Corporate Bonds

Highlights Macro outlook: Global growth will continue to decelerate into early next year on the back of brewing EM stresses and an underwhelming policy response from China. Equities: Stay neutral for now, while underweighting EM relative to DM stocks. Within DM, overweight the U.S. in dollar terms. Bonds: Global bond yields may dip in the near term, but the longer-term path is firmly higher. Currencies: The dollar is working off overbought conditions, but will rebound into year-end. EM currencies will suffer the most. Commodities: Favor oil over industrial metals. Precious metals will also remain under pressure until the dollar peaks next year, before beginning a major bull run as inflation accelerates. Feature I. Economic Outlook The Fed Can Hike A Lot More If 2017 was the year of a synchronized global growth recovery, 2018 is turning out to be a year where desynchronization is once again the name of the game. The U.S. economy continues to fire on all cylinders, while much of the rest of the world is struggling to stay afloat. The divergence in economic outcomes has been mirrored in central bank policy. The Fed is now hiking rates once per quarter whereas most other major central banks are still sitting on their hands. How high can U.S. rates go? The answer is a lot higher than investors anticipate. Market participants currently expect the Fed funds rate to rise to 2.37% by the end of this year and 2.84% by the end of 2019. No rate hikes are priced in for 2020 and beyond. The Fed dots are somewhat higher than market expectations (Chart 1). The median dot rises to about 3.4% in 2020-21, but then falls back to 3% over the Fed's longer-run horizon. Both investors and the Fed have apparently bought into Larry Summers' secular stagnation thesis. They seem convinced that rates will not be able to rise above 3% without triggering a recession. While we have a lot of sympathy for Summers' thesis, it must be acknowledged that it is a theory about the long-term determinants of the neutral rate of interest. Over a shorter-term cyclical horizon, many factors can influence the neutral rate. Critically, as discussed last week, most of these factors are pushing it higher: Fiscal policy is extremely stimulative. The IMF estimates that the U.S. cyclically-adjusted budget deficit will reach 6.8% of GDP in 2019. In contrast, the euro area is projected to run a deficit of only 0.8% of GDP (Chart 2). The relatively more expansionary nature of U.S. fiscal policy is one key reason why the Fed can raise rates while the ECB cannot. Chart 1Markets Expect No Fed ##br##Hikes Beyond Next Year 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Chart 2Fiscal Policy Is More Expansionary ##br##In The U.S. Than In The Euro Area Fiscal Policy Is More Expansionary In The U.S. Than In The Euro Area Fiscal Policy Is More Expansionary In The U.S. Than In The Euro Area Credit growth has picked up. After a prolonged deleveraging cycle, private-sector nonfinancial debt is increasing faster than GDP (Chart 3). The recent easing in The Conference Board's Leading Credit Index suggests that this trend will continue (Chart 4). Chart 3U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend Chart 4U.S. Credit Growth Will Remain Strong U.S. Credit Growth Will Remain Strong U.S. Credit Growth Will Remain Strong Wage growth is accelerating. Average hourly earnings surprised on the upside in August, with the year-over-year change rising to a cycle high of 2.9%. This followed a stronger reading in the Employment Cost Index in the second quarter. A simple correlation with the quits rate suggests that there is plenty of upside for wage growth (Chart 5). Faster wage growth will put more money into workers' pockets who will then spend it. The savings rate has scope to fall. The personal savings rate currently stands at 6.7%, more than two percentage points higher than what one would expect based on the current level of household net worth (Chart 6). If the savings rate were to fall by two points over the next two years, it would add 1.5% of GDP to aggregate demand. Chart 5The Quits Rate Is Signaling Upside For Wage Growth The Quits Rate Is Signaling Upside For Wage Growth The Quits Rate Is Signaling Upside For Wage Growth Chart 6The Personal Savings Rate Has Room To Fall 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back A back-of-the-envelope calculation suggests that these cyclical factors will permit the Fed to raise rates to 5% by 2020, almost double what the market is discounting.1 An Absence Of Major Financial Imbalances Will Allow The Fed To Keep Raising Rates The past three recessions were all caused by financial market overheating rather than economic overheating. The 1991 recession was mainly the consequence of the Savings and Loan crisis, compounded by the spike in oil prices leading up to the Gulf War. The 2001 recession stemmed from the dotcom bust. The Great Recession was triggered by the housing bust. Today, it is difficult to point to any clear imbalances in the economy. True, housing activity has been weak for much of the year. However, unlike in 2006, the home vacancy rate stands near record-low levels (Chart 7). Tight supply will limit downside risks to both construction and home prices. On the demand side, low unemployment, high consumer confidence, and a rebound in the rate of new household formation should help the sector. Despite elevated home prices in some markets, the average monthly payment that homeowners must make to service their mortgage is quite low by historic standards (Chart 8). The quality of mortgage lending has also been very high over the past decade, which reduces the risk of a sudden credit crunch (Chart 9). Chart 7Low Housing Inventories Will Support Home Prices And Construction Low Housing Inventories Will Support Home Prices And Construction Low Housing Inventories Will Support Home Prices And Construction Chart 8Housing Affordabiity Is Not Yet Stretched Housing Affordabiity Is Not Yet Stretched Housing Affordabiity Is Not Yet Stretched Chart 9Mortgage Lenders Are Being Prudent Mortgage Lenders Are Being Prudent Mortgage Lenders Are Being Prudent Unlike housing debt, there are more reasons to be concerned about corporate debt. The ratio of corporate debt-to-GDP has risen to record-high levels. So-called "covenant-lite" loans now make up the bulk of corporate leveraged loan issuance. While there is no doubt that the corporate debt market is the weakest link in the U.S. financial sector, some perspective is in order. U.S. corporate debt levels are quite low by global standards. Corporate debt in the euro area is more than 30 points higher as a percent of GDP than in the United States (Chart 10). Moreover, the interest coverage ratio - EBIT divided by interest expense - for U.S. corporates is still above its historic average (Chart 11). While this ratio will fall as interest rates rise, this will not happen very quickly. Most U.S. corporate debt is at fixed rates and average maturities have been rising. This reduces both rollover risk and the sensitivity of debt-servicing costs to higher short-term rates. An increasing share of U.S. corporate debt is held by non-leveraged investors. Bank loans account for only 18% of nonfinancial corporate sector debt, down from 40% in 1980 (Chart 12). This is important, because what makes a spike in corporate defaults so damaging is not the direct impact this has on the economy, but the second-round effects rising defaults have on financial sector stability. Chart 10U.S. Corporate Debt Not That High By Global Standards U.S. Corporate Debt Not That High By Global Standards U.S. Corporate Debt Not That High By Global Standards Chart 11Interest Coverage Ratio Is Above Its Historic Average Interest Coverage Ratio Is Above Its Historic Average Interest Coverage Ratio Is Above Its Historic Average Chart 12Banks Have Been Reducing Their Exposure To The Corporate Sector Banks Have Been Reducing Their Exposure To The Corporate Sector Banks Have Been Reducing Their Exposure To The Corporate Sector In any case, we already had a dress rehearsal for what a corporate debt scare might look like. Credit spreads spiked in 2015. Default rates rose, but the knock-on effects to the financial system were minimal. This suggests that corporate America could handle a fair bit of monetary tightening without buckling under the pressure. The Fed And The Dollar If the Fed is able to raise rates substantially more than the market is discounting while most central banks cannot, the short-term interest rate spread between the U.S. and its trading partners is likely to widen. History suggests that this will produce a stronger dollar (Chart 13). Chart 13Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials Some have speculated that the Trump administration will intervene in the foreign-exchange market in order to drive down the value of the greenback. We doubt this will happen, but even if such interventions were to occur, they would not be successful. Presumably, currency interventions would take the form of purchases of foreign exchange, financed through the issuance of Treasurys. The purchase of foreign currency would release U.S. dollars into the financial system, but the sale of Treasury securities would suck those dollars back out of the system. The net result would be no change in the volume of U.S. dollars in circulation - what economists call a "sterilized" intervention. Both economic theory and years of history show that sterilized interventions do not have lasting effects on currency values. The Fed could, of course, provide funding for the Treasury's purchases of foreign exchange, leading to an increase in the monetary base. This would be tantamount to an unsterilized intervention. However, such a deliberate attempt to weaken the dollar by expanding the money supply would fly in the face of the Fed's efforts to cool growth by tightening financial conditions. We highly doubt the Fed's current leadership would go along with this. Emerging Markets In The Crosshairs The combination of rising U.S. rates and a stronger dollar is bad news for emerging markets. Eighty percent of EM foreign-currency debt is denominated in dollars. Outside of China, EM dollar debt is now back to late-1990s levels, both as a share of GDP and exports (Chart 14). The wave of EM local-currency debt issued in recent years only complicates matters. If EM central banks raise rates to defend their currencies, this could imperil economic growth and make it difficult for local-currency borrowers to pay back their loans. Rather than hiking rates, some EM central banks may simply choose to inflate away debt. Consider the case of Brazil. The fiscal deficit stands at nearly 8% of GDP and government debt has soared from 60% of GDP in 2013 to 84% of GDP at present (Chart 15). Ninety percent of Brazilian sovereign debt is denominated in reais. The Brazilian government won't default on its debt per se. However, if push comes to shove, Brazil's central bank can always step in to buy government bonds, effectively monetizing the fiscal deficit. This could cause the real to weaken much more than it already has. Chart 14EM Dollar Debt Is High EM Dollar Debt Is High EM Dollar Debt Is High Chart 15Brazil's Perilous Fiscal Position Brazil's Perilous Fiscal Position Brazil's Perilous Fiscal Position Chinese Stimulus To The Rescue? When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. The stimulus measures in 2015 followed an even greater wave of stimulus in 2009. While these stimulus measures invigorated China's economy and helped put a floor under global growth, they came at a price: China's debt-to-GDP ratio has swollen from 140% in 2008 to over 250% at present, which has endangered financial stability (Chart 16). Excess capacity has also increased. This can be seen in the dramatic rise in the capital-to-output ratio. It can also be seen in the fact that the rate of return on assets within the Chinese state-owned enterprise sector, which has been the main source of rising corporate leverage, has fallen below borrowing costs (Chart 17). Chart 16China: Debt And Capital Accumulation Went Hand In Hand China: Debt And Capital Accumulation Went Hand In Hand China: Debt And Capital Accumulation Went Hand In Hand Chart 17China: Rate Of Return On Assets Below Borrowing Costs For SOEs China: Rate Of Return On Assets Below Borrowing Costs For SOEs China: Rate Of Return On Assets Below Borrowing Costs For SOEs Chinese banks are being told that they must lend more money to support the economy, while ensuring that their loans do not turn sour. Unfortunately, that is becoming an impossible feat. The Chinese economy produces too much and spends too little. The result is excess savings, epitomized most clearly in a national savings rate of 46% (Chart 18). As a matter of arithmetic, national savings must be transformed either into domestic investment or exported abroad via a current account surplus. Now that the former strategy has run into diminishing returns, the Chinese authorities will need to concentrate on the latter. This will require a larger current account surplus which, in turn, will necessitate a relatively cheap currency. Above-average productivity growth has pushed up the fair value of China's real exchange rate over time. However, the currency still looks expensive relative to its long-term trend line (Chart 19). Pushing down the value of the yuan against the dollar will not be that difficult. Chart 20 shows that USD/CNY has moved broadly in line with the one-year swap spread between the U.S. and China. The spread was about 3% earlier this year. Today, it stands at only 0.6%. As the Fed continues to raise rates, the spread will narrow further, taking the yuan down with it. Chart 18China Saves A Lot China Saves A Lot China Saves A Lot Chart 19The RMB Is Still Quite Strong The RMB Is Still Quite Strong The RMB Is Still Quite Strong Chart 20USD/CNY Has Tracked China-U.S. Interest Rate Differentials USD/CNY Has Tracked China-U.S. Interest Rate Differentials USD/CNY Has Tracked China-U.S. Interest Rate Differentials Unlike standard Chinese fiscal/credit easing, a stimulus strategy focused on weakening the yuan would hurt other emerging markets by undermining their competitiveness in relation to China. A weaker yuan would also make it more expensive for Chinese companies to import natural resources, thus putting downward pressure on commodity prices. The Euro Area: Back In The Slow Lane After putting in a strong performance in 2017, the economy in the euro area has struggled to maintain momentum this year. Growth is still above trend, but the overall tone of the data has been lackluster at best, with the risks to growth increasingly tilted to the downside. Weaker growth in China and other emerging markets certainly has not helped. However, much of the problem lies closer to home. Bank credit remains the lifeblood of the euro area economy. The 12-month credit impulse - defined as the change in credit growth from one 12-month period to the next - tends to track GDP growth (Chart 21).2 Euro area credit growth accelerated over the course of 2017, but has been broadly stable this year. As a result, the credit impulse has fallen, taking GDP growth down with it. It will be difficult for euro area GDP growth to increase unless credit growth starts rising again. So far, there is little sign that this is about to happen. According to the latest euro area bank lending survey, while banks continue to ease standards for business loans, they are doing so at a slower pace than in the past. A net 3% of banks eased lending standards in the second quarter, compared to 8% in the first quarter. Loan demand growth has been fairly stable. This suggests that loan growth will remain positive, but is unlikely to increase much from current levels. Worries about the health of European banks will further constrain credit growth. European banks in general, and Spanish banks in particular, have significant exposure to the most vulnerable emerging markets (Chart 22). Chart 21Euro Area Credit Growth Has Flatlined Euro Area Credit Growth Has Flatlined Euro Area Credit Growth Has Flatlined Chart 22Spain Most Exposed To Vulnerable EMs 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Concerns about the ability of the Italian government to service its debt obligations will also restrain bank lending. Investors breathed a sigh of relief last month when the Italian government signaled a greater willingness to pare back next year's proposed budget deficit, in accordance with the dictates of the European Commission. Tensions remain, however, as evidenced by the fact that the ten-year spread between BTPs and German bunds is still 120 basis points higher than in April (Chart 23). The European political establishment is terrified of the rise in populism across the region and would love nothing more than to see Italy's populist parties implode. This means that any help from the ECB and the European Commission will only arrive once a full-fledged crisis is underway. Anyway, it is far from clear that a smaller budget deficit would actually translate into a lower government debt-to-GDP ratio. Like China, Italy also has a private sector that saves too much and spends too little. A shrinking population has reduced the need for firms to invest in new capacity. The prior government's pension cuts have also incentivized people to save more for their retirement. The result is a private sector savings-investment surplus that stood at 5% of GDP in 2017 compared to close to breakeven a decade ago (Chart 24). Chart 23Italian/Bund Spreads Signal Lingering Fiscal Strain Italian/Bund Spreads Signal Lingering Fiscal Strain Italian/Bund Spreads Signal Lingering Fiscal Strain Chart 24Italy: Private Sector Saves Too Much And Spends Too Little Italy: Private Sector Saves Too Much And Spends Too Little Italy: Private Sector Saves Too Much And Spends Too Little Unlike Germany, Italy cannot export its excess production because it does not have a hypercompetitive economy. Nor does it have the ability to devalue its currency to gain a quick competitiveness boost. This means that the Italian government has to absorb excess private-sector savings with its own dissavings - a fancy way of saying that it has to run a large budget deficit. This has effectively been Japan's strategy for over two decades. However, unlike Japan, Italy does not have a lender of last resort that can unconditionally buy government debt. This raises the risk that Italy's debt woes will resurface, either because the government abandons austerity measures, or because the lack of fiscal support causes nominal GDP to stagnate, making it all but impossible for the country to outgrow its debt burden. Receding Policy Puts The discussion above suggests that many of the "policy puts" that investors have relied on are in the process of having their strike price marked down to deeper out-of-the-money levels. Yes, the Fed will ease off on rate hikes if U.S. growth is at risk of stalling out completely. However, now that the labor market has reached full employment, the Fed will welcome modestly slower growth. Remember that there has never been a case in the post-war era where the three-month average of the unemployment rate has risen by more than a third of a percentage point without a recession taking place (Chart 25). The further the unemployment rate falls below NAIRU, the more difficult it will be for the Fed to achieve the proverbial soft landing. Chart 25Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Likewise, the "China stimulus put" - the presumption that most investors have that the Chinese authorities will launch a barrage of fiscal and credit easing at the first sign of slower growth - has become less reliable in light of the government's competing objectives namely reducing debt growth and excess capacity. The same goes for the "ECB put." Yes, the ECB will bail out Italy if the entire European project appears at risk. But spreads may need to blow out before the cavalry arrives. Meanwhile, just as the aforementioned policy puts are receding, new policy risks are rising to the fore, chief among them protectionism. We expect the trade war to heat up, with the Trump administration increasingly directing its ire at China. Trump's macroeconomic policies are completely at odds with his trade agenda. Fiscal stimulus will boost aggregate demand, which will suck in more imports. An overheated economy will prompt the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. All this will result in a wider trade deficit. What will Trump tell voters two years from now when he is campaigning in Michigan and Ohio about why the trade deficit has widened rather than narrowed under his watch? Will he blame himself or Beijing? No trophy for getting that answer right. II. Financial Markets Global Equities The combination of slower global growth, rising economic vulnerabilities outside the U.S., and a more challenging policy environment caused us to downgrade our view on global equities from overweight to neutral in June,3 while reiterating our preference for developed market equities relative to EM stocks. For now, we are comfortable with our bearish view towards emerging market stocks. While EM equities have cheapened, they are not yet at washed out levels (Chart 26). Bottom fishers still abound, as evidenced by the fact that the number of shares outstanding in the MSCI iShares Turkish ETF has almost tripled since early April (Chart 27). Chart 26EM Assets: Valuations Not Yet At Washed Out Levels EM Assets: Valuations Not Yet At Washed Out Levels EM Assets: Valuations Not Yet At Washed Out Levels Chart 27EM Bottom Fishers Still Abound EM Bottom Fishers Still Abound EM Bottom Fishers Still Abound At some point - probably in the first half of next year - investors will liquidate their remaining bullish EM bets. At that point, EM stocks will rebound. European and Japanese equities should also start to outperform the U.S., given their more cyclical nature. As far as the absolute direction of the S&P 500 is concerned, the next few months could be challenging. U.S. stocks have been able to decouple from those in the rest of the world, but this state of affairs may not last. Recall that the S&P 500 fell by 22% peak-to-trough between July 20 and October 8, 1998, in what otherwise was a massive bull market. We do not know if there is another Long-Term Capital Management lurking around the corner, but if there is, a temporary selloff in U.S. stocks may be hard to avoid. Such a selloff would present a buying opportunity over a horizon of 12-to-18 months. If we are correct that cyclical forces have lifted the neutral rate of interest, it will take a while for monetary policy to reach restrictive territory. This means that both fiscal and monetary policy will stay accommodative at least for the next 18 months. As such, the S&P 500 may not peak until 2020. Appendix A - Chart I presents a stylized diagram of where we think global equities are going. It incapsulates three phases: 1) a challenging period over the next six months, driven by EM weakness; 2) a blow-off rally in equities starting in the middle of next year; 3) and finally, a recession-induced bear market beginning in late-2020. Appendix B also presents our valuation charts, which highlight that long-term return prospects are better outside the United States. Fixed Income After advocating for a long duration strategy for much of the post-crisis recovery, BCA declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016, the very same day that the 10-year U.S. Treasury yield hit a record closing low of 1.37%. Cyclically and structurally, we continue to expect U.S. bond yields to rise more than the market is discounting. As noted above, the Fed is underestimating how high rates will need to go before they reach restrictive territory. This means that the Fed will end up behind the curve in normalizing monetary policy, causing the economy to overheat and inflation to rise above the Fed's comfort zone. Chart 28Bond Sentiment Is Extremely Bearish Bond Sentiment Is Extremely Bearish Bond Sentiment Is Extremely Bearish Granted, the Fed is willing to tolerate a modest inflation overshoot. However, a core PCE reading above 2.3%, which is at the top end of the range of the Fed's own forecast, would prompt the Fed to expedite the pace of rate hikes. A bear flattening of the yield curve - a situation where long-term yields rise, but short-term rates go up even more - would be highly likely in that environment. Over a shorter-term horizon spanning the next six months, the outlook for yields is more benign. The combination of a stronger dollar, slower global growth, and flight-to-quality flows into the Treasury market from vulnerable emerging markets can cap yields. Add to this the fact that sentiment towards bonds is currently extremely bearish (Chart 28), and a temporary countertrend decline in yields becomes quite probable. Developed market bond yields in general are likely to follow the direction of U.S. yields, both on the upside and the downside, but in a more muted manner. Outside the periphery, euro area yields have less scope to fall in the near term given that they are already so low. European yields also have less room to rise once global growth bottoms next year because the neutral rate of interest is much lower in the euro area than in the United States. Ironically, a more dovish ECB would help reduce Italian bond yields, as higher inflation is critical for increasing Italian nominal GDP. Since labor market slack is still elevated in Italy, continued monetary stimulus would also lift wages in core Europe more than in Italy, helping to boost Italy's competitiveness relative to the rest of the euro area. Japanese yields have plenty of scope to rise over the long haul. An aging population is pushing more people into retirement, which will cause the national savings rate to fall further. A decline in the savings pool will increase the neutral rate of interest in Japan. Instead of raising the policy rate, the Japanese authorities will let the economy overheat, generating inflation in the process. This will cause the yield curve to steepen, particularly at the very long end (e.g., beyond 10 years) which is the part of the yield curve that is the least susceptible to the BoJ's yield curve control regime. We are positioned for this outcome through our short 20-year JGB/long 5-year JGB trade recommendation. Appendix A - Chart II shows our expectations for the major government bond markets over the coming years. Turning to credit markets, high-yield credit typically underperforms in the latter innings of business-cycle expansions, a period when the Fed is raising rates. Thus, while