultra-low interest rates have waned, while others have reached an inflection point. For example, the age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool as people retire and begin to deplete their nest eggs. Household savings rates will trend sharply lower in the coming years. Again, we encourage readers to read the 2017 Special Report for a full account of the structural factors that are shifting in a less bond-bullish direction. QE Reversal To Weigh On Bond Prices And let's not forget the unwinding of central bank balance sheets. The idea that central bank asset purchases on their own had a significant depressing effect on global bond yields is controversial. Some argue that the impact on yields occurred more via forward guidance; quantitative easing was a signal to markets that the central bank would stay on hold for an extended period, which pulled down yields far out the curve. This publication believes that QE had a meaningful impact on global bond yields on its own (Chart II-16). Nonetheless, either way, the Fed is now shrinking its balance sheet and the European Central Bank will soon end asset purchases. This means that the private sector this year is being forced to absorb a net increase in government bonds available to the private sector for the first time since 2014 (Chart II-17). Investors may demand juicier yields in order to boost their allocation to fixed-income assets. Chart II-16Reverse QE To Weigh On Bonds Reverse QE To Weigh On Bonds Reverse QE To Weigh On Bonds Chart II-17Private Investors Will Have To Buy More November 2018 November 2018 We are not making the case that real global bond yields are going to quickly revert to pre-Lehman averages. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations suggest that investors still have an overly benign view on the outlook for yields. For example, implied real short-term rates remain negative until 2027 in the Eurozone, while they stay negative out to 2030 in the U.K. (Chart II-18). The implied path of real rates in the U.S. looks more reasonable, but there is still upside potential. Moreover, there is room for the inflation expectations component of nominal yields to shift up, as discussed above. Chart II-18Real Yields Still Too Low Real Yields Still Too Low Real Yields Still Too Low Another way of making this point is shown in Chart II-19. The market expects the 10-year Treasury yield in ten years to be only slightly above today's spot yield, which itself is still very low by historical standards. Market expectations are equally depressed for the 5-year/5-year forward rate for the U.S. and the other major economies. Chart II-19Market Expectations Still Low Market Expectations Still Low Market Expectations Still Low Bottom Line: Global bond yields fell to unprecedented levels due to a combination of cyclical and structural factors. The bond-bullish structural factors were reinforced by shifts in desired savings and business investment as a result of the Great Recession and financial crisis. Some of these structural factors will linger in the coming years, but others are shifting in a less bond-bullish direction. We do not expect nominal bond yields to return to pre-Lehman norms, and yields could even return close to previous lows in the case of a recession. Nonetheless, we expect a yield pattern of higher lows and higher highs over the coming business cycles. Mark McClellan Senior Vice President The Bank Credit Analyst Appendix 1: Key Factors Behind The Decline In Equilibrium Global Bond Yields The so-called Global Savings Glut has been a bullish structural force for bonds for the past couple of decades. A key factor is population aging in the advanced economies. Ex-ante desired savings rose as baby boomers entered their high-income years. China became a major source of global savings after it joined the WTO, and its large trade surplus was recycled into the global pool of savings. A slower pace of labor force growth in the developed countries resulted in a permanently lower level of capital spending relative to GDP. Slower consumer spending growth, as a result of a more moderate expansion in the working-age population, meant a reduced appetite for new factories, malls, and apartment buildings. The integration of the Chinese and Eastern European workforces into the global labor pool during the 1990s and 2000s resulted in an effective doubling of global labor supply in a short period of time. The sudden abundance of cheap labor depressed real wages from what they otherwise would have been, thus incentivizing firms to use more labor and less capital at the margin. The combination of slower working-age population growth in the advanced economies and a surge in the