we do not think that U.S. corporate debt levels will be a major source of systemic financial risk for the broader economy, this is hardly a reason to be overweight spread-product. A more cautious stance towards credit outside the U.S. is also warranted. Currencies And Commodities The dollar is working off overbought conditions, but will rebound into year-end, as EM tensions intensify and hopes of a massive credit/fiscal-fueled Chinese stimulus package fizzle. EM currencies will weaken the most against the dollar over the next three-to-six months, but the euro and, to a lesser extent, the yen, will also come under pressure. Granted, the dollar is no longer a cheap currency, but if long-term interest rate differentials stay anywhere close to current levels, the greenback will remain well supported. Consider the dollar's value against the euro. Thirty-year U.S. Treasurys currently yield 3.20% while 30-year German bunds yield 1.12%, a difference of 208 basis points. Even if one allows for the fact that investors expect euro area inflation to be lower than in the U.S. over the next 30 years, EUR/USD would need to trade at a measly 82 cents today in order to compensate German bund holders for the inferior yield they will receive.4 We do not expect EUR/USD to get down to that level, but a descent into the $1.10-to-$1.12 range over the next six months is probable. Sterling will remain hostage to Brexit negotiations. It is impossible to know how talks will evolve, but our bias is to take a somewhat pound-positive view. The main reason is that support for Brexit has faded (Chart 29). Opinion polls suggest that if a referendum were held again, the "bremain" side would almost certainly prevail. Lacking public support for leaving the EU, it is unlikely that British negotiators could simply walk away from the table. This reduces the odds of a "hard Brexit" outcome. Indeed, a second referendum that leads to a "no-Brexit" verdict remains a distinct possibility. The combination of slower global growth and a resurgent dollar is likely to hurt commodity prices. Industrial metals are more vulnerable than oil. China consumes around half of all the copper, nickel, aluminum, zinc, and iron ore produced around the world (Chart 30). In contrast, China represents less than 15% of global oil demand. Chart 29When Bremorse Sets In When Bremorse Sets In When Bremorse Sets In Chart 30China Is A More Dominant Consumer Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil The supply backdrop for oil is also more favorable than for metals. Not only are Saudi Arabia and Russia maintaining production discipline, but U.S. sanctions against Iran threaten to weigh on global crude supply. Further reduction in Venezuela's oil output, as well as potential disruptions to Libyan or Iraqi exports, could also boost oil prices. The superior outlook for oil over metals means we prefer the Canadian dollar relative to the Aussie dollar. While AUD/CAD has weakened in recent months, the Aussie dollar is still somewhat expensive against the loonie based on our long-term valuation model (Chart 31). We also see an increasing chance that Canada will negotiate a revamped trade deal with the U.S., as Trump focuses his attention more on China. Should this happen, it will remove the NAFTA break-up risk discount embedded in the Canadian dollar. Finally, a few words on precious metals. Precious metals typically struggle during periods when the dollar is appreciating (Chart 32). Consequently, we would not be eager buyers of gold or other precious metals until the dollar peaks, most likely around the middle of next year. As inflation starts to accelerate in late-2019 and in 2020, gold will finally move decisively higher. Chart 31Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar Chart 32Gold Won't Shine Until The Dollar Peaks Gold Won't Shine Until The Dollar Peaks Gold Won't Shine Until The Dollar Peaks Appendix A - Chart III and Chart IV present an illustration of where the major currencies and commodities are heading. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Depending on which specification of the Taylor rule one uses, a one percent of GDP increase in aggregate demand will increase the neutral rate of interest by half a point (John Taylor's original specification) or by a full point (Janet Yellen's preferred specification). Fiscal policy is currently about 3% of GDP too stimulative compared to a baseline where government debt-to-GDP is stable over time. Assuming a fiscal multiplier of 0.5, fiscal policy is thus boosting aggregate demand by 1.5% of GDP. Nonfinancial private credit has increased by an average of 1.5 percentage points of GDP per year since 2016. Assuming that every additional one dollar of credit increases aggregate demand by 50 cents, the revival in credit growth is raising aggregate demand by 0.75% of GDP, compared to a baseline where credit-to-GDP is flat. The labor share of income has increased by 1.25% of GDP from its lows in 2015. Assuming that every one dollar shift in income from capital to labor boosts overall spending on net by 20 cents, this would have raised aggregate demand by 0.25% of GDP. Lastly, if the personal savings rate falls by two points over the next two years, this would raise aggregate demand by 1.5% of GDP. Taken together, these factors are boosting the neutral rate by anywhere from 2% (Taylor's specification) to 4% (Yellen's specification). This is obviously a lot, and easily overwhelms other factors such as a stronger dollar that may be weighing on the neutral rate. 2 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. Euro area private-sector credit growth accelerated from -2.6% in May 2014 to 3.1% in March 2017, but has been broadly flat ever since. Hence, the credit impulse has dropped. 3 Please see Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. 4 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The annual inflation differential of 0.47% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.52 after 30 years. If one assumes that the euro reaches that level by then, the common currency would need to trade at 1.52/(1.0208)^30=0.82 today. Appendix A Appendix A Chart IMarket Outlook: Equities 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix A Chart IIMarket Outlook: Bonds 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix A Chart IIIMarket Outlook: Currencies 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix A Chart IVMarket Outlook: Commodities 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix B Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Macro outlook: Global growth will continue to decelerate into early next year on the back of brewing EM stresses and an underwhelming policy response from China. Equities: Stay neutral for now, while underweighting EM relative to DM stocks. Within DM, overweight the U.S. in dollar terms. Bonds: Global bond yields may dip in the near term, but the longer-term path is firmly higher. Currencies: The dollar is working off overbought conditions, but will rebound into year-end. EM currencies will suffer the most. Commodities: Favor oil over industrial metals. Precious metals will also remain under pressure until the dollar peaks next year, before beginning a major bull run as inflation accelerates. Feature I. Economic Outlook The Fed Can Hike A Lot More If 2017 was the year of a synchronized global growth recovery, 2018 is turning out to be a year where desynchronization is once again the name of the game. The U.S. economy continues to fire on all cylinders, while much of the rest of the world is struggling to stay afloat. The divergence in economic outcomes has been mirrored in central bank policy. The Fed is now hiking rates once per quarter whereas most other major central banks are still sitting on their hands. How high can U.S. rates go? The answer is a lot higher than investors anticipate. Market participants currently expect the Fed funds rate to rise to 2.37% by the end of this year and 2.84% by the end of 2019. No rate hikes are priced in for 2020 and beyond. The Fed dots are somewhat higher than market expectations (Chart I-1). The median dot rises to about 3.4% in 2020-21, but then falls back to 3% over the Fed's longer-run horizon. Both investors and the Fed have apparently bought into Larry Summers' secular stagnation thesis. They seem convinced that rates will not be able to rise above 3% without triggering a recession. While we have a lot of sympathy for Summers' thesis, it must be acknowledged that it is a theory about the long-term determinants of the neutral rate of interest. Over a shorter-term cyclical horizon, many factors can influence the neutral rate. Critically, most of these factors are pushing it higher: Fiscal policy is extremely stimulative. The IMF estimates that the U.S. cyclically-adjusted budget deficit will reach 6.8% of GDP in 2019. In contrast, the euro area is projected to run a deficit of only 0.8% of GDP (Chart I-2). The relatively more expansionary nature of U.S. fiscal policy is one key reason why the Fed can raise rates while the ECB cannot. Chart I-1Markets Expect No Fed Hikes Beyond Next Year October 2018 October 2018 Chart I-2Fiscal Policy Is More Expansionary In ##br##The U.S. Than In The Euro Area Fiscal Policy Is More Expansionary In The U.S. Than In The Euro Area Fiscal Policy Is More Expansionary In The U.S. Than In The Euro Area Credit growth has picked up. After a prolonged deleveraging cycle, private-sector nonfinancial debt is increasing faster than GDP (Chart I-3). The recent easing in The Conference Board's Leading Credit Index suggests that this trend will continue (Chart I-4). Chart I-3U.S. Private-Sector Nonfinancial Debt Is ##br##Rising At Close To Its Historic Trend U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend Chart I-4U.S. Credit Growth Will Remain Strong U.S. Credit Growth Will Remain Strong U.S. Credit Growth Will Remain Strong Wage growth is accelerating. Average hourly earnings surprised on the upside in August, with the year-over-year change rising to a cycle high of 2.9%. This followed a stronger reading in the Employment Cost Index in the second quarter. A simple correlation with the quits rate suggests that there is plenty of upside for wage growth (Chart I-5). Faster wage growth will put more money into workers' pockets who will then spend it. The savings rate has scope to fall. The personal savings rate currently stands at 6.7%, more than two percentage points higher than what one would expect based on the current level of household net worth (Chart I-6). If the savings rate were to fall by two points over the next two years, it would add 1.5% of GDP to aggregate demand. Chart I-5The Quits Rate Is Signaling Upside For Wage Growth The Quits Rate Is Signaling Upside For Wage Growth The Quits Rate Is Signaling Upside For Wage Growth Chart I-6The Personal Savings Rate Has Room To Fall October 2018 October 2018 A back-of-the-envelope calculation suggests that these cyclical factors will permit the Fed to raise rates to 5% by 2020, almost double what the market is discounting.1 An Absence Of Major Financial Imbalances Will Allow The Fed To Keep Raising Rates The past three recessions were all caused by financial market overheating rather than economic overheating. The 1991 recession was mainly the consequence of the Savings and Loan crisis, compounded by the spike in oil prices leading up to the Gulf War. The 2001 recession stemmed from the dotcom bust. The Great Recession was triggered by the housing bust. Today, it is difficult to point to any clear imbalances in the economy. True, housing activity has been weak for much of the year. However, unlike in 2006, the home vacancy rate stands near record-low levels (Chart I-7). Tight supply will limit downside risks to both construction and home prices. On the demand side, low unemployment, high consumer confidence, and a rebound in the rate of new household formation should help the sector. Despite elevated home prices in some markets, the average monthly payment that homeowners must make to service their mortgage is quite low by historic standards (Chart I-8). The quality of mortgage lending has also been very high over the past decade, which reduces the risk of a sudden credit crunch (Chart I-9). Chart I-7Low Housing Inventories Will Support ##br##Home Prices And Construction Low Housing Inventories Will Support Home Prices And Construction Low Housing Inventories Will Support Home Prices And Construction Chart I-8Housing Affordabiity Is Not Yet Stretched Housing Affordabiity Is Not Yet Stretched Housing Affordabiity Is Not Yet Stretched Chart I-9Mortgage Lenders Are Being Prudent Mortgage Lenders Are Being Prudent Mortgage Lenders Are Being Prudent Unlike housing debt, there are more reasons to be concerned about corporate debt. The ratio of corporate debt-to-GDP has risen to record-high levels. So-called "covenant-lite" loans now make up the bulk of corporate leveraged loan issuance. While there is no doubt that the corporate debt market is the weakest link in the U.S. financial sector, some perspective is in order. U.S. corporate debt levels are quite low by global standards. Corporate debt in the euro area is more than 30 points higher as a percent of GDP than in the United States (Chart I-10). Moreover, the interest coverage ratio - EBIT divided by interest expense - for U.S. corporates is still above its historic average (Chart I-11). While this ratio will fall as interest rates rise, this will not happen very quickly. Most U.S. corporate debt is at fixed rates and average maturities have been rising. This reduces both rollover risk and the sensitivity of debt-servicing costs to higher short-term rates. Chart I-10U.S. Corporate Debt Not That High By Global Standards U.S. Corporate Debt Not That High By Global Standards U.S. Corporate Debt Not That High By Global Standards Chart I-11Interest Coverage Ratio Is Above Its Historic Average Interest Coverage Ratio Is Above Its Historic Average Interest Coverage Ratio Is Above Its Historic Average An increasing share of U.S. corporate debt is held by non-leveraged investors. Bank loans account for only 18% of nonfinancial corporate sector debt, down from 40% in 1980 (Chart I-12). This is important, because what makes a spike in corporate defaults so damaging is not the direct impact this has on the economy, but the second-round effects rising defaults have on financial sector stability. In any case, we already had a dress rehearsal for what a corporate debt scare might look like. Credit spreads spiked in 2015. Default rates rose, but the knock-on effects to the financial system were minimal. This suggests that corporate America could handle a fair bit of monetary tightening without buckling under the pressure. The Fed And The Dollar If the Fed is able to raise rates substantially more than the market is discounting while most central banks cannot, the short-term interest rate spread between the U.S. and its trading partners is likely to widen. History suggests that this will produce a stronger dollar (Chart I-13). Chart I-12Banks Have Been Reducing Their ##br##Exposure To The Corporate Sector Banks Have Been Reducing Their Exposure To The Corporate Sector Banks Have Been Reducing Their Exposure To The Corporate Sector Chart I-13Historically, The Dollar Has Moved ##br##In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials Some have speculated that the Trump administration will intervene in the foreign-exchange market in order to drive down the value of the greenback. We doubt this will happen, but even if such interventions were to occur, they would not be successful. Presumably, currency interventions would take the form of purchases of foreign exchange, financed through the issuance of Treasurys. The purchase of foreign currency would release U.S. dollars into the financial system, but the sale of Treasury securities would suck those dollars back out of the system. The net result would be no change in the volume of U.S. dollars in circulation - what economists call a "sterilized" intervention. Both economic theory and years of history show that sterilized interventions do not have lasting effects on currency values. The Fed could, of course, provide funding for the Treasury's purchases of foreign exchange, leading to an increase in the monetary base. This would be tantamount to an unsterilized intervention. However, such a deliberate attempt to weaken the dollar by expanding the money supply would fly in the face of the Fed's efforts to cool growth by tightening financial conditions. We highly doubt the Fed's current leadership would go along with this. Emerging Markets In The Crosshairs The combination of rising U.S. rates and a stronger dollar is bad news for emerging markets. Eighty percent of EM foreign-currency debt is denominated in dollars. Outside of China, EM dollar debt is now back to late-1990s levels, both as a share of GDP and exports (Chart I-14). The wave of EM local-currency debt issued in recent years only complicates matters. If EM central banks raise rates to defend their currencies, this could imperil economic growth and make it difficult for local-currency borrowers to pay back their loans. Rather than hiking rates, some EM central banks may simply choose to inflate away debt. Consider the case of Brazil. The fiscal deficit stands at nearly 8% of GDP and government debt has soared from 60% of GDP in 2013 to 84% of GDP at present (Chart I-15). Ninety percent of Brazilian sovereign debt is denominated in reais. The Brazilian government won't default on its debt per se. However, if push comes to shove, Brazil's central bank can always step in to buy government bonds, effectively monetizing the fiscal deficit. This could cause the real to weaken much more than it already has. Chart I-14EM Dollar Debt Is High EM Dollar Debt Is High EM Dollar Debt Is High Chart I-15Brazil's Perilous Fiscal Position Brazil's Perilous Fiscal Position Brazil's Perilous Fiscal Position Chinese Stimulus To The Rescue? When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. The stimulus measures in 2015 followed an even greater wave of stimulus in 2009. While these stimulus measures invigorated China's economy and helped put a floor under global growth, they came at a price: China's debt-to-GDP ratio has swollen from 140% in 2008 to over 250% at present, which has endangered financial stability (Chart I-16). Excess capacity has also increased. This can be seen in the dramatic rise in the capital-to-output ratio. It can also be seen in the fact that the rate of return on assets within the Chinese state-owned enterprise sector, which has been the main source of rising corporate leverage, has fallen below borrowing costs (Chart I-17). Chart I-16China: Debt And Capital ##br##Accumulation Went Hand In Hand China: Debt And Capital Accumulation Went Hand In Hand China: Debt And Capital Accumulation Went Hand In Hand Chart I-17China: Rate Of Return On Assets ##br##Below Borrowing Costs For SOEs China: Rate Of Return On Assets Below Borrowing Costs For SOEs China: Rate Of Return On Assets Below Borrowing Costs For SOEs Chinese banks are being told that they must lend more money to support the economy, while ensuring that their loans do not turn sour. Unfortunately, that is becoming an impossible feat. Chart I-18China Saves A Lot China Saves A Lot China Saves A Lot The Chinese economy produces too much and spends too little. The result is excess savings, epitomized most clearly in a national savings rate of 46% (Chart I-18). As a matter of arithmetic, national savings must be transformed either into domestic investment or exported abroad via a current account surplus. Now that the former strategy has run into diminishing returns, the Chinese authorities will need to concentrate on the latter. This will require a larger current account surplus which, in turn, will necessitate a relatively cheap currency. Above-average productivity growth has pushed up the fair value of China's real exchange rate over time. However, the currency still looks expensive relative to its long-term trend line (Chart I-19). Pushing down the value of the yuan against the dollar will not be that difficult. Chart I-20 shows that USD/CNY has moved broadly in line with the one-year swap spread between the U.S. and China. The spread was about 3% earlier this year. Today, it stands at only 0.6%. As the Fed continues to raise rates, the spread will narrow further, taking the yuan down with it. Chart I-19The RMB Is Still Quite Strong The RMB Is Still Quite Strong The RMB Is Still Quite Strong Chart I-20USD/CNY Has Tracked China-U.S. Interest Rate Differentials USD/CNY Has Tracked China-U.S. Interest Rate Differentials USD/CNY Has Tracked China-U.S. Interest Rate Differentials Unlike standard Chinese fiscal/credit easing, a stimulus strategy focused on weakening the yuan would hurt other emerging markets by undermining their competitiveness in relation to China. A weaker yuan would also make it more expensive for Chinese companies to import natural resources, thus putting downward pressure on commodity prices. The Euro Area: Back In The Slow Lane After putting in a strong performance in 2017, the economy in the euro area has struggled to maintain momentum this year. Growth is still above trend, but the overall tone of the data has been lackluster at best, with the risks to growth increasingly tilted to the downside. Weaker growth in China and other emerging markets certainly has not helped. However, much of the problem lies closer to home. Bank credit remains the lifeblood of the euro area economy. The 12-month credit impulse - defined as the change in credit growth from one 12-month period to the next - tends to track GDP growth (Chart I-21).2 Euro area credit growth accelerated over the course of 2017, but has been broadly stable this year. As a result, the credit impulse has fallen, taking GDP growth down with it. It will be difficult for euro area GDP growth to increase unless credit growth starts rising again. So far, there is little sign that this is about to happen. According to the latest euro area bank lending survey, while banks continue to ease standards for business loans, they are doing so at a slower pace than in the past. A net 3% of banks eased lending standards in the second quarter, compared to 8% in the first quarter. Loan demand growth has been fairly stable. This suggests that loan growth will remain positive, but is unlikely to increase much from current levels. Worries about the health of European banks will further constrain credit growth. European banks in general, and Spanish banks in particular, have significant exposure to the most vulnerable emerging markets (Chart I-22). Chart I-21Euro Area Credit Growth Has Flatlined Euro Area Credit Growth Has Flatlined Euro Area Credit Growth Has Flatlined Chart I-22Spain Most Exposed To Vulnerable EMs October 2018 October 2018 Concerns about the ability of the Italian government to service its debt obligations will also restrain bank lending. Investors breathed a sigh of relief last month when the Italian government signaled a greater willingness to pare back next year's proposed budget deficit, in accordance with the dictates of the European Commission. Tensions remain, however, as evidenced by the fact that the ten-year spread between BTPs and German bunds is still 120 basis points higher than in April (Chart I-23). The European political establishment is terrified of the rise in populism across the region and would love nothing more than to see Italy's populist parties implode. This means that any help from the ECB and the European Commission will only arrive once a full-fledged crisis is underway. Anyway, it is far from clear that a smaller budget deficit would actually translate into a lower government debt-to-GDP ratio. Like China, Italy also has a private sector that saves too much and spends too little. A shrinking population has reduced the need for firms to invest in new capacity. The prior government's pension cuts have also incentivized people to save more for their retirement. The result is a private sector savings-investment surplus that stood at 5% of GDP in 2017 compared to close to breakeven a decade ago (Chart I-24). Chart I-23Italian/Bund Spreads Signal Lingering Fiscal Strain Italian/Bund Spreads Signal Lingering Fiscal Strain Italian/Bund Spreads Signal Lingering Fiscal Strain Chart I-24Italy: Private Sector Saves Too Much And Spends Too Little Italy: Private Sector Saves Too Much And Spends Too Little Italy: Private Sector Saves Too Much And Spends Too Little Unlike Germany, Italy cannot export its excess production because it does not have a hypercompetitive economy. Nor does it have the ability to devalue its currency to gain a quick competitiveness boost. This means that the Italian government has to absorb excess private-sector savings with its own dissavings - a fancy way of saying that it has to run a large budget deficit. This has effectively been Japan's strategy for over two decades. However, unlike Japan, Italy does not have a lender of last resort that can unconditionally buy government debt. This raises the risk that Italy's debt woes will resurface, either because the government abandons austerity measures, or because the lack of fiscal support causes nominal GDP to stagnate, making it all but impossible for the country to outgrow its debt burden. Receding Policy Puts The discussion above suggests that many of the "policy puts" that investors have relied on are in the process of having their strike price marked down to deeper out-of-the-money levels. Yes, the Fed will ease off on rate hikes if U.S. growth is at risk of stalling out completely. However, now that the labor market has reached full employment, the Fed will welcome modestly slower growth. Remember that there has never been a case in the post-war era where the three-month average of the unemployment rate has risen by more than a third of a percentage point without a recession taking place (Chart I-25). The further the unemployment rate falls below NAIRU, the more difficult it will be for the Fed to achieve the proverbial soft landing. Chart I-25Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Likewise, the "China stimulus put" - the presumption that most investors have that the Chinese authorities will launch a barrage of fiscal and credit easing at the first sign of slower growth - has become less reliable in light of the government's competing objectives namely reducing debt growth and excess capacity. The same goes for the "ECB put." Yes, the ECB will bail out Italy if the entire European project appears at risk. But spreads may need to blow out before the cavalry arrives. Meanwhile, just as the aforementioned policy puts are receding, new policy risks are rising to the fore, chief among them protectionism. We expect the trade war to heat up, with the Trump administration increasingly directing its ire at China. Trump's macroeconomic policies are completely at odds with his trade agenda. Fiscal stimulus will boost aggregate demand, which will suck in more imports. An overheated economy will prompt the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. All this will result in a wider trade deficit. What will Trump tell voters two years from now when he is campaigning in Michigan and Ohio about why the trade deficit has widened rather than narrowed under his watch? Will he blame himself or Beijing? No trophy for getting that answer right. II. Financial Markets Global Equities The combination of slower global growth, rising economic vulnerabilities outside the U.S., and a more challenging policy environment caused us to downgrade our view on global equities from overweight to neutral in June,3 while reiterating our preference for developed market equities relative to EM stocks. For now, we are comfortable with our bearish view towards emerging market stocks. While EM equities have cheapened, they are not yet at washed out levels (Chart I-26). Bottom fishers still abound, as evidenced by the fact that the number of shares outstanding in the MSCI iShares Turkish ETF has almost tripled since early April (Chart I-27). Chart I-26EM Assets: Valuations Not Yet At Washed Out Levels EM Assets: Valuations Not Yet At Washed Out Levels EM Assets: Valuations Not Yet At Washed Out Levels Chart I-27EM Bottom Fishers Still Abound EM Bottom Fishers Still Abound EM Bottom Fishers Still Abound At some point - probably in the first half of next year - investors will liquidate their remaining bullish EM bets. At that point, EM stocks will rebound. European and Japanese equities should also start to outperform the U.S., given their more cyclical nature. As far as the absolute direction of the S&P 500 is concerned, the next few months could be challenging. U.S. stocks have been able to decouple from those in the rest of the world, but this state of affairs may not last. Recall that the S&P 500 fell by 22% peak-to-trough between July 20 and October 8, 1998, in what otherwise was a massive bull market. We do not know if there is another Long-Term Capital Management lurking around the corner, but if there is, a temporary selloff in U.S. stocks may be hard to avoid. Such a selloff would present a buying opportunity over a horizon of 12-to-18 months. If we are correct that cyclical forces have lifted the neutral rate of interest, it will take a while for monetary policy to reach restrictive territory. This means that both fiscal and monetary policy will stay accommodative at least for the next 18 months. As such, the S&P 500 may not peak until 2020. Appendix A - Chart I presents a stylized diagram of where we think global equities are going. It incapsulates three phases: 1) a challenging period over the next six months, driven by EM weakness; 2) a blow-off rally in equities starting in the middle of next year; 3) and finally, a recession-induced bear market beginning in late-2020. Appendix B also presents our valuation charts, which highlight that long-term return prospects are better outside the United States. Fixed Income After advocating for a long duration strategy for much of the post-crisis recovery, BCA declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016, the very same day that the 10-year U.S. Treasury yield hit a record closing low of 1.37%. Cyclically and structurally, we continue to expect U.S. bond yields to rise more than the market is discounting. As noted above, the Fed is underestimating how high rates will need to go before they reach restrictive territory. This means that the Fed will end up behind the curve in normalizing monetary policy, causing the economy to overheat and inflation to rise above the Fed's comfort zone. Granted, the Fed is willing to tolerate a modest inflation overshoot. However, a core PCE reading above 2.3%, which is at the top end of the range of the Fed's own forecast, would prompt the Fed to expedite the pace of rate hikes. A bear flattening of the yield curve - a situation where long-term yields rise, but short-term rates go up even more - would be highly likely in that environment. Over a shorter-term horizon spanning the next six months, the outlook for yields is more benign. The combination of a stronger dollar, slower global growth, and flight-to-quality flows into the Treasury market from vulnerable emerging markets can cap yields. Add to this the fact that sentiment towards bonds is currently extremely bearish (Chart I-28), and a temporary countertrend decline in yields becomes quite probable. Chart I-28Bond Sentiment Is Extremely Bearish Bond Sentiment Is Extremely Bearish Bond Sentiment Is Extremely Bearish Developed market bond yields in general are likely to follow the direction of U.S. yields, both on the upside and the downside, but in a more muted manner. Outside the periphery, euro area yields have less scope to fall in the near term given that they are already so low. European yields also have less room to rise once global growth bottoms next year because the neutral rate of interest is much lower in the euro area than in the United States. Ironically, a more dovish ECB would help reduce Italian bond yields, as higher inflation is critical for increasing Italian nominal GDP. Since labor market slack is still elevated in Italy, continued monetary stimulus would also lift wages in core Europe more than in Italy, helping to boost Italy's competitiveness relative to the rest of the euro area. Japanese yields have plenty of scope to rise over the long haul. An aging population is pushing more people into retirement, which will cause the national savings rate to fall further. A decline in the savings pool will increase the neutral rate of interest in Japan. Instead of raising the policy rate, the Japanese authorities will let the economy overheat, generating inflation in the process. This will cause the yield curve to steepen, particularly at the very long end (e.g., beyond 10 years) which is the part of the yield curve that is the least susceptible to the BoJ's yield curve control regime. Appendix A - Chart II shows our expectations for the major government bond markets over the coming years. Turning to credit markets, high-yield credit typically underperforms in the latter innings of business-cycle expansions, a period when the Fed is raising rates. Thus, while we do not think that U.S. corporate debt levels will be a major source of systemic financial risk for the broader economy, this is hardly a reason to be overweight spread-product. A more cautious stance towards credit outside the U.S. is also warranted. Currencies And Commodities The dollar is working off overbought conditions, but will rebound into year-end, as EM tensions intensify and hopes of a massive credit/fiscal-fueled Chinese stimulus package fizzle. EM currencies will weaken the most against the dollar over the next three-to-six months, but the euro and, to a lesser extent, the yen, will also come under pressure. Granted, the dollar is no longer a cheap currency, but if long-term interest rate differentials stay anywhere close to current levels, the greenback will remain well supported. Consider the dollar's value against the euro. Thirty-year U.S. Treasurys currently yield 3.20% while 30-year German bunds yield 1.12%, a difference of 208 basis points. Even if one allows for the fact that investors expect euro area inflation to be lower than in the U.S. over the next 30 years, EUR/USD would need to trade at a measly 82 cents today in order to compensate German bund holders for the inferior yield they will receive.4 We do not expect EUR/USD to get down to that level, but a descent into the $1.10-to-$1.12 range over the next six months is probable. Sterling will remain hostage to Brexit negotiations. It is impossible to know how talks will evolve, but our bias is to take a somewhat pound-positive view. The main reason is that support for Brexit has faded (Chart I-29). Opinion polls suggest that if a referendum were held again, the "bremain" side would almost certainly prevail. Lacking public support for leaving the EU, it is unlikely that British negotiators could simply walk away from the table. This reduces the odds of a "hard Brexit" outcome. Indeed, a second referendum that leads to a "no-Brexit" verdict remains a distinct possibility. The combination of slower global growth and a resurgent dollar is likely to hurt commodity prices. Industrial metals are more vulnerable than oil. China consumes around half of all the copper, nickel, aluminum, zinc, and iron ore produced around the world (Chart I-30). In contrast, China represents less than 15% of global oil demand. Chart I-29When Bremorse Sets In When Bremorse Sets In When Bremorse Sets In Chart I-30China Is A More Dominant Consumer Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil The supply backdrop for oil is also more favorable than for metals. Not only are Saudi Arabia and Russia maintaining production discipline, but U.S. sanctions against Iran threaten to weigh on global crude supply. Further reduction in Venezuela's oil output, as well as potential disruptions to Libyan or Iraqi exports, could also boost oil prices. The superior outlook for oil over metals means we prefer the Canadian dollar relative to the Aussie dollar. While AUD/CAD has weakened in recent months, the Aussie dollar is still somewhat expensive against the loonie based on our long-term valuation model (Chart I-31). We also see an increasing chance that Canada will negotiate a revamped trade deal with the U.S., as Trump focuses his attention more on China. Should this happen, it will remove the NAFTA break-up risk discount embedded in the Canadian dollar. Finally, a few words on precious metals. Precious metals typically struggle during periods when the dollar is appreciating (Chart I-32). Consequently, we would not be eager buyers of gold or other precious metals until the dollar peaks, most likely around the middle of next year. As inflation starts to accelerate in late-2019 and in 2020, gold will finally move decisively higher. Chart I-31Canadian Dollar Still Somewhat ##br##Cheap Versus The Aussie Dollar Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar Chart I-32Gold Won't Shine Until The Dollar Peaks Gold Won't Shine Until The Dollar Peaks Gold Won't Shine Until The Dollar Peaks Appendix A - Chart III and Chart IV present an illustration of where the major currencies and commodities are heading. Peter Berezin Chief Global Strategist Global Investment Strategy September 28, 2018 Next Report: October 25, 2018 1 Depending on which specification of the Taylor rule one uses, a one percent of GDP increase in aggregate demand will increase the neutral rate of interest by half a point (John Taylor's original specification) or by a full point (Janet Yellen's preferred specification). Fiscal policy is currently about 3% of GDP too stimulative compared to a baseline where government debt-to-GDP is stable over time. Assuming a fiscal multiplier of 0.5, fiscal policy is thus boosting aggregate demand by 1.5% of GDP. Nonfinancial private credit has increased by an average of 1.5 percentage points of GDP per year since 2016. Assuming that every additional one dollar of credit increases aggregate demand by 50 cents, the revival in credit growth is raising aggregate demand by 0.75% of GDP, compared to a baseline where credit-to-GDP is flat. The labor share of income has increased by 1.25% of GDP from its lows in 2015. Assuming that every one dollar shift in income from capital to labor boosts overall spending on net by 20 cents, this would have raised aggregate demand by 0.25% of GDP. Lastly, if the personal savings rate falls by two points over the next two years, this would raise aggregate demand by 1.5% of GDP. Taken together, these factors are boosting the neutral rate by anywhere from 2% (Taylor's specification) to 4% (Yellen's specification). This is obviously a lot, and easily overwhelms other factors such as a stronger dollar that may be weighing on the neutral rate. 2 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. Euro area private-sector credit growth accelerated from -2.6% in May 2014 to 3.1% in March 2017, but has been broadly flat ever since. Hence, the credit impulse has dropped. 3 Please see Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. 4 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The annual inflation differential of 0.47% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.52 after 30 years. If one assumes that the euro reaches that level by then, the common currency would need to trade at 1.52/(1.0208)^30=0.82 today. APPENDIX A APPENDIX A CHART IMarket Outlook: Equities October 2018 October 2018 APPENDIX A CHART IIMarket Outlook: Bonds October 2018 October 2018 APPENDIX A CHART IIIMarket Outlook: Currencies October 2018 October 2018 APPENDIX A CHART IVMarket Outlook: Commodities October 2018 October 2018 APPENDIX B Long-Term Return Prospects Are Slightly Better Outside The U.S. October 2018 October 2018 Long-Term Return Prospects Are Slightly Better Outside The U.S. October 2018 October 2018 Long-Term Return Prospects Are Slightly Better Outside The U.S. October 2018 October 2018 Long-Term Return Prospects Are Slightly Better Outside The U.S. October 2018 October 2018 II. Is It Time To Buy Value Stocks? Per the most commonly referenced growth and value indexes, growth has been outperforming value for over 11 years, the longest stretch in the history of the series. Growth's extended winning streak has split investors into two camps: those who believe that value is finished because of overexposure and shortened investor timeframes, and those who are trying to identify the point at which reversion to the mean will ensue. In this Special Report, we argue that the traditional off-the-shelf indexes are poor proxies for true value. Their methodology strays quite far from the principles enumerated by Benjamin Graham, the father of value investing, and Fama and French, the researchers who demonstrated that lower-priced stocks have outperformed over time. The headline S&P 500 indexes currently differentiate between growth and value stocks using simplistic metrics that introduce considerable sector bias, reducing the difference between growth and value to a binary choice between Tech and Financials. Using tools developed by BCA's Equity Trading Strategy service, we create sector-neutral U.S. value and growth indexes that correct for the off-the-shelf indexes' flaws, and broaden the range of metrics Fama and French employed to make style distinctions. The ETS-derived indexes appear to better distinguish between value and growth stocks. The ETS value-versus-growth portfolio beat its Fama and French counterpart by four percentage points annually over its 22-year life. We join our custom value and growth indexes to Fama and French's to study the impact of macro variables on relative style performance over time for the purpose of gaining insight into the most opportune points to shift between styles. Relative style performance has not corresponded consistently or robustly enough with the business cycle, inflation, interest rates, or broad market direction to support reliable style-decision rules. We find that monetary policy settings, as defined by our stylized fed funds rate cycle, are a consistently reliable predictor of relative style performance. Per the fed funds rate cycle, tight policy is most conducive to value outperformance. From this perspective, value's decade-long slump is not a surprise, given that the ultra-accommodative tide has been lifting all boats. There is no rush to increase value exposure while policy remains easy, but investors should look to load up on value once policy becomes tight, using the metrics in our ETS model to identify true value stocks. We expect that the policy inflection will occur sometime in the second half of 2019, or the first half of 2020. Growth stocks have been on a tear for the longest stretch in the history of the series, based on the most commonly referenced growth and value indexes, even if their gains haven't yet matched the magnitude of the 1990s (Chart II-1). It is no surprise, then, that growth stocks are as expensive as they have ever been, outside of the tech-bubble era in the late 1990s. Many investors are thus wondering if the next "big trade" is to bet on an extended reversion to the mean during which value regains the ground it has given up. Chart II-1A Lost Decade For Value Stocks A Lost Decade For Value Stocks A Lost Decade For Value Stocks In this Special Report, we argue that the traditional off-the-shelf indexes are not very good at differentiating growth from value stocks. Trends in relative performance have much more to do with sector performance than intrinsic value, making the indexes a poor proxy for investors who are truly interested in selecting stocks based on their value and growth profiles. We create U.S. value and growth indexes that are unaffected by sector performance, using stock selection software provided by BCA's Equity Trading Strategy service. The results will surprise readers who are used to dealing with canned measures of value and growth. What Is Value Investing? Value investing principles have been around at least since the days when Benjamin Graham was a money manager himself. Style investing has been a part of the asset-management lexicon for four decades. Yet there is no universally agreed-upon definition of a value stock versus a growth stock. Based on our reading of Graham's Intelligent Investor, we submit that an essential element of value investing is the identification of stocks that are temporarily trading below their intrinsic value. The temporary drag may persist for a while - stock markets can remain oblivious to fundamentals for extended stretches - but it is ultimately expected to dissipate. Value investing is a play on negative overreaction or neglect, and dedicated value investors have to be contrarians, not to mention contrarians with strong stomachs. The temporary nature of undervaluation is a recurring theme in Graham's book. The stock market's ever-present proclivity toward overreaction ensures a steady supply of value opportunities: "The market is always making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.1" "[W]hen an individual company ... begins to lose ground in the economy, Wall Street is quick to assume that its future is entirely hopeless and it should be avoided at any price.2" "[T]he outstanding characteristic of the stock market is its tendency to react excessively to favorable and unfavorable influences.3" Graham viewed security analysis as the comparison of an issue's market price to its intrinsic value. He advised buying stocks only when they trade at a discount to intrinsic value, offering an investor a "margin of safety" that should guard against significant declines. His favorite measure for assessing intrinsic value was a sober, objective estimate of average future earnings, grossed-up by an appropriate multiple. A low price-to-average-earnings ratio was the linchpin of his margin-of-safety mantra. Decades after Graham's heyday, University of Chicago professors Eugene Fama and Kenneth French bestowed the academy's seal of approval on value investing. Their landmark 1992 paper found that low price-to-book ("P/B") stocks consistently and convincingly outperformed high P/B stocks.4 Several "growth" and "value" indexes have been developed over the years, but they bear no more than a passing resemblance to Graham's, and Fama and French's, work. It is important to realize that the off-the-shelf indexes are far from an ideal proxy for the value factor that Fama & French tried to isolate. Traditional Growth And Value Indexes Are Wanting The off-the-shelf growth and value indexes shown in Chart II-1 all share similar cyclical profiles, with only small differences in long-term returns. Given the similarity of the indexes, we will focus on Standard & Poor's/Citigroup methodology for the purposes of this report.5 The headline S&P 500 indexes currently differentiate between growth and value stocks using the following metrics: 3-year growth rates in EPS, 3-year growth rates in sales-per-share, and 12-month price momentum; along with valuation yardsticks including price-to-book, price-to-earnings, and price-to-sales. Companies with higher growth rates in earnings and sales, and better price momentum, are classified as growth stocks, while those with lower valuation multiples are considered value stocks. Several stocks are cross-listed in both indexes, which is baffling and counterproductive for an investor seeking to implement a rigorous style tilt.6 Table II-1 contains a summary of the current sector breakdowns for the S&P 500 Growth and Value indexes. Table II-2 sheds light on each index's aggregate geographical and U.S. business cycle exposure, the former of which is based on our U.S. Equity Strategy service's judgment. Table II-1Current S&P 500 Style Index Exposures October 2018 October 2018 Table II-2The Value Index Has Less Global ##br##And Late Cyclical Exposure October 2018 October 2018 Growth is currently heavily weighted in Health Care, Technology and Consumer Discretionary sectors, while value has a high concentration of Financials, Energy and Consumer Staples (Table II-1). Table II-2 shows that the growth index has a clear current bias toward sectors with global economic exposure that typically outperform the broad equity market late in the business cycle. The value benchmark flips growth's global/domestic exposure, and has slightly more exposure to defensive sectors, while splitting its cyclical exposure evenly between early and late cyclicals. Sector Dominance Unfortunately, the reigning methodology creates a major problem - shifts in the relative performance of growth and value indexes are dominated by sector performance. Financials' higher debt loads, and banks' low-margin operations, depress their multiples relative to nonfinancial firms. Thus, Financials hold permanent residency in the off-the-shelf value indexes. Conversely, Tech stocks perennially account for an outsized proportion of most growth indexes' market cap. Value-versus-growth boils down to a binary choice between Financials and Tech.7 The growth/value price ratio has closely tracked the Technology/Financials price ratio since the late 1990s (Chart II-2, top panel). The correlation was much less evident before 1995, when Tech stocks accounted for a much smaller share of market capitalization. Chart II-3 demonstrates that the positive correlation between growth/value and Tech has steadily climbed over the decades to almost 1, while the correlation with Financials has become increasingly negative (currently at -0.75). Chart II-2The S&P 500 Style Indexes Merely Mimic Relative Sector Performance The S&P 500 Style Indexes Merely Mimic Relative Sector Performance The S&P 500 Style Indexes Merely Mimic Relative Sector Performance Chart II-3Style Capture Style Capture Style Capture In contrast, the Fama/French approach, which focuses exclusively on price-to-book while ensuring equal representation for large- and small-market-cap stocks, appears much less affected by sector skews; the growth/value index created from their data has not tracked the Tech/Financials ratio, even after 1995 (Chart II-2, second panel). Moreover, note that the extended downward trend in the Fama/French growth/value ratio is consistent with other academic research that shows that value stocks outperform growth over the long-term. The off-the-shelf indexes show the opposite, but that is because they are merely tracking the long-term outperformance of Tech relative to Financials. The bottom line is that the standard indexes incorporate flawed measures of growth and value that limit their usefulness for true style investing. Conventional Wisdom With respect to style investing and the economic cycle, the prevailing conventional wisdom holds that: Inflation - Growth stocks perform best during times of disinflation and persistently low inflation, whereas value stocks perform best during periods of accelerating inflation; Interest Rates - Periods of high and rising interest rates favor value stocks at the expense of growth; and Business Cycle - It is believed that growth stocks outperform value during recessions, because the latter tend to be more highly leveraged to the economic cycle than their growth counterparts. According to the conventional view, value stocks shine in the early and middle phases of a business cycle expansion. Growth stocks return to favor again in the late states of an expansion, when investors begin to worry about the pending end to the business cycle and are looking for reliable and consistent earnings growth. Do the traditional measures of growth and value corroborate this conventional wisdom? Chart II-4 shows that the S&P value/growth index and headline CPI inflation have both trended lower since the early 1980s, but there has been no tendency for value to outperform when inflation rises. Value has shown some tendency to outperform during rising-rate phases since the mid-1980s, but the relationship with the level of the fed funds rate is stronger than its direction, as we discuss below. The growth-over-value relationship with the business cycle is complicated by the tech bubble in the late 1990s, which heavily distorted relative sector performance. The Citigroup measure of growth began to outperform very late in the cycle and through the subsequent recession in some business cycles (1979-1981, 1989-1991, and 2007-2009; Chart II-5). The early and middle parts of the cycles, however, were a mixed bag. Chart II-4Spiting The Conventional Wisdom Spiting The Conventional Wisdom Spiting The Conventional Wisdom Chart II-5No Consistent Relationship With The Business Cycle No Consistent Relationship With The Business Cycle No Consistent Relationship With The Business Cycle The bottom line is that there appears to be some rough correspondence between the Citigroup index and the interest rate and growth cycles, but it is too variable to point to reliable rules for shifting between styles. Ultimately, determining the direction of the growth and value indexes is more about forecasting relative Tech and Financials performance than it is about identifying cheap stocks. A Better Value Approach We identify four broad shortcomings of off-the-shelf value indexes: They exclusively use trailing multiples, a rear-view mirror metric. They rely