global labor force resulted in a decline in desired global capital spending. The increase in ex-ante savings and reduction in ex-ante capital spending resulted in a substantial drop in equilibrium global interest rates. The wave of cheap labor also aggravated the trend toward greater inequality in the advanced economies and the downward trend in labor's share of the income pie. A positive labor supply shock should benefit global living standards in the long run, but the adjustment costs related to China's integration into the global economy imposed on the advanced economies were huge and long-lasting. The lingering adjustment phase contributed to greater inequality in the major countries. Management was able to use the threat of outsourcing to gain the upper hand in wage negotiations. Moreover, technology appears to be resulting in faster, wider and deeper degrees of hollowing-out than in previous periods of massive technological change. The result has been a rise in the share of income going to high-income earners in the Advanced Economies, at the expense of low- and middle-income earners. This represents a headwind to growth that requires lower interest rates all along the curve. In other words, firms in the developed world either replaced workers with machinery in areas where technology permitted, or outsourced jobs to lower-wage countries in areas that remained labor-intensive. Both trends undermined labor's bargaining power, depressed labor's share of income, and contributed to inequality. 1 We make the simplifying assumptions that companies do not issue any more debt over the three years, and that EBIT is unchanged, in order to isolate the impact of higher interest rates. 2 The average credit rating for the U.S. is unavailable before 2000 in the Bloomberg Barclays index. However, other data sources confirm the long-term downward trend. 3 Please see The Bank Credit Analyst Special Report "Leverage And Sensitivity To Rising Rates: The Eurozone Corporate Sector," dated May 31, 2018, available at bca.bcaresearch.com 4 Please see Global Investment Strategy Special Reports "1970s-Style Inflation: Could It Happen Again? (Part 1)," dated August 10, 2018 and "1970s-Style Inflation: Could It Happen Again? (Part 2)," dated August 24, 2018, available at gis.bcaresearch.com 5 The lower bound is zero in the U.S., but is in negative territory for those central banks willing to impose negative rates on the banking sector. 6 For more background on the zero bound debate, the usefulness of a large central bank balance sheet and ways to lift r-star, please see The Bank Credit Analyst Special Report "Herding Cats At the Fed," dated October 2016, available at bca.bcaresearch.com 7 Please see The Bank Credit Analyst Special Report "Beware Inflection Points In The Secular Drivers Of Global Bonds," dated April 27, 2017, available at bca.bcaresearch.com 8 The Global Economic Recovery 10 Years After the 2008 Financial Meltdown. IMF World Economic Outlook, October 2018.

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

Highlights Duration: Our Fed Policy Loop provides a framework for understanding last week's equity market correction and its implications for future Fed policy. So far, the equity sell-off is not severe enough to deter the Fed. Maintain below-benchmark portfolio duration. Credit: With the Fed lifting rates and the market still not priced for the likely pace of hikes, it is highly likely that we will witness further periods where corporate spreads and Treasury yields rise in unison. We recommend steps investors can take to insulate their portfolios from this risk. Inflation: The macroeconomic environment remains highly inflationary. The unemployment rate is very low and wage growth is rising. However, recent trends suggest that the year-over-year growth rate in core CPI will stay close to its current level, near the Fed's target, for the next six months. This will not alter the Fed's "gradual" +25 bps per quarter rate hike pace. Feature Chart 1The Second Rate Shock Of 2018 The Second Rate Shock Of 2018 The Second Rate Shock Of 2018 Last week's equity market rout was the second time this year that stocks reacted negatively to a sharp rise in bond yields (Chart 1). As was the case in February, our Fed Policy Loop remains the appropriate framework for understanding the relationship between bond yields and the stock market (Chart 2).1 It can be explained as follows: Chart 2The Fed Policy Loop Rate Shock Rate Shock Step 1: The perception of easy Fed policy fuels strong performance in the stock market. Rising stock prices and "easing financial conditions" cause economic growth to strengthen and sow the seeds of inflation. Step 2: Equity investors