on simple price-to-book multiples, which flatter serial acquirers. They rely entirely on reported earnings, which are an imperfect proxy for cash flow. A share of stock ultimately represents a claim on its issuer's future cash flows. They make no attempt to place relative metrics into historical context. Without a mechanism to compare a particular segment's valuation relative to its history, structurally low-multiple stocks will be over-represented and structurally high-multiple stocks will be under-represented. BCA's Equity Trading Strategy (ETS) platform provides a way of differentiating value from growth stocks that avoids these problems. The web-based platform uses 24 quantitative factors to rank approximately 10,000 individual stocks in 23 countries. Users can rank and score individual equities to support a broad set of investment strategies and apply macro and sector views to single-name investments. The ETS approach has an impressive track record. Historically, the top decile of stocks ranked using the "BCA Score" methodology has outperformed stocks in the bottom decile by over 25% a year. The overall BCA Score includes all 24 factors when ranking stocks, but to develop our custom value index, we use only the five valuation measures in the ETS database: trailing P/E, forward P/E, price-to-tangible-book, price-to-sales and price-to-cash flow. Every quarter we rank the stocks within each of the 11 sectors based on an equally-weighted composite of the five valuation measures. Note that we are using the data to rank stocks only against other stocks in the same sector. We calculate the total return from owning the top 30% of stocks by value in each sector. We do the same with the bottom 30% and refer to this as our "growth" index.8 We then compute an equally-weighted average of the total returns for the growth indexes across the 11 sectors. We do the same for the value indexes. By comparing stock valuation only to other stocks in the same sector, this approach avoids the sector composition problem suffered by the off-the-shelf measures. Chart II-6 compares the ETS value/growth total return index to the Fama/French value/growth index. Data limitations preclude comparing the two measures before 1996, but the ETS index confirms the Fama/French result that value trumps growth over the long term. The ETS index follows a similar cyclical profile to the Fama/French index from 1997 to 2009, rising and falling in tandem. The two series subsequently diverge: per the criteria ETS uses to identify value and construct an index, lower-priced stocks have outperformed higher-priced ones for most of this expansion, while the Fama/French methodology suggests the reverse. Chart II-6The ETS Model Builds On Fama And French's Work The ETS Model Builds On Fama And French's Work The ETS Model Builds On Fama And French's Work By avoiding sector composition problems and using a wider variety of value measures, the ETS approach appears to be a superior measure of value. An investor that consistently over-weighted value stocks according to the ETS approach would have outperformed someone who did the same using the Fama methodology by an annual average of four percentage points from 1996 to 2018. The history of our ETS index only covers two recessions, limiting our ability to gauge its performance vis-Ã -vis a variety of macro factors, so we extend the ETS index back to 1926 using the Fama/French index. While joining two indexes with different methodologies is less than ideal, we feel the drawbacks are outweighed by the benefit of observing growth and value relative performance across more business cycles. The top panel of Chart II-7 shows U.S. real GDP growth, shaded for recessions. The bottom panel presents our extended ETS value/growth index, shaded for declines of more than 10%. The shaded periods overlap in many, but not all, cycles (indicated by circles in the chart). That is, growth stocks have tended to outperform during economic downturns, although this is not a hard-and-fast rule. Chart II-7No Hard-And-Fast Relationship With The Business Cycle... No Hard-And-Fast Relationship With The Business Cycle... No Hard-And-Fast Relationship With The Business Cycle... Value-over-growth relative returns exhibit some directionality with the overall equity market when looking at corrections (peak-to-trough declines of at least 10%, as shaded in the top panel of Chart II-8), though it should be noted that it is nearly impossible to flag a correction in advance. The relationship weakens when considering bear markets, i.e. peak-to-trough declines of at least 20%, which can be forecast with at least some reliability.9 The bottom panel is the same as in Chart II-7; the extended ETS index, shaded for periods of significant value stock underperformance. The correspondence between the shaded periods is hardly perfect, and there does not appear to be a practical style exposure message, even if an investor could call corrections in advance. Chart II-8...And Market Directionality Has Been An Imperfect Guide Over The Last 50 Years ...And Market Directionality Has Been An Imperfect Guide Over The Last 50 Years ...And Market Directionality Has Been An Imperfect Guide Over The Last 50 Years Valuation Relative valuation also provides some useful information on positioning, though it is not always timely. Chart II-9 presents an aggregate valuation measure for the stocks in our value index relative to that of the stocks in our growth index. Value stocks are expensive relative to growth when the valuation indicator is above +1 standard deviation, and value is cheap when the indicator is less than -1 standard deviation. Historically, investors would have profited if they had over-weighted value stocks when the valuation indicator reached the threshold of undervaluation, although subsequent outperformance was delayed by as much as a year in two episodes. In contrast, the valuation indicator is not useful as a 'sell' signal for value stocks because they can remain overvalued for long periods. Value was overvalued relative to growth for much of the time between 2009 and 2016. Value stocks have cheapened since then, although they have yet to reach the undervaluation threshold. The Fed Funds Rate Cycle While relative style performance may generally lean in one direction or another in conjunction with the business cycle, inflation, interest rates, or broad equity-market performance, there are no hard-and-fast rules. It is difficult to formulate any sort of rotation view between styles, and history does not inspire confidence that any such rule would generate material outperformance. The monetary policy backdrop offers a path forward. We have found the fed funds rate cycle offers a consistent guide to equity and bond returns in other contexts, and our Global ETF Strategy service has found a robust link between the policy cycle and equity factor performance.10 We segment the fed funds rate cycle into four phases, based on whether or not the Fed is hiking or cutting rates, and whether policy is accommodative or restrictive (Chart II-10). Our judgment of the state of policy is derived from comparing the fed funds rate to our estimate of the equilibrium fed funds rate, the policy rate that neither encourages nor discourages economic activity. Chart II-9Sizeable Undervaluation Flags Turning ##br##Points, But You May Have To Wait A While Sizeable Undervaluation Flags Turning Points, But You May Have To Wait A While Sizeable Undervaluation Flags Turning Points, But You May Have To Wait A While Chart II-10The Fed Funds Rate Cycle October 2018 October 2018 As defined by Fama and French, value stocks outperform growth stocks by a considerable margin when monetary policy is restrictive (Table II-3 and Chart II-11, top panel). Considering value and growth stocks separately, both perform extremely well when policy is easy (Chart II-11, second panel), but growth stocks barely advance when policy is tight, falling far behind their value counterparts. A strategy for generalist investors may be to seek out value exposure when policy is tight, while investing without regard to styles when it is easy. Table II-3The State Of Monetary Policy Is The ##br##Best Guide To Style Performance October 2018 October 2018 Chart II-11The State Of Monetary Policy Drives Style Performance The State Of Monetary Policy Drives Style Performance The State Of Monetary Policy Drives Style Performance Investment Conclusions: U.S. equity sectors that have traditionally been considered "growth" have outperformed value sectors for an extended period. The long slump has led some investors to argue that value investing is finished, killed by a combination of overexposure and short-term performance imperatives. Other investors see value's long drought as an anomaly, and are looking for the opportune time to bet on a reversal. We are in the latter camp. The difficulty lies in finding an indicator that reliably leads value stocks' outperformance. Most macro measures are unhelpful, though broad market direction offers some insight, as stocks with low price-to-book multiples have outperformed their high-priced peers by a wide margin during bear markets. Bear markets aren't the most useful timing guide, however, because one only knows in retrospect when they begin and end. The monetary policy backdrop holds the most promise as a practical guide. Although our determination of easy or tight policy turns on the modeled estimate of a concept and should not be looked to for absolute precision, it has provided a timely, reliable guide to value outperformance. We expect the relationship will persist because of the cushion provided by less demanding multiples. Earnings and multiples surge when policy is easy, lifting all boats. It is only when policy is tight, and the tide is going out, that the margin of safety offered by lower-priced stocks yields the greatest benefit. Per our estimate of the equilibrium fed funds rate, we are still firmly ensconced within Phase I of the policy rate cycle, and expect that we will remain there until sometime in the second half of 2019. We therefore expect that value, in Fama and French terms, will continue to underperform growth for another year. The clock is ticking for growth, though, as the expansion is in its latter stages and building inflation pressures will likely force the Fed to take a fairly hard line in this rate-hiking cycle. Once monetary policy turns restrictive, investors should hunt for value candidates using a range of valuation metrics, and combine them in a sector-neutral way, as we have via our Equity Trading Strategy service's model. Mark McClellan Senior Vice President The Bank Credit Analyst Doug Peta Senior Vice President U.S. Investment Strategy 1 Graham, Benjamin, The Intelligent Investor, Harper Collins: New York, 2005, p. 97. 2 Ibid, p. 15. 3 Ibid, p. 189. 4 Fama, Eugene F. and French, Kenneth R., "The Cross-Section of Expected Stock Market Returns," The Journal of Finance, Volume 47, Issue 2 (June 1992), pp. 427-465. 5 S&P currently brands its Growth and Value Indexes as S&P 500 Dow Jones Indexes, but Citigroup has the longest history of compiling S&P 500 Growth and Value Indexes, beginning in 1975, so we join the Citigroup S&P 500 style indexes to the Standard & Poor's series to obtain the maximum style-index history. We use the terms Citigroup and S&P interchangeably. 6 The Pure Value and Pure Growth indexes include only the top quartile of value and growth stocks, respectively, with no overlap between indexes, and are therefore better gauges of true style investing. 7 The Tech-versus-Financials cast of the indexes endures because all of the other sectors, ex-regulated Telecoms and Utilities, which account for too little market cap to make a difference, regularly move between the indexes as their fundamental fortunes, and investor appetites, wax and wane. The current Early Cyclical/Late Cyclical/Defensive profiles are not etched in stone and should be expected to shift, perhaps considerably, over time. 8 We created a second growth index by taking the top 30% of stocks ranked by earnings momentum. However, it made little difference to the results, so we will use the bottom 30% of stocks by value as our measure of "growth" for the purposes of this report, consistent with Fama/French methodology. 9 Please see The Bank Credit Analyst. September 2017, available on bca.bcaresearch.com 10 Please see the May 17, 2017 Global ETF Strategy Special Report, "Equity Factors And The Fed Funds Rate Cycle," available at getf.bcaresearch.com. III. Indicators And Reference Charts Our equity indicators continue to signal that caution is warranted, but U.S. profits remain potent enough to drown out scattered negative messages. Our Monetary Indicator remains at the low end of a multi-year range, suggesting that liquidity conditions have tightened. Our Composite Technical Indicator is in no-man's land, not far above the zero line that marks a sell signal, but coming close to issuing a buy signal by crossing above its 9-month moving average. Our Composite Sentiment Indicator is in a healthy position that suggests that the current level of investor optimism is sustainable. On the other hand, not one of our Willingness-to-Pay (WTP) Indicators is moving in the right direction. The U.S. version is still weak and slowly getting weaker; the European one has flat-lined; and our Japanese WTP extended its decline, albeit from a high level. 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. On balance, our indicators continue to suggest that the underlying supports of the U.S. equity bull market are eroding. Surging U.S. profits are papering over the cracks, and may still have some legs. Earnings surprises are at an all-time high, and the net revisions ratio remains elevated. The 10-year Treasury yield's march higher is due to run out of steam. Valuation (slightly cheap) and technicals (oversold by almost 2 standard deviations) imply that a countertrend pullback is not too far around the corner. 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: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: ##br##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 Doug Peta Senior Vice President U.S. Investment Strategy

Highlights The upcoming changes to the Global Industry Classification Standard will substantially alter the sector composition of the MSCI China Investable index, by hollowing out the information technology sector (to the benefit of consumer discretionary and the new communication services sector). The new communication services sector will become a market-neutral (but barbelled) sector from the perspective of cyclicality, with high- and low-beta components. The inclusion of Alibaba in the consumer discretionary sector warrants the closure of our most successful trade over the past year: long consumer staples / short discretionary. Feature S&P Dow Jones and MSCI Inc. will be implementing major structural changes to the Global Industry Classification Standard (GICS), effective after the market close on September 28, 2018. The changes are among the most significant since the GICS was launched in 1999, and there are meaningful implications for investors. In this brief special report, we summarize the key changes as they pertain to the Chinese investable equity benchmark, and provide a counterfactual simulation of historical performance had the upcoming changes been in effect over the past three years.1 For the MSCI China index, the main investable equity benchmark, the changes to the GICS structure will largely impact three sectors: information technology, consumer discretionary, and telecommunication services: The telecommunication services sector will be renamed to "communication services", and this new level 1 sector will be much broader in scope. Communication services will include companies that facilitate transformation in the way of communication, entertainment, and information seeking. In addition to the companies currently classified within telecommunication services, communication services will include media stocks formerly in the consumer discretionary sector, including advertising, broadcasting, cable & satellite, publishing, movies & entertainment sub-sectors. In addition, home entertainment software and some internet software & services companies, currently classified under the information technology sector, will also move to communication services. These include prominent stocks like Baidu, Tencent, Sina, and Sohu. The consumer discretionary sector will include online retailers, such as Alibaba, from information technology sector under its internet & direct marketing retail sub-sector. Chart 1 shows that these changes will have a very substantial impact on the sector composition of the MSCI China index. The weight of the information technology sector will drop dramatically from 37% to 3% after the GICS changes occur, because all three of the BAT stocks (Baidu, Alibaba, and Tencent) will move to other sectors. The weight of consumer discretionary is set to rise from 8% to 20%, as the inclusion of Alibaba offsets the removal of media (Alibaba alone will account for 60% of the consumer discretionary sector after the GICS changes). Relative to the current weight of telecommunication services, the new communication services sector weight will be substantially higher, at 27% (versus its 5% current weight). Chart 2 provides both factual and counterfactual perspectives on what relative performance for these three sectors would have looked like since 2016, had the upcoming changes been in effect. The chart shows that the relative performance of consumer discretionary and communication services sector would have been considerably stronger, while the tech sector would have underperformed (in sharp contrast to what has actually occurred). Chart 3 provides some perspective on the cyclicality of China's new communication services sector. The telecommunication services sector is clearly a defensive sector, and has exhibited a beta less than 0.5 over the past year. However, the chart shows that communication services (had it existed), would have basically been a market-neutral sector in terms of market beta because of the offsetting impact of both including high-beta internet software & services companies and low-beta telecommunication services. In effect, the new communication services will become a barbelled sector from the perspective of cyclicality, with high- and low-beta components. Chart 1A Hollowing Out Of The Information Technology Sector A Hollowing Out Of The Information Technology Sector A Hollowing Out Of The Information Technology Sector Chart 2CD And Comm Services Would Have Outperformed Over The Past Three Years CD And Comm Services Would Have Outperformed Over The Past Three Years CD And Comm Services Would Have Outperformed Over The Past Three Years Chart 3Comm Services: A Market-Neutral, Barbelled Sector Comm Services: A Market-Neutral, Barbelled Sector Comm Services: A Market-Neutral, Barbelled Sector Finally, the beta of consumer discretionary sector would have been higher over the past two years in our counterfactual scenario, thanks to the inclusion of Alibaba. Consumer discretionary stocks have fared poorly in response to a trade war with the U.S., but the imminent inclusion of Alibaba in the discretionary sector will substantially alter the character of its future performance. As such, we have decided to close our long MSCI China Consumer Staples / short MSCI China Consumer Discretionary trade at a fantastic return of 47.6%. Qingyun Xu, Senior Analyst qingyunx@bcaresearch.com 1 For China, we proxy the upcoming changes to the GICS structure using a simple set of rules that aims to capture an overwhelming majority (but not all) of the upcoming changes. As such, investors should view our methodology as an approximation, rather than an exact application of the firm-by-firm changes that MSCI will make. Clients who are interested in a similar exercise for the global IMI benchmark should refer to Neeraj Dabake, Craig Feldman. (September, 2018) The New GICS Communication Services Sector. MSCI Research Paper, Retrieved from https://www.msci.com/www/research-paper/the-new-gics-communication/01107886967. Cyclical Investment Stance Equity Sector Recommendations

Highlights Duration: The housing market is the key channel through which monetary policy impacts the economy. As such, it is unlikely that Treasury yields will peak until housing shows meaningful weakness. While residential investment has decelerated in recent quarters, we expect this weakness will prove temporary and that Treasury yields have further cyclical upside. Maintain below-benchmark portfolio duration. Yield Curve: The Fed will maintain its 25 bps per quarter rate hike pace for the time being, but could be forced to pause next year if weak foreign growth migrates to the U.S. via a stronger dollar. We recommend hedging this risk via a long position in the 7-year bullet versus a short position in the 1/20 barbell. Corporate Health: Strong profit growth - both organic and as a result of corporate tax cuts - has led to a significant improvement in corporate balance sheet health during the past few quarters. This improvement will not persist for much longer. We recommend only a neutral allocation to corporate bonds, both investment grade and junk. Feature This time last week the 10-year Treasury yield was bumping up against 3% and money markets were on the cusp of discounting an extra rate hike between now and the end of 2019. Both resistance levels broke during the past seven days. The 10-year yield is now 3.07% and the January 2020 fed funds futures contract is fully priced for four rate hikes (Chart 1). Chart 1Past Resistance Levels Past Resistance Levels Past Resistance Levels With the 10-year yield back above 3%, many investors are once again speculating about where it will ultimately peak for the cycle. Any answer to this question relies on an assumption about the neutral fed funds rate, the level of interest rates above which monetary policy turns restrictive and acts to slow economic growth and inflation. In past reports we have suggested several measures investors can track to help decide whether interest rates are close to breaking above neutral.1 In this week's report we focus on one particularly important indicator - the housing market. In his essential 2007 paper "Housing Is The Business Cycle", Edward Leamer notes that of the ten post-WWII U.S. recessions, eight were preceded by a significant slowdown in residential investment.2 Given that recessions are also typically preceded by tightening monetary policy, it is not a stretch to connect the two. In fact, there is good reason to believe that housing is the main channel through which monetary policy impacts the economy. Since leverage is employed in the acquisition of new homes, interest rates impact the cost of homeownership more directly than other assets. A similar claim could be made about leveraged investment from the corporate sector, but business investment is also beholden to swings in expected future demand. Households can easily postpone the acquisition of a new home if the interest rate environment makes it uneconomical, businesses need to act when the market demands it. But most importantly, Leamer's paper demonstrates that, unlike residential investment, weaker business investment does not consistently provide advance warning of recession. The State Of U.S. Housing Turning to the data, we see that Leamer's claim is validated by the top panel of Chart 2. Residential investment tends to decline in the year preceding a U.S. recession. Housing starts and new home sales display a similar pattern (Chart 2, panels 2 & 3). Chart 2The Housing Market Predicts Recessions The Housing Market Predicts Recessions The Housing Market Predicts Recessions What's worrying is that residential investment has barely grown at all during the past year (Chart 2, bottom panel). If this weakness continues it would signal that interest rates are too high for the housing market, and that we are likely very close to the cyclical peak in bond yields. However, we doubt the current weakness will persist. For one, the recent decline in construction activity has been concentrated in the multi-family sector while single-family construction continues to expand at a steady rate (Chart 3). This could simply reflect a shift in demand away from multi-family toward single-family, reversing the trend witnessed between 2010 and 2012. It's possible that some households who were forced into the rental market in the aftermath of the Great Recession now find themselves able to switch back. But even if we focus on the multi-family sector exclusively, there is little reason to believe that construction will see significantly more downside. The rental vacancy rate remains very low, and the National Multi Housing Council's Survey of Apartment Market Conditions suggests that there is no strong upward or downward pressure on the vacancy rate at the moment (Chart 3, bottom 2 panels). The fact that single-family housing starts have not declined casts some doubt on the notion that higher mortgage rates are to blame for the deceleration in residential investment. This is further borne out by the fact that, while higher mortgage rates have certainly increased the cost of homeownership, mortgage payments as a percent of median income are not stretched compared to history (Chart 4). The demand back-drop for housing also remains robust, with household formation in a clear uptrend (Chart 4, panel 2) and homebuilders as optimistic as ever about future sales activity (Chart 4, bottom panel). Chart 3A Temporary Weakness In Residential Investment A Temporary Weakness In Residential Investment A Temporary Weakness In Residential Investment Chart 4Higher Mortgage Rates Are Not The Culprit Higher Mortgage Rates Are Not The Culprit Higher Mortgage Rates Are Not The Culprit We conclude that interest rates are still too low to meaningfully impact the housing market. Residential investment will re-accelerate in the coming quarters and Treasury yields have plenty of room to rise before reaching their cyclical peak. Bottom Line: The housing market is the key channel through which monetary policy impacts the economy. As such, it is unlikely that Treasury yields will peak until housing shows meaningful weakness. While residential investment has decelerated in recent quarters, we expect this weakness will prove temporary and that Treasury yields have further cyclical upside. Maintain below-benchmark portfolio duration. Hedging Weak Foreign Growth With Steepeners The resilience of the U.S. housing market makes it likely that interest rates will continue to rise for