catch a whiff of inflation and start to price-in a more restrictive monetary environment. This leads to a stock market correction. Step 3: Falling stock prices and "tightening financial conditions" cause the Fed to downgrade its economic outlook and adopt a more dovish policy stance. Return To Step 1. The Equity Correction For Bond Investors At this juncture, the important question for bond investors is whether financial conditions have tightened enough to prompt a slower pace of rate hikes from the Fed. If so, then it might be appropriate to buy the dip in the bond market. We think such a move would be premature, for two reasons. First, the increase in bond yields that spooked the equity market was concentrated at the long-end of the curve and was fueled by Fed Chairman Powell's comment that the funds rate is "a long way from neutral." A steeper yield curve offsets some of the financial conditions tightening caused by falling stock prices (Chart 3). This is because it signals that monetary policy is becoming more accommodative - the fed funds rate is further below neutral than previously thought. This intuition is confirmed by the bounce in gold, a move that often coincides with an upward rerating of the neutral fed funds rate.2 Chart 3Steeper Curve Will Reassure The Fed Steeper Curve Will Reassure The Fed Steeper Curve Will Reassure The Fed Second, the amount of financial market pain that the Fed can tolerate depends on the economic environment. Our Fed Monitor is an indicator that is designed to signal whether the Fed should be hiking or cutting interest rates (Chart 4). It consists of 44 variables that can be grouped into three categories: Chart 4The BCA Fed Monitor The BCA Fed Monitor The BCA Fed Monitor Economic growth indicators (Chart 4, panel 3). Inflation indicators (Chart 4, panel 4). Financial conditions indicators (Chart 4, bottom panel). The overall Fed Monitor is currently deep in positive territory, signaling that rate hikes are appropriate. This is true despite the fact that the financial conditions component of the monitor has been falling (tightening) since the beginning of the year. Last week's equity market drop will not be reflected in the indicator until the end of the month, so further downside in the financial conditions component is forthcoming. But so far, tighter financial conditions have barely made a dent in the overall Fed Monitor because they have been offset by rising economic growth and stronger inflation. The conclusion is that the Fed is able to tolerate more market pain when growth is strong and inflation is high. Viewed through this lens, it is clear that a lot more market pain is required before the Fed backs away from its +25 bps per quarter rate hike pace. In fact, the Fed likely views some tightening of financial conditions as desirable, as long as the tightening doesn't severely impede the economic outlook. Just last week New York Fed President John Williams said: Normalization of the monetary policy, I think, has the added benefit of reducing somewhat, on the margin, some of the risk of imbalances in financial markets.3 While a few weeks ago, Fed Governor Lael Brainard noted: The past few times unemployment fell to levels as low as those projected over the next year, signs of overheating showed up in financial-sector imbalances rather than in accelerating inflation.4 In other words, the Fed is increasingly cognizant of the fact that higher interest rates might be necessary to prevent excessive risk-taking in financial markets, even if inflation stays well contained near target. Unless financial conditions tighten so much that they cause the reading from our Fed Monitor to hook down, the Fed will be inclined to view the market correction as healthy. It is also important to note that while a large increase in long-maturity Treasury yields prompted last week's stock market action, the short-end of the yield curve didn't move much at all. In fact, overnight index swap forwards show that the market is just barely priced for three rate hikes during the next 12 months. According to our golden rule of bond investing, if you expect the Fed to lift rates by more than what is priced in for the next 12 months, you should keep portfolio duration low.5 Bottom Line: Last week's equity market sell-off is not enough to prompt the Fed to back away from its +25 bps per quarter rate hike pace. Investors should maintain below-benchmark portfolio duration. On The Correlation Between Yields And Spreads It wasn't just the stock market that struggled to digest higher Treasury yields last week. Corporate bond spreads also widened, particularly in the high-yield credit tiers (Chart 5). As with equities, this is the second