quite some time. However, this does not preclude weak foreign growth - and the resultant dollar strength - from forcing the Fed to slow its 25 basis point per quarter rate hike pace at some point during the next 6-12 months. In fact, we have flagged in recent reports that, since 1993, every time the Global (ex. U.S.) Leading Economic Indicator (LEI) has fallen below zero, the U.S. LEI has eventually followed (Chart 5).3 Unless foreign growth suddenly recovers, it is quite likely that dollar strength will drag the U.S. LEI lower in the first half of next year. At that point, the Fed may be forced to pause its rate hike cycle in order to take some shine off the dollar, allowing the recovery to continue. Chart 5Weak Global Growth Could Bring Down The U.S. Weak Global Growth Could Bring Down The U.S. Weak Global Growth Could Bring Down The U.S. Drops in the U.S. LEI to below zero almost always coincide with a recommendation for easier monetary policy from our Fed Monitor (Chart 5, bottom panel). Although one notable exception did occur in 2005. An examination of the three components of our Fed Monitor reveals that a falling LEI caused the economic growth component of our monitor to decline in 2005 (Chart 6). However, this was offset by an elevated inflation component and extremely easy financial conditions (Chart 6, bottom 2 panels). Chart 6The Three Components Of Our Fed Monitor The Three Components Of Our Fed Monitor The Three Components Of Our Fed Monitor As in 2005, inflation pressures are once again elevated and financial conditions remain accommodative. It follows that it could take a significant deterioration in economic growth before the Fed is forced to pause its 25 bps per quarter rate hike cycle, one that is not yet evident in the data. Nevertheless, we cannot ignore the risk that weak foreign growth will infiltrate the U.S. via a stronger dollar, forcing the Fed to pause. With only two 25 basis point rate hikes currently discounted for 2019, some pause is already in the price. This makes us reluctant to advocate shifting away from below-benchmark portfolio duration. We think a better way to hedge the risk of a Fed pause is through yield curve steepeners. Since short-dated yields are more heavily influenced by the expected near-term pace of rate hikes than long-dated yields, any Fed pause will cause the yield curve to steepen. Steepeners are also very attractively priced at the moment, meaning that they should even perform well in a mild curve flattening environment.4 Our preferred method for implementing a curve steepener is to go long a bullet maturity near the middle of the curve and short a duration-matched barbell consisting of the very short and very long ends of the curve.5 With that in mind, we can determine the best yield curve trade to implement by answering the following two questions: Which bullet over barbell combination offers the most attractive value? Which bullet over barbell combination is most likely to outperform in the "Fed pause" scenario we are trying to hedge? In response to the first question, we consider the 2-year, 3-year, 5-year and 7-year bullet maturities all relative to a duration-matched 1/20 barbell. All of those butterfly spreads offer approximately the same yield pick-up (Chart 7). They also all offer approximately the same yield pick-up relative to our fair value models, which are based on regressions of the butterfly spread versus the 1/20 slope of the curve (Chart 8).6 To answer the second question, we try to identify which of the 2-year, 3-year, 5-year or 7-year yields is likely to decline the most in response to the market pricing-in a pause in Fed rate hikes. To do this we look at the historical correlations between different yield curve slopes and our 12-month Fed Funds Discounter - the change in the fed funds rate that is priced into the market for the next 12 months. The correlations are displayed in Chart 9, and they show that monthly changes in the 7/10 slope are almost always negatively correlated with monthly changes in the 12-month discounter. In other words, when the discounter falls, the 7-year yield falls by more than the 10-year yield. Chart 7Different Bullets, Similar Yield Pick-Up I Different Bullets, Similar Yield Pick-Up I Different Bullets, Similar Yield Pick-Up I Chart 8Different Bullets, Similar Yield Pick-Up II Different Bullets, Similar Yield Pick-Up II Different Bullets, Similar Yield Pick-Up II Chart 9Hedging The "Fed Pause" Scenario Hedging The "Fed Pause" Scenario Hedging The "Fed Pause" Scenario Monthly changes in the 5/7 slope are also usually negatively correlated with changes in the discounter, though the correlation has been closer to zero in recent years. This makes it difficult to say with certainty whether the 5-year or 7-year yield would fall by more in response to a decline in the discounter. Chart 9 also shows that changes in both the 2/3 and 3/5 slopes are positively correlated with changes in the 12-month discounter. This means that when the discounter falls, the 3-year yield falls by more than the 2-year yield and the 5-year yield falls by more than the 3-year yield. In general, we can safely conclude that the 5-year and 7-year bullets are better hedges against a Fed pause than the 2-year or 3-year bullets. The 7-year in particular appears to be a safe bet. Given that the differences in valuation between the different options are miniscule, we are inclined to maintain our current yield curve position: long the 7-year bullet and short the 1/20 barbell. This week we also close our recommendation to favor the 5/30 barbell over the 10-year bullet for a small loss of 2 bps. This trade was designed to hedge the risk of Fed overtightening leading to an inverted yield curve. This trade would underperform in the event of a Fed pause, which we now view as the greater risk. Bottom Line: The Fed will maintain its 25 bps per quarter rate hike pace for the time being, but could be forced to pause next year if weak foreign growth migrates to the U.S. via a stronger dollar. We recommend hedging this risk via a long position in the 7-year bullet versus a short position in the 1/20 barbell. Corporate Balance Sheet Reprieve Last week's release of the second quarter U.S. Financial Accounts (formerly Flow of Funds) allows us to update our indicators of nonfinancial corporate balance sheet health. Overall, there has been a significant improvement in our Corporate Health Monitor (CHM) since the end of 2016. It has fallen from deep in "deteriorating health" territory to close to the "improving health" zone (Chart 10). By far, the biggest driver of the CHM's improvement has been the sharp increase in after-tax cash flows (Chart 10, panel 2). This is partly due to the recent corporate tax cuts, but also reflects a significant rebound in pre-tax cash flows (Chart 10, bottom panel). Despite the rebound in profits, we remain cautious on the outlook for corporate balance sheets going forward. First, our bottom-up samples of firms included in the investment grade and high-yield Bloomberg Barclays bond indexes both show that the median firm's net debt-to-EBITDA has improved in recent quarters, but remains elevated compared to history (Chart 11). Chart 10After-Tax Cash Flows Drive CHM Improvement After-Tax Cash Flows Drive CHM Improvement After-Tax Cash Flows Drive CHM Improvement Chart 11Debt Levels Still High Debt Levels Still High Debt Levels Still High Second, we see increasing headwinds to profit growth going forward. The positive impact from tax cuts is set to wane, while the stronger dollar and faster wage growth will both weigh on pre-tax profits during the next year.7 It is important to note that it will not take much deceleration in pre-tax profits for corporate balance sheets to worsen. Our measure of gross leverage - total debt over pre-tax profits - has only managed to flatten-off during the past few quarters, even as profit growth has surged. This means that the rapid gains in profits have only managed to keep pace with the rate of debt growth. Even a small deceleration in profits will cause leverage to rise, and rising leverage tends to occur alongside an increasing default rate (Chart 12). Chart 12Gross Leverage And Corporate Defaults Gross Leverage And Corporate Defaults Gross Leverage And Corporate Defaults Bottom Line: Strong profit growth - both organic and as a result of corporate tax cuts - has led to a significant improvement in corporate balance sheet health during the past few quarters. This improvement will not persist for much longer. We recommend only a neutral allocation to corporate bonds, both investment grade and junk. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Tracking The Two-Stage Treasury Bear", dated August 14, 2018, available at usbs.bcaresearch.com 2http://www.nber.org/papers/w13428 3 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Playing Catch-Up", dated September 11, 2018, available at usbs.bcaresesarch.com 5 For further details on why we prefer this trade construction, please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 6 We calculate the butterfly spread as: the bullet yield minus the yield of the duration-matched barbell. 7 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The Trump administration's decision to effectively tariff the second round of imports at 25% materially raises the odds of another significant uptick in Chinese financial market volatility. Even if China ramps up its stimulus efforts in response, the lesson of the 2014-2016 episode is that investors are likely to wait for earnings clarity before buying stocks aggressively. Stay neutral China, at best, relative to global stocks, and overweight low-beta sectors within the investable equity universe. We have a contrarian view about Chinese corporate bonds, and recommend holding a long but diversified position over the coming 6-12 months. Feature Chart 1The RMB Is Acting As A "Panic Barometer" ##br##For Domestic Stocks The RMB Is Acting As A "Panic Barometer" For Domestic Stocks The RMB Is Acting As A "Panic Barometer" For Domestic Stocks The Trump administration finally announced its decision this week on the second round of tariffs on Chinese imports, essentially applying a 25% rate. While the rate will initially start at 10%, it will rise to 25% by the end of the year, and the administration has threatened to immediately seek public consultation on tariffs on all remaining imports from China if the country retaliates against the second round (which was announced yesterday). With news reports having suggested that China would reject new trade talks merely if the second round moves forward, the prospect of a breakthrough in negotiations seems dim, at best. We have highlighted in past reports that the RMB has acted as a panic barometer for domestic equities (Chart 1), as evidenced by the recent spike in the correlation between the two. During this period, the percent decline in CNY-USD seems to have closely followed the magnitude of proposed tariffs as a percent of Chinese exports to the U.S., as would be implied in a simple open economy model with flexible exchange rates. Based on this framework, Chart 2 suggests that the RMB may come under considerable further market pressure, even if investors only assume a 10% rate on the third round of tariffs. A break above the psychologically-important level of 7 for USD-CNY appears likely barring a major intervention from the PBOC, suggesting that a meaningful uptick in Chinese financial market volatility is forthcoming. Chart 2USDCNY = 7 Is Likely To Be Breached Barring Strong Action From The PBOC USDCNY = 7 Is Likely To Be Breached Barring Strong Action From The PBOC USDCNY = 7 Is Likely To Be Breached Barring Strong Action From The PBOC Stimulus To The Rescue? Given that Chinese policymakers have signaled their willingness to stimulate in response to a negative external environment, some investors have argued that China is actually about to enter a mini-cycle upswing. For now, two points suggest that this conclusion is premature: A 10% tariff rate on all remaining imports from China would imply close to $90 billion in tariffs collected, once the second round rate rises to 25%. As noted above, a simple equilibrium exchange rate framework would imply material further weakness in the RMB to counter protectionism of this magnitude. Besides heralding a further selloff in Chinese stocks, this could lead to competitive currency devaluation amongst China's largest trading partners, a "beggar-thy-neighbor" policy that tends to exacerbate rather than alleviate shocks to aggregate demand. As we have noted numerous times over the past year, China's old economy was slowing in the lead up to the U.S./China trade war, and it is not yet clear whether the announced stimulus will generate enough "lift" to convince investors that the low in economic activity is behind them. Chart 3 shows that the August rise in adjusted total social financing as a share of GDP was extremely muted, and that there is no sign yet of a pickup in government spending. Even if China ramps up its stimulus efforts in response to this week's decision from the Trump administration, Chart 4 highlights an important point for investors: there was a considerable lag between a policy response and the low in stock prices during the 2014-2016 episode (a lag that may re-occur today). The chart shows that despite an ongoing depreciation in the RMB and a rebound in our BCA leading indicator for the Li Keqiang index, Chinese stock prices continued to decline for several months. This gap was caused by a lagged decline in earnings, and underscores that investors may ignore the current efforts by policymakers to stabilize the economy until clarity on the stability of earnings presents itself. Chart 3No Sign Yet Of##br## Major Stimulus No Sign Yet Of Major Stimulus No Sign Yet Of Major Stimulus Chart 4History Suggests Investors Need Both ##br##Stimulus And Earnings Clarity History Suggests Investors Need Both Stimulus And Earnings Clarity History Suggests Investors Need Both Stimulus And Earnings Clarity And for now, several signs point to potentially material downside risk for earnings: While the now considerably larger shock from U.S. tariffs has yet to impact the Chinese economy, trailing earnings growth has already peaked and has recently fallen below its trend (Chart 5, panel 1). Despite the recent deceleration in trailing earnings growth and the sharp decline in stock prices, analysts' 12-month forward growth estimates remain quite elevated (Chart 5, panel 2). This suggests that forward earnings could be vulnerable to a decline above and beyond what occurs to trailing earnings, as a full 1/3rd of the increase in the former since late-2015 has been due to very significant shift in growth expectations. The rise in trailing earnings over the past few years appears to be stretched, based the trend in profit margins (Chart 6). The chart highlights that 12-month trailing earnings have well surpassed sales since late-2016, causing margins to rise to their highest level on record and raising the risk of a significant mean-reversion in response to a meaningful economic shock. Net earnings revisions have done a good job at predicting inflection points in forward earnings growth over the past decade, and have recently fallen into negative territory (Chart 7). Chart 5Lofty Earnings Growth Expectations ##br##Are A Risk To Stocks Lofty Earnings Growth Expectations Are A Risk To Stocks Lofty Earnings Growth Expectations Are A Risk To Stocks Chart 6The Earnings Recovery Has Been Partly ##br##Reliant On A Margin Expansion The Earnings Recovery Has Been Partly Reliant On A Margin Expansion The Earnings Recovery Has Been Partly Reliant On A Margin Expansion Chart 7Earnings Revisions Herald ##br##Slowing Earnings Momentum Earnings Revisions Herald Slowing Earnings Momentum Earnings Revisions Herald Slowing Earnings Momentum It is true that some of the above-average levels for profit margins and 12-month forward growth expectations can be explained by the substantial rise in the share of the tech sector in the MSCI China index, whose constituents are significantly more profitable than ex-tech stocks, may have better longer-term growth prospects, and may be more immunized from the trade war with the U.S. Still, Chart 8 illustrates the high earnings hurdle rate for tech stocks over the coming year. Bottom-up analysts continue to expect tech stocks to grow their earnings more than 20% over the next 12 months, despite: Chart 8Are Chinese Tech Stocks Going To Be##br## Able To Grow Earnings 20+%? Are Chinese Tech Stocks Going To Be Able To Grow Earnings 20+%? Are Chinese Tech Stocks Going To Be Able To Grow Earnings 20+%? A poor economic outlook that is likely to impact consumer spending (even if households "outperform" the business sector), and The fact that tech sector net earnings revisions have fallen deeply into negative territory (panel 2). How should investors allocate capital within China in the middle of a trade war with the U.S? First, despite the fact that Chinese stocks have already fallen significantly from their early-January high, it is clearly too early to bottom fish either domestic or investable stocks. Stay neutral China, at best, relative to global stocks. Second, investors should certainly favor low-beta sectors within the Chinese equity universe. Currently, our low-beta equity portfolio includes industrials, telecom services health care, utilities, and consumer staples, but we update the portfolio weights at the end of every month. Third, as discussed below, investors should ignore the very bearish narrative towards Chinese corporate bonds, and hold a long but diversified position over the coming 6-12 months. Bottom Line: The Trump administration's decision to effectively tariff the second round of imports at 25% materially raises the odds of another significant uptick in Chinese financial market volatility. Even if China ramps up its stimulus efforts in response, the lesson of the 2014-2016 episode is that investors are likely to wait for earnings clarity before buying stocks aggressively. Stay neutral China, at best, relative to global stocks, and overweight low-beta sectors within the investable equity universe. Chinese Corporate Bonds: A Contrarian Long Our analysis of the earnings risk facing equities suggests that it is probably still too early to buy Chinese stocks, but in our (contrarian) view there is still one pro-cyclical asset that investors should favor: Chinese corporate bonds. Headlines about defaults in China's corporate bond market continue to appear in the financial press, with concerns most recently focused on low recovery rates of defaulted issues.1 We last wrote about Chinese corporate bonds in June,2 and took a contrarian (i.e. optimistic) stance towards the market. In the meantime, our long China onshore corporate bond trade has continued to gain ground, and an analysis of the inferred credit rating of the market actually strengthens our conviction to stay long. One key element of the bearish narrative towards Chinese corporate bonds is the fact that investment-grade issues in the market are trading like junk. Table 1 highlights that this is largely true: the table presents the spread-inferred credit rating of the four major rating categories of the ChinaBond Corporate Bond Index, and shows that AAA bonds are trading on the border of equivalent maturity investment- and speculative-grade bonds in the U.S. Bonds rates AA+/AA/AA- in China are trading between lower-B and high-CAA, which is firmly in speculative-grade territory. However, in our view market participants are making a mistake when they assume that de-facto junk ratings on Chinese corporate bonds will translate into U.S. junk-style default rates on bonds over the coming 6-12 months (or, frankly, beyond). Chart 9 presents an estimate of the market-implied default rate for the four rating categories shown in Table 1, and suggests that investors are pricing in roughly a 1% default rate for AAA-rated corporate bonds and a 4-5% default rate for AA+/AA/AA-. Table 1Chinese Corporate Bonds Are Trading##br## Like Speculative-Grade Issues Investing In The Middle Of A Trade War Investing In The Middle Of A Trade War Chart 9Allowing Market-Implied Default Rates##br## To Occur Would Be A Huge Policy Error Allowing Market-Implied Default Rates To Occur Would Be A Huge Policy Error Allowing Market-Implied Default Rates To Occur Would Be A Huge Policy Error There are two important factors to consider when gauging the validity of these expectations: Based on Moody's most recent Annual Default Study, the market's current expectations for Chinese corporate bond defaults are actually above the average historical one-year default rates for their inferred credit ratings. Average default rates almost never actually occur over a given 12-month period. Chart 10 highlights that default rates in the U.S. have a binary distribution that is almost entirely determined by whether the economy is in recession (not just slowing down). The late-1980s and the post-2015 environment have been exceptions to this rule, which in large part can be explained by industry-specific events (namely, a surge of energy-sector defaults due to a collapse in the price of oil). But the key point is that investors are likely to overestimate the actual default rate over a given 12 month period when assuming an average historical rate, unless the economy shifts from an expansion to an outright recession over the period. From our perspective, the combination of the market's default expectations and the fact that China is easing suggests an outright long position in Chinese corporate bonds is warranted over the coming year. In our judgement, there is simply no way that policymakers can allow default rates on the order of what is being priced in to occur, as it would constitute an enormous policy mistake that would risk destabilizing the financial system at a time when officials are attempting to counter the looming shock to the export sector. In fact, we doubt that China's typical policy of gradualism when liberalizing its economy and financial markets would allow default rates to rise from 0% to 5% over a year in any economic environment, particularly the current one. As a final point, Chart 11 highlights why a significant rise in the default rate is required in order for investors to lose money on Chinese corporate bonds. The chart shows the 12-month breakeven spread for the ChinaBond AA- Corporate Bond index, unadjusted for default. The breakeven spread represents the rise in yields that would be required for investors to lose money over a 12-month horizon (i.e. the yield change that exactly erases the income return from the position), assuming no defaults. Chart 10"Average" Default Rates ##br##Do Not Really Occur "Average" Default Rates Do Not Really Occur "Average" Default Rates Do Not Really Occur Chart 11A 2% Rise In Yields From Tighter Policy Is Not##br## Going To Occur Over The Coming Year A 2% Rise In Yields From Tighter Policy Is Not Going To Occur Over The Coming Year A 2% Rise In Yields From Tighter Policy Is Not Going To Occur Over The Coming Year The chart shows that AA- bond yields would have to rise approximately 215 bps over the coming year before investors suffer a negative total return, which would be an enormous rise that has a near-zero probability of occurring due of tighter monetary policy. As such, defaults (or the pricing of default risk) remains the only real credible source of potential capital loss from these bonds over the coming year. Our bet, with high conviction, is that holders of Chinese corporate bonds hold a put option that will prevent this from occurring. Bottom Line: Fade investor concerns about rising defaults, and stay long Chinese corporate bonds over the coming 6-12 months. We acknowledge that idiosyncratic risk is likely to be elevated for this asset class, and we recommend that investors take a diversified, portfolio approach when investing in China's corporate bond market. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 For example, please see "In China, Less Than 20% Defaulted Bonds Have Been Paid Back" by Bloomberg News, August 27, 2018 2 Pease see China Investment Strategy Weekly Report "A Shaky Ladder", dated June 13, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights U.S. Treasuries: EM market declines have, so far, shown no signs of impacting U.S. economic growth. The underlying acceleration of U.S. growth and inflation in the face of the EM turmoil suggests that bond investors should remain strategically underweight U.S. Treasuries with a below-benchmark duration stance. EM Contagion: The current EM turmoil has not yet spilled over into U.S. financial markets, as occurred during the 2013 and 2014/2015 EM selloffs, because the U.S. economy is in a much stronger position now. It will take a bigger tightening of U.S. financial conditions, likely through higher U.S. interest rates and a larger increase in the U.S. dollar, before U.S. risk assets suffer the type of decline that could trigger a pause in the Fed rate hike cycle. Feature Chart of the WeekBond Yields Following Inflation & QT, Not EM Bond Yields Following Inflation & QT, Not EM Bond Yields Following Inflation & QT, Not EM Have investors become too complacent? The selloff in emerging market (EM) assets is intensifying. The White House is threatening to slap tariffs on virtually all Chinese imports in the U.S. Accelerating wage and price inflation in the U.S. is keeping Fed rate hikes in play. The divergence between the strong U.S. economy and the rest of the world is growing wider, keeping the U.S. dollar elevated. Yet despite all that, non-EM markets show a surprising lack of concern over the EM volatility. U.S. equity indices remain close to all-time highs, while corporate bond spreads in the major developed markets are generally stable. Government bond yields remain well above levels implied by measures of economic sentiment like the global ZEW expectations index (Chart of the Week). For yields, the big issue remains, as always, the outlook for inflation and monetary policy. On that note, yields are being supported by inflation expectations, which have been boosted by faster realized inflation, tight labor markets and high oil prices. These trends are most pronounced in the U.S., where the Fed is not only hiking rates but also slowly reducing the size of its swollen balance sheet. This comes on top of the diminished pace of asset purchases by the European Central Bank (ECB) and Bank of Japan (BoJ), with the former still on track to end its net new buying of bonds at the end of the year. Against that backdrop of rising inflation and tightening global liquidity conditions, it is incorrect to solely make comparisons between today and the most recent period of EM weakness in 2014/15 that eventually spilled back violently into non-EM markets and caused the Fed to pause after only its first post-QE rate hike. The current backdrop also has similarities to the 2013 "Taper Tantrum", when the Fed surprised the markets by signaling that it was considering ending QE, triggering a spike in Treasury yields and a selloff in global risk assets. Chart 2China Remains The Key To Global Growth China Remains The Key To Global Growth China Remains The Key To Global Growth Then, global growth was accelerating and inflation expectations were at levels consistent with policymaker targets in the U.S. and Europe, yet central bank liquidity was slowing rapidly (mostly due to a contracting ECB balance sheet at a time when the Fed's balance sheet growth had already slowed). EM markets sold off alongside the rapid rise in U.S. Treasury yields during the Taper Tantrum. Yet with global growth accelerating and the U.S. dollar staying relatively stable, the EM selloff ended when the Fed delayed the start of the taper into 2014, providing a monetary boost to a global economy that did not need it. Today, realized inflation is even faster and central bank liquidity is again slowing rapidly. Yet market-based inflation expectations are still a bit below central bank targets, while non-U.S. growth expectations are slowing. Worries about the impact on the world economy from the brewing U.S.-China trade war are clearly weighing on the latter. The wild card will be how China responds to the tariff threat through policy stimulus. Already, China's policymakers have allowed some depreciation of the renminbi, along with some modest easing of monetary and fiscal policies, to counteract the growth threat from the Trump tariffs. BCA's China experts do not expect anything close to the massive 2015/16 package of fiscal/monetary stimulus, given the stated goal of President Xi Jinping to crack down on systemic financial risk.1 Yet the most recent figures on Chinese import growth, and higher-frequency data incorporated in the Li Keqiang index, are showing some reacceleration after the 2017 slowdown (Chart 2). At the same time, the most recent data point on the OECD's global leading economic indicator is potentially stabilizing (middle panel). A continuation of these trends could help reverse the cooling of non-U.S. growth seen so far in 2018 (bottom panel). Given all the uncertainties surrounding the U.S.-China trade battle, EM volatility and Chinese growth - at a time when global QE has turned into "QT", or "quantitative tightening", with an associated reduction in global capital flows - we continue to recommend only a neutral stance on global spread product, favoring U.S. corporates vs non-U.S. equivalents (especially avoiding EM credit). We also are maintaining our strategic recommended underweight stance on overall developed market duration, but favoring countries where monetary tightening will be more difficult to deliver (overweight U.K., Japan and Australia versus underweight U.S., euro area and Canada). A Quick Update On U.S. Treasuries: Stay Defensive Chart 3Stronger U.S. Growth = UST Underperformance Stronger U.S. Growth = UST Underperformance Stronger U.S. Growth = UST Underperformance The main U.S. data releases last week, the ISM surveys and the Payrolls report for August, came as a big surprise for the U.S. Treasury market. The headline ISM Manufacturing index hit a 17-year high of 61, led by increases in both the growth and inflation sub-components of the index (Chart 3), while the U.S. economy added another 200k jobs. The big shock came from the wage data in the Payrolls report, with Average Hourly Earnings rising by 0.4% in August, pushing the year-over-year growth rate to 2.9%, the highest since 2009. The Treasury market responded to data as expected, with the 10-year yield rising back to 2.94%. One of our favorite chart relationships shows the ISM Manufacturing index as a leading indicator of the momentum (12-month change) of core CPI inflation in the U.S. (Chart 4). The recent acceleration of U.S. core inflation can be explained as a lagged response to the U.S. economic growth acceleration since the start of 2016. If the relationship in this chart holds up, the current levels of the ISM are consistent with core CPI inflation accelerating to the 2.5-3% range next year. That outcome would keep the Fed on its planned rate hike path in 2019. At the moment, the market pricing of Fed rate expectations in the Overnight Index Swap (OIS) curve remains below the latest FOMC projections for the funds rate for the next two years (Chart 5). The 10-year TIPS breakeven inflation rate, which now sits at 2.1%, is still priced below the 2.3-2.5% levels that, in the past, have been consistent with inflation expectations staying well-anchored around the Fed's 2% inflation target. A combination of accelerating U.S. growth, faster wages, and a market that has not fully discounted the likely outcome for inflation and the funds rate is not a bullish one for U.S. Treasuries. We acknowledge that there could be a short-term flight-to-quality bid for Treasuries if the EM turbulence becomes more violent and finally spills over into the U.S. markets (likely through a rapid rise in the U.S. dollar). Yet without any signs of a meaningful slowing of U.S. growth or inflation, such a move would prove to be a short-lived trading opportunity rather than a true change in the rising trend for bond yields. Chart 4U.S. Inflation Acceleration Will Continue U.S. Inflation Acceleration Will Continue U.S. Inflation Acceleration Will Continue Chart 5Market Still Underpricing Fed Rate Hikes Market Still Underpricing Fed Rate Hikes Market Still Underpricing Fed Rate Hikes Bottom Line: EM market declines have, so far, shown no signs of impacting U.S. economic growth. The underlying acceleration of U.S. growth and inflation in the face of the EM turmoil suggests that bond investors should remain strategically underweight U.S. Treasuries with a below-benchmark duration stance. EM Turmoil, Then & Now, In Charts As discussed earlier, we see signs today of both of the most recent EM selloffs in 2013 and 2014/15 that were fueled by rising U.S. interest rates and a higher U.S. dollar. In the sets of charts beginning on Page 7 we present "cycle-on-cycle" analyses of several economic and financial indicators during those episodes, as well as this year. The charts are set up so that the blue lines represent the current EM selloff and the dotted lines in each panel represent how the same data series responded in 2013 (top panel of each chart) and 2014/15 (bottom panel of each chart). The vertical line represents the date of the trough in the U.S. dollar for each episode, which occurred in February 2018 for the current cycle. By looking at these charts, we can see how the current backdrop is evolving versus those prior episodes. The goal is to try to determine where things are similar, and different, to EM market declines in recent history. We are focusing on the areas where we believe there is the greatest concern over the potential spillovers from the current bout of EM stress - U.S. economic growth, Chinese economic growth and U.S. financial markets. We present the charts in a rapid "chartbook" format, with our overall conclusions at the end. Leading Economic Indicators: The OECD's leading economic indicator for the U.S. (Chart 6A) is currently off the high seen at the beginning of the year, following a path similar to 2014/15, but the latest data point has ticked higher. More importantly, the level is higher than at the same point in the 2013 and 2014/15 cycles. Meanwhile, the OECD (ex-U.S.) global leading economic indicator (Chart 6B) is following the depressed path of the 2014/15 episode, rather than the acceleration seen during the 2013 Taper Tantrum. Chart 6AU.S. Leading Indicator Following 2014/15 Path U.S. Leading Indicator Following 2014/15 Path U.S. Leading Indicator Following 2014/15 Path Chart 6BGlobal Leading Indicator Following 2014/15 Path Global Leading Indicator Following 2014/15 Path Global Leading Indicator Following 2014/15 Path U.S. Dollar: The rising dollar of 2018 (Chart 7A) looks more like the 2014/15 episode in terms of magnitude, although the greenback is at a lower level than during that earlier cycle (note that all lines are indexed to 100 at the date of the trough in the dollar at the vertical line). In 2013, the increase in the dollar was fairly mild, even with U.S. bond yields soaring higher, due to fact that non-U.S. growth was improving at the time. Chart 7AU.S. Dollar Following 2014/15 Path...So Far U.S. Dollar Following 2014/15 Path...So Far U.S. Dollar Following 2014/15 Path...So Far Chart 7BU.S. Investment Grade Returns Matching 2014/15 Path U.S. Investment Grade Returns Matching 2014/15 Path U.S. Investment Grade Returns Matching 2014/15 Path U.S. Corporate Bonds: The path of excess returns for U.S. investment grade corporate debt (Chart 7B) is tracking extremely tightly to the 2014/15 experience, with larger losses compared to this similar point during the Taper Tantrum. EM Equities & Credit: The widening in USD-denominated EM sovereign credit spreads in 2018 (Chart 8A) is in line with the 2014/15 cycle and has already surpassed the 2013 episode. The decline in EM equities (Chart 8B) has been worse than both prior EM selloffs. Chart 8AEM Equities Worse Than Both 2013 & 2014/15 EM Equities Worse Than Both 2013 & 2014/15 EM Equities Worse Than Both 2013 & 2014/15 Chart 8BEM Spreads Matching 2014/15 Path EM Spreads Matching 2014/15 Path EM Spreads Matching 2014/15 Path U.S. Interest Rates: Our 12-month fed funds discounter, which measures the amount of Fed rate hikes expected by the market over the next year, is higher than the 2014/15 episode and much higher than 2013 (Chart 9A). 10-year Treasury yields are at the same level as occurred at this point during the Taper Tantrum, and well above the levels seen in 2014/15 (Chart 9B). Chart 9AMore Fed Hikes Expected Than 2013 & 2014/15 More Fed Hikes Expected Than 2013 & 2014/15 More Fed Hikes Expected Than 2013 & 2014/15 Chart 9BUST Yields Following 2013 Path UST Yields Following 2013 Path UST Yields Following 2013 Path U.S. Labor Markets: Perhaps the biggest difference between the current backdrop and the prior EM selloffs is state of the U.S. labor market. The unemployment rate of 3.9% is much lower than the 5.6% rate seen during the 2014/15 cycle and the 7.6% level seen at this point during the Taper Tantrum (Chart 10A). That is translating to a faster pace of U.S. wage growth, measured by the annual percentage change in Average Hourly Earnings, than in either of the previous episodes of USD strength and EM turmoil (Chart 10B). Chart 10AMuch Lower U.S. Unemployment In 2018... Much Lower U.S. Unemployment In 2018... Much Lower U.S. Unemployment In 2018... Chart 10B...With Faster U.S. Wage Growth ...With Faster U.S. Wage Growth ...With Faster U.S. Wage Growth U.S. Inflation: Realized U.S. inflation, using core CPI, is higher now than in either of the previous episodes (Chart 11A). That can also been seen in the ISM Prices Paid index, which is far above the levels seen in both 2013 and 2014/15 (Chart 11B). Chart 11AHigher U.S. Inflation In 2018... Higher U.S. Inflation In 2018... Higher U.S. Inflation In 2018... Chart 11B...With Greater Inflation Pressures ...With Greater Inflation Pressures ...With Greater Inflation Pressures U.S. Economy: We can obviously show many charts here, but we think the most relevant are those related to signs that non-U.S. market turmoil and slowing growth is spilling back into the U.S. On that note, we show the ISM New Orders index in Chart 12A and the annual growth rate of total U.S. exports in Chart 12B. The New Orders index today is as strong as it was at this point during the Taper Tantrum, and much healthier compared to 2014/15 when New Orders were falling sharply. U.S. export growth is faster than both prior episodes, especially 2014/15 when exports contracted outright. Chart 12AStronger ISM New Orders In 2018... Stronger ISM New Orders In 2018... Stronger ISM New Orders In 2018... Chart 12B...With Healthier Export Demand ...With Healthier Export Demand ...With Healthier Export Demand China Economy: Again, we could use any number of data series in these charts, but we are keeping it simple and choosing indicators that show the impact of Chinese growth on the world economy. Chinese nominal GDP growth, currently at 9.8%, is the same as it was at this point in the 2013 cycle but much faster than during the 2014/15 period (Chart 13A). Importantly, however, China nominal GDP growth is decelerating now as it was in both of the prior episodes. Chinese annual import growth, up 19% in RMB terms, is faster now than in both prior periods of EM stress, especially compared to the contraction seen during the 2014/15 episode (Chart 13B). Chart 13AFaster, But Still Slowing, China GDP Growth Faster, But Still Slowing, China GDP Growth Faster, But Still Slowing, China GDP Growth Chart 13BStronger China Import Growth In 2018 Stronger China Import Growth In 2018 Stronger China Import Growth In 2018 U.S. Corporate Profits: Here is perhaps the biggest difference between today and the previous EM stress episodes. The annual growth in earnings-per-share for the S&P 500 rose to 18% in the 2nd quarter of this year, far above the zero growth rate seen at this point of the 2013 and 2014/15 cycles (Chart 14A). A big reason for the difference is the impact of the Trump corporate tax cuts this year, which has boosted operating margins well beyond levels seen in the prior two episodes (Chart 14B). Chart 14AFaster U.S. Profit Growth In 2018... Faster U.S. Profit Growth In 2018... Faster U.S. Profit Growth In 2018... Chart 14B...With Wider Margins Thanks To Tax Cuts ...With Wider Margins Thanks To Tax Cuts ...With Wider Margins Thanks To Tax Cuts EM Growth: An aggregate of EM Purchasing Managers Indices (PMIs) shows that the current bout of softer EM growth looks similar to the slowdowns in 2013 and 2014/15 (Chart 15A). In both prior cases, the PMIs eventually fell below 50, signifying economic contraction. In the 2013 episode, however, the PMI rebounded around the same point in the cycle as we are at today. Chart 15AEM Growth Slowing Similar To 2013 & 2014/15 EM Growth Slowing Similar To 2013 & 2014/15 EM Growth Slowing Similar To 2013 & 2014/15 Chart 15BU.S. Financial Conditions Tightening Like 2014/15 U.S. Financial Conditions Tightening Like 2014/15 U.S. Financial Conditions Tightening Like 2014/15 U.S. Financial Conditions: U.S. financial conditions are tighter now than the level seen at this point in the 2013 cycle and are as tight as witnessed at this point in the 2014/15 period (Chart 15B). After looking through all these charts, we can come up with the following conclusions: Chart 16Is It All Just "Q.T."? Is It All Just "Q.T."? Is It All Just "Q.T."? EM financial stress today is worse than 2013 and 2014/15 The U.S. economy is stronger today than in 2013 and 2014/15 U.S. external demand and corporate profits are both more robust today than in 2013 and 2014/15 U.S. inflation pressures are greater today than in 2013 and 2014/15 China's economy today, while slowing, is still growing faster than in 2013 and 2014/15 EM economic growth is slowing at the same pace as in 2013 and 2014/15. In terms of "benchmarking" where we are now compared to the previous two EM big EM selloffs, the fact that U.S. and Chinese economic growth is stronger today, and U.S. inflation is faster today, are the most important differences. This may even explain why U.S. markets are not reacting more negatively to the growing protectionist threats from the White house. Against this backdrop, it will require higher U.S. interest rates and a much stronger dollar before U.S. equities and credit markets finally suffer a serious pullback. In the end, though, the fact that U.S. and Chinese growth is better today does not suggest that a cautious investment stance is unwarranted. For the best correlation can be seen in our final chart (Chart 16), which shows the growth rate of the major developed market central bank balance sheets as a leading indicator of EM equity returns and developed market credit returns (and as a coincident indicator of government bond yields). If one were to only look at this chart, the weaker returns from global risk assets in 2018 can be fully explained by "quantitative tightening" and the resulting pullback in risk-seeking global capital flows compared the 2016/17. Bottom Line: The current EM turmoil has not yet spilled over into U.S. financial markets, as occurred during the 2013 and 204/15 EM selloffs, because the U.S. economy is in a much stronger position now. It will take a bigger tightening of U.S. financial conditions, likely through higher U.S. interest rates and a larger increase in the U.S. dollar, before U.S. risk assets suffer the type of decline that could trigger a pause in the Fed rate hike cycle. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy/China Investment Strategy Special Report, "China: How Stimulating Is The Stimulus?", dated August 8th 2018, available at gps.bcaresearch.com and cis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index EM Contagion? Or Just Q.T. On The QT? EM Contagion? Or Just Q.T. On The QT? Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Wage Growth Playing Catch-Up To Curve Wage Growth Playing Catch-Up To Curve Wage Growth Playing Catch-Up To Curve Last Friday's employment report confirmed that the U.S. economy remained on a solid footing through August, even as leading indicators outside of the U.S. have weakened. Our back-of-the-envelope GDP tracking estimate - the year-over-year growth in aggregate weekly hours worked (2.14%) plus average quarterly productivity growth since 2012 (0.86%, annualized) - points to U.S. growth of approximately 3%. But strong GDP growth is old news for markets. Rather, it was the 0.4% month-over-month increase in average hourly earnings that caused bond yields to jump last Friday. Rising wage growth is usually a bear-flattener, consistent with both higher yields and a flatter curve (Chart 1). But in recent years the yield curve has flattened considerably while wage growth has lagged. The curve's front-running suggests that continued gains in wage growth will keep the Fed on its current tightening path, but may not translate into much curve flattening. Investors should maintain below-benchmark duration, but look for attractively valued curve steepeners. We also recommend only a neutral allocation to spread product to hedge the risk from weakening global growth. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 43 basis points in August, dragging year-to-date excess returns down to -93 bps. The index option-adjusted spread widened 5 bps on the month, and currently sits at 113 bps. Despite recent spread widening, corporate bonds remain expensive with 12-month breakeven spreads for both the A and Baa-rated credit tiers near their 25th percentiles since 1989 (Chart 2). Further, with inflation now close to the Fed's target, monetary policy will provide much 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.1 On a positive note, gross leverage for the non-financial corporate sector likely declined for the third consecutive quarter in Q2 (panel 4), but we remain pessimistic that such declines will continue in the back-half of the year. As we noted in a recent report, weaker foreign economic growth and the resultant dollar strength will eventually weigh on corporate revenues.2 Accelerating wage growth will also hurt profits if it is not completely passed through to higher prices. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Playing Catch-Up Playing Catch-Up Table 3BCorporate Sector Risk Vs. Reward* Playing Catch-Up Playing Catch-Up 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 14 basis points in August, bringing year-to-date excess returns up to +220 bps. The average index option-adjusted spread widened 2 bps on the month, and currently sits at 336 bps. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses is currently 226 bps, slightly 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 excess high-yield returns of 226 bps over duration-matched Treasuries, assuming also that there are no capital gains/losses from spread tightening/widening. However, we showed in a recent report that the default loss expectations embedded in our calculation are extremely low relative to history (panel 4).3 Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.15% during the next 12 months. The only historical period to show significantly lower default losses was 2007, a time when corporate balance were in much better shape than today. While most indicators suggest that default losses will in fact remain low for the next 12 months, historical context clearly demonstrates that the risks are to the upside. It will be critical to track real-time indicators of the default rate such as job cut announcements, which have increased since mid-2017 (bottom panel), for signals about whether current default forecasts are overly optimistic. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in August, dragging year-to-date excess returns down to -18 bps. The conventional 30-year zero-volatility MBS spread widened 5 bps on the month, driven by a 3 bps increase in the compensation for prepayment risk (option cost) and a 2 bps widening of the option-adjusted spread. The excess return Bond Map 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 very favorable for the sector. In a recent report we showed that the two main factors that influence MBS spreads are mortgage refinancing activity and residential mortgage lending standards.4 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), but the Fed's most recent Senior Loan Officer Survey reports that standards remain at the tighter end of the range since 2005. The still-tight level of lending standards suggests that further easing is likely going forward. The amount of MBS running off the Fed's balance sheet has failed to exceed its cap in recent months, meaning that the Fed has not needed to enter the market to purchase MBS. This will probably continue to be the case going forward, due to both limited run-off and increases in the monthly cap. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 12 basis points in August, dragging year-to-date excess returns down to -10 bps. Sovereign debt underperformed the Treasury benchmark by 48 bps on the month, dragging year-to-date excess returns down to -83 bps. Foreign Agencies underperformed by 14 bps on the month, dragging year-to-date excess returns down to -36 bps. Local Authorities underperformed by 20 bps on the month, dragging year-to-date excess returns down to +41 bps. Supranationals performed in line with Treasuries in August, keeping year-to-date excess returns at +12 bps. Domestic Agency bonds outperformed by 5 bps, bringing year-to-date excess returns up to +4 bps. Despite poor returns relative to Treasuries, Sovereign debt managed to outperform similarly-rated U.S. corporate debt in recent months. The outperformance is particularly puzzling given the unattractive relative valuation and the strengthening U.S. dollar (Chart 5). We reiterate our underweight allocation to Sovereign debt. The excess return Bond Map shows that both Local Authorities and Foreign Agencies offer exceptional risk/reward trade-offs compared to other U.S. bond sectors. We remain overweight both sectors. The excess return Bond Map also shows that while Supranational and Domestic Agency sectors are very low risk, expected returns are feeble. Both sectors should be avoided. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 70 basis points in August, dragging year-to-date excess returns down to +116 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 3% in August, and currently sits at 85% (Chart 6). This is more than one standard deviation below its post-crisis mean and only slightly higher than 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.5 For example, we observe that a 5-year Aa-rated municipal bond carries a yield of 2.29% versus a yield of 3.35% for a comparable corporate bond index. This implies that an investor with an effective tax rate of 32% 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. What's more, municipal bonds are also more insulated from the risk of weak foreign growth than the U.S. corporate sector, and recent enacted revenue increases at the state level should lead to lower net borrowing in the coming quarters (bottom panel). All in all, attractive relative yields and lower risk make municipal bonds preferable to corporates in the current environment. Remain overweight. 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 has flattened since the end of July, with yields at the short-end of the curve slightly higher and yields at the long-end slightly lower. The 2/10 Treasury slope currently sits at 23 bps and the 5/30 slope is currently 29 bps. The yield curve is already quite flat, consistent with a late-cycle economy. However, the economic data do not yet synch up with the curve's assessment. Chart 1 shows that wage growth is lagging the yield curve, while another yield curve indicator - nominal GDP growth less the fed funds rate - is moving in the opposite direction (Chart 7). We are likely to see both accelerating wage growth and decelerating nominal GDP growth during the next few quarters, but such outcomes are to a large extent in the price. In other words, the pace of curve flattening is likely to moderate in the coming months. With that in mind, we maintain our position long the 7-year bullet versus a duration-matched 1/20 barbell. That position is priced for 20 bps of 1/20 flattening during the next six months (Table 5). Table 4Butterfly Strategy Valuation (As Of August 3, 2018) Playing Catch-Up Playing Catch-Up Table 5Discounted Slope Change During Next 6 Months (BPs) Playing Catch-Up Playing Catch-Up Curve flatteners look more attractive at the long-end of curve. For example, the 5/30 barbell over 10-year bullet is priced for no change in 5/30 slope during the next six months. We also continue to hold this position to take advantage of the attractive value, and as a partial hedge to our position in the 1/7/20. TIPS: Overweight Chart 8TIPS Market Overview Inflation Compensation Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 17 basis points in August, dragging year-to-date excess returns down to +122 bps. The 10-year TIPS breakeven inflation rate declined 4 bps on the month and currently sits at 2.10%. The 5-year/5-year forward TIPS breakeven inflation rate declined 6 bps on the month and currently sits at 2.22%. 