time in 2018 that credit spreads widened sharply alongside higher Treasury yields. Chart 5Credit Also Struggling With Higher Rates Credit Also Struggling With Higher Rates Credit Also Struggling With Higher Rates Credit spreads and Treasury yields tend to be negatively correlated, a feature that benefits bond investors by reducing the volatility in corporate bond yields and total returns. But, as evidenced by last week's price moves, the correlation does occasionally turn positive. This is particularly damaging during sell-offs when both the rate and spread components of corporate bond yields rise. Chart 6 shows the frequency of negative and positive yield/spread correlations since 1994, using 3-month investment horizons. It shows that yields and spreads were negatively correlated in 64% of 3-month periods. Yields fell alongside tighter spreads in 23% of cases, while yields and spreads rose together only 13% of the time. Chart 6The Correlation Between Yields And Spreads Is Typically Negative Rate Shock Rate Shock Since those periods when both yields and spreads rise in unison are particularly damaging for bond investors, it is worth exploring them in more detail. Table 1 lists all 13 quarters since 1994 when junk spreads and duration-matched Treasury yields rose together. Using the logic of our Fed Policy Loop, we also identify three risk factors that might be associated with those periods. The main idea being that yields and spreads are likely to rise together in periods when the market starts to price-in much more restrictive monetary policy, and an earlier end to the economic recovery. The three risk factors we identify are: Table 1Periods When Both Treasury Yields And Junk Spreads Rose Since 1994 Rate Shock Rate Shock Whether the Fed raised interest rates during the investment horizon. Whether our 12-month Fed Funds Discounter increased during the investment horizon, meaning that the market priced-in a more aggressive near-term rate hike path. Whether the 5-year/5-year forward TIPS breakeven inflation rate rose during the investment horizon. Higher long-dated inflation expectations could cause the Fed to respond with a more restrictive monetary policy. The single most important risk factor is whether the Fed raised rates during the investment horizon. Nine of the 13 episodes coincided with a Fed rate hike, and three of the four episodes that didn't coincide with a rate hike occurred between Q2 2013 and Q4 2015. The fed funds rate was pinned at zero during that period, but the Fed was starting to turn hawkish by backing away from QE and preparing for liftoff. This leaves the second quarter of 2007 as the only true outlier. The Fed did not lift rates during this period, but it is clear that markets were spooked by overly restrictive Fed policy all the same. The 2/10 Treasury slope was only 7 bps at the start of the quarter, signaling that monetary policy was already quite restrictive. Meanwhile, long-dated inflation expectations rose during the quarter and the market went from discounting 60 bps of rate cuts during the next 12 months to only 17 bps. An inflationary shock when monetary policy is already restrictive is an environment where yields and spreads are very likely to rise at the same time. An upward move in our 12-month discounter is also associated with periods of rising yields and spreads in 9 out of 13 cases. This risk factor didn't work in Q4 2005 or Q2 2006, but once again it is quite clear that markets were spooked by overly restrictive monetary policy in those periods. The yield curve was inverted in both of those quarters, and the Fed lifted rates despite an inverted yield curve. That combination sends a clear signal to markets that the Fed is trying to choke off the recovery. The 12-month discounter also failed to send the correct signal in Q3 1999 and Q2 2000. In those cases the culprit appears to be a large jump in long-dated inflation expectations while the Fed was in the midst of a rate hike cycle. Since rate hikes should dampen inflation, rising inflation expectations suggest that rate hikes might need to speed up. Thinking about the current environment, we are very much in the danger zone where yields and spreads could rise at the same time. The Fed is in the midst of a rate hike cycle and the market is still not priced for quarterly rate hikes to continue for the next 12 months. Finally, long-dated TIPS breakeven inflation rates are almost back to the 2.3% to 2.5% range that is consistent with "well-anchored" inflation expectations (Chart 7). The higher long-dated breakevens get, the more likely it is that the Fed will respond forcefully to further increases. Chart 7Almost Re-Anchored Almost Re-Anchored Almost