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 breakevens have remained relatively firm in recent weeks even as commodity prices have declined sharply (Chart 8). This suggests that breakevens are increasingly taking cues from the U.S. inflation data, and might now be less sensitive to the global growth outlook. Core inflation should remain close to the Fed's 2% target going forward. This will gradually wring deflationary expectations out of the market, allowing long-dated TIPS breakevens to reach our 2.3% to 2.5% target range. While the macro back-drop remains highly inflationary - pipeline inflation measures are elevated (panel 4) and the labor market is tight - we noted in a recent report that the rate of increase in year-over-year core inflation will probably moderate in the months ahead, due to base effects that have become less supportive.6 ABS: Neutral CHart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 8 basis points in August, bringing year-to-date excess returns up to 18 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 1 basis point on the month and now stands at 37 bps, 10 bps above its pre-crisis low. The excess return Bond Map 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. Further, credit quality trends have been slowly moving against the 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). The New York Fed's Household Debt and Credit report showed that consumer credit growth increased at an annualized rate of 4.6% in the second quarter, compared to 3.3% in Q1. However, the prospects for further acceleration in consumer credit are probably limited. A rising delinquency rate and tightening lending standards will both weigh on future credit growth (panel 3). 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 28 basis points in August, bringing year-to-date excess returns up to +126 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 2 bps on the month and currently sits at 68 bps (Chart 10). In a recent report we showed that the macro picture for CMBS is decidedly mixed.7 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 10 basis points in August, bringing year-to-date excess returns up to +41 bps. The index option-adjusted spread was flat on the month and currently sits at 45 bps. The Bond Maps 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 7, 2018) Playing Catch-Up Playing Catch-Up Chart 12Total Return Bond Map (As Of September 7, 2018) Playing Catch-Up Playing Catch-Up Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem", dated July 17, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "The Powell Doctrine Emerges", dated September 4, 2018, available at usbs.bcaresearch.com 7 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 2018 YTD Summary: Investment grade corporate debt in the developed economies has performed poorly so far in 2018, led by lagging returns in Financials and some steepening of credit curves. U.S. credit has outperformed European equivalents. These trends are likely to continue over at least the next six months. Our Sector Portfolios: Our investment grade sector model portfolios have underperformed modestly so far in 2018 (-3bps each in the U.S., euro area & U.K.) - primarily due to our overweight stance on Financials which have performed poorly. Looking Ahead: We are maintaining a neutral level of target spread risk (i.e. duration-times-spread equal that of the benchmark index) in our sector model portfolios for the U.S., euro area and U.K. We will look to reduce that spread risk on signs of a deeper global growth slowdown, which we expect will unfold in 2019. Feature Chart of the WeekReversal Of Fortune Reversal Of Fortune Reversal Of Fortune The performance of investment grade (IG) corporate bonds in the developed markets, as an asset class, has been underwhelming so far in 2018. Using the total return indices from Bloomberg Barclays, IG corporates in the U.S., euro area and U.K. - the regions with the three largest corporate bond markets among the developed economies - have lost -2.0%, -0.3% and -1.1%, respectively. The numbers do not look much better when shown on an excess return basis versus duration-matched government bonds: U.S. IG -0.8%, euro area -1.2% and the U.K. -1.3%. The sluggish performance for IG corporates is a mirror image of the strong showing in 2017 when looking at credit spreads, which reached very tight levels at the end of last year (Chart of the Week). The 2017 rally left global corporates exposed to any negative shocks, of which there have been many so far in 2018 (the February VIX spike, the Q1 global growth slowdown, intensifying U.S.-China trade tensions, ongoing Fed tightening, a strengthening U.S. dollar, less dovish non-U.S. central banks, Italian politics, emerging market turmoil). Given the more challenging environment for overall corporate bond performance, the role of sector selection as a way to generate alpha, by mitigating losses from beta, is critical. In this Weekly Report, we take a brief look at IG sector performance so far this year and update our sector allocations based on our relative value models for IG corporates in the U.S., euro area and U.K. 2018 YTD Global Corporates Performance: A Down Year The major IG sector groupings for the U.S., euro area and U.K. are presented in Table 1, ranked by the 2018 year-to-date excess returns (all are shown in local currency terms). The overall index return for each region is also shown (highlighted in gray) in the table, to highlight how individual sectors have performed relative to the overall IG index. Table 12018 Year-To-Date Investment Grade Sector Returns For The U.S., Euro Area & U.K. A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors As is always the case with IG corporates, the performance of the broad Financials grouping (which includes banks, insurance companies, REITs, etc.) heavily influences the returns of the overall IG index given the large weighting of Financials within the Corporates index across all three regions. In both the euro area and U.K., the sharp underperformance of Financials seen year-to-date (-1.3% and -1.4%, respectively) has created a somewhat odd situation where the majority of sectors have outperformed the overall index. That could only happen given the large weight of Financials in the euro area index (40%) and U.K. index (43%). Financials are also a big part of the U.S. index (32%), but there is more balance in the U.S. IG index which has helped boost the "beta" return from U.S. corporates. Specifically, the weightings of the top three largest U.S. broad sector groupings - Energy (9%), Technology (8%) and Communications (9%) - are a combined 26% of the overall U.S. IG index. Those three sectors are also among upper tier of the 2018 performance table in the euro area and U.K., but only represent a combined 15% and 8%, respectively, of each region's IG index. The conclusion is that index composition has flattered the performance of U.S. IG corporates versus European equivalents, given the latter's heavier weighting in Financials. The poor performance of Financials can be attributed to flattening global government bond yield curves (which is a negative for banks) and poor returns from global credit, especially in emerging markets (which is a negative for insurers that invest in spread product). We do not anticipate either of those trends reversing anytime soon - particularly the ongoing selloff in emerging market assets - thus Financials are likely to remain a drag on corporate bond performance for at least the next 3-6 months. One other factor that has weighed on overall IG corporate performance has been the steepening of credit spread curves. The gaps between credit spreads for Baa- and A-rated corporates have widened since the end of January, most notably in the euro area and the U.K. where growth has been slower than in the fiscal-policy fueled U.S. economy (Chart 2). With Baa-rated debt now representing one-half of the IG index for the U.S., euro area and U.K. (Chart 3) - a function of rising corporate leverage - continued underperformance of lower quality sectors will negatively impact the future overall returns from IG corporates. Chart 2Spread Curves Are##BR##Steepening In Europe Spread Curves Are Steepening In Europe Spread Curves Are Steepening In Europe Chart 31/2 Of Investment Grade Corporate Indices##BR##Are Now Baa-Rated 1/2 Of Investment Grade Corporate Indices Are Now Baa-Rated 1/2 Of Investment Grade Corporate Indices Are Now Baa-Rated Looking ahead, credit investors should be wary of the potential for downgrade risk in their portfolios given the high proportion of Baa-rated debt in the IG benchmark indices. This risk will become more acute when the global business cycle runs out of steam (a 2019 story, at the earliest, in our view). Bottom Line: Investment grade corporate debt in the developed economies has performed poorly so far in 2018, led by lagging returns in Financials and some steepening of credit curves. U.S. credit has outperformed European equivalents. These trends are likely to continue over at least the next six months. Our Corporate Sector Valuation Models: Winners & Losers Our recommended IG sector allocations come from our relative value model, which measures the valuation of each individual sector compared to the overall Bloomberg Barclays corporate bond index for each region. The methodology takes each sector's individual option-adjusted spread (OAS) and regresses it in a panel regression with all other sectors in each region. The dependent variables in the model are each sector's duration, convexity (duration squared) and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that panel regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS is our valuation metric used to inform our sector allocation ranking. The latest output from the models can be found in the tables and charts in the Appendix starting on Page 13. We also show the duration-times-spread (DTS) for each sector in those tables, which we use as the primary way to measure the riskiness (volatility) of each sector. The scatterplot charts in the Appendix show the tradeoff between the valuation residual from our model and each sector's DTS. We then apply individual sector weights based on the model output and our desired level of overall spread risk in our recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. That target portfolio DTS is the first decision in our discretionary allocation process, which is informed by our strategic views on corporate credit in each region. For example, if we were recommending an overweight allocation to U.S. IG corporates, then we would target a portfolio DTS that was greater than the index DTS. If we then became a bit more cautious on U.S. corporates, we could reduce the target DTS (spread risk) of our model sector portfolio while maintaining an overall overweight allocation to U.S. corporates versus U.S. Treasuries. That is exactly what we did one year ago, when we began to target a weighted DTS of all our individual sector tilts that was roughly equal to the overall IG corporate index DTS for each region (U.S. euro area, U.K.) while maintaining an overall overweight stance on global corporate credit versus government debt. More recently, we have downgraded our stance on global spread product to neutral, while continuing to favor the U.S. over Europe, in response to growing tensions from emerging markets and the brewing U.S.-China trade war.1 Chart 4Performance Of Our IG Sector Allocations A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors We last presented a performance update for our global IG corporate sector allocations back on April 12th of this year. Since then, our recommended tilts have modestly underperformed the benchmark index in excess return terms by a combined -3bps (Chart 4). This came entirely from the euro area, with both the U.S. and U.K. sector allocations simply matching the benchmark index. Year-to-date, our IG sector allocations have underperformed the benchmark by a combined -9bps in excess return terms, split equally among the U.S., euro area and U.K. This is a result entirely consistent with our long-standing stance to overweight Financials in all three regions, which continue to appear cheap in our valuation framework. Also, an increasing number of sectors had become expensive within that framework, in all three regions, so some portion of that overweight to global Financials was "by default" given that our model portfolios must be fully invested (finding value has been a persistent problem for credit investors over the past year). The return numbers for our U.S. sector allocations can be found in Table 2. Since our last update in April, the best performing sectors (in excess return terms) within our recommended tilts have all been underweights: Pharmaceuticals (+1.2bps), Electric Utilities (+1.1bps), Retailers (+0.6bps), Health Care (+0.6bps), Diversified Manufacturing (+0.5bps) and Chemicals (+0.4bps). These were fully offset, however, by underperformance from our large overweights to Energy (-4.1bps) and Financials (-2.7bps). Table 2U.S. Investment Grade Performance A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors The return numbers for our euro area sector allocations - shown here hedged into U.S. dollars as is the case when we present all our model portfolio returns - can be found in Table 3. Since our last update in April, the best performing sectors (in excess return terms) within our recommended tilts have been underweights to Transportation (+2.0bps) and Electric Utilities (+0.6bps), with underperformance coming from our underweight to Food/Beverage (-2.4bps) and overweight to Life Insurers (-3.1bps). Table 3Euro Area Investment Grade Performance A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors The return numbers for our U.K. sector allocations (again, hedged into U.S. dollars) can be found in Table 4. Since our last update in April, the best performing sectors (in excess return terms) within our recommended tilts have been our underweight to Utilities (+2.0bps) and Consumer Non-Cyclicals (+0.9bps), but this was nearly fully offset by our large overweight to Financials (-2.6bps). Table 4U.K. Investment Grade Performance A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Despite the underperformance of our sector portfolios year-to-date, the cumulative alpha from the portfolios since we began tracking the performance of the recommendations remains positive (+2bps in the U.S., +9bps in the euro area, +42bps in the U.K.). Bottom Line: Our investment grade sector model portfolios have underperformed modestly so far in 2018 (-3bps each in the U.S., euro area & U.K.) - primarily due to our overweight stance on Financials which have performed poorly. Changes To Our Sector Model Portfolios As mentioned earlier, the first choice we make when determining the recommended sector allocations within our model portfolios is how much spread risk (DTS) to take. For the U.S., euro area and U.K., we have already been maintaining a portfolio DTS that is close to the index DTS since August 2017. After our recent decision to downgrade global spread product allocations to neutral versus government bonds, we do not feel a need to further reduce our spread risk by targeting a below-index DTS. That would likely be our next decision when we wish to get more defensive on credit, which would await evidence that global leading economic indicators are sharply slowing and/or global monetary policy is becoming restrictive. Within that neutral level of spread risk, we are making the following portfolio changes based on the updated output from our valuation models presented in the Appendix Tables on pages 13-18. The goal is to favor sectors that have a DTS close the index DTS but have positive valuation residuals from our model: U.S.: We downgrade Tobacco and Wireless to Neutral; we downgrade Paper to Underweight. Euro Area: We upgrade Transportation, Other Industrials, Natural Gas, Brokerages/Asset Managers and Finance Companies to Overweight; we upgrade Automotive, Retailers and Tobacco to Neutral; we downgrade Wireless to Neutral; we downgrade Diversified Manufacturing & Media Entertainment to Underweight. U.K.: We upgrade Health Care, Transportation and Other Industrials to Overweight; we upgrade Integrated Energy to Neutral; we downgrade Technology & Wireless to Neutral; we downgrade Metals & Mining and Supermarkets to underweight. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Time To Take Some Chips Off The Table: Downgrade Global Corporate Bond Exposure To Neutral", dated June 26th 2018, available at gfis.bcaresearch.com. Appendix Appendix Table 1U.S. Corporate Sector Valuation And Recommended Allocation* A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Appendix Chart 1U.S. Corporate Sector Risk Vs. Reward* A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Appendix Table 2Euro Area Corporate Sector Valuation And Recommended Allocation* A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Appendix Chart 2Euro Area Corporate Sector Risk Vs. Reward* A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Appendix Table 3U.K. Corporate Sector Valuation And Recommended Allocation* A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Appendix Chart 3U.K. Corporate Sector Risk Vs. Reward* A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear Client, There will be no U.S. Bond Strategy report next week. Our regular publishing schedule will resume on September 4th. Best regards, Ryan Swift Highlights Global Growth Divergences: The impact of weak foreign growth will eventually be felt in the U.S. and could even result in the Fed pausing its rate hike cycle for a time. But history tells us that the resulting decline in Treasury yields will not last long. Investors should hedge the risk of weak foreign growth by maintaining only a neutral allocation to spread product, but should maintain below-benchmark portfolio duration. Corporates: As global growth divergences deepen and the dollar strengthens, corporate profit growth will eventually fade and corporate leverage and defaults will rise. Accelerating wages will exacerbate the problem, much like in the late 1990s. Municipal Bonds: Municipal bonds offer attractive yields relative to corporate bonds, especially considering that they are more insulated from weakening foreign growth. Remain overweight municipal bonds. Feature "It is just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress." - Alan Greenspan, September 19981 Fed Chairman Alan Greenspan uttered the above sentence in early September 1998. Russia had just defaulted on its government debt and a few weeks later the heavily-exposed hedge fund Long-Term Capital Management would require a bail-out, kicking off a period of turmoil in U.S. financial markets. The Federal Reserve responded by cutting interest rates by 75 basis points between September 30th and November 4th, despite a domestic labor market that Chairman Greenspan described as "unusually tight." We recall this tumultuous period because a divergence between strong U.S. and weak non-U.S. growth is once again putting upward pressure on the U.S. dollar, leading to pain in emerging markets. So far it is the Turkish lira bearing the brunt of the sell-off, but the lesson from the late 1990s is that other EMs, and eventually the U.S., are also vulnerable. A joint Special Report, published last week, from our Foreign Exchange Strategy and Geopolitical Strategy services provides a blow-by-blow account of the late 1990s period, with implications for today's currency markets.2 In this week's report, we focus on what divergences between strong U.S. growth and weak non-U.S. growth mean for U.S. bond portfolios. A History Of False Starts The divergence between strong U.S. and weak non-U.S. growth is illustrated in Chart 1. The shaded regions in the chart correspond to periods when the Global (ex. U.S) leading economic indicator (LEI) is contracting while the U.S. LEI continues to rise. There have been 10 such episodes since 1966. In the four instances that occurred prior to 1993, the U.S. economy remained insulated from flagging growth in the rest of the world. That is, the U.S. LEI continued to expand and the Global (ex. U.S.) LEI eventually recovered into positive territory. However, since 1993, every time the Global (ex. U.S) LEI has dipped below zero the U.S. LEI has eventually followed. In other words, prior to 1993 the U.S. economy acted very much like an oasis of prosperity. But global events have become much more important since then. Chairman Greenspan's claim was correct in 1998 and remains relevant today. Case Study: 1997 Two of the post-1993 growth divergence episodes are particularly relevant for bond investors today. The first occurred in 1997 (Chart 2). The Fed tried to kick off a rate hike cycle in March 1997, but the combination of a Fed rate hike and weak foreign growth led to a surge in the dollar. Eventually, the strong dollar dragged our Fed Monitor below zero and the Fed was forced to abandon rate hikes until June 1999. In the interim, the Fed's dovish turn caused the dollar to halt its uptrend (Chart 2, panel 3). Treasury yields collapsed and then recovered (Chart 2, panel 4). Credit spreads moved in line with the exchange rate (Chart 2, bottom panel), widening alongside a stronger dollar in 1997/98, and then leveling off as the Fed eased policy and the dollar moved sideways. The end result of the 1997 episode is that Treasury yields took a round trip, falling as the Fed backed away from its rate hike path, then rising again once rate hikes resumed. Credit spreads, however, never fully recovered their 1997 tights. Case Study: 2015 More recently, growth divergences flared again in 2015 (Chart 3). This time, our Fed Monitor was already recommending rate cuts in late-2015, but the Fed pressed on and delivered the first rate hike of the cycle that December. Once again, the combination of a hawkish Fed and weak foreign growth put upward pressure on the dollar (Chart 3, panel 3), and the Fed was forced to pause its rate hike cycle. Chart 1The Weight Of The World The Weight Of The World The Weight Of The World Chart 2False Start 1997 False Start 1997 False Start 1997 Chart 3False Start 2015 False Start 2015 False Start 2015 Much like in 1997, Treasury yields declined as the Fed went on hold and then started to rise again as rate hikes resumed (Chart 3, panel 4). Also like 1997, credit spreads widened alongside the strengthening dollar, though this time they actually managed to tighten back to new lows when the Fed went on hold and the upward pressure on the dollar abated in 2016/17 (Chart 3, bottom panel). Implications For The Present Day Chart 4Inflation Is Much Closer To Target Inflation Is Much Closer To Target Inflation Is Much Closer To Target What lessons can we take away from these two episodes? The first is that if growth divergences continue to worsen and the dollar continues to appreciate, it will eventually cause our Fed Monitor to dip below zero and the Fed will likely pause its rate hike cycle. Such a dovish pause will lead to a decline in Treasury yields and a flattening-off, or even depreciation, of the dollar. However, we also know from history that any decline in Treasury yields is likely to prove fleeting. Once dovish Fed action takes the shine off the dollar, foreign economic growth will improve and the Fed will soon be able to resume rate hikes. This was the case in both 1997 and 2015. There is even reason to believe that any pause in Fed rate hikes could be particularly short-lived this time around. Inflation is already closing-in on the Fed's target and there is some evidence that long-dated inflation expectations have become stickier. Long-maturity TIPS breakeven inflation rates have not fallen much in recent weeks, even as weakening foreign growth has dragged down commodity prices (Chart 4). As for credit spreads, history shows that they are likely to widen as global growth divergences deepen and the dollar appreciates. Then, any pause in Fed rate hikes will improve credit's outlook for a time. Once again, because relatively strong inflation will limit the length of time that the Fed can pause lifting rates, we think any period of spread tightening that coincides with more dovish Fed policy will be short-lived. We also see similarities with the 1997 episode in terms of the outlook for corporate defaults. Such similarities bode ill for credit spreads, as is discussed in the next section. Bottom Line: The impact of weak foreign growth will eventually be felt in the U.S. and could even result in the Fed pausing its rate hike cycle for a time. However, history tells us that the resulting decline in Treasury yields will not last long. Investors should hedge the risk of weak foreign growth by maintaining only a neutral allocation to spread product, but should maintain below-benchmark portfolio duration. Corporate Defaults: Look To The Late 1990s Considering the two case studies presented above, the reason corporate bonds performed worse in 1997 compared to 2015 is that in 1997 corporate leverage and defaults started to creep higher and did not peak until the 2001 recession. In contrast, corporate leverage flattened-off and defaults fell once the Fed paused its rate hike cycle in 2016 (Chart 5). Chart 5Corporate Defaults: The Late 1990s Roadmap Corporate Defaults: The Late 1990s Roadmap Corporate Defaults: The Late 1990s Roadmap Looking closer, the bottom panel of Chart 5 shows that once profit growth fell below the rate of debt growth in 1997 it continued to trend down. In 2015/16, profit growth was again dragged lower by the strong dollar, but it quickly rebounded once the Fed turned dovish. In our view, if global growth divergences continue to worsen and the dollar continues to strengthen, the next increase in corporate leverage will probably look more like 1997. To see why, we consider the two reasons why profit growth decelerated in 1997. The first is the obvious reason that the strong dollar started to weigh on corporate revenues. The growth in business sales moderated and the PMI dipped below 50 (Chart 6). Today, we have not yet seen enough dollar strength to weigh on business sales or the manufacturing PMI, which is still hovering around 60 (Chart 6, bottom panel). But this will change as the emerging market turmoil spreads and eventually impacts the U.S. business sector. The second reason why the 1997 corporate default episode is the most comparable to the present day is that much like in 1997, but unlike in 2015, the labor market is extremely tight and wages are starting to accelerate (Chart 7). The growth