Re-Anchored With all three of our risk factors present, it is highly likely that we will see more episodes where credit spreads widen and Treasury yields rise. The risk will only dissipate once the full extent of the Fed's rate hike cycle is reflected in the Treasury curve, but we are not there yet. While this is not a great environment for bond investors, there are steps investors can take to limit the damage from periods of rising spreads and yields. First, investors should maintain portfolio duration at below-benchmark. Second, while it is too early in the cycle to completely abandon credit, a more defensive posture is advisable. We recommend only a neutral allocation to spread product, focused on the higher-quality credit tiers.6 To the extent possible, investors should also seek to focus their spread exposure at the long-end of the maturity spectrum, while also limiting overall portfolio duration by favoring the short-end of the Treasury curve.7 Inflation Uptrend On Hold Lost in the shuffle amidst last week's market turmoil, the consumer price index (CPI) for September was released and it delivered a soft month-over-month print for the second month in a row. The top panel of Chart 8 shows that the year-over-year trend in core CPI rose rapidly earlier in the year, but now appears to be leveling off. We do not envision a meaningful deceleration in core CPI, but it seems likely that the year-over-year rate of change will stay near current levels for the next six months. Chart 8Core Inflation & Pipeline Pressures Core Inflation & Pipeline Pressures Core Inflation & Pipeline Pressures Our Pipeline Inflation Indicator remains consistent with rising inflationary pressures in the economy, but it has softened of late. This is mostly due to weaker commodity prices (Chart 8, bottom panel). Further, our Base Effects Indicator - based on rates of change in the core CPI that have already been realized - is now consistent with a lower year-over-year core CPI growth rate six months from now (Chart 9).8 Chart 9Expect Year-Over-Year Core CPI To Flatten-Off, Or Even Decline Expect Year-Over-Year Core CPI To Flatten-Off, Or Even Decline Expect Year-Over-Year Core CPI To Flatten-Off, Or Even Decline Looking at the main components of core CPI, the last two monthly prints have been dragged down by the core goods component, with most of the weakness in apparel and used vehicles (Chart 10). This could reverse in the near-term as core goods prices catch up with import prices, which have been rising for some time. However, non-oil import prices have decelerated recently, on the back of a stronger dollar. In other words, any near-term increase in core goods inflation will probably not last very long. Chart 10Core CPI Components Core CPI Components Core CPI Components The core services excluding shelter component continues to have the most potential upside, since it is highly geared to rising wage growth. Shelter inflation, the largest component of core CPI, has been flat for some time and our models suggest this will continue to be the case for the next six months. Bottom Line: The macroeconomic environment remains highly inflationary. The unemployment rate is very low and wage growth is rising. However, recent trends suggest that the year-over-year growth rate in core CPI will stay close to its current level, near the Fed's target, for the next six months. This will not alter the Fed's "gradual" +25 bps per quarter rate hike pace. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see BCA U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com. 2 Please see BCA U.S. Bond Strategy Weekly Report, "A Signal From Gold?" dated May 1, 2018, available at usbs.bcaresearch.com. 3https://www.bloomberg.com/news/articles/2018-10-10/williams-says-fed-rate-hikes-helping-curb-financial-risk-taking 4https://www.federalreserve.gov/newsevents/speech/brainard20180912a.htm 5 Please see BCA U.S. Bond Strategy Special Report, "The Golden Rule Of Bond Investing," dated July 24, 2018, available at usbs.bcaresearch.com. 6 Please see BCA U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty," dated June 19, 2018, available at usbs.bcaresearch.com. 7 Please see BCA U.S. Bond Strategy Weekly Report, "Out Of Sync," dated July 3, 2018, available at usbs.bcaresearch.com. 8 Please see BCA U.S. Bond Strategy Weekly Report, "The Powell Doctrine Emerges," dated September 4, 2018, available at usbs.bcaresearch.com. Fixed Income Sector Performance Recommended Portfolio Specification

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

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

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

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