in unit labor costs started to outpace the growth in corporate selling prices in 1997, and this caused our Profit Margin Proxy to fall (Chart 7, panel 2). At present, our Profit Margin Proxy is very close to the zero line, but with a sub-4% unemployment rate further downside is likely. Finally, much like in 1997, small businesses are increasingly citing labor quality as a more important problem than lack of sales (Chart 7, bottom panel). The difference between the rankings of these two problems has done a good job tracking profit growth historically. This indicator is currently at levels that are much more reminiscent of the late 1990s. Chart 6Dollar Strength Drags Down Revenue Dollar Strength Drags Down Revenue Dollar Strength Drags Down Revenue Chart 7Wages Will Weigh On Profits Wages Will Weigh On Profits Wages Will Weigh On Profits Bottom Line: As global growth divergences deepen and the dollar strengthens, corporate profit growth will eventually fade and corporate leverage and defaults will rise. Accelerating wage growth will exacerbate the problem, much like in the late 1990s. Take Shelter In Municipal Bonds Chart 8Munis As A Safe Haven Munis As A Safe Haven Munis As A Safe Haven Another implication of the divergence in growth between the U.S. and the rest of the world is that fixed income sectors that are more exposed to the domestic U.S. economy and less exposed to foreign growth and the exchange rate should fare better. In this regard, municipal bonds are an obvious candidate. While state & local government net borrowing has flattened off at a relatively high level during the past few quarters, state governments have recently re-committed to austerity (Chart 8). Data from the National Association of State Budget Officers show that states enacted a net $9.9 billion increase in revenues in fiscal year 2018, with another $2.8 billion planned for fiscal year 2019. Historically, revenue raises of this magnitude have led to declines in net borrowing, which should ensure that municipal ratings upgrades continue to outpace downgrades for the time being (Chart 8, bottom panel). But there's an even better reason for investors to favor municipal bonds. Quite simply, yields remain attractive compared to the riskier corporate alternatives, particularly at longer maturities. The top section of Table 1 shows relevant statistics for the 5-year, 10-year and 20-year tax-exempt Bloomberg Barclays Municipal bond indexes, along with the closest comparable indexes from the investment grade corporate sector. We observe that a 5-year Aa-rated municipal bond carries a yield of 2.18% versus a yield of 3.26% for a comparable corporate bond index. This implies that an investor with an effective tax rate of 33% should be indifferent between the two bonds. Any investor exposed to an effective tax rate above 33% should favor the municipal bond, even before considering the differences in risk between the two sectors. Moving further out the curve, the breakeven tax rate falls to 24% at the 10-year maturity point and to either 13% or 21% at the 20-year maturity point, depending on whether you use Aa-rated or A-rated corporate debt as the relevant comparable. We also find that High-Yield municipal debt looks attractive compared to the corporate alternative. The Bloomberg Barclays High-Yield Muni Index (excluding Puerto Rico) trades at a breakeven tax rate of 18% relative to a Ba-rated corporate bond, and 33% relative to a B-rated corporate bond. Even the taxable municipal space is attractive. The bottom section of Table 1 shows that the average yield on the 1-5 year taxable municipal bond index is slightly higher than that of the closest comparable corporate bond index. The same goes for the 5-10 year taxable muni index. Table 1A Comparison Of Municipal And Corporate Bond Yields An Oasis Of Prosperity? An Oasis Of Prosperity? Finally, drawing on work we presented in a recent Special Report, we provide total return forecasts for different municipal bond indexes along with the comparable corporate sector indexes (Table 2).3 We show results for three different effective tax rates, depending on how many rate hikes you expect from the Fed during the next 12 months and whether you expect Municipal / Treasury yield ratios to remain flat, widen to their post-2016 highs, or tighten to their post-2016 lows. Table 2Municipal Bonds Total Return Forecasts Vs. Corporate Sector Comparables An Oasis Of Prosperity? An Oasis Of Prosperity? For example, in an environment where the Fed delivers four rate hikes during the next 12 months and Municipal / Treasury yield ratios remain flat, an investor with a 24% effective tax rate can expect a total return of 2.81% from the 10-year Municipal bond index. If we adjust returns using the top marginal tax rate of 37% the expected total return rises to 3.52%. In the same scenario, where corporate spreads also remain flat, investors can expect a total return of 2.86% from a corporate bond with similar duration and credit rating. Bottom Line: Municipal bonds offer attractive yields relative to corporate bonds, especially considering that they are more insulated from weakening foreign growth. Remain overweight municipal bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/boarddocs/speeches/1998/19980904.htm 2 Please see Foreign Exchange Strategy / Geopolitical Strategy Special Report, "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "The Golden Rule Of Bond Investing", dated July 24, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights It has not been a lot of fun being a corporate bond investor in 2018. Global credit markets have struggled to deliver positive returns, amid a news flow that has been overwhelming at times. Geopolitical uncertainty, shifting monetary policy biases, greater inflation pressures, intensifying trade tensions, a rising U.S. dollar, slowing Chinese growth - all have combined to form a backdrop where investors should require wider risk premiums to own risky assets like corporate debt. Yet are wider spreads justified relative to the underlying financial health of companies? Feature Chart 1Global Corporates: Fading Support From##BR##Growth & Monetary Policy Global Corporates: Fading Support From Growth & Monetary Policy Global Corporates: Fading Support From Growth & Monetary Policy Against this backdrop of more uncertainty in credit markets, we are presenting our latest update of the BCA Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) that are designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 16. The broad conclusion from the latest readings on our CHMs is that global credit quality has been enjoying a cyclical improvement across countries, regions and credit tiers. The U.S. has delivered the biggest improvement in corporate health, compared to the recent past and to bearish investor perceptions as well. Much of that can be attributed to the impact of the Trump corporate tax cuts, though. At the same time, there have even been significant improvements in profitability metrics in regions that have lagged during the current global economic expansion, like Peripheral Europe. We recently downgraded our overall global spread product allocation to neutral.1 This reflected the increased concerns of the BCA Strategists that valuations on global risk assets looked rich compared to growing geopolitical risks (U.S.-China trade tensions, U.S.-Iran military tensions). Yet it also was related to the ongoing development of our biggest investment theme for 2018 - the eventual likely collision between tightening global monetary policy and rich valuations on global risk assets. Looking ahead, the tailwinds that have been supportive for corporate health and the performance of global corporate debt in the past couple of years - a coordinated cyclical upturn driving solid earnings growth, with low inflation allowing monetary policies to stay accommodative - are becoming headwinds (Chart 1). The overall OECD leading economic indicator, which is well correlated to the annual excess returns of global high-yield debt, has peaked. Central banks are either delivering rate hikes, talking about rate hikes, or cutting back on the pace of balance sheet expansion. All of these factors will weigh on corporate bond returns over the next 6-12 months. U.S. Corporate Health Monitors: Improving Thanks To Resilient Growth & Tax Cuts Chart 2Top-Down U.S. CHM:##BR##Boosted By Cyclically Strong Profits Top-Down U.S. CHM: Boosted By Cyclically Strong Profits Top-Down U.S. CHM: Boosted By Cyclically Strong Profits Our top-down CHM for the U.S. has been in the "deteriorating health" region for fifteen consecutive quarters dating back to the middle of 2014 (Chart 2). That streak appears set to end soon, as the indicator has been falling since peaking in 2016 and now sits just above the zero line. The resilience of the U.S. economy, combined with the positive impact on U.S. profitability from the Trump corporate cuts, has put U.S. companies in a cyclically healthier position, even with relatively high leverage. It is important to note that the top-down CHM uses after-tax earnings measures in several of the ratios the go into the indicator: return on capital, profit margin and debt coverage. All three of those ratios saw significant upticks in the first quarter of 2018, which is the latest available data for the top-down CHM. The Trump tax cuts did take effect at the start of the year, but given the robust results seen in reported second quarter profits reported so far, a bigger impact will likely be visible once we are able to update the CHM for the most recently completed quarter. The ability for U.S. companies to continue expanding margins will be tested in the next 6-12 months. The tight U.S. labor market is pushing up wage growth, which will pressure margins and prompt some firms to try and raise prices to compensate. Firming U.S. inflation is already keeping the Fed on a 25bps-per-quarter pace of rate hikes, and perhaps more if U.S. inflation continues to accelerate without any slowing of U.S. economic growth. If the Fed starts actively targeting a slower pace of U.S. growth to cool off inflation, credit markets will take notice and U.S. corporate debt will underperform. From a fundamental perspective, the top-down U.S. CHM suggests that the U.S. credit cycle is being extended by the stubborn endurance of the U.S. business cycle. There are no imminent domestic pressures on U.S. corporate finances that should require wider credit spreads to compensate for rising default risk. The bottom-up versions of the U.S. CHMs for investment grade (IG) corporates (Chart 3) and high-yield (HY) companies (Chart 4) have also both improved, with the HY indicator now crossing over the zero line into "improving health" territory. This confirms that the signal from our top-down CHM is being reflected in both higher-rated and lower quality companies. Yet the longer-term issues of high leverage and low interest/debt coverage are not going away, suggesting that potential problems are being stored up for the next U.S. economic downturn. What also remains worrying is the fact that IG interest coverage has fallen in recent years, despite high profit margins and historically low corporate borrowing rates. This indicates that the stock of U.S. corporate debt is now so large that the interest expense required to service that debt is eating up a greater share of corporate earnings, even at a time when profit growth is still quite strong. This will raise downgrade risk if corporate borrowing rates were to rise significantly or if U.S. earnings growth slows sharply. We moved our recommended stance on U.S. IG and HY to neutral at the end of June as part of our downgrade of overall global spread product exposure. We may consider a move back to overweight (versus U.S. Treasuries) on any meaningful spread widening given our optimistic view on U.S. economic growth and the positive measure on credit risk signaled by our CHMs. Yet it may be difficult to get such an opportunity. The U.S. is reaching a more challenging point in the monetary policy cycle with the Fed likely to shift to a restrictive stance within the next 6-12 months. At the same time, there are risks to the U.S. economy stemming from the widening U.S.-China trade conflict, a stronger U.S. dollar and, potentially, the growing turmoil in emerging markets. Yet the state of U.S. corporate health has improved substantially, leaving companies less immediately vulnerable to any of those shocks. Given this balance of risks, a neutral stance on U.S. corporates remains appropriate (Chart 5). Chart 3Bottom-Up U.S. Investment Grade CHM:##BR##Stable, But Watch Profit Margins Bottom-Up U.S. Investment Grade CHM: Stable, But Watch Profit Margins Bottom-Up U.S. Investment Grade CHM: Stable, But Watch Profit Margins Chart 4Bottom-Up U.S. High-Yield CHM:##BR##Cyclical Improvement Bottom-Up U.S. High-Yield CHM: Cyclical Improvement Bottom-Up U.S. High-Yield CHM: Cyclical Improvement Chart 5U.S. Corporates:##BR##Stay Neutral IG & HY U.S. Corporates: Stay Neutral IG & HY U.S. Corporates: Stay Neutral IG & HY Euro Corporate Health Monitors: Strong Economy, Big Improvements Our top-down euro area CHM remains in "improving health" territory, as has been the case for the past decade (Chart 6). The indicator had been worsening towards the zero line during 2016-17, but rebounded in the first quarter of 2018 thanks to a pickup in profit margins and debt coverage. Those positive developments are even more impressive since they occurred during a quarter when there was some cooling from the robust pace of economic growth seen in 2017. Chart 6Top-Down Euro Area CHM: Modestly Improving Top-Down Euro Area CHM: Modestly Improving Top-Down Euro Area CHM: Modestly Improving Interest coverage and liquidity remain in structural uptrends, supported by the super-easy monetary policies of the European Central Bank (ECB) that have lowered corporate borrowing costs (negative short-term interest rates, liquidity programs designed to prompt low-cost bank lending, and asset purchase programs that include buying of corporate bonds). Our bottom-up versions of the CHMs for euro area IG (Chart 7) and HY (Chart 8), which are based on individual company earnings data, both confirm the positive message from the top-down CHM. For IG, a noticeable gap has opened up between domestic and foreign issuers in the euro area corporate bond market. Return on capital, operating margins, interest coverage and debt coverage all ticked higher in the first quarter of this year, while leverage slightly declined. Those developments were not repeated among the foreign issuers in our sample. Within the Euro Area, our bottom-up CHMs show that the gap has closed between IG issuers from the core countries versus the periphery, but both remain in the "improving health" zone. (Chart 9). Somewhat surprisingly, the only ratios where there is a material difference are leverage (150% and falling in the periphery, 100% and stable in the core countries) and interest coverage (rising sharply toward 5x in the periphery, stable just above 6x in the core). Despite the improvement in the CHMs, credit spreads for euro area IG and HY have both widened over the course of 2018, while excess returns have been negative year-to-date (Chart 10). Looking ahead, we see the biggest threat for euro area corporate bond performance to come from a shift in ECB policy. We expect the ECB to follow through on its commitment to fully taper net new government bond purchases by the end of 2018, while continuing to reinvest the proceeds of maturing debt in 2019 and beyond. It is less clear what the ECB will do with its corporate bond buying program, and there has been some speculation that the ECB could leave its corporate program untouched while tapering the government purchases. We doubt that the ECB would want to make such a distinction that would artificially suppress corporate borrowing costs relative to government yields. The ECB is more likely to end both programs concurrently at the end of the year, which will remove a major prop under the euro area corporate bond market. This is a main reason why we are currently recommending an underweight stance on euro area corporates versus U.S. corporates. Chart 7Bottom-Up Euro Area Investment Grade CHMs: Domestic Issuers Looking Better Bottom-Up Euro Area Investment Grade CHMs: Domestic Issuers Looking Better Bottom-Up Euro Area Investment Grade CHMs: Domestic Issuers Looking Better Chart 8Bottom-Up Euro Area High-Yield CHMs: Falling Leverage, Mediocre Profitability Bottom-Up Euro Area High-Yield CHMs: Falling Leverage, Mediocre Profitability Bottom-Up Euro Area High-Yield CHMs: Falling Leverage, Mediocre Profitability Chart 9Bottom-Up Euro Area IG CHMs: Periphery Improving vs Core Bottom-Up Euro Area IG CHMs: Periphery Improving vs Core Bottom-Up Euro Area IG CHMs: Periphery Improving vs Core Yet the bigger reason why we prefer corporates from the U.S. over the euro area is that the relative improvement in corporate health has been bigger in the U.S. The gap between our top-down CHMs for the U.S. and Europe has proven to be an excellent directional indicator for the relative performance of U.S. credit vs Europe (Chart 11). That CHM gap continues to favor U.S. credit, which has been outperforming over the past several months (on a common currency basis compared to euro area debt hedged in USD). Chart 10Euro Area Corporates:##BR##Stay Underweight IG & HY Euro Area Corporates: Stay Underweight IG & HY Euro Area Corporates: Stay Underweight IG & HY Chart 11Relative Top-Down CHMs:##BR##Continue To Favor U.S. over Europe Relative Top-Down CHMs: Continue To Favor U.S. over Europe Relative Top-Down CHMs: Continue To Favor U.S. over Europe U.K. Corporate Health Monitor: Deteriorating Amid Rising Domestic Risks The U.K. CHM saw a significant deterioration in the first quarter of 2018, thanks largely to slowing U.K. growth that has impacted all the profit-focused ratios (Chart 12). The CHM is still in the "improving health" zone, but just barely. Seeing the return on capital, profit margin, interest coverage and debt coverage ratios all roll over at historically low levels is a worrying sign for future U.K. credit quality. This is especially true given the extremely stimulative monetary policy run by the Bank of England (BoE) since the 2008 Global Financial Crisis. The only ratio in the U.K. CHM that has seen steady improvement over the past decade is short-term liquidity (bottom panel), which has been boosted by steady increases in working capital. The performance of U.K. credit has benefited from the BoE's additional monetary policy measures taken after the shock Brexit vote in 2016. This involved both interest rate cuts and asset purchases, which included buying of U.K. corporate bonds. The BoE has shifted its policy bias from easing to tightening over the past year, even with sluggish U.K. economic growth and still-unresolved uncertainty about the future U.K. trading relationship with the European Union. This has raised the risks that the BoE could commit a policy error through additional interest rate hikes over the next 6-12 months, especially if policymakers focus more on targeting higher real policy rates as we discussed in a recent Weekly Report.2 U.K. corporates have been a laggard among global credit markets throughout 2018 and especially so in the month of July during a generally positive month for global corporate debt (Chart 13). We see the underperformance continuing in the coming months, as wider spreads will be required given the uncertainties surrounding Brexit, economic growth and BoE monetary policy. Stay underweight U.K. corporate debt within an overall neutral allocation to global spread product. Chart 12U.K. Top-Down CHM: Cyclical Deterioration U.K. Top-Down CHM: Cyclical Deterioration U.K. Top-Down CHM: Cyclical Deterioration Chart 13U.K. Corporates: Stay Underweight U.K. Corporates: Stay Underweight U.K. Corporates: Stay Underweight Japan Corporate Health Monitor: No Problems Here We added Japan to our suite of global CHMs earlier this year.3 Although the Japanese corporate bond market is small (the Bloomberg Barclays Japan Corporates index only has a market capitalization of $116bn), the asset class does provide opportunities for investors to pick up a bit of yield versus zero-yielding Japanese government bonds (JGBs) Japanese corporate health has been excellent for the past decade, with the CHM steadily holding in "improving health" territory (Chart 14). The trends in the Japan CHM ratios since 2008 are quite different than those seen in the CHMs for other countries. Leverage has been steadily falling, return on capital has been steadily rising (and has now converged to the 6% level seen in other countries' CHMs), and the interest coverage multiple of 9.6x is by far the largest in our CHM universe. Default risk is non-existent in Japan. Only pre-tax operating margins for our bottom-up Japan CHM have lagged those in other countries, languishing at 6% for the past three years. Yet Japanese corporate profits are at all-time highs, a logical outcome when companies can borrow at less than 50bps and earn a return on capital of 6%. That wide gap should allow Japanese companies to continue to earn steady, strong profits even with wage inflation finally showing life in Japan alongside a 2.3% unemployment rate. Japanese corporate bond spreads have widened a bit in 2018, but remain far more stable compared to corporates in other developed markets (Chart 15). The lack of spread volatility has allowed Japanese corporates to steadily outperform JGBs since 2011, even as all Japanese bond yields have collapsed. That trend is likely to continue, as the Bank of Japan (BoJ) is still a long way from being able to credibly pull off any upward adjustment of the current 0% BoJ yield target on 10-year JGBs. Chart 14Japan Bottom-Up CHM: Still Healthy,##BR##But Has Cyclical Improvement Peaked? Japan Bottom-Up CHM: Still Healthy, But Has Cyclical Improvement Peaked? Japan Bottom-Up CHM: Still Healthy, But Has Cyclical Improvement Peaked? Chart 15Japan Corporates:##BR##Stay Overweight vs JGBs Japan Corporates: Stay Overweight vs JGBs Japan Corporates: Stay Overweight vs JGBs Importantly, the BoJ recently introduced new forward guidance that states there will be no interest rate hikes until at least 2020. This will positively affect Japanese corporate health by keeping borrowing costs extremely low and preventing any unwanted strength in the yen that could damage Japanese competitiveness. There is a risk that increasing global trade tensions could impact the export-heavy Japanese economy and damage corporate profit growth and corporate bond performance. We do not yet see that as a major risk that could derail the Japanese economy and we continue to recommend an overweight stance on Japanese corporate debt vs JGBs. Canada Corporate Health Monitor: Faster Growth Hiding Structural Warts We introduced both top-down and bottom-up CHMs for Canada in our previous CHM Chartbook in April. As was the case then, both CHMs are in "improving health" territory (Chart 16). These CHMs are typically correlated to the price of oil, as befits Canada's status as a major energy exporter. Yet the strong CHMs also reflect the solid pace of overall Canadian economic growth. Looking at the individual components of the Canada CHMs, the leverage ratios for both measures have been steadily rising and currently sit above 100%. The return on capital has been in a structural downtrend, as is the case for most countries in our CHM universe (excluding Japan), but has ticked up alongside faster economic growth over the past couple of years. There was a noticeable drop in the margin ratio for the bottom-up CHM, coming entirely from the HY firms within our sample group of companies. Interest coverage and debt coverage ratios remain depressed, even with some improvement in corporate profits. This is partially due to rising interest rates as the Bank of Canada (BoC) has been tightening monetary policy - a trend that we expect to continue over the next 6-12 months. Canadian corporate bond spreads have widened slightly since the start of 2018, but remain tight relative to a longer-term history (Chart 17). Excess returns over Canadian government bonds have flattened out after enjoying a very solid period of outperformance in 2016-17. Looking ahead, there are balanced risks to the outlook for Canadian corporate debt. Chart 16Canada CHMs: Cyclically Improving,##BR##But Longer-Term Problems Are Building Canada CHMs: Cyclically Improving, But Longer-Term Problems Are Building Canada CHMs: Cyclically Improving, But Longer-Term Problems Are Building Chart 17Canadian Corporates:##BR##Stay Neutral Vs Canadian Government Debt Canadian Corporates: Stay Neutral Vs Canadian Government Debt Canadian Corporates: Stay Neutral Vs Canadian Government Debt We continue to expect the BoC to hike rates because of solid growth and faster inflation in Canada. Yet we do not see the BoC moving rapidly to a restrictive monetary stance that would damage growth expectations and trigger some credit spread widening. At the same time, we also see risks stemming from Canada-U.S. trade disagreements that could hurt Canadian growth and cause investors to demand cheaper valuations for Canadian corporate bonds. Adding it all up, a neutral stance on Canadian corporates versus government debt remains appropriate, largely as a carry trade. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Top-down CHMs are now available for the U.S., euro area, the U.K. and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.4 The financial data of a broad set of individual U.S. and euro area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. Table 1Definitions Of Ratios That Go Into The CHMs BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Appendix Chart 1We Now Have CHM Coverage For 92% Of The Developed Market Corporate Bond Universe BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News 1 Please see BCA Global Fixed Income Weekly Report, "Time To Take Some Chips Off The Table; Downgrade Global Corporate Bond Exposure To Neutral", dated June 26 2018, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "An R-Star Is Born", dated August 7th 2018, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Sticking With The Plan", dated March 13th 2018, available at gfis.bcaresearch.com. 4 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors APPENDIX 2: ENERGY SECTOR APPENDIX 2: ENERGY SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: TECHNOLOGY SECTOR APPENDIX 2: TECHNOLOGY SECTOR APPENDIX 2: UTILITIES SECTOR APPENDIX 2: UTILITIES SECTOR Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns